The Fortune of Loss
Do you want to get-rich-quick by investing in the stock market? Think again…and read this no-nonsense look at the only true way to beat the market in the long run.
"People who cannot know what will make them happy tomorrow might be unable to resist short-term oriented investment strategies today."
– Seth Klarman, Annual Letter 2003, Baupost Limited Partnership
"Well then, what do you want!?"
My father’s words were not so much spoken as barked. And they have been etched upon my memory ever since.
We were driving through the parking lot of the Jolly Roger amusement park in Ocean City, Maryland. My parents were in the front seat of our enormous old green Ford station wagon. My three sisters and I were in the back seat.
Dear old dad’s impatience with dear old mom had reached bursting point.
I can’t remember my mother’s answer, but it was a classic American family vacation moment of indecision and flaring tempers. It could be seamlessly written into any one of a dozen films. Whatever my father had proposed for that particular outing wasn’t what mom wanted. And yet, she had had no idea what she really wanted, as far as I can remember.
I doubt my father knew what he wanted out of that vacation, either. As for me, I probably wanted to get away from everybody, which – living in a three-bedroom house with 8 other people – is all I ever wanted at the time.
Harvard psychologist David Gilbert studies a question much like the one dad barked at mom so many years ago, posed in a more academic fashion: How good are people at predicting how future events will affect their happiness?
Sequoia Fund: Impact Bias
Gilbert studies something called "impact bias." If you think getting a big pay raise will make you very happy for a long time, and it only makes you marginally happy for a few hours, your impact bias is large. If you do not expect a raise and don’t get one, your impact bias is zero.
For most people, Gilbert concludes, impact bias tends to be rather large. In other words, most people simply don’t know what they want.
Did you get that?
People are not unhappy because they can’t get what they want. People are unhappy because they don’t have a clue about what they want in the first place. Like a redneck surrounded by 100 shiny new pickup trucks, they don’t know which way to go in life.
The consistent failure of those who frequent the public equity markets and other gambling establishments falls hard upon David Gilbert’s findings. It makes sense that people who don’t really know what they want can’t resist short- term, momentum-oriented "investing" strategies. Yet it’s well known that about 90% of all day traders in the market today will be out of money within a year. It’s even better known that nearly every mutual fund manager will fail to beat the market.
They all think buying stocks will make them very happy very soon. An enormous impact bias awaits them.
What about those successful investors? What’s their experience like? Does their long-term investment success feel good every step of the way? Is it made up of a series of pleasurable short-term gains? Or does getting rich investing in stocks require significant periods of underperformance, and the pain of holding losses, sometimes for years at a time?
Sequoia Fund: The Managers of the Sequoia Fund.
To answer these questions, let us recall the history of the highly successful mangers of the Sequoia Fund.
That’s the fund Warren Buffett recommended to his former clients in 1970, the year after he closed his investment partnership. Former Ben Graham students Bill Ruane and Richard Cunniff still run Sequoia.
The Sequoia Fund under-performed the S&P 500 in its first four years. It has under-performed the S&P500 in 14 of the last 34 years. That’s 41% of the time.
But in the last 34 years, Sequoia has averaged 16.57% annual returns. A $10,000 investment in 1970 is worth about $1.8 million today versus $463,000 for the S&P 500. If you’d pulled your money out after those first four years and put it in an index fund, you’d have made a huge mistake.
Think about that. Four years wasn’t enough time to give a true picture of the soundness of Sequoia’s basic value- oriented approach to investing. Nearly half the time, getting rich felt like losing ground when compared to the rest of the market. In some years, getting rich by giving your money to Sequoia felt exactly like losing money.
Likewise you will find periods of under-performance in the track records of Warren Buffett, the Oakmark Fund, Longleaf Partners, Third Avenue Value Fund, Clipper Fund, Tweedy Browne…all the most successful investors under-perform in the short-term sooner or later.
If you want to get rich in the stock market, you have to know what to expect, not merely for the next few days or months, but for the next several years.
That’s what it really takes to get rich in the stock market, no matter what the spam in your e-mail inbox tells you. You have to be able to stick to your guns for five years at a clip without even beating the S&P 500. You have to be so confident in your approach that you never waiver from it, even when there’s zero short-term success to brag about. (Oh yes, and your approach has to be one that works.)
