Intelligent Investor - Ch. 3

[DesertCat]

In this chapter Ben reviews stock prices over the last century, comparing the prices to some interesting data points. Things of interest include...

Table 3.1 - note how the Dow Jones average peaked at 380 in 1929, and hit a low of 161 in 1949, twenty years later. Now index values don't account for dividends, so my seat of the pants guess is that a passive index holder probably made a small positive return of 1-2% per year during these periods. But sweet jebus! Imagine how it must have felt to be a stock market investor (like Ben) during those twenty years! By the end you might be certain that common stocks were dangerous, horrible, frauds, not investments. You would happily put every dime you have in bonds and other "safe" investments.

On page 67 Ben refers to a study that indicated average returns of 14% per year from 1949 to 1967, a 17 year period that by no coincidence starts where the previous period ended. Imagine making 14% year after year, without the slightest bit of thought or effort (doubling your portfolio every 5 years!). Don't you think if you lived through this period, you might start regarding that handsome fellow you gaze upon in your shaving mirror each morning as one of the greatest investors of all time? Might you also regard anyone invested in bonds as an utter fool?

Page 70 he notes that the trailing PE ratio for the S&P was 6.3 in 1949. Today it's close to three times that level (16-18 I think). And it's my understanding that the historical average is close to 15.

Table 3-3 has one very interesting line, "stock earnings yield/bond yield". In 1948, before one of the greatest long term bull markets in history, the average investor required almost 4x the earnings yield from stocks than bonds, due to the conviction that common stocks were so dangerous. In 1971, two years before the start of one of the worst bear markets in history, investors were accepting a substantially lower earnings yield from stocks than bonds, because they were so convinced that stocks would always appreciate.

I think Ben is trying to say, predicting the market is hard, and you can't do it by extrapolating the past blindly like many often do. And while you can't predict every turn of the market via fundamental valuations (i.e. be wary of trying to time the market), the market will eventually return to it's real fundamental value.

[notluck]

Many people in the world dogmatically quote that the stock market averages returns of at least 8%-9%; some correctly add that this a long run average.

“In the long-run we are all dead”- John Maynard Keynes

What is important to consider for each individual investor is their investment horizon. Even for someone as young as me, 20 years of flat growth would be devastating. Though it is very important to plan for the future, the long run should NOT be an excuse, to be passive. This whole historically view makes me wonder if it is in some sense a crime (maybe a bit of stretch) to tell people that “markets” average X% in the long run. Sure it averages that, but as the prospectus of all mutual funds says “Past performance does not guarantee future returns.”

So what am I driving at here? (i) One must be aware of the averages but to use it as a basis for investing saying, “I can randomly average X%, because that is what has been over 100 years” is just down right wrong. Ben on many occasions points out that the only constant is change (sure I extrapolated a bit, but I think he would agree). It is wrong because it simple isn’t true in a PARTICAL sense, since 20 years of sub inflation growth would be crippling, not only financial by physiologically. I am going to use this argument to make the point that if you are not an “enterprising” investor, than set your expectations low. Coincidentally, if you are enterprising, I would be ready to set them even lower, until one achieves a proven track record (catch 22, well aware).

Lastly, and this may be a stretch, but to me personally I would rather try to fight (i.e., be enterprising) and lose (not beat the market). Then to helpless sit and not beat inflation due to the particular stage of the market, which as quoted earlier, can last for 20 years. Though this point changes significantly if I am underperforming the market by 1%, compared to 8%, then again maybe this is the meta-game of stock investing? Let me know if what I wrote made any coherent sense. I look forward to your replies.

-Alex

[Riddick]

Thanks again, DesertCat, for conducting this, I hope to get more involved when finals week is over. I'll have some Chapter 2 and 3 comments/questions up in a few days.

[sef]

First excuse me for my poor English, I'll do my best though [img]/images/graemlins/smile.gif[/img] I have read almost 5 chapters of the book, which seems very well written indeed. But what do I know, I am a beginner investor. [img]/images/graemlins/smile.gif[/img]

Dow was only 161 in 1949 and it is over 11.000 this year. It certainly seems to me that stocks are seriously overpriced these days. It is plausible though, more and more people are investing, while yields from bonds are simply unattractive to a small investor, what is 5% anyway [img]/images/graemlins/smile.gif[/img]. Stocks are OTOH like roulette in some sense, every stock can hit. Decent money can be made with bond investment only if someone has invested close to a million $.

