Markets

Want to Be Smarter? Disagree!

As most readers of the Accountable Update probably know, I’m a Fightin’ Texas Aggie. Like many of my fellow farmers, I’m proud to have attended one of the two flagship universities in the Great State of Texas. As a resident of Austin for the last decade or so, however, I have met many graduates and fans of that other school, the University of Texas (t.u.).

When I first moved to ATX in 2007, the Longhorns (tsips) were riding high. They had recently won national championships in football and baseball in 2005. On my daily slog from Westlake up to the Arboretum, it was hard to find respite from all things related to The Forty Acres as they more or less dominate the local news and talk radio. The sports channels that I favor spent the majority of their air time discussing when the next Longhorn team would light up that God forsaken tower with another #1.

One evening in early January 2010, as I was creeping home on Loop 360, one local sports radio personality almost caused me to drive off the Pennybacker Bridge when he posed the question, “Has there ever been a better time to be a Texas Longhorn in Austin, Texas?” He went on to remind listeners that Mack Brown was about to lead his team back to the Rose Bowl for what could be their second championship in five years, the baseball team had just finished second in the previous season’s College World Series and were ranked #1 leading into the 2010 campaign, and the basketball team had also just been ranked #1 for the first time ever.

While it was a great time to be a Longhorn in Austin, maybe it wasn’t quite so awesome to be an Aggie marooned here. I turned off the radio and swore to never listen to any tsip themed sports show again. We Aggies are known for our steadfastness and resolve. We’re also very fond of our traditions and history, even if we have to go back a while to find things to celebrate. (Did you know our 1917 football team was unbeaten and unscored upon?)

We enjoy commiserating to one another about being ranked too low, t.u. being ranked too high, some perceived snub in the reporting of a big win or positive story, or a commentary that is considered unflattering. It’s probably not a lot different than being a Chicago Cubs fan prior to 2016.

Perhaps nowhere is this phenomenon more prevalent than the message boards on Texags.com. A search of their site using Google’s Advanced Search for the term “disrespect” returned 10,700 results. I couldn’t find any other college site that registered more than 2,500. Aggies really have a hard time understanding why others don’t like us as much as we like ourselves. On second thought, we’re probably less like the Cubs and more like Sally Fields before the 1985 Oscars.

Eventually I tuned back into the local channels, though, because I missed hearing the orange tinted version of the world, no matter how misguided. Gradually, I’ve come to realize that being unranked in the preseason is less about the BOMC (Burnt Orange Media Conspiracy) keeping the Aggie man down and more a reflection of the market’s sentiment. Last year, for instance, the Ags football team began unranked but rose to the top 10 in most polls after winning their first 6 games. The 2-4 finish, on the other hand, only served to reinforce that at least the sum of media pollsters knew what they are talking about. 

While I frequently find myself disagreeing with the opinions of my many bovine aficionado friends & acquaintances, I have found that my own expectations and beliefs wind up more grounded as a result of engaging in conversations with them about both our similarities and our differences. I’ve also found this to be the case with politics, religion, and even finance.

The modern world has made it easy to create our own personal echo chambers. With a click of the mouse, we can ignore a “friend” on social media that offers different world views. If we don’t like the spin on a news story, we just change the channel to a more liberal or conservative alternative. But by limiting our exposure to sources or audiences that we only agree with, we may be missing an opportunity to make ourselves smarter, as discussed in this 2014 Scientific American® article.

If we allow this tendency to extend into our investment opinions, the results can be costly. So, if you tend to read glass half empty perspectives such as Zero Hedge or Nouriel Roubini, you should also take in some more optimistic points of view from folks like Jeremy Siegel or even Jim Cramer. The views and perspectives may vary widely, but that’s the point. Get more information and then make informed decisions.

That’s how markets work. They take all the available information, knowledge, and opinions and integrate that into prices. Together, we know more than we do alone.

At the end of the day, broadening your circle may help you wind up with more money. You’ll almost certainly have more friends, which is probably worth even more.