Seth Klarman, in his 2003 annual letter to investors, meditates on the inherent level of pain that keeps most investors from learning to employ a sound strategy:
"Perhaps standing apart from the crowd, as value investing requires, makes people feel as though they, and not just their investments, are out-of-favor. Perhaps holding cash for what seems like forever, awaiting the emergence of an investment opportunity, is simply too emotionally difficult for them. Maybe exposure to criticism or second-guessing as a result of standing apart from the crowd is more than they can comfortably bear. Maybe it is the continued price erosion one can experience from buying corporate misfits and rejects – the relentless drain of out-of-favor securities continuing to melt away – that turns investors off. Perhaps it is hard to sound cool or even sane at cocktail parties when you don’t own the hottest IPOs, and when no one has heard of the unpopular and obscure holdings that comprise your net worth."
Sequoia Fund: Either They’re Ignorant, or Think You Are
All that unpleasantness…and still I would adjure you to ignore anyone who promises you consistent short-term trading profits. (It felt wonderful just to say those words: "consistent short-term trading profits". They have the same impact as "guilt-free sex with nubile fashion models".)
People who promise big profits from short-term trading strategies are either ignorant or they think you’re inexperienced enough to believe them. Obviously, you can’t afford to align yourself with either party. (The fact that you might receive such drivel in your e-mail inbox, with my name at the bottom, makes that painful advice to give, I assure you.)
So, while I can’t promise you consistent short-term riches today (or ever), I can promise you two things.
I can promise you that: 1) you need rational expectations and a long-term view to get rich investing, and 2) that a disciplined, highly selective, value-oriented approach, adhered to religiously over a period of many years, is your only hope of getting rich by investing in stocks.
Maybe I should just promise you what my best friend’s father told him as a child, "Son, you get out of life what you put into it, or a little bit less."
for The Daily Reckoning
June 15, 2004
EDITOR’S NOTE: Dan Ferris is the Editor of Extreme Value, an investment advisory service that uncovers the safest, cheapest stocks in the market. Dan has recently published an 80-page analysis on his latest discovery – a way to own some of the most valuable real estate in the world, at a 99% discount, through a handful of companies listed on the NYSE.
Ronald Reagan deserved better. A likable and decent man, he should have been carried off by six jolly cowboys and bid farewell by honest drunks and tearful remembrances.
The nation should have sent him off with a soft heart, in other words. Instead, its head turned to mush; his obsequies and eulogies were as full of solemn humbug as a national election.
We are told that the Gipper set off a huge economic boom in the land of the free. He cut marginal tax rates. He helped get the government off our backs. America raced ahead of its competitors. The Chinese were so impressed, they decided to loose the dogs of capitalism; now they are nipping at our heels and stealing our food. The Soviets were so discouraged they decided to give up being soviets; now, they are Russians or Lithuanians or Khazaks.
Of course, the West was probably better off before it had to compete with 3 billion now-liberated entrepreneurs and consumers. The price of oil rises…soon, it will be the price of beef.
But if America got so much richer, why did real wage rates not rise? A man sweats, humps, busses, totes and schleps today, on average, for about the same wage he got before the Reagan revolution fired its first shot. Go figure.
And now, from today’s International Herald Tribune, comes more evidence that America’s great boom was a scam.
"More than two-thirds of older households – those headed by people 47 to 64 – had someone earning a pension in 1983," says the article. "By 2001, fewer than half did…"
"New evidence suggests that the waning of the pension has, imperceptibly but surely, stripped older workers of an immense store of wealth – much more than they probably guessed…"
And here’s the money paragraph:
"When the holdings of typical households are traced… today’s near-retirees turn out to be a little poorer, in constant dollars, than the previous generation was when it approached retirement in 1983."
Edward Wolff, an economist at NYU, looked at 18 years of household financial data from the Fed. Somehow he retained his sanity long enough to discover that "the net worth of the median older household…declined by 2.2%, or $4,000, during the period [1983-2001] to $199,900."
We look upon that fact in shock and awe.
How could it be, dear reader, that after the biggest explosion of wealth-creation in the history of man, the average man is not richer, but poorer?
We ask the question again, merely to be impertinent. We recall the Carter years: the nation was at peace. Despite inflation, Americans were still getting richer. Wages were rising. The country still enjoyed a positive balance of trade…and the rest of the world still owed it more than it owed to foreigners.
