Stock Market Investing for the 21st Century
Steven Thorley and Grant McQueen
• Lesson 1: Invest in stocks for the long-run
• Lesson 2: Free-ride on the market competition
• Lesson 3: Avoid the hidden price-tags of trading
• Lesson 4: Don’t fall into the data-mine
Stock Strategies: Four Important Lessons
• Topics not in this presentation
– Personal finance
– Get-rich-quick schemes
– Beating the market
• picking stocks
• market timing
– Hot tips
– The things that matter most
• family
• health
• gospel
Stock Strategies: Four Important Lessons
• Lesson 1: Invest in stocks for the long-run
– Stocks will have higher returns, on average
Wealth Index for U.S. Capital Markets 1947:12 to 2007:12
S&P500
SmallCap
T-bond
T-bill
CPI
$10,000
$2827
$1,000
$100
$32
$16
$10
$9
$0
S&P 500
Small Cap
T-bond
T-bill
CPI
11.88%
14.16%
5.95%
4.75%
3.74%
20
07
12
20
02
12
19
97
12
19
92
12
19
87
12
19
82
12
19
77
12
19
72
12
19
67
12
19
62
12
19
57
12
19
52
12
$1
19
47
12
Dollar Value (Log Scale)
$844
The Long-term Return on the Stock Market
Stock market risk-premium = market return - risk free return
7.13%
=
11.88% 4.75%
… but the U.S. in the last half-century has been “lucky”
compared to other developed markets and time periods.
Going forward, the expected stock market risk-premium is
about 5 percent. With the risk-free rate at about 3 percent, the
long-term expected return on stocks is about
8 percent per year
(standard deviation of 20 percent per year)
Stock Strategies: Four Important Lessons
• Lesson 1: Invest in stocks for the long-run
– Stocks will have higher returns, on average
– Stock market risks are acceptable, if you:
• Diversify
• Invest for the long-run
Average annual standard deviation (%)
Diversify Across Stocks
49% -
24% -
Diversifiable Risk
19% -
Total Risk
Nondiversifiable Risk
1
10
20
Number of stocks in portfolio
25
Best and Worst Annualized Returns
(1948-2007)
60%
45%
30%
S&P 500
15%
T-Bonds
0%
-15%
-30%
T-Bills
1
5
10
20
Holding Period (years)
Based on compounding annual returns from Stocks, Bonds, Bills, and Inflation., 2007 Yearbook, Ibbotson Associates
Chances of Loss
(1948-2007)
30%
25%
20%
15%
10%
5%
0%
S&P 500
T-Bonds
T-Bills
1
5
10
20
Holding Period (years)
Based on annual returns from Stocks, Bonds, Bills, and Inflation, 2007 Yearbook, Ibbotson Associates
From: “The Time Diversification Controversy” by Steven Thorley, Financial Analysts Journal,
Vol. 51, No. 3, pp 68-76 (May/June 1995).
Table 1. Risk-Free versus Risky Investment Options
under Different Investment Horizons given $1,000
Horizon
(years)
1
5
10
20
40
Risk-Free
Value ($)
1,041
1,221
1,492
2,226
4,953
------------ Risky Value ($) ------------ Under-Performance
Mean 10 percentile 90 percentile
Probability (%)
1,142
918
1,384
30.9
1,943
1,152
2,882
13.2
3,773
1,736
6,350
5.7
14,239
4,406
27,578
1.3
202,755
33,220
444,451
0.1
Stock Strategies: Four Important Lessons
• Lesson 1: Invest in stocks for the long-run
– Stocks will have higher returns, on average
– Stock market risks are acceptable, if you have a long
enough time horizon
– Question and Answer
Stock Strategies: Four Important Lessons
• Lesson 2: Free-ride on the market competition
– Most actively managed funds and brokerage accounts
will under-perform index funds over the long-run
– Choose “total market” index funds
Ten-Year Annualized Return on the 30 Largest Mutual Funds
Investor return for calendar years 1995 to 2004 (largest funds as of year-end 1994)
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
Fidelity Magellan
Investment Company of America
Washington Mutual Investors
Vanguard Windsor
American Century Ultra
Janus
Fidelity Growth and Income
Fidelity Contrafund
Vanguard Windsor II
Fidelity Equity-Income II
Fidelity Equity-Income
MSDW Dividend Growth
Putnam Growth and Income
American Mutual
Growth Fund of America
10.16
13.04
13.54
12.81
10.40
9.32
11.04
13.82
13.71
11.65
11.94
9.62
10.76
11.93
14.79
Average mutual fund return:
Vanguard 500 Index fund return:
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
Fidelity Growth Opportunity
AXP New Dimensions
Pioneer II
American Centuary Growth
Lord Abbett Affiliated
American Century Select
AIM Weingarten
Putnam Voyager
Putnam Growth and Income B
Fidelity Blue Chip Growth
Fidelity Destiny
T. Rowe Price Equity Income
Fidelity Independence
Waddell & Reed
Fidelity Growth Company
10.78%
12.00%
Funds outperforming the index: 9 out of 30 (30%)
Correlation to prior decade return:
-.250
6.81
10.64
8.98
8.73
12.89
9.50
6.16
9.10
9.94
8.82
6.76
13.00
10.63
10.37
12.57
Index Funds Have Low Fees
Performance comes and goes, but
costs roll on forever.
