As investors, we've been taught that success comes from sticking to a few basic ideas: Cheap stocks outperform expensive ones; earnings quality matters; prices move on momentum. Market anomalies can be exploited for profit and have helped make so-called "smart beta" exchange-traded funds a hit in recent years. But what if the widely followed investment factors underpinning these investments don't really function as expected?
Many investors may not be aware, but the idea of an exchanged traded fund was originally conceived by the U.S. Securities and Exchange Commission in response to the 1987 stock market crash. The idea for an ETF-like vehicle, which was labelled a "market basket instrument," was discussed by the SEC as a way to buffer the equity market from the futures market, writes Eric Balchunas in his book The Institutional ETF Toolbox. As Mr. Balchunas points out, "the U.S. government had a hand in inventing the ETF."
The odds of winning a coin flip beat the chances of hand-picking a winning portfolio of stocks. This effect has been well documented over the last year as active fund managers failed to beat broad market benchmarks such as the Standard & Poor's 500. J.B. Heaton, a lawyer and PhD in financial economics, has written recently about a phenomenon called "skewness" that helps explain why stock pickers can't get an edge. His work builds on previous academic research on the subject from as far back as 20 years ago.
Warren Buffett's Berkshire Hathaway currently has $86-billion (U.S.) cash at its disposal to acquire companies or take bigger stakes in existing stock holdings, as it did with Apple shares in the final three months of 2016. Shareholders and followers of Mr. Buffett have come to expect big moves from the billionaire, who is known for focusing on the long term. But in his annual letter to shareholders last month he spent some time trying to talk readers into accepting a practice that has been vilified for encouraging short-term thinking: share buybacks.
Warren Buffett's No. 1 rule of investing is "never lose money," followed quickly by his second rule - "Repeat No. 1." But it's OK to bend this rule - ignore it during times when a stock is purchased at a price that may seem high and make a short-term decline more likely. Berkshire Hathaway does when it buys stocks of companies that pay hefty dividends and buy back their shares. Berkshire owns 81 million shares of IBM and another 61 million shares of Apple, a stake that was increased considerably in the fourth quarter. Some consider Berkshire's interest in IBM and Apple a curiosity. Both of these technology giants are leaders in their sectors but many believe their best days are behind them.
Markets have a psychological effect on spending habits, even for billionaires, it seems. When markets are up, confidence rises and people are apt to spend a little more. They feel they can splurge on that trip or go out to an expensive restaurant. Conversely, when markets are down, confidence wanes and people tend to rein in spending. In a new documentary from HBO titled Becoming Warren Buffett, we get insights into the many habits and traits of potentially the greatest long-term investor of all time.
A new body of research shows being an extraordinary investor such as Warren Buffett or George Soros may in fact be possible for other investors if they use a few tried and true yardsticks to evaluate stocks. The report, titled Alternative Thinking: Superstar Investors, was produced by AQR Capital Management, the program-driven investment firm. The researchers compared returns for superstar investors to portfolios it constructed with a small set of buy and sell signals that tracked the investing styles of Mr. Buffett, Mr. Soros and others. It managed to get results that were pretty close to the real thing. The conclusion of AQR's research is investors don't have to pick exactly the same stocks as the masters to generate benchmark-beating returns.
Even the best ideas flounder some of the time. The overwhelming majority of top mutual fund managers - those who had the best record over a decade - spent at least three years lagging well behind others during that time, according to Joel Greenblatt, a hedge fund manager and author of the "The Little Book That Still Beats the Market." More than three-fourths of these star managers spent three years at the very bottom of the performance ladder, something short-term-minded investors tend to flee. But too bad for them. These managers all outperformed over the longer run - the decade-long period through the end of 2009.
In March of 2009, the S&P 500 bottomed at 666. Today it's trading near 2200, which equates to a 226 percent increase in the large-cap stock index over the last seven-and-a-half years. There is no question that this bull market has been strong and long-lasting. Over the past few months, some experts have argued the current trend is long in the tooth and that stock valuations (as measured by metrics, such as the Shiller P/E) are stretched. There are others, however, who say stocks have room to run, particularly now with a Trump victory and a strong rotation into financials and other segments of the market, and that equities are the best alternative compared to other asset classes they compete with. Both arguments are compelling, so what's an investor to do?
It is a discussion in a Woody Allen movie, but it is also a line from the Greek poet Archilochus, who described foxes as self-critical thinkers who can adjust their beliefs and hedgehogs as people with one big idea who try to persuade others to follow along. It's the same idea Philip Tetlock, a psychology and management professor at the University of Pennsylvania, studied over decades as he tried to determine what gives one so-called expert more credibility than any other, well, so-called experts.
Not all that long ago, "stock-picking" entailed tedious, relentless research. In order to get the complete financial picture of a firm and its shares, individual investors had to scour the pages of financial newspapers or pore over scores of thick, dull annual reports. You either spent hours upon hours in the local library or you turned your study into a repository for piles upon piles of financial documents.All that changed with the arrival of the Internet Age. Today, quantitative stock-picking screens are just about everywhere.
"How to Find the Best Dividend Stocks"; "Stocks for a Bear Market"; "Five Stocks to Take Advantage of Central Bank Policies" - just about everywhere you look in the financial media, you'll find tips on buying stocks. Far, far less often will you find advice on when you should sell a stock, however - and knowing when to sell may be even more important than knowing what to buy.
"Stop-loss." For investors, the term has a comforting ring to it. Who wouldn't want to put a cap on the amount you could lose on one of your holdings? In reality, however, stop-loss orders (which require a stock to be automatically sold if and when it hits a predetermined loss) are a double-edged sword. If not used properly, they can wreak havoc on your portfolio - particularly if you are a value investor.
The consensus continues to be that the Federal Reserve will start raising U.S. interest rates in September, and that has many equity investors feeling uneasy. Rising rates, the theory goes, spell trouble for stocks.
For some - particularly those who believe in efficient markets - a successful quantitative investment strategy is akin to a beautiful, quiet, undiscovered beach: Enjoy it while you can because once the masses get wind of it, its secluded beauty will be no more.