Want to discuss or debate?

Get in touch.

A Sports Lesson For Investors

If you are a baseball fan, it doesn’t get much better than the treat we were all served this week by the Chicago Cubs and Cleveland Indians. In addition to a fantastic series capped off by an epic extra innings Game 7, those of us that don’t consider ourselves fans of either team got to watch the tortured anticipation that Cubs and Tribe fans suffered through on each pitch of the final game.

Seemingly, each time the cameras panned the crowd in the later innings, you would see people with their hands covering their eyes, hats pulled over faces, and hands clasped as if in a church filled with the faithful. It ultimately worked out for the previously hapless (at least since 1908) Cubs, but as I tend to do, I saw a lesson for investors in the faces of those beleaguered fans.

I like to draw analogies from my own experiences and interests, such as last year when I wrote about treating investing the same way we do spectator sports. In that update, I shared studies that demonstrated that fans experience physiological changes, such as testosterone boosts to their bodies, when watching their favorite teams.

But after watching so much pain, strain, and torment of so many in the stadium, and no doubt in bars and living rooms across the county, maybe there is something else at work too. Why do fans keep watching even when their team is facing elimination, down 3 games to 1? Why even bother turning on the TV when your team is facing an overwhelming favorite, such as the 1980 US Olympic Hockey game vs the USSR. What about when the market has had a run of bad days, such as the last week or so? Why bother tuning in to a business channel? Is it because misery loves company?

In my opinion, it's the opposite of why you might think. For in spite of our worst instincts, it ultimately is optimism that keeps us from turning away.

No matter how reasonable our brain tries to be, at heart most of us are optimists. We expect the worst but hope for the best. It is in that mindset that we can we can also learn to be better investors. All too often we look for reasons to not be optimistic, even though history has repeatedly rewarded those that stay the course. Embrace the glass that is half full, but know that there will be terrifying moments where it appears certain that it may run empty or even fall of table. Cover your eyes if you have to, but stay in your seat.

And if today doesn’t end in our favor, there is always next year.  In the meantime, enjoy this Issue Brief on The Power of Markets.


The Power of Markets

In 1958, economist Leonard Read published an essay entitled “I, Pencil: My Family Tree as Told to Leonard E. Read.”

The essay, narrated from the point of view of a pencil, describes the “complex combination of miracles” necessary to create and bring to market the commonplace writing tool that has been used for generations. The narrator argues that no single individual possesses enough ability or know-how to create a pencil on their own. Rather, the mundane pencil—and the ability to purchase it for a “trifling” sum—is the result of an extraordinary process driven by the knowledge of market participants and the power of market prices.

THE IMPORTANCE OF PRICE

Upon observing a pencil, it is tempting to think a single individual could easily make one. After all, it is made up of common items such as wood, paint, graphite, metal, and a rubber eraser. By delving deeper into how these seemingly ordinary components are produced, however, we begin to understand the extraordinary backstory of their synthesis. Take the wood as an example: To produce wood requires a saw, to make the saw requires steel, to make steel requires iron. That iron must be mined, smelted, and shaped. A truck, train, or boat is needed to transport the wood from the forest to a factory where numerous machines convert it into lumber. The lumber is then transported to another factory where more machines assemble the pencil. Each of the components mentioned above and each step in the process have similarly complex backstories. All require materials that are sourced from far-flung locations, and countless processes are involved in refining them. While the multitude of inputs and processes necessary to create a pencil is impressive, even more impressive are the coordinated actions required by millions of people around the world to bring everything together. There is the direct involvement of farmers, loggers, miners, factory workers, and the providers of capital. There is also the indirect involvement of millions of others—the makers of rails, railroad cars, ships, and so on. Market prices are the unifying force that enables these millions of people to coordinate their actions efficiently.

