Hal Varian: Sometimes the Stock Does Better Than the Investor That Buys the Stock

Think you can time the stock market's ups and downs and beat a buy and hold strategy? U.C. Berkeley economist Hal Varian says "Trying to outguess the market is a sucker’s game":

Sometimes the Stock Does Better Than the Investor That Buys the Stock, by Hal Varian, Economic Scene, NY Times: Stocks have been a great investment in the last 80 years, with an average return of about 10 percent a year. But have investors in the stock market done as well as stocks? Surprisingly, the answer is no. The average dollar invested in the stock market in those years has earned only about 8.6 percent a year.

The discrepancy between stock market return and investor return is examined by Ilia D. Dichev, a University of Michigan accounting professor, in a paper ... in ... The American Economic Review, “What Are Stock Investors’ Actual Historical Returns? Evidence From Dollar-Weighted Returns.”

To understand the difference between a stock’s return and an investor’s return, consider someone who buys 100 shares of a company at ... $10 a share. A year later, the share price is up to $20, and the investor buys 100 more shares. Alas, the investor’s luck has run out. By the end of the next year, the price has fallen back to $10 and the investor sells his 200 shares.

A buy-and-hold investor who bought at $10, held the stock for two years, and then sold at $10 would have had a zero return.

But our friend who tried to time the market did much worse: over the two years, he invested $3,000 in the stock and ended up with only $2,000. Even though the stock broke even, the investor lost money because of bad timing: most of his money was invested right before the market fell. ...

When Mr. Dichev calculates the dollar-weighted returns on this stock according to his preferred method, our hypothetical investor’s average yearly return ends up being negative 16.8 percent, far below the zero return that the buy-and-hold investor would have received. ... Mr. Dichev’s contribution is to [calculate dollar-weighted returns for] the stock market as a whole...

An investor who bought a value-weighted portfolio of stocks in the New York Stock Exchange and American Stock Exchange in 1926 and held them until 2002 would have earned an average annual return of about 10 percent. By contrast, an individual who bought in 1926 but moved his dollars in and out of the market in the same pattern as the average dollar invested in the market would have earned a return of only 8.6 percent a year.

For Nasdaq, the difference between buy-and-hold and dollar-weighted returns is even larger. ... This is true not just in the United States — the same thing occurred in 18 of 19 international markets that Mr. Dichev examined.

It appears that taken as a whole, investors just aren’t very good at market timing. But why?

There’s an old adage on Wall Street: “Buy on the rumor, sell on the news.” Unfortunately, small investors do not seem to follow this rule. Terrance Odean, a finance professor at ... Berkeley, has found that small individual investors tend to buy stocks when they are mentioned in the media: they buy on the news. The professional and institutional investors are happy to sell to retail investors in such periods.

A recent article in The Financial Analysts Journal by Thomas Arnold, John H. Earl Jr. and David S. North, all finance professors at the University of Richmond, called “Are Cover Stories Effective Contrarian Indicators?” offers an intriguing finding.

The professors look at how a company’s stock responds to a cover story in BusinessWeek, Fortune and Forbes. They find that ... the appearance of a cover story tends to signal the end of the abnormal performance. Hence, individuals who trade on such “news” are not likely to do well.

This is not to say that articles in the financial press are not worth reading. Quite the contrary. They often provide insightful reporting and in-depth analysis. But by the time the articles have been researched, written and published, they are no longer news — the market price of the stock already reflects the company’s future prospects.

Taken together, this research offers yet more support for the time-tested investment strategy of buy and hold. Anything that you think is news is old hat to the professionals. Trying to outguess the market is a sucker’s game.

Comments

[spencer]

This article does not include fees and other transactions cost that also significantly reduce the actual returns
the typical receives.

Ross Miller at
http://home.earthlink.net/~millerrisk/index.html

has done some very good work on this issue that suggest
that these costs reduce realized returns several percentage points below what the conventional wisdom
assumes.

[Lafayette]

In Europe, with the average savings rate at somewhere around 4%, twice that amount is nonetheless very attractive - even if it is only index funds. (BTW, the results of the study noted are at odds with earlier long-term gain estimates that I had seen at 12%. Perhaps this present study was done "net of cost" of transactions? And, maybe not ...)

