Beside the Still Water

This series of notes has been inspired and informed by Peter Bernstein’s book, Against the Gods. It is a rumination about the odds of making money in the stock market. As I waded in, I discovered that the water is much deeper than I thought…and much more full of rocks and tangley things that seem to wrap around your ankles and pull you down.

So far, we’ve seen that what most "investors" are doing is not investing. Investing is an activity that requires careful research and close study. No one can know what the future will produce, so investors reduce uncertainty by actually learning something about the businesses in which they invest…and investing in businesses where reasonable assumptions may be made on the basis of quantifiable, proven information. None of this is possible with Internet stocks, by the way. Nor does it describe what most people who buy stocks actually do.

If they’re not investing…what are they doing? The answer: some form of gambling or speculation. This, of course, can be a winning proposition too…but only if you have an edge and know how to use it.

A zero sum, even odds game makes no sense — except for entertainment purposes. (Because of the principle of declining marginal utility of money…a dollar won is not as valuable as a dollar lost.)

Even with the odds in your favor — you will still lose money unless you manage your bets (manage your portfolio) shrewdly. My thanks to Steve Sjuggerud for the example of the Ph.Ds used yesterday.

However, the stock market is not a casino. (You can tell, because no one offers you free drinks.) It is not a zero-sum game. And even if every individual investor is not Warren Buffett, he can still benefit from stocks because even the most pathetic little dinghy will rise when the tide comes in.

Insofar as stocks reflect economic activity generally….the stock market is not a zero sum game. Even investors for whom the only Graham in their lives is on a cracker box can still make a buck or two by buying a broad assortment of stocks. All that is required is for the stocks to go up. And fortunately for all the magnificent brokers’ yachts as well as the pathetic little dinghies moored nearby, stocks do tend to go up. They’ve gone up with such tedious regularity for nearly two decades that one might be excused for thinking that they only go up. It is as if this vehicle rolled off the assembly line missing the customary Reverse gear.

Regularity, however, is not the same as reliability. The US experienced an economic boom for 62 years after 1867…interrupted by only two years of backpedaling. This boom was so persuasive that most investors in 1929 expected the good times to return very quickly. Alas, that did not happen.

Just as the economy normally grows, stocks normally go up. Graham and Dodd proposed a reason for why this is so. They said it was because companies tend to pay out less in dividends to shareholders than they earn in profit. This accumulated income increases the capital value of the company — which is reflected in the share price. Thus, a reasonable investor should add in a small expectation of a capital gain to the expectation of a dividend, when analyzing a stock, and compare the total return to what might be expected from a bond or other investment.

I don’t even need a calculator to do this math. Stocks are averaging about 2% earnings…and paying out about 1% in dividends. So, we might assume that they’re compounding the 1% not paid out…and that it will be reflected in the capital value…and hence the stock price…someday. Thus, I might expect a total return of what…2%? What the heck… this is a new era…3%! Now, I’ll compare that to bonds yielding 6%. Hmmm…

Of course, people do not expect a 3% return. The latest figure I’ve seen is that they expect 15% a year for the next 5 years. And they have "reasons" why this has to be so. Of course, no one can predict the future. And if stocks go into reverse, there will be plenty of "reasons" why this is so too. So, forget the reasons. Let’s look at the odds. Even though the stock market is not a zero sum game, it can bear a closer resemblance to a casino than an investment exchange — when "investors" come to have unrealistic expectations and begin treating their investments like poker chips…that is, when they forsake investing and begin speculating. And when they gamble with no sense of the actual odds, or the house’s take…under the delusion that they are "investing"… they are almost certain to lose money. Peter Bernstein describes a similar situation. There are "moments," he says, "when the laws of probability are forgotten." He discusses the Nifty Fifty market of the late 60s…when the risk was not "the risk of overpaying, but …the risk of not owning them: the growth prospects seemed so certain that the future level of earnings and dividends would, in God’s good time, always justify whatever price they paid."

"This view reached such an extreme point that investors ended up by placing the same total market value on small companies like International Flavors and Fragrances, with sales of only $138 million, as they placed on a less glamorous business like US Steel, with sales of $5 billion. " I’m sure I don’t have to point out that $138 million compares very favorably with many billion dollar Internet companies.

The prospect of profits was dazzling. But the probability was slight. Like today’s valuations, they required a number of things to fall into place. And each component in a chain of probabilities is multiplied by the previous one…producing an exponentially rising level of remoteness.

Stock market bulls will counter that…"the market just has to go up…which it usually does." Though I have previously argued that the market is not like a pair of dice in which each toss is independent (instead it is a natural feedback loop, in which the odds on each succeeding bull market year become more remote…). For my present purpose I will assume that the question is simply unapproachable by the laws of probability.

Since you can’t know whether the stock market will go up or down…you are in a position not too different from Blaise Pascal when he tried to prove that God exists. Ultimately, there was no way to know. But there were, like the difference between bull and bear markets, only two answers — either God exists or doesn’t. So, Pascal looked at the costs of one decision or the other. If he believed that God existed, and he led his life accordingly, he may be disappointed. But if he led his life as though God didn’t exist…and it turned out he was wrong…he would surely roast in hell. Since the latter cost was higher than the former…and the odds were 50/50…he had little trouble deciding the issue.

The hope of heaven is the hope that people will get what’s coming to them. Maybe the market will go up…maybe it will go down. But I see a lot more to lose than to gain. Even at the fantastic rate of 15% upside profit…there’s a lot more than that on the downside. And even if it were a 60% probability that the market would go up rather than down, as we saw in the example of the gambling Ph.Ds yesterday, you would be crazy to put all your money in stocks. But that is exactly what people are being urged to do. Surely, if there is a God he will make sure that the people who urge you to put all your money in stocks roast in hell.

Bill Bonner
July 30, 1999