Rick Ferri says the following in an article at IndexUniverse about passive investing;
Market timing strategies are a zero-sum game in the marketplace. The financial markets don’t earn any more or any less return just because one person is buying and another is selling. If one investor buys in at the right time it means another investor must have sold at the wrong time.
Who loses if you buy a stock at $10, you sell it at $20 and the person who bought it from you takes it to $30? What if you sell half your position at $20 and it goes to $30, who loses?
Yesterday's post about gold being in a mania was re-run at Seeking Alpha and it drew a couple of comments laying out in one form or another the case for why gold is where it is and why it is likely to keep going up. Actually the way I read the comments I think both people were saying gold cannot go down in price because of the fundamentals behind it--fundamentals being how messed up the US is right now.
Anything can go down in price at any time for no reason at all. Some sort of price correction would not necessarily mean the fundamental story had changed but as something that is traded actively in markets it can drop for no reason at all.
People used to think that real estate could not go down in price. The internet stock niche got decimated yet the actual internet exceeded expectations as far as how much it has changed our lives.
The title is a bit of a joke, my wife says my entire life is like the weekend.
21 comments:
Anything can go down in price at any time for no reason at all.
I disagree with the no reason at all part. That just means you did not see it coming or did not expect the level of volatility something has.
if the reason is unforeseen than might that be know reason at all?
Taleb would say that not everything has an explanation. Humans like things to have explanations but not everything has an explanation.
Large volatility may be unexpected when it is actually normal and that may be viewed as no reason when it is really just normal volatility and rather chaotic.
As for other large directional moves I disagree I think the reason is simply not understood by most or not yet understood.
Some people saw the housing bubble and its consequences. Most did not and some are still saying how did that happen. It was rather obvious to some of us.
that one event could be explained does not mean every event can be explained. kind of a take on Karl Popper. All of the positives can't prove something they can only support something. It only takes one incident to disprove something.
After/before/when QEII finishes, commodities could quite easily fall off of their perches. This wouldn't be because of a change in fundamentals but the reason(s) would be endlessly debated. QEII ending would seem a likely reason but may be completely incorrect.
I don't see equities falling dramatically because of the end of QEII, as buying volumes have been low - ironically feeding an argument that the indices will likely fall - and so stocks couldn't have been bought up with QE dollars. Could they?
Is it just me, or are other investors reacting like a deer to headlights putting new money to work within a balanced portfolio?
I am in portfolio gridlock. Maybe a trip to Vegas is in order to prop up their economy.
Roger,
Have you looked at the Ishares XGB ETF as a vehicle for buying Canadian debt? It trades on the Toronto exchange. I do no know if there are issues related to non Canadian ownership.
Marshall
Market timing strategies are a zero-sum game
A 200 day moving average timed approach, reviewed once monthly as per Mebane Faber's Quantitative model approach (10 month moving average is the same as 200 day moving average), will on average have you IN for 70% of time and OUT for 30% of time.
A continually held blend of 70-30 stocks/bonds is on average no different to being fully IN stocks for 70% of the time and fully IN bonds for 30% of the time.
In the same way that a 70-30 (or 60-40) stock/bond blend is near the efficient frontier, providing better risk adjusted rewards (albeit not higher actual rewards) than 100% stock, market timing maybe a zero sum game, but the risks are lower, and as such can provide better risk adjusted rewards.
I think I've mentioned XGB once before, I think it is difficult to access a Canadian fund from the US but I am not certain.
I think portfolio gridlock is a good way to describe my situation. NOthing looks like a great investment right now, but there's nothing that's outright telling me to reduce equity position. So here I am with a little more cash than usual, a slightly lower total equity position than normal, etc. 2010 results certainly didn't make that look dumb.
Roger,
As a long-time reader, I've tried several times in the past to have this discussion with you about the zero-sum nature of active portfolio management. It seems to me that no amount of logic will ever change your mind on this topic, no matter how clear the mathematics and reasoning. But I'll try again (because I'm a masochist I guess).
What Rick Ferri said about market timing is 100% correct. Investors as a whole can neither "pull money out" nor "put new money in" to the stock market. Once a security is created, *somebody* has to hold it. An individual investor can put money in or pull money out, but not investors as a whole.
So: let's take your example, which I'll call "Timing Example". Investor A buys a stock at $10. Once it gets to $20 he's worried that it's going down, so he "pulls out" his money and stays in cash. Well, there must be a corresponding investor B who has cash and decides $20 is a good entry price. So B gets A's stock and A gets B's cash. Now let's consider the "No Timing Example". In this case, after buying in for the long-term at $10, A doesn't make any attempt to figure out when it's going down. So when it gets to $20 he just holds onto his stock. Correspondingly, B just holds onto his cash.
Now let's assume the stock goes to $30 and figure out who won/lost in the "Timing Example" versus the "No Timing Example". Well, since the stock continued to go up after it hit $20, it should be clear that A ends up with less asset value, and B ends up with more asset value, in the "Timing Example" as compared to the "No Timing Example". So A lost and B won in their mutual attempt to time the market. Note: if you compute the *total* asset value A+B, it's the same in both examples because it's not possible for investors as a whole to time the market.