In terms of investment strategy, that is, net worth management, putting all one's eggs into the one equity basket is perhaps folly. Not only should equity risk be spread (as index funds do), but the risk/return on all components of net worth including, obviously, one's principle residence.

[robertdfeinman]

The strange thing is that even those mutual funds which preach against the idea of timing the market engage in churning.

The fact that the evidence shows that buy and hold works better (especially for retirement funds) somehow doesn't apply to them. Every fund manager thinks they are smarter than average. Of course half of all funds do worse than average, but hope springs eternal...

[baileyman]

Add to Spencer's comment the PV of the fee stream in perpetuity. that is, if you think you're going to get maybe 6% real return on equities, but you pay 1.5% for it, you might as well give 25% of your portfolio to the management company in exchange for zero fee management.

And if you get timing advice that costs you 3% over time, you might as well give that adviser another third of your portfolio.

Personally, these seem like prices for management and advice that are too high.

[Bill Jefferys]

robertdfeinman says...

"Of course half of all funds do worse than average, but hope springs eternal..."

I had thought that it was more like 80% of funds do worse than average (where average means a broad index, buy and hold).

[anne]

Having read the Hal Varian's article and Stephen Ross' paper, I am at a loss to understand what the illustration means and I have been reading John Bogle on indexing for years and know Bogle's work cold. Hal Varian is a gem, but the point of investing is to save and invest and save and invest and more so. We buy when we have cash and find a relatively reasonable value, which means we buy through time at relatively higher and lower prices, generally holding what we buy.

Time is kind to an investor who finds value and is and can afford to be patient. Accumulate is the point, which is what Berkshire Hathaway has been doing for decades and what investors in Berkshire have been doing in turn.

What am I missing?

[anne]

John Bogle has written a number of papers showing just how poor the returns of investors have been these last 20 to 25 to 30 years, when indexing was possible as an alternative to managed mutual funds or stocking picking. Costs are a prime problem in eating up returns. Berkshire Hathaway has astonishingly low costs, by the way. Costs are a prime problem, and investors including porofessional managers have a habit of being out of the market when stocks are most valuable and in the market when stocks are least valuable.

[anne]

Indexing after Vanguard costs has returned over 12% these 30 years, but mutual funds have returned about 2.5 percentage point less or 9.5% a year while individual investors have poorly timed mutual funds in turn and done more poorly. But, remember, investing regularly looking to relative value means buying bargains now and again but fairly priced stocks often, possibly most of the time, and patiently waiting.

I do not worry about price falling in the near term when I have understood the value of an asset or when I am indexing. Even when indexing however I look to value, for there is a significant choice in indexing.

[anne]

Hal Varian is a gem, but the article is curiously confusing when using John Bogle would have made the points Varian is teaching clear.

[anne]

http://www.vanguard.com/bogle_site/bogle_lib.html

Here are the archived Speeches by John C. Bogle, when there is time I will look for an appropriate study of long term investing returns. Bogle repeatedly though runs through historical mutual fund returns comparing indexes and managed investment pools using true costs for each.

[Outside the Box]

Most people are not good at active investing. Most people are better off buying and holding a low cost index fund. The few people who are good at investing are the ones who keep the economy humming for everyone else.

[Lafayette]

anne: mutual funds have returned about 2.5 percentage point less or 9.5% a year while individual investors have poorly timed mutual funds in turn and done more poorly. But, remember, investing regularly looking to relative value means buying bargains now and again

You’ve mentioned in that statement, the nub of the matter.

One strategy is short(er)-term (buying stocks at a bargain) and the other is long(er)-term (buying index funds and just waiting), which are very different horizons.

Both are rational investment strategies, but let’s admit it, one has a risk factor altogether different from the other. Bargain seekers are taking a lot more risk, for a more immediate gain. Buying stocks on the ground-floor is always a risky venture.

It is up to each of us to understand that principle and arrange our portfolios accordingly. When you are young, assuming a more aggressively risky portfolio strategy is perhaps allowable. After all, we are in the prime of our career, supposedly earning good salaries. But, later on in life, this is decidedly not the context. Our career and therefore income are both more constrained. So, we become more conservative in our portfolio management.

Caveat emptor.

[Lafayette]

anne: What am I missing?

