Financial Fibs

IntroductionHow To Think About Investing

Like many investors, I spent years trying to work out the best way to buy and sell stocks. Each time I read a book I decided that I should use the method described whether it was technical analysis, fundamental analysis, quantitative analysis. Should I be a long-term investor like the finance industry recommends or should I be a trader with a shorter term focus? Should I be a momentum or mean reversion investor? Should I be a growth or value investor? Perhaps some combination of the two?

I spent a few years doing a Master of Finance learning what is called the Efficient Market Theory. This is the dominant theory when it comes to money management. And it is nonsense, full of unrealistic assumptions. But one thing it does do is generate an enormous amount of fees for the finance industry.

So, after 25 years in markets having read hundreds of books, thousands of articles and academic papers, bought and sold individual stocks and Exchange Traded Funds (ETFs) and having had fund managers manage some of my money, I eventually worked out 99% of what passes as investment theory and advice is nonsense.

Here is what else I learnt:

• I learnt the finance industry is full of people who mostly do not care one iota about making you money. It is about making them money and the rest is nonsense.
• I learnt the finance industry promotes an investment theory which is nonsense.
• I learnt most finance types are failures when it comes to total returns.
• I learnt average returns are nonsense.
• I learnt time in the market is nonsense.
• I learnt the way the investment industry think about compounding is nonsense.
• I learnt the stock market and economic growth are not correlated and talking about them as if they are is nonsense.
• I learnt having to hold individual stocks for the long term was nonsense.
• And after all that, I finally learnt investing is easy.

Investing is about the change in the price of an asset over time. Whether it is over the short term, the medium term or the long term or whether it is about stocks, property, bonds, vintage stamps or cars, the key question is how you take advantage of that change (what markets call volatility) over time.

There are literally hundreds of ways to make money in the stock market. I understand most of us do not want to dwell on what we believe are the negatives especially when it comes to money, however, the obsession with always focusing on the upbeat and positive is nonsense.

It took time for me to understand that when it comes to investing, it is best to focus on not losing money rather than making money.

My own motto is: making money is easy, losing money is even easier.

So let me tell you what not to do and how to detect financial nonsense when presented to you. When it comes to investing, I promise you will learn more from what not to do than what to do. For insights on what to do you can look at my first book Low Rates High Returns or listen to the podcast of the same name or my most recent podcast Total Money Management.

My experience with mentoring people to manage their own money is a need to first understand how markets work which then allows them to grasp the reasons why certain investment strategies are more successful than others. The simple mathematics of market fluctuations shows you why you should focus on not losing rather than trying to make money. Especially when it comes to the long term.

There are plenty of investment books out there, but most, if not all, focus on making money. The unique aspect of this book and what I teach is a focus on how to avoid losing money. And paradoxically, if you understand that one simple point you will end up with more money.

The aim of this book is simple: to provide you with a framework in how to think about investing and markets and help you take charge of your investment journey.

It hardly needs to be said, but this book is not exactly what the finance industry wants. The finance industry is always on about where the opportunities are to make money, in bonds, in stocks, in residential or commercial property, in cryptocurrencies or new themes such as Environmental, Social and Governance (ESG), artificial intelligence, or alternative investments. All these ideas are designed with the primary aim of generating income and fees for the industry. Delivering you investment returns is a fairly low priority.

Following is a discussion about the three major themes, time, theory and incentives, which I believe every investor needs to understand for investing.

However, it is not all doom and gloom and in that vein, I have included a final chapter which gives you a simple way of looking at investments as they arise to determine whether there is an opportunity to generate solid and safe investment returns over the long term.

Theme OneTime

“In the long run we are all dead.”John Maynard Keynes

One of the major financial fibs is the way the finance industry seeks to have us invest for the long term. According to the finance industry, you can maximise wealth by maintaining a long-term focus, regardless of how it is defined, and use the wonders of compounding.

I want to show you how understanding time, and especially stock market time, in a unique way can deliver better returns over the long term.

One of the key points is valuation. You will hear fund managers discuss company valuations all the time, but seldom do they discuss market valuation. However, a simple glance at a long-term chart demonstrates there are good and bad times to invest and markets offer high or low returns at different points in time. The central question is: does timing your investments offer higher long-term returns?

Let me show you why time, more specifically timing, is critical to investment returns. But let me first ask you a simple question: do you want to compound your investments at 10% or 2%? Here is a chart of rolling 10 year returns of the S&P 500 in the United States.

You can clearly see the variation in returns depending on the starting point. Starting in 1920 or thereabouts and ending in 1929, you get high double-digit returns (19.97%). However more recently, starting in 2000 and ending 2010, you receive negative returns (-5.93%). That is per year on average and with dividends reinvested!

The question is, can you select those periods where future 10-year returns will be high and avoid those periods where returns are low or even negative? The answer is yes, you can. And this can be achieved by a simple valuation metric called the cyclically adjusted price earnings ratio, or CAPE for short.

We will discuss CAPE in more detail later, but for now the simple point is when CAPE is high, future returns are low and vice versa.

Waiting patiently for a low valuation in relation to future earnings is the approach used by the likes of Warren Buffett and I think you would agree that he has done a fairly good job of compounding over an extended period of time.

Securing the 19% returns comes from waiting until the market offers attractive long-term returns, i.e. timing the market. And here is the rub. It is not about timing, but valuation. If you wait for the good times, where the compounding rate is high, then it takes less time to reach your financial goal.

So now you have an answer of how to generate 10% rather than 2% compounding. Wait for the fat pitch. But according to the industry, you have to stay invested all the time to benefit from compounding over the long term. Sitting in cash is not what the industry wants because they cannot charge fees. It is as simple as that.

The chart demonstrates an amazingly simple point: timing of investments is critical to returns. Simply investing when markets are highly valued leads to lower future returns.

The Rule of 72

Compound returns are calculated by the rate of return and the time for which you hold the investment.

