Ben Graham, teacher, investment manager, author, the driving force behind creation of the CFA designation, and champion of individual investors, dominated the thoughts and practices of professional investing for decades, prior to his death in 1976. His book, Security Analysis, co-authored with David Dodd, was required reading for anyone entering the field of portfolio management. His short version of this work, The Intelligent Investor, along with Security Analysis, continues to be the investment bible for those of us who believe in value investing.
William F. “Bill” Sharpe is the STANCO 25 Professor of Finance, Emeritus at Stanford University’s Graduate School of Business. In 1990, he was awarded the Nobel Memorial Prize in Economic Sciences for his work on equilibrium pricing in capital markets. He was one of the originators of the Capital Asset Pricing Model (CAPM), developed the Sharpe Ratio for investment performance analysis, the binomial method for the valuations of options, the gradient method for asset allocation optimization, and returns-based style analysis for evaluating the style and performance of investment funds. His work has dominated the thoughts and practices of professional investing for the past three decades.
In 1956, Bill Sharpe joined the RAND Corporation, where he met Harry Markowitz. For the next few years they worked together. As Harry worked on Modern Portfolio Theory (MPT), Bill, with guidance and advice from Harry, worked on a single factor model of security prices. Within a year or two, the CAPM was born. Their work with others who believe and promote the concept of efficient markets quickly replaced Ben Graham’s Security Analysis as the preferred method of investment training in Universities across the country.
The efficient market theory is based on the idea that the financial markets are so efficient that one cannot achieve returns in excess of average market returns on a risk-adjusted basis. Because of this, it is worthless to attempt any form of security analysis. Obviously, this is in direct contrast with Ben Graham’s idea that market prices can vary substantially from the intrinsic value of a business.
All of you are aware of my belief in value investing. It just makes sense to me. Warren Buffett, Ben Graham’s most famous student has said, “[Ben Graham] also taught me to see a stock not as something with a ticker symbol that wiggles around but to think about it as part of a business. Don’t get elated because something had gone up or depressed because it went down. If I knew the facts, and it went down, I bought more of it”.
Although these two forces of investment beliefs are in constant battle, there is one common belief; Both believe that any attempt to “time the market” is not an intelligent approach to investment management.
Here are two brief excerpts from Ben Graham and Bill Sharpe’s publications. Market Fluctuation as a Guide to Investment Decisions is from the last edition of Ben Graham’s The Intelligent Investor published in 1973. In the March/April 1975 edition of the Financial Analysts Journal Bill Sharpe’s Likely Gains from Market Timing appeared.
Market Fluctuations as a Guide to Investment Decisions
We lack space here to discuss in detail the pros and cons of market forecasting. A great deal of brain power goes into this field, and undoubtedly some people can make money by being good stock-market analysts. But it is absurd to think that the general public can ever make money out of market forecasts. For who will buy when the general public, at any given signal, rushes to sell out at a profit? If you, the reader, expect to get rich over the years by following some system or leadership in market forecasting, you must be expecting to try to do what countless others are aiming at, and to be able to do it better than your numerous competitors in the market. There is no basis either in logic or in experience for assuming that any typical or average investor can anticipate market movements more successfully than the general public, of which he is himself a part.
There is one aspect of the “timing” philosophy which seems to have escaped everyone’s notice. Timing is of great psychological importance to the speculator because he wants to make his profit in a hurry. The idea of waiting a year before his stock moves up is repugnant to him. But a waiting period, as such, is of no consequence to the investor. What advantage is there to him in having his money un-invested until he receives some (presumably) trust worthy signal that the time has come to buy? He enjoys an advantage only if by waiting he succeeds in buying later at a sufficiently lower price to offset his loss of dividend income. What this means is that timing is of no real value to the investor unless it coincides with pricing--that is, unless it enables him to repurchase his shares at substantially under his previous selling price.
Likely Gains from Market Timing
The investment manager who hopes to outperform his competitors usually expects to do so either by the selection of securities within a given class or by the allocation of assets to specific classes of securities. Potentially, one of the most productive forms of the latter strategy is to hold common stocks during bull markets and cash equivalents during bear markets (“market timing”).
In a perfectly efficient market, any attempt to obtain performance superior to that of the overall “market portfolio” (taking into account both risk and return) by picking and choosing among securities would fail. Although few investment managers are ready to admit that U. S. security markets are completely efficient, there is a growing awareness that inefficiencies are few: Any divergence between the price of a security and the “intrinsic value” that would be assigned to it by well informed and highly skilled analysts is likely to be small, temporary and difficult to identify in advance. Empirical studies of the performance of the professionally managed portfolios yield results consistent with this view: Few, if any, provide better-than-average returns relative to risk year in and year out.
Some have argued that abnormal gains from selection of individual stocks or even industry groups are likely to be too small to justify the costs associated with attempts to identify and take advantage of apparent inefficiencies. Instead, it is said, the big gains are to be made by successful market timing. This approach is sufficiently popular to be recognized as one of several major “management styles”. When portfolio values shrink in extended bear markets, investors increasingly regard this style as a likely cure for their ills. Thus managers committed to timing strategies with the skill or luck to have moved to cash equivalents in the bear market of 1973-1974 were able to attract money in the latter part of 1974, while their competitors suffered both decreases in the market value of assets and often actual loss of accounts. Market efficiency implies that it should be at least as difficult to predict market turns as to identify specific securities that will perform abnormally well or poorly. Moreover, attempts to take advantage of such predictions entail non-recoverable transaction costs, and expose investment funds to larger losses when errors are made. ON the average, stocks outperform short-term money market instruments. Without superior predictive ability, one is likely to forgo return by shifting from stock to cash equivalents. But this is to state the obvious. How superior must one’s predictions be to implement a market timing style effectively?
The conclusion is fairly clear. Attempts to time the market are not likely to produce incremental returns of more than four per cent per year over the long run. Moreover, unless a manger can predict whether the market will be good or bad each year with considerable accuracy (e. g., be right at least seven times out of ten), he should probably avoid attempts to time the market altogether.
This pessimistic view will not appeal to those who feel that they can avoid the next bear market by judicious shifts of funds out of stocks and into short-term low-risk instruments. Some are now doing this, and others are actively considering it. Overall, of course, funds cannot be “shifted” beyond any changes in the market values of relevant securities outstanding. But individual investors can and do make such shifts.
It is said that the military is usually well prepared to fight the previous war. A number of investors now engaging in active market timing appear to be preparing for the previous market. Unfortunately for the military, the next war may differ from the last one. And unfortunately for investors, the next market may also differ from the last one.
Until next time,
Kendall J. Anderson, CFA
Kendall J. Anderson, CFA, Founder
Justin T. Anderson, President