You may be evoking a personal belief and assuming it applies to others?

Americans have abandoned typical savings to jump into stock market investments because the returns where simply too juicy to overlook. That is a generational attitude formed in the great run-up of the nineties that climaxed in early 2000.

That mentality still prevails generally in the population. (“I want it all and I want it now! ”) This inability for “investment-wise patience” is an attribute of a country on the rush. (It is most observable from without - since from within it is difficult to tell the forest from the trees.) Why is the phenomenon observable? Good question, but the response is perhaps from the realm of the sociology rather than that of economics.

There is an analogy from the hard sciences here: called Brownian Motion.

Essentially, BM is the observation that a molecule moving faster than others is impacted more so by other molecules than the average rate of collision. Applied to the stock market, this explains its randomness in terms of outcome, particularly of those who try to “beat the market” (meaning go faster than the average over time).

[Cyrille]

I personnally add an extra strategy to that: on that I might call the "traders are hysterical sheeps" strategy.

What I'd mean by that is that reaction to a piece of news will every now and then be totally out of proportion. And therefore create quite a gap between the real value of the stock, and its traded value. The reason is simple: day to day variation is bigger that the real change in the company value anyway, and if you add to that some extra piece of news, soon you may trigger automatic orders, and after a short while everybody is trading in the same direction, purely because seing everybody doing so, the expect everybody to do so.

The return to sanity can take anything from an hour to a couple of years, so I'll never try to sell short when the price rises too fast. But I try to always have the possibility to buy something that's obviously too low (usually with the dividends from stocks I keep). So far, I haven't been too disappointed -but then I've been quite careful to only pick blatant overreactions.

[anne]

No; I have no idea what buying stocks on the ground floor means, nor could anyone else unless that means going back to 1974 or some such and having years of cash and and buying when there is no buying. The best that can be understood is where relative value may reside at any time.

No; Americans are not abandoning typical savings and jumping into the stock market. Good grief. When typical savings are bank accounts, savers are completely lost. Investing in stocks and bonds and real estate from saving is just what is needed and just what should be typical.

Saving with and investing with Vanguard has been a wonder for millions of Americans for more than 30 years.

[Lafayette]

anne: I have no idea what buying stocks on the ground floor means

I was thinking of IPOs, if they are now offered publicly and not reserved for "prime clientele" as in the past.

There is also the unofficial rumor mill. When mergers are in the offing, private detectives are hired to follow corporate executives to find if meetings are in progress and, even, the content of those meetings. This information is then brokered to an "in crowd", which sometimes makes it into the press. If hooked into this crowd, however, it is possible to exploit a "ground floor" public offering.

Thirdly, there is the "start up" crowd that go directly to the public, bypassing the VCs. These are rare, but do exist. Of course, the risk is obvious. Also, if there is ever a rumor of "mezzanine funding", meaning a company needing to bridge a period to product production, but with a product in its final stages. That too is a "ground floor" opportunity, if the company has gone public. (Which is why some barflies at Silicon Valley hot spots become such a rich crowd.)

Indeed, these are all very special cases.

[Lafayette]

otb: The few people who are good at investing are the ones who keep the economy humming for everyone else.
.

Oh, really? In an eleven trillion dollar economy, it’s investors who keep it humming?

I thought rather it was consumers. Wrong again. I must remember to send back that useless degree in economics. What a waste of time it was.

[anne]

Agreed; now I understand. There are rules for investing that should be basic for personal accounts, and as Hal Varian repeats never try to think you are a professional. Professionals may and do have all sorts of problems, but as a class never imagine you can compete with them. What can be done is work with fine professionals, absent professional fees, and that is the beauty of indexing.

[anne]

Interestingly, European stock and bond markets are less friendly to investors than American and Japanese markets are simply awful. Even Canadian and Australian markets are problematic for domestic investors.

[Outside the Box]

With respect to investing, a certain number of talented active investors are needed to allocate the loin's share of resources to the most productive enterprises. If everyone chose index funds, Joe's corner gas station would have a market value that was about the same as Exxon or GE. Joe might be a nice guy, but he probably has no idea how to productively put billions of dollars to the most efficient use. Talented active investors sell shares of Joe's station to keep its market value at about the level it is worth. Exxon can use its larger market value to raise money for large projects.

