I normally don’t write about stock prices, because my interest is successful company strategies, on the assumption that prices will eventually work out.
However, I would encourage all investors to read Jason Zweig’s Intelligent Investor column in Saturday morning’s Wall Street Journal. Five minutes changed how I think about investing forever.
The nominal premise of the column is to review two books, Safety Net by James K. Glassman (co-author of the 1999 tome Dow 36,000) and also The Most Important Thing by Howard Marks.
Glassman says the asset classes he recommended in 1999 were wrong, but now he has it right. Either way, stocks are better investments than bonds in the long run.
Marks disagrees. We all know about avoid market bubbles, but the implications are more invidious than that. As Zweig summarizes Marks:
Riskier assets don't necessarily offer higher returns, Mr. Marks says; they only appear to do so. "It's really simple," he says. "If risky investments could be counted on for higher returns, then they wouldn't be risky. And if investments weren't risky, then they probably wouldn't appear to promise higher returns."It’s easy to find an example of this. In the 1990s US stocks exploded, while in the 2000s the market went sideways for a decade. Are the businesses less attractive as going concerns? No, what’s changed is the market sentiment.
By chasing the potential for higher return in riskier assets, investors drive prices up. Under the classic definition of risk—how widely the returns deviate from the average—that alone doesn't make assets more dangerous. But by Mr. Marks's common-sense definition of risk—"the likelihood of losing money"—rising prices are pure investment poison. The higher and faster prices go up, the farther and harder they have to fall.
The (Nobel prize-winning) capital asset pricing model — calculating risk-adjusted returns — assumed that riskier investments will be discounted and thus provide a bigger potential upside. Marks says that only works if market sentiment hasn’t pushed up the price of that investment (or investment class).
So theories of efficient markets, risk-adjusted returns, and modern portfolios have to take a back seat to a much simpler and older investment theory.
Buy low, sell high.
In other word, go back to Dogs of the Dow, Value Line, or other value-based investment strategies. That means missing the run-up in Apple shares (other than the first few years of Jobs II), but also not riding Microsoft, Intel and Nokia down over the past decade.