If you divide 72 by the compound rate of interest you get the time aspect. Let us aim to double an initial investment of $10,000. Compounding at 14.4% per year means your initial amount, $10,000, becomes $20,000 over 5 years, which is the time aspect (72/14.4). The return aspect can be calculated simply as 72/5, which means you need 14.4% for 5 years to double your money.

Compound at 7.2% (half of 14.4%) and you double the time required to double your money. So 72/7.2 equals 10 years.

Compound at 3.6% and you take 20 years to double. At 1.8%, it takes 40 years to double the initial investment.

The industry says you need to start investing as soon as possible because compounding works over the long term. But this is not correct.

The rate at which you compound is the key, not the time, and that means waiting for the right time.

Timing matters. Big time.

Theme TwoTheory

“The study of money, above all other fields in economics, is one in which complexity is used to disguise truth, or to evade truth, not to reveal it.”John Kenneth Galbraith

Finance, like many endeavours, requires a theory upon which to understand the object it seeks to explain. Any theory should aim to be a close approximation and explanation of reality, close enough to be useful, easy to understand, widely agreed upon, and useful as a model to guide experts in the field.

The Efficient Market Theory (also called the Efficient Market Hypothesis) is widely used and taught in the finance sector as the model for understanding markets and stock prices.

By way of short background, the Efficient Market Theory (EMT) came to life around 1960 and today remains the bedrock of investment theory. Briefly, it assumes all investors are rational and at any point in time stock prices contain all information, so there is no opportunity for any individual investor to generate excess returns. Investors all have the same information at the same time and so no-one is any smarter than anybody else. I think most people would agree that to assume there is no advantage in studying stocks or history is, to put it bluntly, ridiculous.

I find it rather difficult to believe that in a contest between you or me and Warren Buffett, each of us has all the necessary information and Buffett’s 70 years of experience gives him no advantage. Buffett himself said that teaching people a theory where information is of no use was a wonderful advantage to him.

Assuming all investors are rational and understand their own risk tolerance is simply foolhardy. All asset class bubbles involve irrational buying and speculating by people who do not have any experience in stock markets. As Seth Klarman said, “The stock market is the story of cycles and of the human behaviour that is responsible for overreactions in both directions.”

From an industry perspective, using the EMT delivers a number of benefits. There is the benefit of using a specialised language. In other words, they can baffle you with nonsense.

It gives them a sense of credibility. You would be reluctant to hand over your money to someone who professed that no specialist knowledge was needed for investment success, nor was there a need for a theory.

An air of complexity, using charts and graphs and complex maths, leads to the belief that finance people are very smart when in fact, based on their investment returns, the outcome for investors is miserable.

EMT allows the industry to avoid nuance and deliver certainty, the oft repeated 8-10% average annual returns over the long term, but as I showed earlier this is far from the truth. According to the industry, you cannot beat the market, so just keep putting your money in the market regardless of conditions over different time periods.

The EMT is used widely across the industry, and this allows them to justify high fees. And convincing investors to hold for the long term is the best way to capture ongoing fees.

Promoting the same theory as all other finance folks affords a high degree of safety in terms of career risk. So market crashes result in collective absolution where finance professionals simply point to everyone else as proof that it was not their fault. As John Maynard Keynes said, it is better to fail conventionally than to succeed unconventionally.

Given the way the theory views risk, most investors are lumped together according to their age, risk profile and tolerance, resulting in fairly simple asset allocation strategies where most people’s portfolios look very similar. Because they are buying and selling mostly the same stocks, the results cannot be that different from the crowd, and so if most play it safe, for example by buying the overall index, then there is little chance of outperformance.

The EMT is not a complete failure, but it is seriously questionable when stating that it is the best approach for long term returns.

This would be acceptable if the average returns were sufficient for clients and the fees paid were an acceptable cost for the skill and effort that experts put towards managing your money.

Theme ThreeIncentives

“Show me the incentive and I will show you the outcome.”Charlie Munger

Trust lies at the heart of all economic relationships because without it there would be considerably fewer transactions and a lot more chaos. If relationships are to be beneficial for both parties, there needs to be a high degree of trust.

The person you entrust your money to must be trustworthy, honest, truthful and, most importantly, acting in your best interest.

The finance industry has a difficult job in managing people’s money. Like many industries, it is difficult to explain the finer details of investing or an investment strategy because so much relies on what cannot be predicted with a great degree of certainty.

The first two themes, time and theory, lead to a structure that heavily incentivises the finance sector to maximise their own gains at the expense of the client’s investment returns. I am not saying that this has been established on purpose, although there appears an element of that, but there are some serious asymmetries in the relationship.

The way the industry thinks about time and theory means that investment returns are, over the long term, extremely disappointing. And this is compounded by the incentives structure.

When it comes to judging the finance industry by their long-term returns, you could be forgiven for thinking their performance is not commensurate with the fees paid. If you receive roughly the same returns as everyone else, it is hard to see any underperformance because the underperformance is so widespread!

With fees generated on a percentage basis, not a flat fee basis, there is an overwhelming incentive to encourage investors to remain fully allocated regardless of current conditions and aim at the long term.

When markets rise, the industry collects higher fees but does not do extra work. When markets are rising, the industry can encourage you to stay fully committed, which raises their fees. However, we know from market history that markets do not rise forever, and so you should, perversely, be slowly reducing your exposure since the risk of losses is higher. And when markets fall, the industry collects fees and, using the old “no-one saw it coming,” can absolve themselves of responsibility. There is very little skin in the game, and it results in a situation where heads they win, tails you lose.

It is worth reading Alan Kohler on this, in his piece on how the great investment fee scam hides in plain sight, and how it quietly costs all of us.

A negative event can be a serious decline in any one or two-year period, for example in US markets from 2000 to 2003 or the Global Financial Crisis in 2007-2008, where on both occasions markets fell approximately 50%. Australia is thankfully a little less volatile, but we do suffer from periodic large drawdowns (a cute word meaning losses).