Someone has to make the product before consumers can consume, but certainly consumers are also an essential part of the process. Its certainly not fair, but some worker bees have more talent than others, and if properly motivated will organize the other bees into highly productive enterprises. Once the product has been produced, the consumers can then play their vital role.

Consider, there are lots of consumers in Darfur also, but nothing much gets produced there so consumers have nothing much to consume. The economy is very weak.

[Lafayette]

otb: a certain number of talented active investors are needed to allocate the loin's share of resources to the most productive enterprises..
.

Sorry, I can’t agree with that – not the “lions share”. Once again, it is fixation on a supposed fact that should not be supposed.

In my most humble opinion, and experience, companies make most business investment decisions for the overwhelming part of industrial products and commercial services. The media reports daily on both the failures and the successes of typical, ordinary, garden-variety types of business investment.

The media also makes a heyday out of spectacular jumps in technological innovation and even the less impressive services innovation sectors. Internet was an outgrowth, not of a business project, but a government defence project. It is only now that it has become the commercial success that had been envisioned 15 years ago.

I don’t denigrate the necessity of VCs to take on projects that businesses will not. In fact, many of these are projects “spun off” from businesses unwilling to fund them that find a response from VCs. Yes, these investors keep VC “humming”.

But, that is still a long way from the humdrum investment decisions that businesses make simply to keep in business. – and is the "lion's share" of corporate investment in any country (and dependent upon consumer demand).

[Outside the Box]

"...companies make most business investment decisions for the overwhelming part of industrial products and commercial services."

Yes, I agree. Corporate executives are certainly among the super bees that organize the other bees into productive enterprises. Investor shareholders who own the company choose the executives, and watch over the executives.

I did not mean to imply that it was only venture capitalists that organize the worker bees into productive enterprises. I meant all active investors, including shareholders of large corporations, and the executives who work for the shareholders. Executives are empowered by the investor shareholders to invest money in their name, because shareholders recognize the executives' talent at investing. The more talent that an executive shows, the more money shareholder investors trust him with (larger companies hire him).

[anne]

"With respect to investing, a certain number of talented active investors are needed to allocate the loin's share of resources to the most productive enterprises. If everyone chose index funds, Joe's corner gas station would have a market value that was about the same as Exxon or GE."

This is, of course, absurd; and really the need is to study investing a little and dispense with the metaphors that prevent learning. What investing is about is important enough to learn a little more.

[Lafayette]

otb: Investor shareholders who own the company choose the executives, and watch over the executives..

Surely, you jest. Nothing of the sort happens.

A group of corporate Board Members, in fact a select club of people, decide which executive to chose from a comparatively small pool. With a bit of trickery, one can even stuff the board with company staff as directors – leaving (supposed objective) outside directors in a minority.

All this is cronyism and though it is not common, when cronyism gets aberrant, chaos like Exxon happens. There is little or no shareholder oversight, if not by Board Members.

Shareholders are distant indirect players. Though they have property rights in the company, there is no effective mechanism (except for the annual stockholders meeting) for them to express their opinion, either combined or individual. They are literally voiceless in running the company.

It will take an interpretation of present property law to change that sad fact – by giving shareholders a place on the Board to enjoy oversight of company operations. And, in capitalist America as we know it today, that just ain’t gonna happin.

Corporate governance is still in the stone age.

[Fábio List]

I would like to stress two points. I have tried to reach the -16.8 percent figure reported by Professor Hal Varian, but the IRR of the investment discussed aumounts to -26.8 percent. I suppose there is a typo.

Transactions in the stockmarket make a pressure over prices. A buying market implies higher prices; a selling market generates lower prices. Would it be possible the dollar-weighted returns be higher than the buy-and-hold ones? I don't think so. Therefore the difference between the 10 and 8.6 percent reported by Professor Dichev for NYSE amounts to an average transaction cost associated with the participation on the stockmarket.

[Outside the Box]

"Shareholders are distant indirect players."

In the case of small shareholders, this is certainly true. Only major shareholders have direct access to the executives' ears. Small shareholders can mostly only vote with their feet in between board elections. If a CEO adopts a shareholder unfriendly policy, small shareholders flee, and the value of the CEO's stock options go down along with the company stock price. The CEO is mostly disciplined by being a fellow owner of the company, and thus having his interests aligned with the small shareholder. A situation most boards are careful to implement.