--Jack Bogle
Value of $100,000 investment
33% of your
retirement to
manager
Low Fees or Low Amounts
Vanguard is a pioneer in low cost index funds
(passively managed diversified mutual funds with fees often
below 0.2% per year)
www.vanguard.com
Homestead Funds is a pioneer in managing small
accounts (minimum of $200 for IRA and $500 for regular
accounts—NO minimum if automatic scheduled investments)
homesteadfunds.com
From: “The Inefficient Markets Argument for Passive Investing"" by Steven Thorley, Marriott School working paper, 1999.
Figure 1a: Distribution of Simulated Portfolio Returns for 1996
Before Costs
1000
Index Fund Return
900
Portfolio Count
800
700
600
500
400
300
200
100
0
-20 -15 -10
-5
0
5
10
15
20
Percent Return
25
30
35
40
45
50
From: “The Inefficient Markets Argument for Passive Investing"" by Steven Thorley, Marriott School working paper, 1999.
Figure 1b: Distribution of Simulated Portfolio Returns for 1996
After Costs
1000
Index Fund Return
900
Portfolio Count
800
700
600
500
400
300
200
100
0
-20 -15 -10
-5
0
5
10
15
20
Percent Return
25
30
35
40
45
50
Stock Strategies: Four Important Lessons
• Lesson 2: Free-ride on the market competition
– Most actively managed funds and brokerage accounts
will under-perform index funds over the long-run
– Choose “total market” index funds
– The competition in stock-market research is intense,
and will get more competitive going forward
– Market indexing or “passive investing” is a free-ride on
the competition
Stock Strategies: Four Important Lessons
An essential element of profitable economic activity …
- Barriers to entry (Porter’s five forces)
- Sustainable competitive advantage (Strategic Theory)
- Economic Rents (Microeconomic Theory)
- A “moat” (Warren Buffet)
Benjamin Graham on security analysis, 1976:
This was a rewarding activity, say forty years ago, when our
textbook “Graham and Dodd ” was first published; but the
situation has changed a good deal since then. In light of the
enormous amount of research now being carried on, I doubt
whether in most cases such extensive efforts will generate
sufficiently superior selections to justify their cost.
Trouble with Timing
Period of Investment
January 2, 1985 - December 30, 2005
NYSE/AMEX/
NASDAQ
Return
Annualized
+12.48%
Value of
$10,000
Invested in
Jan. 1985
$118,089
Less the 10 biggest days
+ 9.81%
$71,389
Less the 20 biggest days
+7.84%
$48,827
Less the 30 biggest days
+6.13%
$34,854
Less the 40 biggest days
+4.60%
$25,695
Data Source: CRSP Value-Weighted Index with
Dividends
Investment Catagories - Annual Return from 1996-2000
2000
1999
1998
1997
1996
Gov Bonds
Tech
Tech
Large Caps
Sm all Caps
10.48%
128.45%
74.81%
32.63%
24.98%
Corp. Bonds
Foreign
Large Caps
Utilities
Large Caps
9.75%
77.91%
29.91%
26.53%
24.62%
Utilities
Sm all Caps
Utilities
Sm all Caps
Foreign
7.83%
71.21%
20.69%
25.43%
20.95%
Sm all Caps
Large Caps
Foreign
High Yld Bonds
Tech
5.95%
28.68%
20.18%
13.35%
15.52%
Large Caps
Utilities
Corp. Bonds
Foreign
High Yld Bonds
-1.59%
22.06%
7.61%
11.05%
13.90%
Gov. Bonds
Corp. Bonds
Utilities
High Yld Bonds High Yld Bonds
-5.03%
6.17%
6.74%
9.68%
12.17%
Foreign
Gov. Bonds
Sm all Caps
Tech
Gov. Bonds
-10.72%
0.75%
4.72%
9.13%
4.64%
Tech
Corp. Bonds
High Yld Bonds
Gov. Bonds
Corp. Bonds
-31.40%
-0.29%
2.18%
8.78%
4.51%
S&P 500