There are also secular (long term) bear markets where stock and property markets are expensive in valuation terms and spend an extended period of time, say 10 to 20 years, basically treading water. There are quite often decades where investment returns are very low. In Australia, the stock market index essentially went nowhere for years from its 2007 peak. Not exactly a great promotion for buy and hold long term investing. And all the while you are paying fees.

If you don’t hold any financial expertise or knowledge, then you simply have to accept and believe what the finance industry tells you, unless you choose to do lots of research yourself.

In finance, the incentives for the individuals, and the industry as a whole, matter.

Financial FibMarkets Require Experts

The finance industry generates large fees from the illusion that investing is hard and requires expertise. The first thing to understand is investing does not require any special expertise. As Warren Buffett says, you don’t need a high IQ to invest money.

A stock market, and most other markets, can do one of three things. It can move up, or down, or nowhere. In addition to this, we know markets generally rise over time, so we can afford to be broadly optimistic about succeeding over the long term.

Because we rely on the finance industry as experts to manage money and tell us about investing, we assume the knowledge they hold is correct. The underlying assumption is that through formal study and government accreditation, a financial adviser or fund manager retains a skill which can lead to better returns. Paying fees is the price of expertise, which in turn should deliver higher returns. However, we know this is not true.

The question is: why should I pay for skill when it is not present?

If you look at returns over a full market cycle, you will see that most fund managers fail to even track the index return once you account for fees, taxes and charges.

When the market is rising and our portfolio performs like the market, we tend to go along for the ride, but it is when the market falls that problems occur. When the market falls a lot, the industry trots out the old standard, “no-one could have seen it coming.”

If they cannot see it coming, then the question is: what if that knowledge is wrong?

One of the most pervasive financial fibs is that in order to succeed in investing in stock, property or any asset market, you need a high skill level. If you don’t possess the right skills, then you will most likely fail. If you do not possess these skills, then you should not attempt to manage your own money, but hand it on to someone who has the necessary skills.

If I say skill, I mean it in the sense that experts are skilled, and therefore they will deliver greater success in stock markets than you can do alone, without skill.

When it comes to investing there are lots of charts, graphs, complicated looking mathematics and specialist language, and if you cannot grasp all this, then it certainly appears easier to hand over your money to an expert to do the hard bit for you.

There is no doubt some skill is necessary when it comes to investing, but the important questions are: what level of skill, and secondly, is there a connection between skills and success?

Firstly, it is important to realise that skill is based on a correct understanding of how finance and markets operate. The assumption in finance is that skills developed from understanding the EMT lead to success and maximise investing returns for clients. If you are using the wrong theory, one that is not an accurate reflection of reality, then skills in this case degrade knowledge and actually lead to lower returns.

Even if you are skilled, or an expert with government approved training, the results show that experts add little, if any, value to a portfolio’s performance over the long term.

One thing most of us find offensive is the idea our investment success is more luck than skill. Yes, we admit that some luck was involved, but when it comes to our own success, we all believe it was more skill than luck.

When it comes to investing, genuine skill should be demonstrated and rewarded over time.

Most success comes from recognising that an asset class is really cheap. In other words, we can buy $1 for, say, 80 cents.

According to a simple metric, the Cyclically Adjusted Price Earnings (CAPE) ratio, the US stock market was extremely cheap in the late 1970s and early 1980s. Inflation, along with interest rates, started their long multi-year decline, allowing assets to increase in value. The ensuing 1982-2000 bull market in the United States S&P 500 produced an annual compound return of around 16%.

Basically, even if you had no skill, you would have done extremely well by simply being in the right place at the right time and buying a simple index fund (not available at the time) using a simple indicator such as CAPE.

And to demonstrate the value of timing and simple tools like the CAPE ratio, from 2000 (when the CAPE was 44) to 2003, investors, after the spectacular bull market, saw a fall of 50%. There was a 100% return over the following four years from 2003 to 2007 and again, when the CAPE was 27, another 50% fall from 2007 to 2009 in what we now call the Global Financial Crisis.

I have discussed the benefits of using something as simple as the CAPE ratio for your asset allocation, so I won’t repeat myself, suffice to say that we know markets cycle, and while you may not be able to pinpoint the exact moment the market starts its long decline or rise, the CAPE can show that the market, like history, rhymes. There is also no need to get in at the exact bottom or sell at the exact top (as the industry is desperate to point out) because we do not invest that way. Investing is not an all or nothing proposition. We can choose when, where and how much to invest, and knowing even this basic fact, we can see the mainstream method favours the industry rather than the client.

So the question you have to ask is: what skill are you exactly paying for, if when the market rises your portfolio does, and when it falls your portfolio falls too?

If you look at market cycles, it is clear that markets can be cheap or expensive, or somewhere in between.

But managers are not there to deliver you great returns, they are there to collect fees and feed their lifestyles. That is why the aim is for increasing funds under management. As Warren Buffett has said, the larger you are, the less you should expect superior returns.

So, Do We Need Experts?

We accept in most fields a need for specialised knowledge and qualifications. But like many industries where the incentive is to make simple things opaque, investment types use a special language in order to muddy what is really quite simple.

In thinking about fund managers, the belief is their expertise will produce a return on your investment sufficient to deliver your wealth goals. Many people fall short of their goal because the expertise and fees eat into their long-term returns.

The finance industry sells the ability to deliver better than expected returns over the long term due to their expertise. Results show this is expertise not worth paying for, because so few outperform the index over time. They deliver below average returns for a fee, which in itself reduces an investor’s long term returns.

Financial FibThe Stock Market Is the Economy

Humans are always trying to make links between two or more variables because this is how we make sense of separate things or events. We link them and this allows us to make sense of events.