Small shareholders can get issues on the company ballot by convincing enough other shareholders that a policy change makes sense, but this is rare. Small shareholders can collectively elect the board of directors, which has hiring/firing power over executives. Small shareholders rarely bother making changes, as long as the company is running smoothly. This motivates the CEO to keep things running smoothly. His job is pretty secure as long as it does.

Large shareholders can more directly affect policy. Board members and executives take their phone calls. Since large shareholders are generally more adept at investing, this system generally means that the most able individuals make the most decisions.

Certainly not a perfect system.

[anne]

The paper by Ilia D. Dichev is not looking to investment-transaction costs, only to the effects of timing. Timing has always tened to mean that investors are underinvested when stocks are cheap and overinvested when stocks are expensive. So, in 1980, when stocks were absurdly cheap, even professional investors were markedly underinvested. In 2000, professionals were overinvested.

Looking at dollar weighted returns, cuts returns from by and hold indexing markedly. But, in addition, investment costs for actively managed accounts further cuts returns. Again, in addition, there is a further cost and that is taxes. The more timing, the relatively higher the tax bill. Mutual fund managers turnover holdings on average in about 12 months, which is not even remotely long term or tax friendly.

[anne]

Having read the Hal Varian's article and Stephen Ross' paper, should be "Having read the Hal Varian's article and Ilia D. Dichev's paper." Stephen Ross is the name of the Business School, and I am easily muddled it seems at least in the morning.

Ilia D. Dichev's study is clearer to me on another reading. The point is simply and importantly to show that market timers as a class repeatedly miss the time to buy and the time to sell, and harshly underperform the market as a result even without looking to transactions costs and taxes. Timing is not for individuals, and seldom for teams of professionals.

Though I much appreaciate Hal Varian's column, the example used is just not nearly clear enough.

[anne]

As for shareholder influence, the potential for large shareholders, almost always institutional shareholders, to be influential is generally there, but there has been a progressive separation of traditional interests of owners and managers over the last 25 years with institutional owners increasingly interested in the near term and managers echoing.

The example that I think so unclear begins, "To understand the difference between a stock’s return and an investor’s return, consider someone who buys 100 shares of a company at ... $10 a share." The point is dollar-weighted investment studies show that market timers simply are in and out of the market at the wrong times.

Sorry to have been confusing in turn....

[Fábio List]

Anne, thanks for your remarks. By "transaction costs" I was not refering to the fees associated with the transaction, but to a broad economic cost, related to the difficulty of buying or selling the stock.

[Lafayette]

otb: The CEO is mostly disciplined by being a fellow owner of the company, and thus having his interests aligned with the small shareholder.

This is hardly the notion of corporate governance that stopped an Enron from its desultory deeds. Or, any other of the notable cases of corporate fraud over the past few years.

Nor will this sort of VERY indirect pressure stop any CEO from doing precisely what he can convince the BoD is right. Which is why, I maintain, it is crucial that employees become shareholders (through either discounted stocks or incentive stock-option programs) AND as "owner-staff", they obtain the privilege of corporate oversight by sitting on the Board.

That would be a great stride forward in terms of corporate governance.

What you suggest is far too incidental to have any real impact.

[anne]

Fabio List makes an important point that was especially true in the 1970s and earlier. Fortunately, Fabio repeated the point so that I understand. Simply trying to buy and sell stocks and bonds can change the price of the security. This was early on most noticeable for smaller stocks and is most noticed lately in the selling of bonds.

Looking at historical studies of potential stock returns before indexing begins in 1976, always involves transaction cost distortion.

I know of no way an individual with any size account can put together a safe liquid bond portfolio at lower cost including transaction fees than Vanguard can for the investor.

[anne]

Fabio, I will finally find out how to set an accent over a letter today so I can correctly write a name: Fábio.

[John Thacker]

While there are all sorts of reasons to have index funds and not time the market, it has nothing to do with the study cited. The point of the paper is absolutely not:

to show that market timers as a class repeatedly miss the time to buy and the time to sell, and harshly underperform the market as a result even without looking to transactions costs and taxes.

