Mean Markets and Lizard Brains Page 18
Protecting Investments from Changing Interest Rates
What are the implications of this analysis for investors? The 20-year bull market in bonds has largely run its course. U.S. bond prices can fall, go sideways, or rise very modestly. The huge gains of the last two decades cannot continue. In addition, it is likely that the inflation adjusted (real) interest rate will rise.
This is a toxic environment for the backward-looking, pattern-seeking lizard brain. Bond prices have risen for the past 20 years, and the lizard brain is built to predict that the trend will continue. Yet we know that interest rates cannot go below zero. Thus, we have a pending collision between the assumption of the lizard brain and economic reality.
The implication is that most of us have too much riding on low interest rates. The lizard brain has been lulled into interest rate overconfidence by the unsustainable 20-year bull market of rising bond prices and falling interest rates. Thus, most people should adjust their financial position to have lower exposure to rising interest rates. There are three ways to protect ourselves from interest rate rises.
Tip #1: Borrow at Fixed Rates
Borrowing at fixed interest rates reduces risk. If interest rates rise, then it will be great to continue to enjoy today’s low rates. If interest rates fall substantially, then it is always possible to refinance. Thus, fixed-rate debt is lower risk than adjustable or floating-rate debt.
Tip #2: Lend Short Term
If you own bonds, you are a lender. The shorter the term of your loan, the less risk you face from interest rate changes. If you own U.S. government bonds, for example, those that mature soon are less risky than those that mature later.
Tip #3: Borrow Less
If the inflation-adjusted interest rate rises, then the burden of debt will increase. One obvious way to decrease the burden of rising rates is to reduce the amount of borrowing. For those with nonmortgage debts, one route is to sell some stocks or other assets and pay off some debt. Those with mortgage debt can prepay a chunk of the principal. (Some mortgages do not allow or reward partial prepayment, but these mortgages can be refinanced if necessary.)
Acting on these tips will reduce risk and position the investor for profit. It is possible to benefit from rising interest rates. The financial media suggest that rising interest rates would hurt the economy with no benefits. This analysis suffers from two flaws.
First, if the economy is strong, interest rates will rise. One of the few ways to have continued low interest rates is to have a recession or worse. U.S. interest rates in the Great Depression were close to zero. Similarly, Japan has “enjoyed” low interest rates recently because it has suffered through 15 years of economic malaise.
Second, rising interest rates are great for savvy savers. Savers would prefer to get those superhigh interest rates of the early 1980s rather than today’s puny returns. In order to profit from a rise in rates, however, it is important to buy bonds after the rates have risen. Thus, implementing the previous tips will position an investor to benefit from rising rates.
Making money in this interest rate environment requires overruling the lizard brain. The correct course now is likely to be the opposite of what has worked for the last generation. The lizard brain has been fooled by 20 golden years of falling interest rates and rising bonds prices.
Update since the First Edition
U.S. interest rates have gone sideways for the last 5 years (Figure 7.6). After a more than 20-year trend of lower interest rates, the 10-year treasury hit a low 3.11 percent in 2003. Since that period, interest rates have gone sideways to up. Because bond prices move in the opposite direction, bond prices have gone sideways to down over this period.
FIGURE 7.6 Bond Bull Market Has Stalled or Ended
Source: Federal Reserve
While interest rates have followed a boring, sideways pattern for 5 years, the inflation-adjusted interest rate has continued to hit new lows. Figure 7.7 adjusts the U.S. 10-year T-bond interest rate for U.S. consumer price inflation and shows that real interest rates have moved from low levels to negative levels. In January 2008, for example, the 10-year interest rate was 3.74 percent, while the inflation rate was 4.3 percent. Thus, the inflation-adjusted interest rate was negative.
FIGURE 7.7 Real Interest Rates Have Moved from Low to Negative
Source: Federal Reserve
What’s Next?
Interest rates cannot go to below zero unless civilization ends, and therefore current interest rates are close to the lows. Thus, there cannot be any huge bull market in bonds. In addition, real interest rates should not be expected to remain negative. The lizard brain causes the most financial trouble when powerful trends must end. The persistent decline in real interest rates has continued for close to 30 years. The eventual return to positive real interest rates is likely to create significant pain. In particular, low real interest rates are great for borrowers; as real interest rates raise to normal levels, it will be much harder for borrowers to make payments.
chapter eight
STOCKS For the Long Run or for Losers?
“If you had $1 million, what would you do with it?” My students in the spring of 2001 pondered this question. At the time, I was a visiting professor at my alma mater, the University of Michigan. My roommate from my undergraduate years, Peter Borish, had returned to give a short guest lecture to this class of about 150 college students, many of them majoring in economics.
Peter Borish is a famous and accomplished investor. Before posing this investing question, Peter’s comments made it clear that he was extremely knowledgeable and sophisticated about the world of finance. Accordingly, the class was a bit tense as many students thought they knew the “right” answer, but were intimidated. After what seemed like a long time, Gayla, one of the students whom I knew well because she served as an academic liaison between the students and me, broke the silence.
