What to Expect from the Stock Market

Just about all mainstream personal finance writers advise making stocks the centerpiece of your investment plan. Most will quote a reassuring average market return over a reassuringly long period and make the argument that for sober long-term investors such as yourself, stocks are the place to be. But few writers explain what that long term average return really means and what expectations you should draw from it.

The first thing to understand is that you cannot expect to actually get that average return in any given year. Get Rich Slowly has a guest post by Carl Richards that patiently makes this point with the use of an elaborate animated presentation. His data has an average return of 10% over eighty years and shows that only twice in that time did the actual market return for a year fall between 9% and 11%. I would hope that this is a nearly obvious point to all stock market investors, but I know better.

Moreover, I worry that by saying that the market has good years and bad ones, but that the long run average is high, people are led to believe that as long as they can stick it out through the ups and downs, after twenty years or so they will get the promised average return. This is not necessarily so. Those long run averages are not that much more predictable than individual years.

To illustrate, I will run some numbers of my own. Yale’s Robert Shiller has a website with the S&P 500 index returns annually back to 1871 as well as some other useful stuff such as inflation rates. It turns out that, sure enough, the average return for the US stock market, as measured by the S&P 500, was 10.08% per year over the 138 years from 1871 to 2008 inclusive.

What do we know from this? We know that funds invested in the market on December 31, 1870 and held through December 31, 2008 would have made an average of 10.08% a year. We do not know what the average returns for the next 138 years will be. 10.08% is a pretty solid guess, and in fact is almost certainly the best guess we’ve got, but it’s still just a guess. There is no “true” expected stock market return, even over long periods of time. Setting market return expectations is not science, just thoughtful estimation based on what has happened in the past.

To get a better feel for how volatile even long term averages can be, consider the 80 year period that Richards uses. The 80 year average return for the period ending in 2007 was 11.52%. But move it forward a year to end in 2008 and you get only 10.46%. That is a big difference considering those two periods are 98.75% identical.

And 80 years is a lot longer than the typical person will be invested in the stock market. For most, there is a critical twenty years or so from middle age to retirement when the nest egg does or doesn’t grow. And the returns for twenty year periods are all over the place.

As it happens, the best twenty year period in the stock market since 1871 was recent enough that a lot of us remember it well. From 1979 to 1998 the market averaged 17.32% a year. One dollar invested at the end of 1978 grew to $24.41 by the end of 1998. At the opposite extreme, 1929-1948 averaged only 3.00% a year. The $1 invested at the end of 1928 became only $1.80 by the end of 1948.

There aren’t a lot of people still around who remember the stock market in 1929-1948. But your parents or grandparents might be able to tell you about the period 1962-1981. The market went up an average of 6.57% per year, which doesn’t sound so bad until you find out that inflation averaged 5.50% over the same period, leaving stock investors with an average real return of only 1.07%.

If you are like me, in your mid-forties and heading into the intense period of investing for retirement, the big question is will the period 2009-2028 be more like 1979-1998 or 1962-1981? Nobody knows.

There were 118 twenty year periods ending from 1890 to 2008. The average twenty year period had an average annual return of 9.22%, but a forth of those periods had returns worse than 7% and a fourth beat 11.5%. And you only get to do this once. Consider the difference in circumstances of a person born in 1933, who turned 45 in 1979 and enjoyed fat returns on his way to retirement in 1998 at 65, with somebody born in 1916 whose nest egg went nowhere in the twenty years before his retirement.

What can you do about this? In the most direct sense, nothing. Diversification will help some, but not by as much as you might like. Bad decades for the stock market tend to be bad decades for bonds and real estate too. The truth is that this is one of the many things in life that are beyond your control.

But you can take it into account when doing your financial planning. If the difference between 8% and 10% returns over the next twenty years is the difference between a comfortable retirement and hoping your kids can support you, you need to reconsider your plans. Expecting 10% a year from the stock market over the long run is reasonable, but counting on it is foolish.

Frugal Friday the 13th of February

It was a quiet week on the frugal front. It seems like every blog had the same Valentine’s Day hints. The most common tip for saving money was to ignore the holiday entirely, but failing that, you could celebrate it late, when the candy goes on sale.

