Ignore the Noise:John Bogle on Market Fluctuations

John Bogle offered the following during this recent interview with Morningstar's Christine Benz:

"Well, we have to get investors everywhere, and not just retirement plan investors, [onto] the idea that these daily leaps and plummets in the stock market are meaningless. As I've said in more occasions than I care to count, Christine, the stock market is a giant distraction to the business of investing. Because investing is owning corporations that provide goods and services, hopefully more and more efficiently to lower prices, and that's capitalism at work. … They make earnings, they reinvest, pay dividends, reinvest the rest to build the business, that's classic capitalism. That's what I call investment return, dividends and earnings growth..."  

He later added this on the importance of ignoring short-term market price action:

"So, we've got to get people away from looking at the market, and one of my investment rules, as you well know, is don't peak. Don't look at your retirement plan accumulations. If you don't do it for 50 years, you will be thunderstruck with the amount you have when you open that final statement. You won't even believe it. It will be sensational. By looking, all it does is distract you and get you to take action where none should normally be taken."

Underlying fundamentals don't change nearly as much as the daily fluctuations might seems to indicate:  

"And stocks go up and down every day, not based on a change in the fundamentals, because the fundamentals don't change every day for heaven's sake. 

So, we're our own worst enemies. So we want to get a little better investor behavior..."

At a minimum, learn to ignore near-term market fluctuations. Better yet, allow its tendency to misprice assets to serve.

"Mr. Market is there to serve you, not to guide you." - Warren Buffett in the 1987 Berkshire Hathaway (BRKa) Shareholder Letter

In many fields success depends on lots of action. Investment is quite different from that. There's a bunch of hard work involved but it has nothing to do with trading market action; it has to do with understanding what something is worth now and judging how much it is likely to change -- within a range -- over longer time frames. That's hard enough to do well. It's decisively buying what you understand well and being disciplined about allowing for sufficient margin of safety. It's knowing what you don't know. It's about owning sound assets, bought at fair or better prices, while minimizing frictional costs and mistakes.

For most, the index fund bought (not traded) for the long haul consistently over time is a very convenient way to accomplish this. Whether indexation, the purchase of individual marketable stocks, or some combination makes sense as an investment approach is necessarily unique to each investor. Still, no matter what the circumstances, it makes sense to reduce frictional costs and limit trading activity.

Remember that each portfolio move is not only a chance to enhance returns, it's an opportunity to incur additional frictional costs and make additional mistakes.

Respect the illusion of control.

Some underestimate this a great deal and that can be costly.

Of course, none of this applies to someone with a short time horizon but, otherwise, developing the habit and temperament to at least ignore market fluctuations and, if anything, allow market action to serve is a generally good one.

The more confident one is the quality of what they own and what it is worth, the more they should embrace a drop in price. If something was bought at a discount to intrinsic value in the first place why be bothered if the discount temporarily gets even bigger?*

A good test as to whether one is involved in speculation or investment is in their reaction to a drop in price.

Lots of productive assets -- things like private businesses, farms, real estate -- are fine investments but have no quoted market value. The owners of these businesses don't constantly check to see for how much they could sell their ownership position to someone else. Well, it's best treat common stocks -- or the index fund that is holding common stocks -- in a similar fashion.
(The fact that part ownership of a fine business that's reasonably -- or even better than reasonably -- priced can be established very easily and at low transaction costs should be an advantage. It makes no sense to turn it into a disadvantage by constantly trying to buy and sell. Just consider how much more the transaction costs are for the purchase of productive assets other than stocks.)

So, as long as per share intrinsic value gets judged reasonably well, and especially if a discount to that value was paid, a long-term investor should logically like the idea of a drop in price.**

That's the case even if the drop occurs post initial purchase. At the very least, the long-term investor should be neutral toward price drops.

A speculator, understandably, likely will not feel the same way.

Speculation may provide more excitement, at least in the eyes of some, but the evidence more than suggests -- between the mistakes made and the unnecessary frictional costs -- most won't do well who attempt to play that game.

Investment has as its emphasis what an asset can produce over a very long time frame. Speculation has as its emphasis market price action and how to profit from it. Naturally, there's nothing wrong with speculation but it is much less similar to investment than some seem to think.
(No doubt their are individuals who are capable speculators, of course.)

Finally, no matter what investment vehicle(s) makes sense for an individual (again, that's necessarily unique to each person and the circumstances) it's foolish to not allow the magic of compounding to work.

As John Bogle said in this Frontline report earlier this year:

"What happens in the fund business is the magic of compound returns is overwhelmed by the tyranny of compounding cost. It's a mathematical fact. There's no getting around it. The fact that we don't look at it, too bad for us." - John Bogle

It also makes no sense to be held back by "the tyranny of compounding cost".