“I’d buy stocks, I would diversify and try to minimize transaction costs. Accordingly, I would probably not try to pick individual stocks, but rather invest through mutual funds. My mutual funds would focus on companies of all sizes and include some that buy international stocks,” answered Gayla.
Gayla was a great student, and her answer was textbook. In fact, her answer is nearly identical to that given by finance guru Professor Jeremy Siegel of the Wharton School of the University of Pennsylvania. Professor Siegel’s book Stocks for the Long Run is a comprehensive analysis of investing. This book has played an important role in changing the way that Americans invest.
We will review the main statistical findings of Stocks for the Long Run, but before we do, let’s pose the same question to Professor Siegel. “If you had $1 million, what would you do with it?” In the last chapter of his book, Professor Siegel provides his answer.1 In the 1998 edition Professor Siegel told investors: “1. Stocks should constitute the overwhelming proportion of all long-term financial portfolios . . . 2. Invest the largest percentage—the core holding of your stock portfolio—in highly diversified mutual funds with very low expense ratios . . . 3. Place up to one-quarter of your stocks in mid- and small-sized stock funds . . . 4. Allocate about one-quarter of your stock portfolio to international equities.”
The 20-year old college student gave the same answer as Professor Siegel. Buy stocks, diversify, and keep expenses low. This is the main message to investors from many sources.
Conventional wisdom says that if you want to be rich, stocks are the best investment. In fact, this message has become so ubiquitous that it is almost a mantra: Stocks are the best investment. Stocks are the best investment. Stocks are the best investment.
Gayla came through with flying colors and gave the exact same answer as professionals who make their living advising others on what to do. How did Peter Borish respond to this answer? He asked, “Do you drive your car by looking in the rearview mirror?”
When it comes to stocks, Peter’s question is fundamental. U.S. stocks have had an undeniably bright past. Unfortunately, we
are not able to go back in time and buy stocks in 1982 or even 1802 (the beginning of Professor Siegel’s analysis). What is relevant to us is not the past, but the future. To understand the prospects for stocks, we have to dissect the past and see if the sources of past success are likely to continue into the future.
The Big Pile of Stock Market Cash Visible in the Rearview Mirror
It is not a coincidence that Gayla gave the same answer as Stocks for the Long Run. Professor Siegel has played a major role in promoting stock ownership. So much so that it is worth summarizing his main findings. This section uses the analysis of the second edition of Stocks for the Long Run, which was published in 1998. This is important for understanding the cycle of irrationality. This 1998 edition was the one that existed at the height of the technology bubble. From 1802 through the publication of the second edition there was one key to making good investments. It was: To make money as an investor, the correct strategy throughout U.S. history was to buy U.S. stocks.
Professor Siegel’s work shows the following:1. Over the course of history in the United States, stocks provided the best return.
2. For investors with a suitably long-run view, stocks were the best investment in every period.
3. While buying stocks when they were low (after a crash) would obviously have been the best strategy, even buying stocks when they were high (even right before a crash) was a fine strategy.
Let’s look at each of these extraordinary facts (and they are facts) in detail. Table 8.1 shows that U.S. stocks have left other investments in the dust.
A $1,000 investment in stocks in 1802 would have been worth over $7 billion by 1997! This calculation assumes that all proceeds from owning the stocks including dividends were used to purchase more stocks. Thus, stocks were by far the best choice for the 1802 investor.
TABLE 8.1 For 200 Years, U.S. Stocks Have Been Great Investments
Source: Stocks for the Long Run, second edition, p 6
In contrast, from 1802 to 1997 gold did not even keep pace with inflation. The investor who exchanged 10 loaves of bread for gold in 1802 would have been able to buy fewer than 10 loaves of bread with that same gold in 1997. Those who invested in U.S. government bonds could feel smart compared to the gold bugs. Overall, however, the stock investor would have been rewarded with close to 1,000 times more wealth in 1997 than the bond investor.
If you had a time machine and could travel back to 1802, your course of action would be clear. Buy stocks. This is Professor Siegel’s first point—stocks have been the best investment. His second finding addresses the following questions: What if your time machine dropped you off at some point in time other than 1802? Should you, for example, have bought U.S. stocks in 1861, 1914, or 1929?
The answer is that at almost every time in U.S. history the correct answer is stocks. Obviously, U.S. stocks have declined in many individual years so some multiyear period is required for a fair comparison. Professor Siegel does the calculation for 30-year time periods. This can be thought of as an appropriate time frame for a person saving for retirement who begins investing relatively early in his or her career.
The stunning finding: In every 30-year time period, except for 1831 to 1861, stocks performed better than bonds. Stocks were the right decision in every 30-year time period for more than a century. Amazing!