There was some mention of Lincoln on the occasion of his 200th birthday. There was no mention of Charles Darwin, a reasonably important figure in some places, who was also born on February 12, 1809. That Darwin doesn’t rate in Frugal Nation isn’t that surprising. According to The Economist, only 14% of Americans believe that humans evolved over millions of years. The scientifically minded can take heart in the fact that the trend is actually up. In 1982 only 9% believed in human evolution.

Of course, to the frugal, Lincoln is closely associated with that enduring symbol of saving really small amounts of money, the penny. Free Money Finance had an informative post of facts about the penny, including that 63% of Americans think we should keep using them. That’s actually not that high, if you think about it, and shows that at least 37% of Americans are insufficiently frugal. Imagine how much worse it would be if it was widely understood that it costs 1.2 cents to make a penny. (It takes a special kind of government to mint coins at a loss.)

According to Coinstar, which supplied the penny facts to Free Money Finance, the average American household has $90 in coins lying around. Based on the handy converter on their home page, that’s about half a gallon of change. What to do with this hoard of metal disks is of course a concern for the frugal. Dawn at Queercents suggests that you put it in a tin container rather than a glass one. Seeing the money will make you want to spend it. She also suggests other clever ways of hiding money from yourself, including inflating the values of the checks you write in your check register so that your balance is actually higher than you think it is. This has inspired me to convince myself that I belong to a high-end gym and to record imaginary large monthly checks for the membership fee. I think this will work as long as I don’t notice that I am not losing weight.

Speaking of losing weight, Frugal Living Tips suggests saving on food bills by foraging for things to eat in the woods. Not only will you save money, you will lose weight because of the exercise you will get and because you will find so little to eat, especially in February.

And finally, Tip Hero has a post about saving what must surely be many small copper disks with Lincoln on them by making your own half and half for your coffee. The recipe given is one quart light cream to one quart milk. No word on what to do if you need less than half a gallon of the stuff, but you can use that glass bottle you used to store loose change in.

Phil Town’s Rule #1, Part #5

[This is the final part of a multi-part review of Phil Town's book Rule #1, The Simple Strategy for Successful Investing in Only 15 Minutes a Week! If you haven't already, you might want to read Part 1, Part 2, Part 3, and/or Part 4 first.]

Does anybody really believe that they can buy a book containing a sure-fire formula for riches? I do not mean conceding that it is remotely possible, I mean truly believing that Town’s book, or one of its thousands of competitors, will disclose a magic technique to the reader. I am sure that there are a few out there that are that gullible, but I don’t buy the idea that Town’s large readership is made up entirely of such folk.

So maybe my efforts to demonstrate that Rule #1 does not work were a waste of time. If Town’s audience does not really expect his scheme to make them rich, then why bother showing that it will not? Moreover, if we accept that there are very few people out there who are both in the habit of reading books and naïve enough to think that reading a particular one will make them rich, how do these books become bestsellers?

For me, the most meaningful revelation from Rule #1 is just how impractical it is to carry out what Town advises. I expected that his formula for picking stocks would not work in the sense that the stocks picked would not do particularly well. I did not expect that it would not work in the sense that it would barely function, that it would be so hard to use it to pick stocks at all. And you might think that this kind of not working would be a big problem for the sales of the book. A scheme that is easy to operate but does not pick winning stocks at least has the virtue that it could take a year or two before the readers realize it is defective. A scheme that is more or less inoperable from the start would, you would think, be noticed right off and become a hindrance to climbing the bestseller lists.

The flaw in that logic is that it assumes that readers actually attempt to follow Town’s advice and discover it is defective. But just as the vast majority of Town’s readers does not, in the cold light of day, really think that his scheme will make them rich, the vast majority also does not bother to try to follow it. Why would they? They know deep down that it will not work, so why put in the considerable effort required to shatter the illusion that it might work? Which then begs the question, why buy the book at all?

Because Rule #1, like nearly all books (and seminars, for that matter) is, ultimately, primarily a form of entertainment.