When it comes to investing, it would seem obvious there is a strong relationship, or what is called correlation, between economic growth and the stock market. Not a day goes by without discussion of the daily economic events and the impact those events apparently had on the daily rise or fall of the stock market. After all, companies involved in the production and consumption of goods and services are listed on stock markets, so there should be a connection between the performance of the economy and that of the publicly listed companies.

It is easy to assume that A is linked to B and so there is a correlation. If the economy is strong, then the stock market should also be strong, and if the stock market is doing well, then you should get higher returns. Sounds logical, right? So we say there is a correlation.

It may or may not surprise you that stock market returns are not correlated to economic growth but are strongly correlated to valuation.

Investors are looking for stock market returns and naturally equate its performance to that of the economy. I will not go too deep because we have sufficient evidence to show there is little relationship between stock market returns and economic growth (measured by Gross Domestic Product, or GDP). The correlation between the stock market and the economy is actually fairly weak.

The graphic shows US stock market returns in any one year and GDP growth rates, which is used as a proxy for the economy. It will come as a surprise to many that 33 years out of ninety-two, nearly 30% of the time, the stock market returns and the economy don’t see eye to eye. Throughout history the economy sometimes goes one way and stock market returns the other.

Look at 2000-2002, or 2020 when Covid took hold. In 2020, the US economy, or GDP, declined 2.8%, whereas the S&P 500 index returned 18%. While the economy was shrinking, investors appeared to ignore or discount all information to send stocks higher.

Some could argue that annual changes are irrelevant, and that it is the long term that counts. Does taking a longer-term view show a link between market returns and the economy? Nope.

A 2005 study by Professor Jay Ritter from the University of Florida looked at country returns over a 100-year period and showed there was actually a slight negative correlation between stocks and economic growth. Ritter shows that, at the country level, there is little evidence of a link between economic growth and stock market returns. A recent example is China.

China entered the MSCI index in 1993 and its economic growth rate has been spectacular. China’s gross domestic product grew by 3400%, however the China index has returned approximately 35% including dividends!

In fact, an investor would do better than average by taking a contrarian approach, one where they move more funds into the stock market when the economy is struggling, for example during a recession, and reduce their allocation when the economy is booming.

But when markets crash, the finance sector warns of further calamity and sells down their portfolios. How else can the stock market fall by a large amount unless fund managers sell down their holdings? So much for the idea that buy and hold through thick and thin is the way to long term results.

Investing is about laying out money now to receive more in the future. There is no doubt taking a long-term perspective can be helpful, but most investor decisions about buying and selling stocks are influenced by current economic data reported by the media, interpreted by the finance sector and economists, who then make predictions based on the most recent data projected into the future.

When economic growth rises, investors tend to believe this is good for future stock prices. Through the market cycle, more people buy hot sectors or countries, which leads to investors overpaying for the promise of better future returns. Valuation, which does have a correlation with stock market returns, is largely ignored by the economists, the financial media and the government of the day. Spurred on by the finance sector’s discussion of the economy and the media’s constant chatter of rising stock prices, investors tend to bid up prices beyond what can be calculated as reasonable, based on the belief that rosy conditions will continue and higher returns are in store. In valuation terms, this is paying $1.50 for $1 because you believe it will be worth more than $1.50 in the future.

However, from a valuation (and rational) perspective, a rising market results in stocks becoming progressively more expensive in relation to their value, which leads to lower future long-term returns. A falling market, on the other hand, raises the yield and results in cheaper stocks and above average returns over the longer term.

Stock returns have less to do with economic growth and so-called rational analysis. Valuation metrics, which have a stronger correlation with stock market returns than economic growth rates, are largely ignored.

The reality is that it is often better buying stocks when the country is out of favour for whatever reason. A 2014 study called Dogs of the World showed that buying the worst performing stock markets delivers better than average results and, in many cases, regardless of economic growth rates.

We know that over time most national economies grow. There is nothing controversial about that. However, what is probably controversial is the idea that the stock market and the economy are not connected. While this seems counterintuitive, the evidence suggests that if you use simple valuation metrics and ignore the daily chatter from the economists and financial media, you will most likely enjoy superior returns over the long term.

After all, when you look at the long term returns of investors who do listen to the mainstream economists and media, and allow financial advisers to manage their portfolios, you can see the results are less than impressive. You can largely ignore the daily chatter, what we call the noise, surrounding the economy.

Simple metrics like valuation, on both a macro and micro level, will deliver better investment outcomes than economic data.

While the mainstream economists and finance sector believe there is a correlation between the state of the economy and stock market returns, the truth is there is no such link. There is an alternative explanation, however, which revolves around valuation, as discussed by Warren Buffett and Professor Ritter.

Financial FibIt’s Time In the Market, Not Market Timing

This one is probably the industry’s favourite statement: it’s time in the market, not timing the market.

They show a range of carefully selected charts with the aim of convincing you that you cannot time the market. The underlying assumption is that in order to build wealth, you must allow time and compounding to do their work.

This is simply nonsense.

This line of thinking leads to a logical conclusion that price does not matter. Why? Just buy, because over time you are compounding and time works. That is not entirely true, however, and even if it were, what about the level of returns, and can we see a better alternative?

As I discussed earlier, your returns largely depend on when, i.e. timing, you buy, because valuation is important. As above, compounding at 10% doubles your money in 7.2 years. Compounding at 2% takes 36 years, and the longer you compound at the higher rate the more your returns will outstrip those compounding at lower rates. But you must allow for volatility.

So you can be quite comfortable holding cash, à la Warren Buffett, waiting for a good rate at which you want to compound your money.

But of course, the more cash you hold, the less fees can be charged by the finance sector. So they preach time in the market even though there is lots of evidence that this is a certain way to deliver low returns. Remember, regardless of the ups and downs, the industry collects fees, and to maximise fees they encourage and promote the idea that valuation doesn’t matter.

Let’s have a look at an industry favourite: the ten best days myth.