Otherwise, investing well means mostly just getting out of the way while consistently making wise purchases along the way.

Ignore the noise.

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Doing away with DIBS may not solve the problem

There have been much talk about Bank Negara outlawing DIBS or Developer Interest Bearing Scheme. You can basically read about DIBS here and here.

DIBS are bad for the market as it is misleading especially to those whom are unaware of the risks that they are taking. Obviously, the S&P lawyers as well as the banks whom most of the time are representing the developers would not be warning the buyers of the risks, and even if they did, buyers whom have witnessed the emanating rise of the property sector would still be willing to take the risk. I have read and heard of a young guy in his early 30s with 10 properties into his name - basically gearing himself to the maximum and riding on the property boom. Hearing from the market, there is no one such guy but many.

If you walk into the local books section of MPH, quite a number of them on display are how to be rich through properties. There is already a sense of something wrong here as whenever the market is over exuberant, there is always a huge danger. I can probably bet you that if I put a book on stocks investment, it will probably not get picked up as much as a book on property investment.

The rise of the property prices I think pose a problem to Bank Negara and as in most central banks, the trick of the trade is to slowly cool down the sector. It may seem to be easy as reducing credit, coming out with more stringent lending practice will look like able to do the trick. However as in most central banks, they would want to have what you call a Goldilocks economic results from the steps taken - i.e. not too hot and not too cold, just nice. What they are afraid of is it gets too cold after a certain measure has been put in place. That would again jeopardize the economy. Look at what Bernanke has done to the stock markets in the last few days - just from a very honest statement!

Although eliminating DIBS is a must, this I think may still not be enough, though. Why? Singapore has already outlawed DIBS in 2009. The property market in Singapore is still hot and continue to rise - that's one. China has put in place very tough measures - years ago - for those who buy their second home. It did nothing to the market. It was very hot, until very recent few days where there were talks of a probable crash in the property sector there, and obviously the banks are the ones which will get impacted due to over lending. Mark Mobius has come out and made his comment that the Chinese banking sector is seriously in a critical situation.

While eliminating DIBS is a must-do, the core of the problem is not that. It is to do with the players in the sectors - banks and property developers. They have always worked hand in hand. Some banks are giving 100% loan with low interest rates especially during the construction period. Yes, that is not as bad as having DIBS but still...And recently, the government is introducing a 100% financing scheme to families with income below certain level. That is sending the wrong message. Where has the government housing scheme gone to? The government has land, but like what it is for the Kwasa Development under EPF, most probably it will go towards the higher end market - as I see it.

As I walk into some launches or sale at the malls, another indigenous scheme which the developers have come out with is rebates. One which I have come across is a newly-launched property put up for sale at RM1.3 million. And if I were to lock in my purchase by say 31 July 2013, I will get a RM100,000 rebate from the purchase price. That is vastly cheating, in another name. This basically mean that the price of the house is actually RM1.2 million but the developer has just jacked up the price to RM1.3 million and reduce my minimum upfront payment by 77%. That's all. I think sooner or later property developers will just go to Groupon to do their discounted sale.

Another wrong message is, now that pushing up the property price among locals would be difficult, guess what the developers have done - just go overseas to do the launches - Singapore, Hong Kong, China. Like it or not, it will just push up property prices again. That's just what happened to Singapore and many other larger cities in Asia.

I think with just Bank Negara trying hard, it will not do the trick as the other sectorial players together with authorities have not done enough and in fact sending the wrong messages and that would just be very bad for the man on the street.

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Why Airasia X may not be an Airasia

For this article, I am not going to compare financial numbers but would look at in terms of size for each of the company. Airasia X (“AAX”) has just been provided a valuation of RM1.98 billion at RM1.25 per share, hence effectively valuing AAX at a post IPO valuation of RM2.9629 billion of its enlarged share capital.

Now in comparison, let’s look at Airasia. At today’s price of RM3.07 Airasia has a valuation of RM8.5 billion. For the matter, Airasia is going to be 2.5x larger than AAX in terms of market valuation. Airasia has established operations in Malaysia, Thailand, a growing Indonesia and seemed to have sorted out for a good start for India. 

The reason I like Airasia is due to it having a business model that can replicate as long as it manages well in the countries it operates in. Future looks bright for the company with its dominance in the low cost airline business in Asia. One would consider the attractiveness of the growing middle class in Asia to be able to comprehend what’s the outlook for Airasia.