Intuitively, that doesn't make sense. For every buyer in the secondary market, there is a seller. Those effects, absent transaction costs and taxes, cancel each other out and must have the same overall return.

Hal Varian misread Ilia Dichev's study. The study is about how measuring the buy-and-hold return is different from the dollar-cost averaging return because of capital entering and exiting the market, specifically the problems of follow-on public offerings, stock buybacks, and the exercise of options, all of which change the number of outstanding shares.

Consider company X. At one point the stock is at $10. Then it rises to $20. At $20, the company wishes to raise more capital and has a follow-on offering. After a while, the stock price then declines to $5. Wishing to raise the stock price, the company has a stock buyback. Later, the price then returns to $10.

Someone who bought and held the stock at the beginning has a 0% return. However, the company issued additional stock when it was $20, and then the stock declined. Then when the stock was at $5, the amount of outstanding shares (and the dollars in the stock) decreased. More dollars and more investors saw the decline from $20 to $5, and fewer dollars (and fewer investors) saw the rise from $5 to $10. Dollar-averaged, investors or the market as a whole lost money, even though the buy-and-hold return was 0%.

Buy-and-hold analysis ignores the capital that is transferred back and forth from the stock market and the company through new issues, buybacks, and the exercise of options. Since companies tend, overall, to make new issues when the price is relatively high, to buyback when the price is relatively low, and options are exercised (particularly by insiders) when the price is relatively high, these all combine to reduce dollar-averaged return compared to the buy-and-hold return.

It's no wonder that he found that the NASDAQ saw the greatest disparity, since he measured during the tech bubble when many of the NASDAQ companies were issuing lots of stock to raise capital, doing buybacks, and issuing options that were excercised.

[Lafayette]

anne: but there has been a progressive separation of traditional interests of owners and managers over the last 25 years with institutional owners increasingly interested in the near term and managers echoing.

Of course, because institutional “owners” have a massive "vested interest", by means of their shareholdings, in the company. The ordinary shareholder, as an individual, does not have, obviously, the same weight to throw around. Unless, of course, the employees became stock holders and therefore “owners”.

Let’s not miss the point: Under property law, ownership gives one certain privileges. Which need to exercise them, or they are useless. How? Pooling them, for instance, as employees of the company would.

Corporate governance, constrained to strictly the BoD, will be manipulated by either the CEO, particularly if the CEO has managed to stuff the BoD with internal directors. Have a member of the BoD elected by the employee-owners, and watch the shift in political weight on the BoD.

Pass a law officiating an employee-owner’s representation on the BoD, and we’ll see a lot less connivance/cronyism at the BoD level. The whistle-blower must be placed where they have oversight, or the whistle is useless.

Link the Employee representative on the BoD to institutional investors, which might well indeed happen, and relative political weights on the BoD will change considerably. If there is no oversight into operational accounts, one cannot understand what is happening in a company. And, there is no provable reason to blow whistles.

After all, shouldn't the BoD represent the interests of the owners? Are Board members owners? Yes, in token amounts - which means their voting weight on the BoD is HIGHLY disproportional to their ownership weight.

Goodness, we are talking about "publicly held" companies that act as if ownership was effectively concentrated in the hands of only a comparatively small number of people.

There cannot be real corporate governance without the matter of "ownership" being considered as a fundamental principle. For the moment, most stock holders are fixated on P/E ratios, which is why Corporate Managers are also fixated on P/E ratios. All other considerations, and particularly those of ethics, are subordinate.

[Outside the Box]

I agree that the laws governing corporations could be improved upon. However, employees would not have sufficient diversification of their investment portfolios if a substantial percentage of their net worth was held in the form of the company stock. Some financial advisers go so far as to advise people to own no stock at all in the place they work. Employees are already risking their salary/pension/health care if the company falls on hard times. They don't need to risk losing their portfolio at the same time. Better for employees to buy stocks in industries with business cycles different from the industry where they work.

It is an interesting idea, but I am not aware of any evidence that employee owned companies perform substantially better than publicly owned companies. To the contrary, employees tend to vote themselves out sized raises and easy jobs, which makes the company uncompetitive. The employee owned companies that do best tend to hire outside managers who have the authority to make impartial business decisions.