Consider television cooking shows, a genre that dates back to the earliest days of the medium. Although nominally instructive, it is clear that almost all viewers will never cook the elaborate dish that the host prepares. They watch not to so they can follow the instructions, but because it is entertaining. If you are into food, watching a skilled chef prepare and discuss a dish is fun. You can, at least in the abstract, imagine yourself preparing and even eating it, and that is enjoyable for many. I know people who buy and read cookbooks on the same basis.

Or consider cowboy hats. Putting one on has no chance of turning you into a cowboy. But it helps with the fantasy of being one. (In reality, it is probably not a great job: long hours, low pay, lots of big dumb smelly animals, and no Internet access.)

The fantasy that goes with Rule #1, and other books like it, is that you will read them and become rich. That any modestly intelligent reader knows, at some level, that this is really unlikely, does not diminish their appeal. A person can read the book and imagine becoming rich just like the ordinary people in the inspirational stories included in the text. That some of the instructions are, in fact, impractical is unimportant. They only need to seem practical to somebody who will never attempt them. Just as the host of a cooking show can get away with using obscure ingredients or a tricky technique requiring years of practice, Town can get away with vague instructions that do not produce the desired result.

So in a narrow sense, I am willing to forgive these books for being as bad as they are. They fill an entertainment role for some, and, apparently, do it well. The problem is that personal finance is still an area that American adults need to master. After you are done watching the celebrity chef prepare Cajun crawfish stew, somebody still needs to cook dinner.

[Links to parts of this review: Part 1, Part 2, Part 3, Part 4, and Part 5]

Cops and Regulators

It’s a story that is (appropriately) on the back burner in the media, but the slowly unwinding tale of The Greatest Ponzi Scheme Ever continues. In case you have (appropriately) been paying attention to other things, let me offer a quick recap.

Starting as long as twenty years ago, Bernie Madoff, a well known and successful figure on Wall Street, ran a Ponzi scheme. As with all such scams, he pretended to be putting his clients’ money in a make-believe sure-fire investment. Those few who asked to cash out were given money he raised from other investors. By 2008, Madoff’s imaginary investment empire was worth an imaginary $50 billion.

And he never got caught. Like funds of all kinds, last year he was hit by a wave of people wanting to cash out. Unlike other funds, the money he needed for the withdrawals did not exist. So before things got really really ugly, Bernie turned himself in. (Actually that’s not quite right. He confessed to his sons that he had been running a Ponzi scheme and that he planned to turn himself in. They immediately dropped a dime on Ol‘ Dad. Wall Street is a really tough place.)

That’s a pretty good plotline, but it gets better. If you are, like me, an investment professional in Boston, you have probably met a guy named Harry Markopolos. You might also remember that for several years in the middle of this decade Harry tried to make a living as a freelance financial fraud investigator, sort of a bounty hunter for the investment world. Well it turns out that one of his longest running investigations was Madoff’s ponzi scheme. Markopolos figured out it was a scam as soon as he saw the returns Madoff claimed to be getting in 1999. He then spent the following nine years trying to convince the SEC to do something about it.

We do not yet know why the SEC did nothing. Further plot thickeners such as bribery or blackmail are certainly possible, but not likely. The mundane truth is that the SEC is just not that good at what most people think they do for a living. They are regulators and not cops. There is a difference.

To illustrate this, let me change subjects abruptly to an excellent article in the Atlantic last November by Jeffery Goldberg. It is the account of his concerted multi-year effort to get himself placed on the TSA’s notorious No Fly List. He failed, although he did manage to have a nail clipper and a can of shaving cream confiscated. On other occasions he boarded planes with items that ought to have raised some eyebrows, including lengths of rope, dustmasks, full sized Hezbollah flags, and of course, the traditional box-cutter. He also used badly forged boarding passes and at one point ripped up a stack of them in view of a TSA officer. (I thought the article was hysterically funny. Most of my friends swore they’d never fly again. Go figure.)

The TSA didn’t stop Goldberg for the same reason that the SEC didn’t stop Madoff. They are regulators. They employ large numbers of comparatively underpaid and undertalented people to make sure that most folks mostly keep within regulations most of the time. That can be a worthwhile government function (not in the case of the TSA) but it’s completely different from finding the really bad guys and throwing them in jail.