This is the belief that if you miss the ten best days in the stock market, your returns are terrible. First of all, they are asking you to believe that we can know when these days are, and that if you stay out of the market then you miss these 10 special days.

Miss these 10 days and life is miserable.

But very few long term investors care about daily returns!

The ten best days myth is used to bolster their argument about time in the market over timing the market.

Imagine missing the ten best days that happened at the top of the market. Your returns would be terrible if the market sank 20, 30 or 50%. Now imagine those same 10 days when the market is grossly undervalued. Now you get to compound those days over a longer period of time on much more favourable conditions.

What they do not mention is that the ten worst days basically cancel out the ten best days.

What they do not tell you is that volatility clusters, meaning the substantial changes or fluctuations in stock prices happen in a short space of time. So looking at the diagram, you can see that the best days fell roughly in the same month as the worst days in 2020. Hence the ten best days are neutralised by the ten worst days.

In addition to this, evidence shows that both the best and worst days are generally in bear markets, when stock markets are overvalued and geared to deliver low future returns.

If you listen to the industry, there is never an inconvenient time to be invested, get started, or, in the main, be heavily invested.

If you listen to the narrative, at whatever point in the market cycle (and markets cycling is the point) there is always a reason to be invested. It never matters whether markets are cheaply or highly valued. If markets are up, then get in because they are going higher and if you sell you will miss the gains. If they are down, it’s a great time to get in because you are buying cheap!

The default position is always to talk the long term. As we know, markets do generally rise over the long term, but the returns over long periods of time vary considerably. Simply refer back to the chart earlier to see the huge variation in returns over the long term. Twenty year periods can be between 2% and 15% compound!

But of course, the longer you are invested and the more you have at risk, the more fees they generate.

Because of the way compounding works, the industry position promotes the belief that it is best to be fully invested, or close to fully invested, over an extended period of time. That way your money compounds.

Let me demonstrate how compounding really works.

How Should We Think About Time?

This is how a gambler, or investor, should think about time and the stock market.

Investing takes place over a period of time, and so we can think of it as what is called multi-period. So you don’t just get one shot, where you invest all your money and then wait for the outcome. This is not a single roll of the dice. You can actively change your portfolio through asset allocation and rebalancing to adjust your holdings to current conditions.

In the stock market, you can invest daily, weekly, monthly, annually or whenever it suits you. You are not limited to one point in time.

Let me give you an uncomplicated way to think about time and investing. Look at the following example of a market cycle, which is representative of a typical market cycle.

Imagine two investors, Bill and Ben.

Bill, the buy and hold guy, just lets his portfolio ride the ebbs and flows of the market. He does not rebalance his portfolio because his financial adviser says that it is time in the market, not timing the market, that delivers long term gains.

Ben chose to rebalance over the market cycle, perhaps according to something like the CAPE ratio.

Both start with $80,000 in stocks and $20,000 in cash. At the peak of the cycle, Bill stays invested while Ben rebalances, because the CAPE is high and the earnings yield is extremely low. Ben banks much of the previous profit and moves heavily to cash, while Bill rides his full holding all the way up.

Then the market falls 50%, which is quite common in markets and much more common than predicted by the EMT. Bill’s stock holding halves, taking most of his gains with it. Ben’s smaller stock holding also halves, but he is sitting on a large cash pile, so the damage is minor and he has money ready to buy back in cheaply.

Now, into the next cycle, Bill is much worse off than Ben, and you can see the previous returns have been reduced due to the 50% decline.

Let us hope Bill was not planning a retirement any time soon.

What Is the Lesson?

In short, if you rebalance your portfolio (a form of market timing) you make more money over the long term. This is because you avoid the large losses that eat away at your returns, hence why we say it is more beneficial to focus on not losing money rather than making money.

If you look at the stock market over time, you can see there are times when it is better to wait and hold your cash until the cards fall in your favour. This is simply market cycles, and we have sufficient data to show how they operate.

Secondly, the idea that you need to invest over the long term as the way to maximise wealth is incorrect. It depends on the compound rate of return, and that depends on the odds on offer, and we know these odds vary over time. A simple view of stock market history using the earnings yield will demonstrate that great investors wait for high expected returns to invest, rather than the dollar cost averaging method recommended to the retail investor.

We know markets cycle, so it follows logically that it is better to take an active approach to your money rather than a set and forget passive investment strategy, which is generally recommended by the industry. Viewing time differently allows you to understand how timing the market can be a major contributor to your overall investment success.

Financial FibAverage Returns Are What Matters

Here is a simple demonstration highlighting the point. Start with $100. Add 5%, then take away 30%, then add 25%, then add 5%. On a simple arithmetic view the ups and downs look like they should leave you ahead. However, you actually end up with $96.47.

The reason is that you did not lose 30% of $100, you lost 30% of the larger amount you had grown to, and you did not gain your later percentages on the original $100 either. You should recognise this as the way stock markets work. That is because of multiplication, volatility and the sequence of returns. It is the repetition of ups and downs that reduces returns.

When it comes to stock market investing you will mostly hear about the average annual return, a figure somewhere between 8 and 10% you can reasonably expect over the long term. This figure is used in much of the marketing by the investment industry and financial advisers. But it is quite misleading.

The reason is that you do not actually get the arithmetic average return. What you receive is the geometric average return. I will refer to these as the average return and the geometric return.

The geometric return is always lower than the average return, but if you are trying to impress people and get them to hand over their money to you for investment, it pays to talk a lot about the average return rather than the geometric average return. Eight to 10% sounds more impressive than the real return, which ends up around 2 to 3%.

The long touted 8-10% average annual return is misleading because of methodology and because it ignores market cycles, which can have a substantial influence on your total returns. The average return is seldom achieved over any time period, as the market is usually either in a bull market, where returns are above average, or a bear market, where returns are below average. For example, in the 1982-2000 US bull market the average annual return was approximately 17% compound, or 14% inflation adjusted. Happy days indeed. But from 2000 to 2010, the returns were less than 1% per year, and minus 1.3% annually inflation adjusted.