Consider how CEOs pressure boards to give them salaries that are much higher than CEOs in most other countries. If all employees did that, the company would have no hope of competing on the international market. It is bad enough that CEO pay is a drag on performance. Congressman Barney Frank is trying to put CEO pay on the shareholder ballot, so shareholders can decide CEO pay more directly.

[anne]

The significance of market studies showing returns by weighted dollars in the market, is that investors have been underweighted in stocks when prices were relatively low and overweighted when prices were high. When the S&P index could be bought at a price-earning ratio below 10, for years between 1976 and 1982, professional and household investors were avoiding stocks. Investors were overweighted in stocks, especially the most expensive stocks, when the S&P price earning ratio was 20 and 25 and 30.

[anne]

Ilia D. Dichev's example is the problem, whether for Hal Varian or for me. Possibly the whole point of the example is to show what company dilution of share values means for stock prices in time and for investors who buy shares continually as dilution occurs through additional stock issuance to raise money for whatever company purpose or option grants.

[anne]

John Thacker may have read the paper properly, with the lesson supposed to be learned being dilution of share value when it occurs harms investors who have bought a stock as the stock has risen in price. Absolutely; which is why a company that is fairly managed will not dilute its stock. Warren Buffett has complained of stock dilution for many years. Berkshire Hathaway issues no options and rarely issues stock for company purchases, rather buying with cash to protect share value.

Thank you, John Thacker.

[anne]

John Thacker is right....

What Hal Varian has done is read a paper noting the problem with stock dilution as a paper showing the benefits of a buy and hold investment strategy. No wonder the example used initially was so confusing. The arguments Varian wished to make were to show the benefits of long term investing, and I would add indexing since most investors will have no idea when stock dilution has taken place so buy the whole or a large portion of the market.

[Hal Varian]

Fabio List is quite right that there is a typo in the Times article --- the return should be -26.8%, not -16.8%.

John Thatcher is also correct that the Dichev article is about net flows between corporations and individuals. Companies tend to issue stock when the price is high and buy it back when the price is low --- they buy low and sell high. The individuals who take the other side of these transactions therefore buy high and sell low, on average, so they don't do as well as they would do with a buy-and-hold strategy.

If you combine this observation with the other two observations cited in the column---that individuals tend to buy on what they perceive as news, but that the news tends to be outdated---I think that you reach the conclusion stated in the paper: a small investor who is attempting to time the market is sacrificing returns.

That doesn't mean all timing is futile, since (on average) the corporate side gets it right. But of course there isn't much point in a small investor imitating the corporate side as they can do just as well if they buy and hold.

[anne]

Hal Varian:

"That doesn't mean all timing is futile, since (on average) the corporate side gets it right."

Agreed; but the corporate side in buying or selling stock, is actually changing the relative value of the stock and should be right. When stock is used for corporate purchases, managers are telling us the stock is allowing for a less expensive purchase than cash that can be used for other investments is.

Thank you, Hal Varian.

[anne]

Also, Hal Varian claims the corporate side gets timing right on average, which is important to notice. But, if the corporate side gets timing right, why do investment funds managers so readily get timing wrong? Investment fund managers have been getting timing wrong on average, according to John Bogle, for decades. I have no answer to the observation.

[anne]

http://delong.typepad.com/sdj/2007/05/index_index_ind.html

May 7, 2007

Index, Index, Index
Edited by Brad DeLong

Warren Buffett recommends index funds:

INVESTMENT INTELLIGENCER: Warren Buffett: Buy Low-Cost Index Funds: The Oracle delivered some secrets of intelligent investing in a press conference following the Berkshire Hathaway annual investor meeting:

Buy low-cost index funds, which will outperform the majority of other investors (the vast majority).

Avoid hedge funds.

Buffett also said he hoped that Berkshire would outperform the S&P by a couple of percentage points (which wouldn't be surprising, given the value effect). He added that he would be "amazed" if Berkshire did any better than that.

[anne]

The index fund advantages; fair-low management cost, low turnover and low turnover cost, minimal tax consequences of turnover, being fully invested always so there is no market timing, simple diversity. The advantages are worth 2.5 or more percentage points of annual return or an easy return advantage 20% to 25%.