It has the strength, advantage and capabilities of raising funds as opposed to many other of its competitors. This portion of Airasia’s strength should not be underestimated as airline is a hugely difficult business when comes to funding. Airasia is less of that, now as it seems.

Replicating that to AAX? Yes, the brand of Tony Fernandez, the Airasia model seems to be able to cause the take-off of AAX in a much less strenuous manner if one is to start off a low-costs longer haul airline. But yet, it can still be an arduous task. Airasia is a very much a strong local flight operator although a lot of its flights are still inter-country. Inter cities within the country is very lucrative. 

AAX model, on the other hand is entirely inter-country unless one can think of more than 4 hour flight between India’s cities or Australian cities.

Business model

AAX on the other hand is still sorting out its business model with flights now flying off from Malaysia to other destinations beyond the 4 hours threshold. It has changed from a long-haul operator to now calling itself a medium haul operator, flying to destinations like Melbourne, Sydney, Taipei, Tokyo, some cities in China, Jeddah etc.

There are a lot of cities that one can go to but yet for one to take a long haul flight, many factors have to be taken into – comfort, competition (which in this case is way more competitive due to many locally owned national airlines). I provide a scenario of KLM, the Dutch operator – for its flight to Australia for example, it can provide a very competitive rate for those stopover flight in Kuala Lumpur as it has already have a large portion of its plane filled from Europe. This is going to be in competition to AAX. In terms of comfort between AAX and KLM for example, there is a significant difference especially for an 8-hour flight.

Another  thing on competition – SIA for example can allow its market share for shorter haul flight to be lost, but it will never allow its market share for longer haul flight to be greatly affected. Business is about changing to the landscape of competition. If for a short period, SIA, Qantas can afford to lose out, but in the longer run it will not and these are national airlines we are talking about.

These are the things you will see happening to AAX as compared to Airasia which has put itself in a much better situation as compared to its sister company.

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Risk and Reward Revisited

From the Implications and Conclusion section of this paper, co-written by Nardin Baker and Robert A. Haugen:

"As a result of the mounting body of straightforward evidence produced by us and many serious practitioners, the basic pillar of finance, that greater risk can be expected to produce a greater reward, has fallen. It is now clear to a greater and greater number of researchers and practitioners that inside all of the stock (and even some bond) markets of the world the reward for bearing risk is negative."

Paper: Low Risk Stocks Outperform within All Observable Markets of the World

Well, according to the paper, if the "basic pillar of finance" is not necessarily valid then:

"...its invalidation carries critical implications for the theories underlying investment and corporate finance. In our view, existing textbooks on both subjects are dramatically wrong and need to be rewritten."

Buffett explained this negative correlation between risk and reward very well nearly 30 years ago in The Superinvestors of Graham-and-Doddsville.

I highlighted it in this recent post.

Buffett on Risk and Reward

"I would like to say one important thing about risk and reward. Sometimes risk and reward are correlated in a positive fashion. If someone were to say to me, 'I have here a six-shooter and I have slipped one cartridge into it. Why don't you just spin it and pull it once? If you survive, I will give you $1 million.' I would decline -- perhaps stating that $1 million is not enough. Then he might offer me $5 million to pull the trigger twice -- now that would be a positive correlation between risk and reward! 

The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it's riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is." - Warren Buffett in The Superinvestors of Graham-and-Doddsville

Sometimes risk and reward is positively correlated. Sometimes it is not.

Some act as if they must always be correlated in a positive manner.

Note that, for example, the capital asset pricing model (CAPM) doesn't leave any room for the possibility that risk and reward can be correlated in a negative manner.*

Ra = Rf + β(Rm-Rf)

Ra = Expected Return
Rf = Risk Free Rate
β = Beta of the Security
Rm = Expected Market Return

I think it is fair to say that just because an equation happens to have a greek letter, is elegant in appearance, and is widely taught, it doesn't automatically qualify as some great leap of insight.

"...Berkshire's whole record has been achieved without paying one ounce of attention to the efficient market theory in its hard form. And not one ounce of attention to the descendants of that idea, which came out of academic economics and went into corporate finance and morphed into such obscenities as the capital asset pricing model, which we also paid no attention to." - Charlie Munger at UC Santa Barbara back in 2003

Efficient markets and the "descendants" is not just somewhat flawed thinking. It is, to me, worse than useless. Charlie Munger said the following later in the same speech talking about what he calls physics envy:**

"I want economics to pick up the basic ethos of hard science, the full attribution habit, but not the craving for an unattainable precision that comes from physics envy. The sort of precise reliable formula that includes Boltzmann's constant is not going to happen, by and large, in economics." - Charlie Munger at UC Santa Barbara back in 2003

These ideas have -- sometimes quietly and sometimes less so -- influenced real world behavior and system design in far from desirable ways. They continue to do so. The damage done may be subtle but it's real.

