Good reading.....
Posted at 7:10 p.m. PDT Sunday, October 17, 1999
Don't let October scare you
Investors often think October is the cruelest month. Just last week,
the Dow Jones industrial average lost a record 630 points. And 12
years ago this Tuesday, on Oct. 19, 1987, the market lost more than
a fifth of its value on one day.
Volatility in the stock market doesn't worry Meir Statman. The
Santa Clara University finance professor has spent his career
studying how stock market investors make decisions. Some of his
conclusions disturb financial professionals and contradict
conventional stock market wisdom.
Last week he discussed the stock market with Mercury News Staff
Writer Mark Rosenberg. Here is an edited version of the interview:
QStocks crashed in October in 1929, '87 and '97. And this October has already been a rough one
for stocks. Do you think investors should use extra caution this month?
AOctober is not as bad as its reputation. It's not the worst month; September is. From 1926
through 1998 -- 73 years -- there were 36 Septembers that saw the market fall. October had only
30. The differences between all of the months are differences that can be achieved by the equivalent
of tossing a coin. They do not suggest anything symptomatic about October. If you're going to be
afraid, you should be afraid every day.
QWhat is your approach to investing?
AMy approach is that while the market is crazy, people are crazier. People who try to beat the
market, more often than not, end up beaten. You should buy and hold, boring as it seems. Find
excitement elsewhere.
QThe Federal Reserve has been raising interest rates to counter signs of inflation. The dollar is
falling against other currencies. The Standard & Poor's 500 index is selling for 30 times earnings,
which is extremely high by historical standards. Should investors ignore these warning signals?
AYou should never adjust your portfolio because of what the markets are doing. You might make
adjustments because you're getting older, or you need cash because your child is ready for college.
But never change your allocation because you think P/E ratios are too high.
QLet's time-travel back to 1968, when the market was near its high. Say a friend who was heavily
invested in stocks came to you and said he thought prices were too high, and wanted to reduce his
stock holdings. And you told him that he should never sell for that reason. By 1974 the average
stock on the New York Stock Exchange had lost 75 percent of its value and your friend would have
lost most of his net worth. How would you have felt about the advice you gave him?
AI would feel OK about the advice but would feel bad about the results. But I never promised him
that the stock market would go up just for him. It's like a physician who gave the best medical
advice, but nevertheless the patient died.
QA financial professional might say that your advice is not the advice of a physician but more like
the advice of a clergyman. Rather than base your advice on the study of companies and the
economy, you base your advice purely on faith. How do you respond to that?
AYou have it upside down. I provide my advice based on the study of the market. I know that
picking stocks is useless and is a waste. Doing all of this financial analysis is the equivalent of a
physician who orders unnecessary tests, and each test has its own set of risks. There is a risk of
doing harm.
For the physician it is a wonderful thing to order those tests. He gets paid for those tests. Plus when
the patient dies and survivors come, he can say, ''I did everything humanly possible. Look at all the
tests I did!''
This kind of medicine will help them in front of a jury in a malpractice suit, but it is not the best
medicine. Both financial advisers and physicians practice with an eye to the jury, in case something
goes wrong.
QIt sounds like you don't think financial advisers are of much use.
ANo, I think they provide a valuable service to investors. Being a scapegoat is one of them. I am
not saying that in a cynical way. Brokers and advisers have a hard time, not in beating the market but
in dealing with investors who think it is easy to beat the market. If raising children is difficult, raising
investors is even tougher. At least children cannot fire you.
QExtraordinarily high P/E ratios have always preceded market calamities. Are you saying investors
should ignore that?
AThis is an example of the ''illusion of validity,'' where you look for just those pieces of evidence
that support your theory. But if you're going to do a proper analysis, you have to look at all the data.
When you do, you find that high P/Es do not lead to lower performance.
(Bay Area fund manager and financial columnist Kenneth L.) Fisher and I looked at the 126 years
from 1873 to 1998. We divided years into two categories: years when the market produced
above-median returns and years with below-median returns. Most of the years that began with
stocks at high P/Es ended with high returns; and most of the years that began with low P/Es ended
with low returns.
There might be a good reason that P/Es are high. Maybe you have a situation where the economy
has improved drastically and people have not grasped how much it has improved. Maybe the year
began with stocks selling for 20 times earnings and they really should have been selling for 30 times,
and the prices catch up the following year.
QHow much would you advise an average 40-year-old to have invested in the stock market now?
AThere is no formula on how much to put in the market. Earlier this century people thought only
speculators put money in stocks. Now a 40-year-old might be advised to put everything in stocks.
What you have to ask yourself is what will happen if prices go down 30 or 40 percent. Will you be in
the poorhouse? Are you buying stocks with borrowed money? Can you ride out a downturn?
QDo you think the average investor is better off investing in mutual funds or individual stocks?
AIndex funds are a good investment. Very boring, but very good. They provide you with adequate
diversification.
I would stay away from actively managed mutual funds because they eat up a lot of money in
transaction costs and saddle you with a lot of taxes. Index funds have low turnover and cost you less
in taxes.
The only reason to buy and hold individual stocks is the tax reason. You can pretty much hold an
individual stock for your entire life, and when you die the taxes essentially are forgiven (because of
the stepped-up cost basis for heirs). You cheat Uncle Sam out of his share in your wealth. If you
have an estate that is large enough that you can afford to leave money behind, then you might buy
individual stocks and your heirs will thank you.
But people think that if you own 10 or 15 stocks you've exhausted the benefits of diversification, and
that's wrong; you should have 100.
QThat advice is the exact opposite of the advice given by Warren Buffett, one of the most
successful investors of all time, who says investors should own only a few stocks and learn everything
there is to know about them.
AWarren Buffett is a genius. Most people are not. Concentrating your portfolio in only a few stocks
will either make you very rich or very poor. Owning a diversified portfolio will keep you comfortably
in the middle.
QBut how many investors have the time or money to invest in 100 individual stocks?
AIf someone owns 20 or 30 stocks and also owns some real estate and owns his or her own human
capital, then they are fairly well diversified. Human capital is your potential to earn income. But when
it comes to the portfolio itself, you may not need to go all the way to 100, but 10 to 15 is surely too
low.
QBrad M. Barber and Terrance Odean of the University of California-Davis just published a study
of 1,607 investors between 1991 and 1997, before and after they went online. The study shows that
these investors went from outperforming the market by 2.4 percent annually before they started
trading online to underperforming by 3.5 percent after they went online. It appears that the more
people buy and sell, the worse their results will be. Do you believe that?
AYes. I don't understand these day-traders and other active online traders. But I also don't
understand people who get up early on the weekend to go play golf. I'd rather be home reading the
New York Times.
People have different tastes. Some people enjoy sitting in front of the computer and trading. If they
lose money, well, when they go to the movies that also costs them money, but they enjoy the fiction. I
don't want to be a judge of what people do for fun and how much they pay for it.
QDo you think Y2K presents any special risks or opportunities for investors?
ANo. Everyone knows about the Y2K problem. The current level of the market reflects the
consensus opinion as to the severity of the problem. We'll find out if we were right. If nothing
happens at the turn of the century, stock prices might well zoom up.
Contact Mark Rosenberg at mrosenberg@sjmercury.com or (408) 920-5918.
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