S&P 500
S&P 500
S&P 500
S&P 500
-10.10%
19.50%
26.70%
31.00%
20.30%
Stock Strategies: Four Important Lessons
• Lesson 2: Free-ride on the market competition
– Bad reasons to not index
•
•
•
•
•
Passive investing is boring
War stories are fun to share with friends
Doing nothing about your portfolio is unnerving
Promotional material on indexing is lacking
Habit and tradition
– Good reasons not to index
•
•
•
•
You are stuck in funds that have a high exit cost
Index funds are unavailable in some plans and foreign markets
Legal proprietary information is routinely available to you
In taxable accounts, complex tax/donation strategies are possible
– Reason to index
• Superior long-run performance
Stock Strategies: Four Important Lessons
• Lesson 2: Free-ride on the market competition
– Indexing alternatives
• Mutual Funds (Vanguard, Fidelity, etc.)
– Easy, no trading costs (commissions or bid/ask spread)
• Exchange Traded Funds (SPDRs, WEBs now iShares)
– Slightly lower management costs
– Potential better tax effects
– Trading throughout the day (ouch!)
Stock Strategies: Four Important Lessons
• Lesson 2: Free-ride on the market competition
– Question and Answer
Stock Strategies: Four Important Lessons
• Lesson 3: Avoid the hidden price tags of trading
– Transaction costs
• Brokerage commissions
• Bid-ask spread
– Risk
• Indexing is optimal diversification
• Active funds are more volatile than the market as a whole
– Taxes
• Income taxes are triggered by buy and sell transactions
– Time and energy
• Beating the market requires a lot of both
Internal Revenue Service
Publication 586A
The Collection Process
(Income Tax Accounts)
Stock Strategies: Four Important Lessons
• Grant’s day-trading buddy
–
–
–
–
–
–
$500,000 in stocks X 2%
250 days X 1 trade X $15
$0.125 X 100 shares X 250 trades
Gross Trading Profit
Tax @ 39.6%
Net Profit
$10,000
- 3,750
- 3,125
3,125
- 1,237
$ 1,888
Stock Strategies: Four Important Lessons
• Grant’s day-trading buddy
– Trading Profit
– 10 hours/week X 52 weeks
$1,888
520 hours
– Equals $3.63 per hour!
– Not to mention the costs of an office, computer, internet
fee, real time data fee, and …
…THE FACT THAT HE DIDN’T BEAT THE MARKET.
From: “Does the ‘Dow-10 Investment Strategy’ Beat the Dow Statistically and Economically?”
by Grant McQueen, Kay Shields, and Steven Thorley, Financial Analysts Journal, Vol. 53, No.
4, pp. 66-72 (July/August 1997).
Table 2: Annual Mean Percentage Returns and Standard Deviations
for the Dow-10 and Dow-30 Portfolios, 10-year Subperiod Analysis
Nominal
Difference
Risk
Adjusted
Difference
Risk and
Transaction Cost
Adjusted Difference
Subperiod
Dow-10
Dow-30
1946-1955
20.28
(25.39)
17.34
(17.37)
2.94
-3.11
-3.61
1956-1965
13.97
(17.42)
13.21
(15.83)
0.76
-0.25
-0.78
1966-1975
10.36
(22.19)
5.81
(20.22)
4.54
4.12
3.44
1976-1985
19.29
(14.55)
14.45
(16.95)
4.84
6.52
5.93
1986-1995
19.95
(15.74)
17.73
(12.50)
2.23
-0.74
-1.22
Stock Strategies: Four Important Lessons
• Lesson 3: Avoid the hidden price tags of trading
– Question and Answer
Stock Strategies: Four Important Lessons
• Lesson 4: Don’t fall into the data mine
– Intra-generational
S&P 500
The S&P 500
1983-1993
Year
Source for all the S&P 500 data mining graphs is: David Leinweber’s “Data-Snooping Biases in Tests of Financial Asset Pricing Models.”
