Does the Market Know More Than a 6th Grader?

What was your prediction for the stock market this year? Somewhere in the 8-10% range?

While the S&P 500 Index has had an average return of about 10% since the 1920's, it surprises many to learn that the S&P 500 has NEVER had a single year return between 8-10%?

With returns fluctuating around 0% for 2015, I frequently am asked whether the market is expensive, cheap, or fairly priced. You don't have to look far to find many differing opinions on this topic. CNBC populates most of their programming with various experts weighing in with their opinions throughout the day. My answer is always, YES.

Those of you that know me probably are thinking that a flippant remark like that is not unusual, considering the source. I admit that it is at least 1% of me channeling my inner-wisenheimer, but the other 99% is due to my belief in efficient markets. 

My friends at Dimensional Fund Advisors use jelly beans to illustrate how the many different opinions of market participants collectively tend to result in the right answer. The illustration is based on an an exercise that an investment advisor uses to break the ice in presentations. The advisor shared the results of his clients' guesses of how many jelly beans were in a jar that he had on a table at the entrance to a conference. Individual guesses ranged from 409 to 5,365, but averaged out to 1,653. There were actually 1,670 jelly beans, which shows that together, we know more than we do alone. 

Recently, I had the opportunity to test this concept in real life during a visit to my daughter's orthodontist office, Z Orthodontics, in our hometown of Austin. While waiting for her appointment to conclude, I noticed a jar filled with candy corn on the receptionist's counter. Next to the jar were slips of paper that patients could log their best guess as to how many pieces of candy filled the container.

I struck up a conversation with Dr. Travis Tomblyn about the DFA candy jar and how they use it to demonstrate the power of markets. (Ironically, DFA's home office is literally right across the street from his office.) He offered to send me the results of their contest once it ran its course.

The final tally came in a few days later. The guesses ranged from 106 to 1600 pieces. Out of 112 participants, the average guess was 368. The actual number of candy corn pieces in the jar was 456.

Considering that the patients are, on average, around 12 years old, those guesses came pretty darn close. If nothing else, it lends credence to the belief that the market isn't that much smarter than a bunch of 6th graders. 

That's not to say the people making prognostications, stock picks, and managing portfolios aren't thoughtful and well reasoned. There is just scant evidence that all of those smart folks trying to outsmart one another are able to do better than the broad market over the long haul. In fact, the evidence suggests that most will under-perform the market.

So what should you do? In our opinion, you should create a portfolio of low cost index funds in an allocation that suits your risk tolerance. If you don't have the time, interest, or discipline to do that, we should get acquainted.

Investing In The Jimmy's and Joe's

Photo by Kalawin/iStock / Getty Images

There is an old saying about coaching football, “It ain’t so much about the X’s and O’s. It’s about the Jimmy’s and the Joe’s.” Coaches at all levels measure player attributes such as size, speed, agility, and strength, because they know that the bigger, faster, quicker, and stronger their teams are, the more games they are likely to win.

Almost everyone that has ever played a sport has experienced a moment when they realized that another player was just too big, fast, quick, or strong to compete with. College coaches work year round to identify players with those traits and then try to convince them to come to their school.

The National Football League has even made the process of collecting the evidence of those characteristics part of their entertainment package by televising their combine each spring. That’s right, you can watch players run 40 yard dashes, bench press, jump, and get weighed for fun.

To show how important it is to fill a team with the biggest, fastest, quickest, and strongest, a recent review of national championship teams done by Clay Travis of Outkick The Coverage showed that, “Since 1998 every team that has won a national title except for Oklahoma in 2000 has had at least two top ten national signing classes in the four years before a title.”

Clay points out that top recruiting classes don’t guarantee a title, but they are necessary to put a team in position to win it all. What does all of this tell us about in investing?  

Over the past fifty years or so, we’ve learned that investing is more about looking for the right attributes, too. It started in the 1960’s when University of Chicago economist, Eugene Fama, showed that trying to outguess the market’s “Random Walk” was pointless. He demonstrated that while stocks have outperformed bonds and cash as an asset class, trying to choose which stocks will perform best within the asset class is too random to predict and not worth the effort or expense. This work led to the creation of index investing.   

Then in the 1990’s, Fama and Dartmouth finance professor, Ken French, proposed that two types of stocks tend to do better than the overall market. They showed in their 3 Factor Model that smaller company stocks and stocks priced lower relative to their book value, or value stocks, have “excess returns” over larger companies and growth stocks.

Most recently, another economist, Robert Nory-Marx, has shown that companies that have higher return on equity also outperform. In other words, he demonstrated that profitability should be associated with higher returns.

With the knowledge that attributes such as indexing, company size, relative value, and profitability should lead to better returns, investors can build their portfolios using those approaches if they want to increase their odds of success. It won’t insure success every year, just as the most talented teams don’t win every game. But over time, the evidence suggests that indexed portfolios tilted to value, small companies, and profitability will outperform.

Here at ATX Portfolio Advisors, we believe that having a good grasp of the X’s and O’s is important, which is why we create a financial plan for each of our clients. But ultimately, the Jimmy’s and Joe’s are those evidence based factors that give you the edge in the long run.

If you would like to learn more, let’s get acquainted.

What Are We Waiting For?

Photo by Phil Dolby

Recently I was interviewed for articles in TheStreet.Com and Investopedia. In both of the pieces, the theme was how to deal with procrastination with retirement savings. I was going to write my Accountable Update this week on the behavioral economics theories behind why people put off savings and investing, but decided to do my own research instead.

I’ve got my ideas, but would be interested in the reasons you believe people put off planning and saving. I'll share and discuss the results next week!