Hi Craig and all, IMHO this post is worth reading. Interesting questions, equities in general have had a historical return of about 12%. Their return in any given year, or even the average return in a number of years, is far from being predictable. The standard deviation of return for one year is in the order of 20%. The standard deviation for the AVERAGE return for an n year period decreases by a factor of the square root of n. So for example the expected average annual return over 25 years is 12% but the standard deviation of the return is only 20%/(sqroot(25)=4%, a substantial decrease in volatility but the volatility is still there. Why?
(before I continue I apologize for the zillion typos you will find. I think the stuff is readable. I can't put in the extra time editing would require)
When you put your capital in equities you are assuming two types of risk. First and most importantly equity returns are linked to company earnings (an equity is not like an insured CD for example in which your are sure to receive the interest and your capital back). Earnings depend on factors which can not be accurately be predicted, these factors are random events (for example you have a wonderful business, A new technology comes by and you fail to adjust). The other type of risk you face is linked to the time value of money. When you buy a share of stock what you are doing is sacrificing present consumption (using the money now to buy a nice bike) in the hope of gettting future returns in the form of dividends (which of course are linked to earnings) and/or capital appreciation should you sell the stock in the future. However, capital has value people demand a decent risk adjusted return from their capital, how much they demand depends on interest rates and how much of a premium they demand for taking the extra risk.
So the returns investors demand on equities, call this rate r, is linked to the general level of interest rates, for this people take the three month T bill rate (the so called risk free rate since the uncle always pays and even if you want to sell you treasury before it matures you are not subject to significant interest rate risk which affects the price at which you sell) and a risk premium which depends on the individual equity in question and historically has been on average about 8% for the average stock. Given the current love for stocks and the perception of a less risky environment, my guess is that right now investors are quite happy which significantly less than an 8% premium (this hypothesis may partially explain the reason why the market is valued at current levels, people are just willing to demand a lesser return out of equities)
The price you get when you sell/buy a share of stock, IN THEORY is supposed to be the present value of the future cash flows associated with the stock discounted using the rate r. Notice that both, the free cash flows and r, are random and time dependent. Random in the sense that you may predict average cash flows or interest rates but your forecast has an error range(call this the standard deviation of your forecast) which is pretty wide. Cash flows (let's call them earnings for simplicity) have proven to be extremely difficult to forecast with a high level of accuracy, there have been extensive studies on this matter and believe me, the average analyst does not beat, on average, a naive earnings forecast in which you say next year earnings are going to increase at a rate identical to GNP growth!
In essense, even though we have this cute valuation model which is the key building block of fundamental analysis, due to uncertainties, it is extremelly difficult to determine the right value for a stock. In a way we are all playing the same blind's man game: trying to guess the right price. The right answer is within a fairly wide band so therefore we conclude that the price, as determined by market conditions (supply/demand) should be the right price. Needless to say this explains the volatility of stock prices which in turns explains in a way why investors expect a risk premium. Which inturns explains the reason why academicians say why bother, the current price is the right price, lot's of smart (?) people the experts that are trading does equities are assigning the best estimate of the right price for the stock.
In the long term, however, earnigs are indeed the horse pulling the price chariot and it ends up that on average stocks are indeed priced so as to generate about 12% return.
Now, the question is whether for a given level of risk you could achieve better returns than by just picking the stocks blindly (i.e., indexing). This is where we come in and where I give my two cents.
IMO the market prices efficiently about 90% of the securities, 90% of the time. So you may be capable of achieving the excess returns by buing underbalued stocks and shorting the overvalued ones this is what we are alll trying to do, and believe me, I think we domake good choices. The point in which we flunk the test is that we have an extremelly short time horizon. We all now BFIT is EXTREMELLY overvalued you don't need a Ph.D. to realize that. However, this point will only be proven as future quarterly relults prove as right. I guess what I am trying to say is that makinbg money in this business through short term trading is extremelly difficult.
So what do you do? I will tell you from a hard learning experience I am going through right not. The idea if you trust yourself is to buy and hold (sell and hold for shorting). Now, this you can do comfortably if the issue involved is not a significant portion of your portfolio, why would I care if YHOO, AOL, BFIT are going through the roof if each one of them is no more than let's say 3% of my net portfolio value? The problem is that when this positions are pretty large as it is my case with AOL and BFIT you can not afford the luxury of waiting and believe me the wait can be long and in the short run no one knows where prices will go. I am hanging there because I know that stocks are extremelly volatile (the difference between the high and the low for an average stock is about 50%, AOL's YHOO's BFIT's is larger!). But belive me I am no longer sleeping as well as I used to and I wish I had taken smaller bets. Forget the BS I am sure you ahve heard that you can not beat the market without making large bets risk considerations (i.e., price volatility) is also important.
I know I have not answered your question but I hope the above may help. In terms of beating the market CONSISTENTLY many studies have been proformed and the conclusion is that we still don't know if the few guys that have may have done so by shear luck (trivia question: why did Peter Lynch retired at 45?). In a year period or for a single issue any one can do wonders. For example, if you bought BFIT in aerly 96 would you consider yourself a genious? the trick is can you sell BFIT now and buy the next BFIT and the next and the next....
Pancho |