If you point out an obvious wrongdoer to a cop he will arrest him and then, if necessary, work out exactly which crimes have been broken. Point out to a regulator a wrongdoer who is not obviously breaking any regulations, and the outcome will be paralysis. We don’t know for sure yet, but I will bet real money that is what happened at the SEC. They stood around scratching their heads trying to figure out what SEC rules were being broken by Madoff, couldn’t come up with any, added in the fact that there were no complaining victims, and decided to move on to other cases.

If you are confused (or outraged) that the SEC might not see any obvious violations to pursue with Madoff, you are not thinking like a regulator. Regulators work with very detailed and specific rules that they try to jam everybody and everything into. There is no such thing as “the spirit” of a regulation and no general remit for the regulator to fight evil beyond what is very specifically allowed or not. Madoff was not selling securities, as the law defines them. The SEC had a lot of rules about how Madoff could invest his clients’ money in the public markets, but nobody has alleged that he broke any rules there. (Not surprising, given that he apparently didn’t invest his clients’ money at all.) Expecting the SEC to go after Madoff under the general principle that he might have been carrying out the greatest securities related fraud in history is like expecting the airport screener to take a closer look at the unlikely items in the carry-on of the guy in the al-Qaeda tee shirt. (Seriously. Goldberg wore one. Read the article.)

Markopolos had no direct contact with Madoff. (He still mispronounces his name. It’s MADE-off, as in “Bernie made off with a whole lot of money.”) Which raises the question, why didn’t any of the thousands of other people who must have come across the same data in the course of their business come to the same conclusions as Markopolos did and alert the SEC? It’s possible a few did, but it is clear that the vast majority of financial professionals did nothing. Again, because the SEC are regulators, not cops.

Innocent or guilty, dealing with regulators is a painful drag. As a wag once put it “the process is the penalty.” Unless you are absolutely sure something is rotten you just don’t finger your fellow man to a regulator. And even then probably not. You might call the cops if you thought that perhaps your neighbor was beating his wife, but it is almost inconceivable that you would call the IRS because you knew for a fact he was cheating on his taxes.

Obviously, what the Madoff scam needed was cops, not regulators. But there were lots of cops. This was, after all, plain old fraud in fancy packaging. The police in any of the hundreds of jurisdictions where Madoff’s victims lived could have, in principle, investigated him. And of course there was the FBI. But if Markopolos had brought his story to any of these I am sure they would have all sent him back to the SEC. Wall Street fraud is their thing, isn’t it? The final irony is that had Madoff claimed to be investing his clients’ money in something other than regulated securities, Manhattan real estate for example, he almost certainly would have been stopped a long time ago.

Compared to the global economic crisis and our government’s fumbling responses to it, the Madoff story is relatively minor, almost a comic relief. It would be unfortunate, but not all that unexpected, for the two stories to become intertwined in public memory, as popular imagination blames “accounting scandals” like Enron and Worldcom for the tech bubble bursting and blames fraudsters for the great S&L fiasco of the early 1990s. We already hear vague accusations that the root cause of our problems is a failure of regulators to properly regulate. As regards Madoff, the opposite is true. The regulator did everything we could have expected of it. It was our mistake for expecting anything more.

Phil Town’s Rule #1, Part #4

[This is part 4 of a multi-part review of Phil Town's book Rule #1, The Simple Strategy for Successful Investing in Only 15 Minutes a Week! If you haven't already, you might want to read Part 1, Part 2 and/or Part 3 first.]

This is a strained analogy, but I think it works.

You are driving along on a quiet Saturday night. Phil Town pulls up alongside you in a big flashy car. He leans out the window and says “Hey, for $25 ($35 in Canada) I can take you to the coolest party ever.”

“Uh, I dunno…”

“It’s at this really gorgeous mansion on the beach. There’s an open bar, a huge gourmet buffet, and dozens of beautiful scantily-clad young people of both sexes who are tipsy and really open-minded, if you know what I mean. Also, the Rolling Stones said they would drop by later and play a few sets.”