Professor Siegel’s third point addresses the issue of timing (bad timing, to be specific). Years ago, I remember a somewhat cruel TV interview of one investor with extremely bad timing. The unlucky chap had made a major purchase in the stock of Braniff Airlines on the day before it filed for bankruptcy. Braniff never reemerged from bankruptcy; the company was liquidated and stockholders lost every penny.
The reporter asked the investor, “What were you thinking when you invested tens of thousands of dollars into Braniff hours before they went out of business?” The investor (and he was a professional) responded with, “I bought the stock because I thought it would go up in price.”
Whenever I make an investment decision, I wonder if I am going to suffer the fate of the Braniff buyer. Will my purchase be at exactly the wrong time? For these fears, Professor Siegel has a response—relax. So far in U.S. history it has been impossible to buy at the wrong time. In fact, even if you bought on the day before a market crash, stocks have outperformed other investments over the following 30-year period.
The Dow Jones Industrial Average, for example, lost an amazing 89% of its value during the Great Depression.2 To understand this, you have to imagine a modern stock market crash taking the Dow down to about 1,000. So some investors bought stocks in the late 1920s and watched their wealth evaporate. For those who were patient, however, buying stocks on the worst day of a lifetime was still better than buying bonds.
Yes, even the unlucky investor who bought stocks on September 3, 1929—the high-water point before the crash—did better than the investor who bought bonds. Professor Siegel calculates the 30-year return on a $100 investment at the 1929 peak as follows: bonds $141, stocks $565. He makes similar calculations for all other market peaks. (Stocks have not yet recouped their losses since the 2000 peak, but we will not know the “long-run” payoff of late 1990s’ investments for many more years.)
The history of U.S. investing is clear. Always and everywhere the best course for the patient investor is to buy U.S. stocks.
In The Paper Chase, Harvard law professor Charles Kingsfield grills a student about a case. The student is unable to provide any useful analysis. After some verbal flailing, the student blurts out, “I have a photographic memory.” To which Professor Kingsfield responds, “That will do you no good at all.”
Similarly, the fact that stocks look good when we look at pictures of yesterday does no good at all to those of us who want to make money now and tomorrow. To determine if stocks are a good investment now and in the future, we need to go beyond Stocks for the Long Run and look at more than the past return of stocks.
Why Jeremy Siegel Does Not Play Professional Basketball or Live in East Germany
“Better lucky than good” summarizes the feelings of many toward performance. This view suggests that winning is more important than having deserved to win. When it comes to U.S. stocks since 1802, they have indeed won. To decide how much to invest in U.S. stocks today, however, we have to try to divide the past success of U.S. stocks into luck and skill. If U.S. stocks did well because of skill, they are more likely to be good investments now than if their strong performance was simply lucky.
As in many areas of finance, if we are to determine whether U.S. stocks have been lucky or good, we have to confront one of our human shortcomings: our tendency to place too much faith in actual outcomes. One aspect of this problem is called “survivorship bias” and was illustrated in the documentary Hoop Dreams that chronicles the lives of two talented young basketball players in their quest to play professional basketball.
One message of the movie (and there are many) is that these two young men make their decisions based on overly optimistic expectations about playing in the NBA. They devote their lives to basketball in the hopes that they can become rich and famous. One of the causes of over-optimism is the fact that all of us see only the winners in the competition to become NBA players. This bias toward seeing only the survivors causes us to overestimate the chances of success. It causes many people to devote their lives to a quest that is unlikely to succeed.
Being fooled by survivorship bias is almost unavoidable when we watch professional sports. Our arenas and TV screens are filled with professional athletes who have made it to the big time. Even on their bad days we know that these professional athletes live exciting lives filled with cash, cars, and beautiful women and homes (often chronicled in MTV’s show Cribs). All of these athletes are the winners in a competitive athletic world that begins before high school. Except for news reports and documentaries, we do not see the players who have worked just as hard and never earned a penny from athletics.
Because we almost al
ways see only those who survive, and therefore win athletic competitions, we tend to overestimate the ease of becoming a professional athlete. In Hoop Dreams the odds of making it from U.S. high school basketball into the NBA is estimated to be 1 in 7,600. The film shows that young basketball players are far too confident of their chances. Consequently, they make life decisions that are different (and presumably worse) than if they acted upon the true odds.
Survivorship bias is present in many areas of life other than professional sports. We generally see only the winners in politics, modeling, acting, and entertainment. The trouble comes when we make decisions based on our overoptimistic estimates of success. Survivorship bias pushes us toward investing time and money in prospects that appear alluring, but would not be exciting if the true odds were known and understood.
As a kid, my friend Jay was fooled by survivorship bias. The credits of every movie that he saw included “Completion guaranteed by The Completion Bond Company.” This is a form of insurance that pays off if a film isn’t completed. Jay planned to start his own completion bond company when he grew up since every movie that he saw had clearly been made and so insuring them seemed like a sure thing.