From 2003 onwards there was a strong bullish market. These days we have record oil prices in last 30 years I think. Given the ever rising consumption of oil and the production of oil which cannot be high enough, I predict there will be serious recession and possible some sort of black market day in near future. Yes, I am a pessimist, what can I say. [img]/images/graemlins/smile.gif[/img]

I have an investment in various 50%-50% stocks/bonds mutual funds. I am worried about recession (stocks) and inflation (bonds) so I am thinking of selling everything and perhaps keeping cash in order to play bigger limits online. I hope I can beat inflation that way [img]/images/graemlins/smile.gif[/img]. This is the safest investment, since it depends entirely on me. Given that US $ is weakining I am also thinking to convert cash in Euro. I understand that recent dollar fall could be only a minor thing, but with gold reaching new highs it seems that dollar will be even weaker in months to come. Maybe even better than Euro would be Swiss franc which is still backed up in gold.

What do you experts think?

PS. I have to agree with you DesertCat, everyone was a master investor in those days...it is comparable to a day when the cards are flying and it seems like every move just cannot go wrong. Of course there are other type of days (months, grrr) too.

[gmandan]

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Dow was only 161 in 1949 and it is over 11.000 this year.

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Doesn't the makeup of the DJIA change? So wouldn't a direct comparison be inaccurate + you need to readjust for inflation, or are the indices already readjusted (if so, by what metric?)?

[DesertCat]

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Dow was only 161 in 1949 and it is over 11.000 this year.

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Doesn't the makeup of the DJIA change? So wouldn't a direct comparison be inaccurate + you need to readjust for inflation, or are the indices already readjusted (if so, by what metric?)?

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I'm sure it does change occassionally, I don't think it really matters as I believe they add new stocks in at the same value as the stocks they replace. And it isn't adjusted for inflation. And if my math is correct, going from 161 to 11,416 in 57 years computes to about a 7.7% annualized gain. Of course we aren't counting dividends, but but assuming that dividends averaged 3% over that fifty years your annualized returns would be 10.7%. Of course..

- If you were a master market timer, smart enough to get in at 161 and out 5 years ago when the market peak over 11,000, your annualized return would be 11.5% (with 3% dividends). Or ...

- If you were dumb enough to get in the market in 1946 at it's peak of 212 (3 years before the 161 low) and stayed in until today, your real return would be about 9.8% annualized (with dividends.

Some things to think about. Ten percent gains each year is equivilent to doubling your portfolio every 7 years. In 56 years your portfolio will reach 2^8, or 256x your starting investment. Over very long periods you'll see huge increases in portfolio value from even modest annual returns.

Also, we aren't counting inflation or taxes. Even if there were a DJIA index fund in 1949, you'd be paying some annual taxes on your dividends and occasional cap gains that would reduce your annual returns. And if inflation averaged 3% per year over the last 50, the real value of your portfolio would accumulate at a rate 3% lower than these numbers.

[DesertCat]

Nice article about Ben Graham and TII.

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...
Graham emigrated from England with his family when he was barely a year old. He grew up in Manhattan and Brooklyn and went on to Columbia University, where he graduated in 1914. Though he had an opportunity with the family business, Graham instead opted for a career on Wall Street. By 1920, he was a partner at a major securities firm. Six years later, he formed the Benjamin Graham Joint Account, an investment fund he ran with partner Jerome Newman. But hard times would follow. From 1929 to 1932, the Joint Account declined by a breathtaking 70%.

But there was more bad news to come. It turned out that Graham had used substantial margin in making his selections. So when the stock market crashed, the massive debt he had incurred to buy stocks suddenly came due. And that borrowing nearly ruined him.

Graham persevered by selling personal assets and taking out loans with friends and family. Over the next 30 years, he and Newman would deliver 17% annualized returns to investors in the Joint Account. That's a remarkable record by any measure, and well north of the stock market's historical average return of 11% annually.
...


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[cookmg]

A couple of interesting points in Zweig's commentary in the back . . . I'd be interested in everyone's thoughts.

Applying the Gordon Equation in early 2003 Zweig estimates long run average stock returns of 6% given 1.5 to 2% long run average growth in corporate earnings, inflation of 2.4%, and average dividend of 1.9%.

Also, Zweig criticizes studies that show stocks have "always" outperformed bonds in the long run. He points out that most data prior to 1871 is based on just 7 stocks and that prior to the 1920s there is a heavy surviorshship bias in the existing data.

Given these two points, a defensive investor's reasonable expecations would have to be pretty low. Would it also suggest a more conservative allocation of stocks to bonds given the forcasted "risk" premium for stocks is lower than most of the 20th century?

[solucky]

My english is also poor, but i had rare bonds. You must pick up the company with a reason, is it cheap, how is the future what can i expect. And doubling up in 6 years mean not 15%/year sometimes its 120/ in 2 month and than 58 month break even, experience is important and dont believe any " hot penny stock " that you get via mail [img]/images/graemlins/cool.gif[/img]. At sample your dramtic 9/11 catastrophe made many $$ for the most analytic investor, and learn from the history back in the 70s " japanese cant produce cars " in the 80s " korean cant produce cars " and today " chinese cars " what a [censored] [img]/images/graemlins/cool.gif[/img]