Now you are pretty sure this is too good to be true, but there is that slim chance this smooth guy in the expensive car is telling the truth, and it is only $25. So why not? You hand over the money and Phil, assuring you the party is nearby, tells you to follow him. Which you do, weaving in and out of traffic at increasing speeds, making hairpin turns on mountain roads, running red lights, going the wrong way on one-way streets, and so on. Finally, Phil drives off the end of a pier, whereupon you discover that his car is actually amphibious. You stay on shore, watching him sail off into the sunset, calling back to you that the party is just a little farther.

So if by some miracle you have gotten through the main stock selection bits of Rule #1 with your sanity intact and a stock or two to buy, Town has just a little more work for you. We are almost there, you can hear him say.

On page 196 of Rule #1 Town introduces what he calls “the Tools” and what the rest of us investment types call technical indicators. Technical analysis is probably older than you think, possibly as old as the stock market, but at least as old as the familiar charts that show stock prices over time as squiggly lines. It is the developed pseudo-science of chart reading, based on the idea that stock prices follow a pattern that allows you to predict their near-term future. The name “technical” is old too, dating from a pre-computer era when the field seemed high-tech and nearly mystical.

Town is agonizingly ambiguous about the role that the Tools play in Rule #1 and vague about the specifics of how to use them, or even which exact tools to use. He instructs his readers to treat them as something they should follow without hesitation or reflection but also says “I’m not married to the specific set of Tools that I’m about to introduce to you.” He recounts how they have made him money, but seems to sell them to the reader primarily as confidence building accessories that will help a person pull the trigger and invest.

I am not going to conduct a backtest of the Tools. This because: 1) You are probably sick of backtests by now. 2) Town does not quite say that the Tools make money, in fact he is clear that as a stand-alone they do not, so finding that they do not work would not be a refutation of anything. And 3) Town is so unspecific about which tools to use, and how, that whatever results I got could be brushed aside by a true believer on the grounds that I did not do what Town really meant.

The three tools that Town recommends, but is not wedded to, are called MACD, Stochastics, and moving average. They are all, essentially, complex formulas that take only past prices of a stock as inputs and attempt to produce a “signal” that will predict if the stock is on its way up or down in the near future.

I have a lot of disdain for these sorts of tools. (Could you tell?) It is not that the underlying phenomena that they try to capture do not exist. They do. Stock prices really do exhibit some “momentum,” meaning that a stock that has been going up over the past three to six months is a little more likely to go up in the near future than one that has been flat. And over shorter periods, a few weeks for example, stock prices really do tend to revert, that is, stocks that have gone up or down a lot over a short period tend to give or get back some of the price movement right afterwards. These are small effects, but they are real and with enough data a person can prove it.

But these effects are not just small, they are simple. Calculations like MACD are not any more predictive than much less complex measures of price momentum. They have a lot of moving parts, in my opinion, just for the sake of having a lot of moving parts. It makes them seem so much more sophisticated and meaningful that way. In fact, these tools are no more subtle than looking a stock chart and saying “Golly, this has been going up all year. I think I’ll buy some.” or “Gosh, this has really been beaten up this week. I think I’ll buy some.”

Moreover, and here is where Town’s car is revealed to be a boat, these technical buy and sell indicators are by their nature short term. If you follow them you will inevitably be buying and selling every few weeks. Town gives the happy story of a couple who successfully used his system to make lots of money over two years in the stock of the Cheesecake Factory. They bought and sold the stock eleven times during that time. That is almost a trade in or out every month. Understanding, very late in the book, that this is what Town has in mind is probably a jarring surprise for many readers. In most of the book he stresses that he buys companies, not stocks, and that he would never buy a stock he was not willing to hold for ten years. Warren Buffet, an investor known particularly for his patience and long-term view, is cited as an inspiration throughout the book (he appears in the index 29 times) and the title is taken from something the great man said.

And yet, when you get down to it, Rule #1 is a form of investing that relies on a lot of short term trading. Look at any stock’s price chart and it is easy to imagine how profitable it could potentially be to trade in and out, buying on lows and selling on highs, provided, of course, you knew when those lows and highs were. The point is that that is true about any stock, not just that one in a thousand that passed the growth and value screens.

[Links to parts of this review: Part 1, Part 2, Part 3, Part 4, and Part 5]