Workers with specific knowledge about their costs, constraints, and efforts use market prices to leverage the knowledge of others to decide how to direct their own resources and make a living. Consider the farmer, the logger, and the price of a tree. The farmer will have a deep understanding of the costs, constraints, and efforts required to grow trees. To increase profit, the farmer will seek out the highest price when selling trees to a logger. After purchasing the trees, the logger will convert them to wood and sell that wood to a factory. The logger understands the costs, constraints, and efforts required to do this, so to increase profit, the logger seeks to pay the lowest price possible when buying trees from the farmer. When the farmer and the logger agree to transact, the agreed upon price reflects their combined knowledge of the costs and constraints of both growing and harvesting trees. That knowledge allows them to decide how to efficiently allocate their resources in seeking a profit. Ultimately, it is price that enables this coordination. On a much larger scale, price formation is facilitated by competition between the many farmers that sell trees to loggers and between the many loggers that buy trees from farmers. This market price of trees is observable and can be used by others in the production chain (e.g., the lumber factory mentioned above) to inform how much they can expect to pay for wood and to plan how to allocate their resources accordingly.

THE POWER OF FINANCIAL MARKETS

There is a corollary that can be drawn between this narrative about the market for goods and the financial markets. Generally, markets do a remarkable job of allocating resources, and financial markets allocate a specific resource: financial capital. Financial markets are also made up of millions of participants, and these participants voluntarily agree to buy and sell securities all over the world based upon their own needs and desires. Each day, millions of trades take place, and the vast collective knowledge of all of these participants is pooled together to set security prices. Exhibit 1 shows the staggering magnitude of participation in the world equity markets on an average day in 2015.

Embrace Market Pricing.jpg

Any individual trying to outguess the market is competing against the extraordinary collective wisdom of all of these buyers and sellers. Viewed through the lens of Read’s allegory, attempting to outguess the market is like trying to create a pencil from scratch rather than going to the store and reaping the fruits of others’ willingly supplied labor. In the end, trying to outguess the market is incredibly difficult and expensive, and over the long run, the result will almost assuredly be inferior when compared to a market-based approach. Professor Kenneth French has been quoted as saying, “The market is smarter than we are and no matter how smart we get, the market will always be smarter than we are.” One doesn’t have to look far for data that supports this. Exhibit 2 shows that only 17% of US equity mutual funds have survived and outperformed their benchmarks over the past 15 years.

CONCLUSION

The beauty of Leonard Read’s story is that it provides a glimpse of the incredibly complex tapestry of markets and how prices are formed, what types of information they contain, and how they are used. The story makes it clear that no single individual possesses enough ability or know-how to create a pencil on their own but rather that the pencil’s miraculous production is the result of the collective input and effort of countless motivated human beings. In the end, the power of markets benefits all of us. The market allows us to exchange the time we require to earn money for a few milliseconds of each person’s time involved in making a pencil. For an investor, we believe the lesson here is that instead of fighting the market, one should pursue an investment strategy that efficiently and effectively harnesses the extraordinary collective power of market prices. That is, an investment strategy that uses market prices and the information they contain in its design and day-to-day management. In doing so, an investor has access to the rewards that financial markets make available to providers of capital.

Leonard Read’s essay can be found here: http://econlib.org/library/Essays/rdPncl1.html.

 

Source: Dimensional Fund Advisors LP.

There is no guarantee investment strategies will be successful.

US-domiciled mutual fund data is from the CRSP Survivor-Bias-Free US Mutual Fund Database, provided by the Center for Research in Security Prices, University of Chicago. Certain types of equity funds were excluded from the performance study. Index funds, sector funds, and funds with a narrow investment focus, such as real estate and gold, were excluded.

Funds are identified using Lipper fund classification codes. Correlation coefficients are computed for each fund with respect to diversified benchmark indices using all return data available between January 1, 2001, and December 31, 2015. The index most highly correlated with a fund is assigned as its benchmark. Winner funds are those whose cumulative return over the period exceeded that of their respective benchmark. Loser funds are funds that did not survive the period or whose cumulative return did not exceed their respective benchmark.

All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.

Ken French is a member of the Board of Directors for and provides consulting services to Dimensional Fund Advisors LP.