But in 1980, stocks had been going down for 14 years…and bonds had been in a bear market that began in 1945. With eyes in the back of their heads, people must have looked out and seen nothing but trouble. The Vietnam War was still in the near background. And Richard Nixon. And Jimmy Carter himself. Americans were discouraged, we are told; they had lost confidence in themselves.
Then, along came Ronald Reagan with a message of hope, optimism and something-for-nothing. The supply side, the Laffer Curve – suddenly it seemed possible to spend more…and still have more! Government could cut taxes – and get more revenue, said Laffer. Forget the deficit; it will take care of itself. Somehow. The average man figured he could do the same: borrow more…and he would get rich.
Pensions were out. Free people could look out for themselves. They could set up their own 401k plans…and make money in common stocks. All you had to do was buy the companies you liked, said Peter Lynch.
And the companies themselves no longer had to worry about their employees. Managers could focus on cooking the books to give the impression of ‘maximizing shareholder value.’ America soon became ‘Shareholder Nation’…a whole country of capitalists, all getting rich in the freest, most dynamic economy the world had ever seen.
Now we see that the whole thing was a monumental fraud. Employees never quite got around to putting money into their 401k plans – they were too busy trying to keep up with the credit card bills. And managers soon realized that maximizing their own incomes – with stock options, bonuses, and rich retirement plans – was more rewarding than looking out for shareholders.
The shareholders themselves – the millions of lumpen pseudo-investors who owned mutual funds – couldn’t tell the difference. They had neither the time, the money, nor the training to be real capitalists; they were merely chumps for Wall Street.
And now, here we are, nearly a quarter-century since Reagan won the White House: at war, with the biggest trade deficit (April hit a new record, $48.3 billion…edging up towards $600 billion per year), the biggest federal debt, the biggest financing gap, the lowest interest rates in 45 years, and the most consumer debt ever. In real terms, the average man earns less than he did in the Carter years. And the typical household approaches retirement poorer than it would have been in 1980.
But, since 1980, stocks and bonds have gone up. Americans, still pining over the Reagan era, have never been more confident…more optimistic…or more delusional.
Over to you at Eastern Standard Time, for more news:
Eric Fry, from Downtown Manhattan…
– In April, for the 320th consecutive month, Americans consumed more goods and services from abroad than they exported, setting a new record in the process…Bloomberg News called the record-setting trade deficit, "unexpected." Here at the Daily Reckoning, we did not expect America’s titanic consumption to set new records in April, but neither were we surprised by the news. For us, everything is unexpected, but nothing is surprising, least of all America’s record-setting consumption.
– Shortly after the Commerce Department’s "unexpected" news crossed the wires, the stock market unexpectedly tumbled. The Dow dropped 75 points to 10,335 and the Nasdaq slumped 30 points to 1,970. Meanwhile, the bond market buckled under the weight of rising inflation expectations, as the yield on the 10-year Treasury jumped from 4.80% to 4.87% – a new two-year high. Bond investors, evidently, are eager to do what Greenspan is not: raise rates in line with inflationary expectations. The dollar slipped about half a percent against the euro to $1.207, while the gold price retreated one dollar to $383.55 an ounce.
– The monthly U.S. trade deficit widened in April to a new all-time high of $48.3 billion, demonstrating once again that dollar debasement is not the miracle cure its proponents claim. Didn’t Treasury Secretary Snow and the other disciples of ‘Deliverance through Debasement’ assure the nation that weakening the dollar would reverse the trade-deficit trend? And hasn’t the dollar’s value sharply declined over the last three years? Yet, the massive trade deficit persists. Indeed, it is growing…some things – like an octogenarian in a string bikini – just aren’t meant to be.
– The growing trade deficit testifies to the stupidity of managing an economy by mismanaging its currency. The deficit also highlights the infamous American propensity to reap where it does not sow and to gather where it scatters no seed. America is privileged to gather from wherever she scatters her dollar-denominated debts.
– But some day, theoretically, Americans will have scattered one Treasury bond too many. At that point – if we may mix parables – her bonds will land on the rocky soil of international disdain. On that day, foreigners will become less eager to lend money to us at the prevailing rates of interest and will demand a higher rate before agreeing to advance additional funds. They might also demand repayment in a currency other than U.S. dollars.
– What, therefore, does America’s worsening balance of trade – not to mention its growing fiscal deficits and the tendency of its citizens to borrow a whole bunch of money and to save almost none – portend for the U.S. dollar?