Not all flawed ideas deserve to be viewed with contempt (and even a brutal disrespect), but at least some of this stuff just might deserve such treatment.

It's not difficult to show, as Jeremy Grantham points out, that participants do not always behave in the cold, rational manner that the efficient market hypothesis relies upon.***

It's not difficult to show that market prices fluctuate far more than intrinsic business values.

It's not difficult to show that risk and reward are not always positively correlated.

It's not difficult to show that a single greek letter -- in this case β -- cannot possibly be a proxy for risk.

Systems should be designed with these realities in mind. The next generation of business leaders, finance professionals, and economists will be more effective if taught to think about the world the way it is (or, at least, as close as possible to the way it is) instead of an imaginary one built upon certain flawed models and assumptions.

In capital markets, mispricing is the norm and, as we've seen during the past decade and a half or so, sometimes that mispricing goes to extremes.

The paper ends by asking, then attempting to answer, the question"how can it be true that over the course of almost fifty years, millions of unsuspecting students have been trained by thousands of finance professors to believe" in efficient markets?
(Including the many related ideas -- the "descendants" -- that have been spun off from it.)

Well, they say it comes down to the following:

"The answer is that in all but the hardest of sciences, academic research may be influenced by other factors in addition to a pure quest for the truth."

They go on to explain this further. In a nutshell, Baker and Haugen suggest that once ideas like these obtain widespread influence in academia, it is in the interest of those involved to maintain that influence.

In any case, it's usually a good idea to never be surprised by how long it takes for widely adopted, credible sounding, but highly flawed thinking to surrender its costly influence.

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When Japan was an emerging country

Recent wild swings in Japan’s financial markets — stocks, bonds and the yen — make Japan look almost like an emerging country.

Back in the 19th century, Japan was an emerging country, with its feudal society based largely on farming.

According to a paper by U.S. based researchers Chiaki Moriguchi and Emmanuel Saez, Japan’s GDP per capita in 1890 was at the level of U.S. GDP per capita in 1790, or about $1,200 in 2004 dollars. According to them, this is roughly comparable to the GDP per capita of the less developed countries today.

John Dower,  author of Pulitzer-prize winning ”Embracing Defeat” which covered the occupation of Japan by the American forces, describes the late 19th century Japan as “a small country with few obvious resources”.

For over two centuries, intercourse with foreigners had been largely prohibited by its feudal shoguns. Although the economy had become commercialised in those years of seclusion, no industrial revolution had taken place, nor had there been any striking advances in science.

After Japan (unwillingly) opened up in 1868, it quickly modernised, gaining one of the five major world power status by 1919. That reindustrialisation took the proportion of employment in agriculture down from 78 percent in 1876 to 65 percent in 1900 and 42 percent in 1940 (today, it’s less than 5 percent).

The World War Two came and went, and the country was forced to rebuild almost from scratch in August 1945.

Amidst the post-war chaos, it went through a period of hyper inflation as the authorities — under the U.S. occupation — printed money to finance a war-battered economy which saw a surge of population due to people returning from former colonies and the war zone.

Japan’s CPI index (100=1935) more than tripled to 350 when the war ended in August 1945, then rose to a whopping 29,000 in 1949.  On a different measure, consumer prices rose by 5,300% in just 4 years to 1948.

It’s famous history in my family that my great uncle who ran a rapeseed oil business in Kagoshima, southern Japan, took an overnight train to Osaka to sell oil during the post-war chaos, and he came back with pockets full of cash.

The economy began to stabilise. Then, thanks to an export boom during the Korean war, the Tokyo Olympics, and rapid economic reform, Japan enjoyed a period of super high growth which averaged 9.1 percent in 1955-1973. Its GDP per capita grew at an annual compound rate of 2.7 percent in 1886-1940 and at 4.6 percent in 1948-2005.

Much of Japan’s  post-war growth — kick-started with foreign capital — was based on private savings which were channelled by banks to finance massive infrastructure projects. People worked hard, saved and contributed to the development of their economy. By the time it surpassed West Germany to become the world’s second biggest economy in the 1960s, Japan’se economy no longer relied on foreign capital to grow. (A 1960 Japan is where China is at today given its GDP per capita is roughly at  $8,500-10,000)

As gyrations of recent weeks show, ebbs and flows of foreign capital can be damaging. The future for emerging economies today may lie on how they are successful in diversifying their source of growth.

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