Value Investing Commentary on Stock Market: Stay The Course

Value Investing Commentary on Stock Market: Stay The Course
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SMITH BRAIN TRUSTStock Market — This week’s market selloff has made a lot of people itchy to trade stocks. They want to sell before things get worse or, alternatively, maybe pick up some bargains. David Kass, professor of the practice at the University of Maryland’s Robert H. Smith School of Business, explains why you should resist the impulse to guess where the market is headed.Q. People who own stocks are watching the markets tumble and want to do something. Should they resist that urge?A. The natural desire to follow the crowd — herd instinct — can be very detrimental to investment performance over the long run. For example, during the panic selling that occurred at the market open Monday, shares of many of the finest companies in the world were marked down substantially. The supply of shares being sold overwhelmed the demand from buyers. Shares of Apple (AAPL) traded as low as $92.00 soon after the market opened, a discount of 17 percent from Friday’s close of $105.76. The shares subsequently recovered a few hours later, with its price exceeding its previous close. Similarly, J.P. Morgan Chase (JPM), which closed at $63.60 on Friday, traded as low as $50.07 on Monday morning, a discount of 22 percent, before recovering virtually all of its decline. Finally, Kraft Heinz (KHZ) traded as low as $61.42 Monday morning, a 15 percent decline below its previous day’s close of $72.27, before fully recovering.

Short-term traders and market timers are more likely to have their investment decisions dictated by their emotions of fear or greed than sound judgment and analysis performed over time with long-run goals in mind. A buy-and-hold strategy is less likely to be influenced by the behavior of others.

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Q. More generally — apart from unusual episodes like the ones that ended last week and began this one — is it possible to monitor the market carefully to buy low and sell high? 

A. It is extremely difficult to outperform the market over the long run by employing market-timing strategies. Predicting the movement of individual stocks or sectors over the short run is subject to risks resulting from both internal and external shocks. Unexpected events having either a positive or negative impact on an individual company, industry or sector are virtually impossible to anticipate. Major economic or political news, along with natural or man-made disasters, either domestic or international, can create substantial movements in equity prices across the entire market.

By contrast, the antithesis of market timing, which is a buy-and-hold strategy, is likely to succeed. Several academic studies have shown that equities have appreciated by about 9 percent to 10 percent (including dividends) annually over many decades. A well-diversified portfolio of stocks, or a low-cost S&P 500 index fund, such as that offered by Vanguard, should enable an investor to achieve similar returns in the future.

Q. Do market-timing strategies have any other disadvantages?

A. In addition to the challenges of forecasting short-term price movements, frequent trading will result in considerable transaction costs as well as tax liabilities.

Q. Are there any circumstances under which a market timing strategy can succeed?

A. Short-term trading strategies might depend on luck at least as much as skill. Over short periods of time, active traders might be able to outperform the market by correctly anticipating price movements. However, the randomness of events — both internal and external to individual companies — and/or sectors make it very unlikely that outperformance can be achieved over any extended time period. For example, correctly predicting the price of oil over the next few days or weeks might be possible for some, but how many traders will also be able to accurately forecast the level and direction of oil prices beyond this short-time horizon?

Q. How supportive is the academic finance literature of your views on this topic?

A. I am not aware of any academic study indicating that a short-term trading strategy results in long-term outperformance relative to a buy-and-hold strategy such as that offered by a low-cost S&P 500 index fund. The most successful investors, such as Warren Buffett of Berkshire Hathaway, have accumulated their fortunes by primarily being long-term investors. Most investors, individuals and institutions tend to invest at market tops and sell at market bottoms. This “buy high and sell low” behavior, heavily influenced by short-term market psychology, clearly results in underperformance relative to a steady buy-and-hold strategy.

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David I Kass Clinical Associate Professor, Department of Finance Ph.D., Harvard University Robert H. Smith School of Business 4412 Van Munching Hall University of Maryland College Park, MD 20742-1815 Phone: 301-405-9683 Email: [email protected] (link sends e-mail) Dr. David Kass has published articles in corporate finance, industrial organization, and health economics. He currently teaches Advanced Financial Management and Business Finance, and is the Faculty Champion for the Accelerated Finance Fellows. Prior to joining the faculty of the Smith School in 2004, he held senior positions with the Federal Government (Federal Trade Commission, General Accounting Office, Department of Defense, and the Bureau of Economic Analysis). Dr. Kass has recently appeared on Bloomberg TV, CNBC, PBS Nightly Business Report, Maryland Public Television, Business News Network TV (Canada), Fox TV, American Public Media's Marketplace Radio, and WYPR Radio (Baltimore), and has been quoted on numerous occasions by Bloomberg News and The Wall Street Journal, where he has primarily discussed Warren Buffett and Berkshire Hathaway. He has also launched a Smith School “Warren Buffett” blog. Dr. Kass has accompanied MBA students on trips to Omaha for private meetings with Warren Buffett, and Finance Fellows to Berkshire Hathaway’s annual meetings. He is an officer of the Harvard Business School Club of Washington, DC, and is a member of the investment and budget committees of a local nonprofit organization. Dr. Kass received a Smith School “Top 15% Teaching Award” for the 2009-2010 academic year.