Now: I know from experience you're going to reject this argument, even though it's incontrovertible (in my unbiased opion! :-). But I have to ask: why are you so resistant to this basic idea that active potfolio management is a zero sum game? After all, it's entirely possible that a particular manager (you, for instance) can beat the market, it's just not possible for all managers *in the aggregate* to beat the market. So why are you so wedded to the idea that they can?
- aagold
AAgold, I don't think everyone can beat the market, not even close.
I just reject the finite argument for there being far too many moving parts both in the market and with investors (circumstances and objectives) making this far more academic than how I think.
Arghhh...
Let me make this less academic then. Do you think it's possible for *all* investors to use your 200-DMA rule, where you suggest significantly reducing market exposure when the S&P 500 falls below its 200-DMA? Let's say the whole world started reading your blog and believed in your advice to "take defensive action when the demand for equities is unhealthy". Do you think it's possible for investors as a whole to benefit from your advice? Can everybody pull their money out of equities when demand is unhealthy? Obviously not. Any dollar amount pulled out due to your advice must be matched by new money put in, from investors who believe just the opposite. Agreed? (Please?)
"Any dollar amount pulled out due to your advice must be matched by new money put in, from investors who believe just the opposite."
Does investors include liquidity providers (specialists/market makers)? Because a large portion of the trades any of us place will find a liquidity provider on the other end who is more than likely preforming a job function not expressing an investment opinion.
:-)
Are you coming up with these answers just to torture me?
Ok. Let's change the word investor to "market participant", which includes both investors and market makers. Would you agree that it's not possible for all market participants to take your advice about getting out of equities when demand is unhealthy? For instance, if all "investors" listened to you and pulled their money out, it must be true that the "market makers" put the same amount of new money in. Agreed? Please throw me a bone here! :-)
- aagold
this is a fun debate.
of course not everyone can get defensive when the market breaches its 200 DMA but the trouble I have with that example is that I know not everyone will. Some participants (mutual funds and pensions) are not allowed to, which contributes to my belief that this is academic.
The other thing, what if you take get defensive to mean sell everything right now and I take it to mean completely hedge with put options bought on margin meaning nothing is sold? There are countless ways to get defensive which again contributes to what I believe is the academic nature of this argument.
As a clarification options can be bought with "cash available" in a margin account, not "buying power" in a margin account.
Ok, let me tackle this in two parts.
1) Stock options are a type of financial derivative, and any financial derivative is a zero-sum trade. All long positions are matched by equal and opposite short positions - so any profit made by one side is matched by a loss on the other side. Any market participant who reduces equity risk by purchasing put options is matched by some other market participant who increases equity exposure by the same amount. Now before you say that a market maker might sell the put options and hedge their exposure by shorting the underlying equity, that's only possible if someone else takes the other side of *that* trade (i.e., goes long the underlying equity). It doesn't matter how complicated you make this - in order for some set of market participants to decrease equity risk, some other participants have to increase equity risk by the same amount.
2) Now there is one context where I can see your point, and that's in commodity futures contracts. For instance, it’s a win-win when the producer of a commodity sells long-term futures contracts as a hedge, even when the price is below the expected future price, because the hedge may allow that producer to increase risk in other ways such as operating with more financial leverage (thereby increasing earnings and free cash flow). A speculator who takes the other side of the trade also benefits because he bought at a price lower than the commodity is expected to be at expiration. So although the futures contract viewed in isolation is zero-sum (speculator wins on average, hedger loses on average), when viewed in a larger context both can win. There may be a similar example with equities, but it’s not as obvious.
-aagold
What if the ultimate other end of your options trade is part of a spread where "your" option is a loser for this person but the spread "wins?"
Ok, let's say that the S&P breaches the 200-DMA so I want to reduce equity risk using put options. Well common sense should tell you that some one, some how, some way, has to *increase* equity risk by the same amount. After all, if I'm right and equities do decline, cash will end up flowing into my account. So where do you think that money is coming from, heaven?
In the specific case you mentioned of a spread, if the spread "wins" due to an equity decline it must have been a "bear spread", so the seller of my put options must have bought even more valuable put options with a lower strike price from a third party. Well that means this third party has increased *his* equity exposure and will end up paying off both myself and the bear-spread buyer if equities decline.
I'm sure you can come up with an even more complex scenario, but it's not going to change the overall concept.
yes I can continue to add variables which is the point. As I see it, the permutations are not finite therefore the results are not finite. My original point is that there are simply too many moving parts for the finite alpha argument to be so neat and tidy. Invoking Karl Popper it only takes one instance to disprove something and while I realize I have not disproven anything in your opinion but for me the case is clear.
Further, I say repeatedly that most people will not beat the market but I do reject the argument that the reason they won't is because something akin to what Ferri espoused.
actually i am not making a claim about the aggregate. i think my position is one of there being far more outcomes than your position. over some finite period of time like this year the aggregate certainly could outperform but I have no expectation of such an outcome.
Further to my point about too many variables, I wrote a post a while back where I made up an example of a manager who lagged the broad market by five percentage points every year of the up trend from 2003 to 2007 inclusive but who took defensive action going completely to cash at the exact right time late in 2007 missing the entire decline of 2008 with the net result a huge beat for the six years.
Did this person beat the market? Either answer can apply I think. In my opinion they did even though they lagged for five years in a row. There is no refuting someone who says this person lagged the market because they did for five years. There are a couple of variables here of the many that I have thought of in sorting this out for myself and there are countless other scenarios where I believe the argument you are making falters.
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