– Nothing good, we would imagine. Even Alan Greenspan, supreme protectorate of the dollar’s value, acknowledges the possibility of a sizeable exchange rate "adjustment."
– "We, in the United States, have been incurring ever larger trade deficits, with the broader current account measure having reached 5% of our gross domestic product," Chairman Greenspan observed one month ago. "Yet the dollar’s real exchange value, despite its recent decline, remains close to its average of the past two decades. Meanwhile, we have lurched from a budget surplus in 2000 to a deficit that is projected by the Congressional Budget Office to be 4.25% of GDP this year. In addition, we have legislated commitments to our senior citizens that, given the inevitable retirement by our baby-boom generation, will create significant fiscal challenges in the years ahead."
– Even so, the Chairman asserts, America’s superior "relative rates of return" should continue to attract "super-sized" portions of the world’s savings.
– "So the foreigners send us their merchandise," observes Jim Grant, editor of Grant’s Interest Rate Observer, "and we send them our dollars, and everyone – approximately – is happy. But not forever. ‘At some point,’ [Greenspan notes], ‘international investors, private and official, faced with a concentration of dollar assets in their portfolios, will seek diversification, irrespective of the competitive returns on dollar assets. That shift, over time, would likely induce contractions in both the U.S. current account deficit and in the corresponding current account surpluses of other nations.’
– "So," Grant concludes, "add another possible cause of the future dollar bear market to the list: Portfolio-balancing sales of dollars in dollar-denominated securities by America’s now-faithful foreign creditors."
– And while you’re at it, dear reader, add another possible cause of resurgent inflation and rising interest rates to the U.S. stock market’s lengthening list of "Risk Factors."
Bill Bonner, back in London…
*** Gold fell yesterday – to $384. Still a buying opportunity, in our opinion. And still little sign of any inflation.
*** In case you missed this little note from Mogamb
"Arch Crawford publishes the Crawford Perspectives, which tracks the astrological influences on the market. He says ‘Sometime between mid-August 2004 to March 23, 2005, we think that the market will crash again’ and that this is due to a Mars-Uranus thing that happens every two years. The Wall Street Journal reporter, who wrote this up, notes that ‘It doesn’t guarantee a crash – but it has been evident during every crash for the last 100 years.’"
"Whether or not you believe that the stars and planets influence your life doesn’t matter. Enough people DO believe in it, people who will sell on that basis alone, and then it WILL happen, just like he said. And I note that there isn’t a newspaper on the planet that does not have a horoscope section – even the home page of my Internet server has one. And they are there because people want them, and may even believe in them. So, it ought to be an interesting time, to say the least."
*** This weekend Maria was invited to attend the races at Chantilly…the Grand Prix d’Hermes. Her report:
"Oh Daddy, you wouldn’t believe it. It was so elegant. There were women there with hats bigger than they were…with what looked like whole flower gardens on them. The men all wore white pants, ties and blue blazers. Everybody looked so good. It’s amazing how good people can look when they make a little effort. Not at all like those people you see wandering around Paris in their awful outfits…you know, shorts and running shoes…"
"I know, I know…they just want to be comfortable. But you know what they say…you have to suffer for beauty. Well, you do. And it’s worth it in my opinion."
"You know, you need a special invitation from the Hermes family to get in. This boy I know, well, his family must know them…so he invited me as his guest."
"Everybody has a picnic on the lawn. But it’s not a picnic with hotdogs and potato salad. They spread out elegant tablecloths and come with these great wicker hampers of food. And no one uses plastic forks and knives. Noooo…they bring their best silver. And there are even waiters going around. You can order champagne…or get lunch from them too."
*** "You have too many relatives," said Elizabeth last night. The distaff side of the Bonner household is concerned about our up-coming ‘Grand Tour’ of the USA. "We’re not going to have enough time to do all the things we need to do."
The trip is scheduled to begin in just a couple weeks. We will spend 6 weeks crossing the nation…from Maine to California.
"Why are you doing it," asked Michel at lunch last week. "Elizabeth doesn’t want to. You don’t like sightseeing. The kids would rather do something else. It will be hot and disagreeable. You won’t be able to get a decent meal. Why not just stay in Paris? Why not just save yourself a lot of trouble?"
"You don’t understand," we replied. "There are certain things a man’s just got to do, whether he wants to or not…such as taking a vacation…"