January 27, 2017
Yes, the Down Jones broke 20,000 this week, and because it did so, I am societally obligated to talk about it.
20,000, when you think about it, is insignificant numerically. From an investing perspective it's just as interesting if the Dow broke 20,057, or 19,875, but that doesn't make for good headlines, and without good headlines, it's hard to run a news outfit.
My teenage daughter pointed out that if they reported the stock indexes using base two mathematical format instead of base ten, no one would care. Now, that was somewhat nerdy. But it is true that if the constant media reporting machine were obscured, investors would not only feel better, research shows they would make more money.1 (Btw, if you clicked that link and had trouble reading the academic paper, I can just translate it for you: "Cramer on CNBC is a good entertainer and a poor investor and if you watch people like him too much you will get anxious and lose money.")
I am going to use this "seminal event" of 20,000 to point out two things.
One, the index fund that is used matters a lot. There are over 2,000 of them, and many of them appear similar but deliver very different returns. The Dow is a poorly constructed index on many levels. It is based on the price of its underlying securities, not their market capitalization, it is constructed of a small number of firms, and those firms do not reflect our modern economy well (though this has improved recently). If some of that went over your head, the takeway is that the index you own matters. A lot.
The second point we can learn while examining the Dow is how fickle individual corporate performance is over a long period of time. A question for you: of the original 12 firms in the Dow in 1896, how many are still in it?
The answer: one. The blue ribbon goes to General Electric, and it was removed and reinstated twice along the way and required a bailout by Berkshire Hathaway to survive 2009, so it kind of cheated. The others are all gone, long since surpassed by more modern firms. (I'm looking at you, American Cotton Oil and Distilling & Cattle Feeding). Even if an investor buys even powerful, stable, individual stocks, over the long term chances are they will fade, and may well go to zero.
An index, however, doesn't do this. The index fund gradually lets the losers fall away, and they are replaced in the index by up-and-coming companies. This process happens every year, without you being aware of it. The gains from the new, higher-growth firms more than offset the losses from the decliners over time.
You probably know someone who says "I'm a long term investor. I just buy and hold these great individual companies forever." The historical data shows they are on the wrong side of reality. Buy and hold works, but long term it only works in indexing.
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Speaking of reality, there is one other point I want to make today. As an investor, it is important to know what facts are, and what they aren't. In the investing world, unlike others, if you subscribe to alternative facts, there are lots of very smart people on the other side of the trade looking to take advantage of you. You get poor quickly if you convince yourself you know something that is not grounded in both math and history.
At One Day In July, our clients make a lot of money because the counterparties that are on the other side of our trades often have convinced themselves that they know something that is not, in fact, a fact. This is one of the things I love about finance: you get paid for realizing this and being disciplined about it. Other investors transfer their wealth to our patient clients every day, slowly but surely.
The big alternative fact that I see almost daily is that people believe they can time the market. There is no academic or historical evidence that this is true. The market is probably the world's largest, most complex, multivariable system, and it is not predictable by humans or computers. The Nobel prize winning economists running complex computer algorithms nearly blew up the financial world in 1998 because they assumed this wasn't true.2
The bad news is that at One Day In July, we have no idea in the short term what will happen.
The good news is no else does either.
The better news is that, unlike almost everyone in finance, we not only admit this, we proclaim it and use it to our advantage.
By knowing what is not in fact knowable, we become better investors.
Dan Cunningham
1. http://www.nber.org/papers/w15010
2. https://en.wikipedia.org/wiki/Long-Term_Capital_Management
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