Now let us put them together. From 1982 to 2010, the return is 11%, or 8.4% per year inflation adjusted. But remember that this 28 year period included one of the best bull markets the US market has seen.

So what is the difference between the arithmetic average and the geometric average?

Most of us are familiar with the arithmetic average. Take one hundred men, measure their individual heights, add them together and divide by one hundred. Hey presto, the average height. The key here is the use of addition. Each man is an individual and there is no relationship between any of them. One height is added to the next.

The geometric return uses multiplication, not addition. The geometric mean is the average of a data set (think a series of annual investment returns) and is used to calculate the performance of an investment portfolio over time.

It is important to note that the geometric return will always be less than the arithmetic return, because in the stock market you are using multiplication, not addition.

The critical element in these calculations is the level of volatility, and that is somewhat hard to predict. We generally see higher volatility in bear markets, or when the overall value of the stock market is high. A high level of volatility can be extremely damaging to your investment returns.

I am sorry to have to break this to you, but you don’t receive the arithmetic average return.

Along with volatility, the impact from the sequence of returns also affects your end result.

If you do not believe me, then maybe the Reserve Bank can convince you. A 2019 study by the Reserve Bank of Australia found the geometric return of Australian share prices was around 6% per year over the past century, or about 2% after accounting for inflation.

Two per cent after inflation! Using the Rule of 72, that means doubling your money every 36 years. And that does not include management fees and taxes. Not exactly a ringing endorsement for long term returns.

Now you can see why the finance industry likes the arithmetic average, not the geometric. It is so much neater to use, but starting valuation, volatility and the sequence of returns all make serious contributions to your end result, for very different results depending on these variables.

Once you include volatility it gets messy and more complicated. High volatility eats away at returns, and so we should aim to avoid periods of high volatility. We know these extended periods of high volatility are usually in bear markets. But any bout of volatility needs to be included to calculate the real return.

Volatility is simply the fluctuation in the price of an individual stock or the market as a whole. A highly volatile market is one where the daily, weekly or monthly price fluctuates a lot. For example, if a stock is $1 and it fluctuates between $1.20 and eighty cents, then it is considered highly volatile.

The Efficient Market Theory assumed investors would forgo higher returns for less risk, and the theory uses volatility as a measure of risk. Volatility is uncomfortable, and there are few investors who enjoy it because it plays havoc with your emotions, but the really critical point is that it eats away at your returns.

Your real return, the geometric return, depends on the level of volatility in the market. Let us look at how you can calculate volatility and how it impacts your returns. Let us use 20% as the average annual market volatility, which is widely used by the finance industry.

In order to get the geometric return from the average return you use a fairly simple approximation: the geometric return is roughly the arithmetic return minus half of the variance, where the variance is the volatility squared.

So, with an annual average return of 8% and a standard deviation of 20%, the variance is 4% and half of that is 2%. So if you have volatility of 20%, you reduce the arithmetic average return by 2%. Notice how similar this is to the Reserve Bank’s figure. The real return is not 8%, but 6%, once you include volatility.

Now let us raise the volatility to 30%. This means about 4.5% less, so 8% becomes roughly 3.5%. And 40% volatility, which happens, means about 8% less, so 8% becomes close to nothing. This is why volatility can be so tough on returns.

It is also why it is difficult to predict future stock market returns in a geometric system. It is much simpler to just say 8% and be done with it. The investment industry gives you the idea that average returns are 8%. As if 6% was not bad enough, including inflation means 2% is close to miserable.

A big part of the problem is the buy and hold mentality, which we dealt with in an earlier chapter. Your focus should be on not losing money, and on the geometric return, rather than the average return of 8-10%.

It is why avoiding expensive, overvalued markets, which have the highest volatility, is critical to long term returns.

So rather than believe the line that you have to stay in through the large declines, you may well be better off reducing your portfolio in order to avoid large losses.

That is why your focus should be on not losing money, and that means always paying attention to valuation and risk, rather than the industry’s promoted idea that you will receive 8-10% average annual returns over the long term. The belief that a buy and hold portfolio, passively managed, will deliver the best returns is not true. Over a 30 or 40 year period, we know markets will experience at least one, probably two, large 40-50% drawdowns, and these seriously impact your final return.

Again, it becomes obvious there are times when actively managing a portfolio by selling and sitting on the sidelines is beneficial. However, your adviser or fund manager will not earn fees if you take this approach.

Sequence of Returns

As billionaire investor Howard Marks has said, where you start out determines a lot about where you end up.

A 100% gain only needs a 50% loss to be back to even. And worse still, an initial 50% loss needs a 100% gain to get back to even.

If you started investing in the market in 2000, your returns were negative over the next decade. Believing the 8% long term return that is drawn from a buy and hold portfolio, starting in 2000, you would have spent the next three years losing 50%, the next four gaining 100% to break even, the next two, 2007 to 2009, losing 50% again, and finally breaking even around 2013. So your return over 13 years is zero, never mind the emotional rollercoaster.

In Australia’s case, the ASX since the 2007 peak has hardly moved. Many industry folk will throw in the line, “yes, but there are dividends.” And yes, there were, but you must also include fees, taxes and inflation. Over a 15 year period, returns have been terrible regardless, once you calculate the geometric return.

Because we know compounding is about the rate of return, not simply time, it is better to wait for undervalued markets to start investing.

The incentive for the industry is to hold your money for the longest periods of time in order to charge fees. Promoting 8% as the expected average annual return is misleading. This figure is not even applicable when you consider the stock market to be a field where multiplication applies, not addition. You must consider valuation and the sequence of returns.

Understanding the difference between the average return and the geometric return will help you manage your stock market portfolio and deliver better investment returns.