Overfitting the S&P 500
S&P 500
Butter in Bangladesh
R2=.75
Year
Overfitting the S&P 500
S&P 500
Butter Production in Bangladesh and the United States
R2=.95
Year
Overfitting the S&P 500
S&P 500
Butter Production in Bangladesh and the United States
United States Cheese Production
Sheep Population in Bangladesh and the United States
R2=.99
Year
Polynomial Fit to the S&P 500
S&P 500
Big Mistake or Bad Idea?
Year
.25 1016 - .26 1013 y + .12 1010 y2 - 32000 y3 + 56 y4 - .0064 y5 + .49 10-6 y6 - .24 10-10 y7 + .69 10-15 y8 - .88 10-20 y9
Polynomial Fit to the S&P 500
S&P 500
Big Mistake or Bad Idea?
Year
.77 1017 - .88 1014 y + .45 1011 y2 - .14 108 y3 + 2700 y4 - .37 y5 + .000035 y6 - .23 10-8 y7 + .99 10-13 y8 - .25 10-17 y9 + .28 10-22 y10
Stock Strategies: Four Important Lessons
• Lesson 4: Don’t fall into the data mine
– Intra-generational
– Inter-generational
• No story/no future
From: “Mining Fool’s Gold” by Grant McQueen and Steven Thorley, Financial Analysts Journal, Vol. 55,
No. 2, pp. 61-72 (March/April 1999).
Table 1: Summary Statistics for Various
Dow Dividend Portfolios, 1973 to 1996
Dow
Dow 30 Dividend Dow Five Dow Four
Foolish Fractured
Four
Four
Average
15.80
20.31
23.40
26.41
28.03
34.82
Standard
Deviation
17.29
16.50
20.69
22.78
26.97
44.50
Dow 30 is an equally-weighted portfolio of all 30 stocks in the Dow Jones Industrial Average (DJIA).
Dow Dividend is an equally-weighted portfolio of the ten DJIA stocks with the highest dividend yield.
Dow Five is an equally-weighted portfolio of the five lowest-priced stocks in the Dow Dividend Portfolio.
Dow Four is an equally-weighted portfolio of the four highest-priced Dow Five stocks.
Foolish Four is a portfolio of the Dow Four stocks with 20 percent weight on the three highest-priced
stocks and 40 percent weight on the lowest-priced stock.
Fractured Four is the Dow Four in even years and the “penultimate profit prospect” in odd years.
Stock Strategies: Four Important Lessons
• Lesson 4: Don’t fall into the data mine
– Intra-generational
– Inter-generational
• No story/no future
• Out-of-sample testing
From: Investment Strategy Claims: Don’t Fall into the Data Mine, AAII Journal, Feb. 2000, by McQueen and Thorley
Dow 30
In-sample (73-93)
Foolish 4.0
14.8%
28.8%
Out-of-sample (July rebal.)
17.4%
Out-of-sample (52-72)
12.7%
Out-of-sample (Twins)
13.9%
Out-of-sample (since the book)
1994
3.9%
1995
37.6%
1996
26.1%
1997
22.4%
1998
16.9%
1999
15.8%
2000
18.9%
11.9%
14.9%
-6.1%
40.1%
37.3%
28.1%
17.0%
-8.0%
Opps!
Stock Strategies: Four Important Lessons
• Lesson 4: Don’t fall into the data mine
– Intra-generational
– Inter-generational
• No story/no future
• Out-of-sample testing
• Front runners
From: “Mining Fool’s Gold” by Grant McQueen and Steven Thorley, Financial Analysts Journal, Vol. 55, No. 2, pp. 61-72,
(March/April 1999).
Figure 1. Foolish Four Event Study, 1994-97
7
Cumulative Excess Return (%)
6
5
4
3
2
1
0
-15
-10
-5
0
Event Day
5
10
15
Stock Strategies: Four Important Lessons
• Lesson 4: Don’t fall into the data mine
– Question and Answer
Stock Investment Strategies for Individuals:
Four Important Lessons
• Lesson 1: Invest in stocks for the long-run
• Lesson 2: Free-ride on the market competition
• Lesson 3: Avoid the hidden price-tags of trading
• Lesson 4: Don’t fall into the data-mine
Stock Strategies: Four Important Lessons
• Final Question and Answer
Stock Market Investing for the 21st Century:
A Review and Update
• “For the love of money is the root of all evil
…” 1st Timothy 6:10
• “But before ye seek for riches, seek ye first
the kingdom of God” Jacob 2:18