Financial FibStock Picking Is Necessary

One way to generate fees is to encourage investors to believe that building a portfolio of individual stocks or companies is the best method to build wealth: spending 30 years plus buying and selling individual companies as the way to wealth.

This all sounds very sensible. You hire a person who is an expert to buy you good companies and hold them for the long term. After all, the great Warren Buffett has made a fortune, as have others, from developing an understanding of companies and holding them for the long term.

But Buffett also said that if you do not know, or do not want to spend large amounts of time researching individual companies, just buy an index and hold it over the long term.

This is basically what is called fundamental analysis. Look at the industry characteristics, look at the company particulars, and away you go. Ditch the bad ones, buy the good ones and hold.

If you give your money to a fund manager, either directly or through, for example, your superannuation, they will select stocks they believe will generate superior returns over the long term.

Now, let us apply some evidence to see if this is indeed the best approach. The answer, we know, is no. We have evidence that at least 70% of fund managers who select stocks fail to beat the market index.

Here are the raw numbers from studies of the whole market:

• Two out of every five stocks are a money-losing investment (39%).
• Nearly 1 out of every 5 stocks lost at least 75% of their value (18.5%).
• 64% of stocks underperformed the Russell 3000 during their lifetime.
• A small minority significantly outperformed their peers.

So, to borrow a line from Dirty Harry: are you feeling lucky?

A more recent study conducted by Hendrik Bessembinder delivered some seriously unwelcome news to those who think they can pick winners. Bessembinder undertook a series of studies determining whether stocks outperform bonds, the number of extreme winners that outperform over a long series of time, and which industries the outperforming stocks belong to.

What he concluded was that there is considerable skewness in the distribution of returns, and after all, that is what we invest for. The major issue is that a tiny percentage of stocks provide all the returns, so if you do not have those specific stocks then your returns will be lower. Of the roughly 26,000 stocks since 1926, only a tiny fraction are responsible for half of the net returns.

The median time a stock is listed is just 7 years. So much for the long term buy and hold approach.

A single stock strategy (choosing just one stock each month) failed in 96% of the cases, and underperformed an equal weight approach 99% of the time. A stock selection strategy (active management) only outperformed in 28% of the simulations. The top thousand performers, less than 4% of stocks, account for essentially all the wealth.

It is safe to conclude that selecting, or trying to beat the market by selecting, individual companies is a fool’s errand.

The risk of buying the whole market is less than buying a single stock. A single company or stock can go bankrupt, whereas there is virtually zero probability of a broad country index going to zero. I am not saying it cannot fail as an investment, because that depends on other issues such as when you buy, but the risk is far lower.

This is why Buffett says that if you do not know what you are doing, buy an index.

Rather interestingly, the returns you can generate from purchasing a single country’s index, or a single sector, can be quite substantial. And the risk is much reduced from buying a portfolio of individual stocks.

Of course, you are welcome to try to pick a single stock (in fact pick 10 or 20) from a market of over 3000, but you must understand the risk involved in investing in each one.

You can choose to build wealth from stock selection, but if you invest for 30 years you need to make roughly 200 selections over that period, then you need to be correct an awful lot of the time, or be lucky enough to be holding the big winners, which we know is basically impossible to arrange in advance. Stock selection means taking more risk, either by chasing longer odds or increasing the bet. Big upside, big downside.

The evidence shows most investors, including those with so-called expertise, fail to beat a simple index.

In my first book, Low Rates High Returns, I show you how to use market indexes to beat the market.

“The trick is to wait for the pitch right in your sweet spot, then swing.”Warren Buffett, on Ted Williams

I want to show you, using one chart, how to understand stock markets, how to generate superior returns, and just how easy investing really is.

The chart uses the S&P 500 index, but we can use SPY, a large, liquid exchange traded fund listed on the New York Stock Exchange, as a proxy.

The first thing we want to do is buy when the market is cheap. We can use the CAPE ratio as an indicator of when the market is cheap. The long term CAPE average is roughly 17, so a CAPE below that is a good place to start, and the cheaper the better. In 1982 the CAPE was approximately 7, and from there it rose to 44 in 2000, whereupon the market crashed, losing 50%. So using CAPE, you want to start when the market is cheap.

The market tops are simply those points where the market moves from cheap to expensive. Now, I can tell you it is not possible to get the exact bottom or top, but that is not needed.

This is where rebalancing becomes critical. We take an active approach rather than buy and hold. The critical point is when do we rebalance.

Imagine buying at a CAPE of 7 in 1982. Knowing the average is 17, you could generally take a relaxed, dare I say it, buy and hold approach until the CAPE reaches the average. At 17 you will already have benefited from placing, say, 70% or 80% of your funds in when the CAPE was at 7 in 1982. At 17, you will have a very attractive looking performance.

That does not mean we sell down and wait for another cheap CAPE. Here is where we use the long term CAPE to see that real problems start to happen when the CAPE is well overvalued, and history shows us that has been when it reaches roughly 23.

So around 23 is when you should start rebalancing. How much to rebalance? Rebalancing is more art than science, however so long as you rebalance you will do better than a buy and hold portfolio over the long term.

We could keep it simple with a once a year rebalance, moving our portfolio in 10% increments. From the original 80% stocks and 20% cash, we move to 70% stocks and 30% cash (remember this is of the new amount, not your original amount). Twelve months later, if the CAPE is higher still, you move from 70/30 to 60/40, and so on. As the CAPE rises you should avoid becoming frustrated, because the market still rises and you have less exposure, but remember when it falls (and you really can’t predict this with any degree of accuracy) you will lose less because you have banked the profits.

As per my example in the Bill and Ben case, you see that over time you are compounding at a higher rate, because you bought stocks when they were cheap at the start, which delivered a good compounding rate, and then avoided losing too much when the market falls, as inevitably it does.

Yes, you can spread your investments by diversifying, but remember most stock markets are correlated, so if the United States falls, then others will too. However, other markets, such as Emerging Markets, are often cheap when the United States is expensive in CAPE terms, so you can pivot out of US stocks to cheaper Emerging Markets if you wish.

There is not really much else to it. There is no need to constantly be looking for individual stocks.

So What Can This One Chart Teach Us?

• Wait until stocks are cheap. Don’t buy stocks simply because you have money. Compounding is great, but only when it is done at a high rate. Remember you want 10%, not 2%.
• Understand the CAPE ratio is an excellent tool to advise you when markets are cheap. Check the long term average and go from there.
• Don’t invest all your money at once. Save some cash, because cheap markets can always get cheaper. Don’t get greedy and think putting all your money in at once is a quicker way to wealth.
• Volatility can be your friend or your enemy. It’s your friend when stock markets are cheap and your enemy when they are expensive. Losses from a larger number are more impactful, so remember to rebalance systematically.
• Don’t try to predict. Valuation is an excellent tool, and don’t try to second guess markets, because most of the time you will be wrong. Trust the numbers.
• Markets will generally rise over the long term, so don’t despair, because there are always opportunities to buy cheap stock markets.
• If you compound at a high rate, you will beat most investors who simply and mindlessly put their money into markets ignoring valuation.
• Don’t listen to the finance sector. They are only interested in generating fees.

Going a Little Deeper

The case for investing is extremely easy. It is the finance sector, including banks, real estate and finance academia, which makes investing appear complex.

Many people, unfortunately, are deterred from understanding the simple aspects of investing. So I want to set out a simple case of how to think about investing, which I think most people can grasp.

Any investment has three main parts. The income, for example the rental yield on an investment property or the dividend from a company. The capital gain, the difference between the price you pay and the sale price at a future point in time. And the change, or growth, in income and capital value.

Whether it is property or stocks, the widespread belief is that the longer you hold an asset the better the returns. I want to show why that is not always the case. Time can be a great healer, but that does not mean you make solid investment returns.

Every asset, whether it is a residential property or a share of a public company like BHP, is held by a person or some sort of entity. It is important to realise this, as it allows you to focus on the difference between those other concepts, like the average return.

The key takeaway from this section is that price matters, and in most cases much more than time. If you overpay for an asset or a stream of cash flow, then holding for a long period may well condemn you to underperformance. This is the idea behind the question: do you want 10% compound, or 2%?

I am going to ignore tax issues because they are different for each individual, but I also don’t believe you will get rich because of your tax arrangements. They may help to maintain wealth, but seldom is an investment worth it for the tax reasons. Indeed, many investors get caught out by schemes that turn out to lose money.

Tax schemes like negative gearing, for example in property investing, don’t always turn an average investment into a big winner. Buying and selling at the right time will more likely do more than tax issues.

Let me point out that most investors, at the encouragement of the finance and real estate industries, usually direct their attention to the potential for long term capital growth, also known as the capital gain.

When markets are booming, as they are prone to do, our focus is on the capital gain element because the numbers are magnified. For example, if we use leverage for a property investment, a 10% gain on $1,000,000 with $900,000 borrowed looks a lot more enticing than a 10% gain on $100,000 without the borrowed funds. The difference is a matter of leverage and nothing else.

Most investors buy at the wrong time, ignoring the current valuation, which I believe is mostly due to a lack of understanding of how risky an investment is, how to calculate the expected return, and the importance of market cycles and timing. Listening to the finance industry will not result in any greater understanding of how markets work.

That is largely because when an asset class like property or stocks is booming, you do not have to go far to see what appears to be easy money. And most of the information, whether stock market or property market, comes from the industry themselves, and they are of course hardly objective when it comes to your investment interests.

You can choose any number of newspapers or websites where the daily movements of the stock markets are discussed. Much of it, as I have shown, is just there to maintain the hype surrounding the investment. Hot stocks or hot property. They all promote their own industry by showing you how the easy money can be made, with their assistance of course.

Most of the information is simply noise, worthless in the context of investing for the long term. And from there will come a myriad of explanations, all most likely wrong, about why the market moved as it did. I am sure most of you reading this book will be familiar with the daily chatter.

The Value of Timing

Firstly, let us start with property, as it is a straightforward way to understand the mechanics of investing.

We decide to invest and we want to calculate some idea of what we can expect as a return over the long term. As mentioned above, there is the rent or dividend, the capital gain, and the change in valuation.

You pay $1 million for an investment property. It pays rent of $50,000 a year. So $50,000 divided by $1,000,000 equals 5%. Simple enough. Now we need to pay to generate that return, so we can take out the costs for things such as interest repayments, inflation, management fees, upkeep costs (say a new dishwasher) and of course any taxes. This gives us the net amount.

Let us make the total annual costs $25,000, and so now our investment return is not 5% but 2.5% net. At 2.5%, you will double your money in around 28 years. Not that enticing, given we were looking to make money over the long term.

The same methodology applies to stock market investing and buying individual companies. Price matters, valuation matters, and the rate at which you compound matters more than the years you sit there. Wait for the good times, buy cheap, focus on not losing, and let the maths do the rest.

Steve Moriarty

Steve Moriarty is one of the founders of Total Money Management and leads its financial education platform. Over 25 years he has read the field to its foundations, holds a Master of Finance, has managed his own money and watched the industry manage some of it, and has spent that time working out what actually helps investors and what merely helps the people charging them. He is the author of Low Rates High Returns and host of the Total Money Management podcast.

Total Money Management

Total Money Management is an Australian financial education and investment coaching business. We exist to hand everyday investors the tools the industry would rather keep behind a curtain: how markets really work, how to think about valuation and risk, and how to take charge of your own money with confidence. Plain English, no jargon for its own sake, and no barracking for whichever product pays the biggest commission.

If this book did its job, you now see the market a little differently, and a lot of the daily noise has lost its grip on you. Here is how to keep going.