Thursday, December 30, 2010

Beating the market - or not

Who believes in Efficient Market Hypothesis?

I don’t believe that efficient market hypothesis (EMH) completely captures what is going on in the markets. In other words, I believe that some investors can beat the market in long term and it is not just pure luck. According to EMH super investors like Warren Buffett and Charlie Munger of Berkshire Hathaway (BRK.A) are just incredible lucky. I don’t think so. Markets failed miserably in IT bubble, US housing bubble and recent EU debt crisis. The information about the risks was out there long before the crash, but market in general ignored the realities. Mr. Market failed to price assets “correctly” according to publicly available information.

Riding the bubbles with Mr. Market

Tree caricature from South Sea Bubble cards. Copyright expired. Source: "Extraordinary Popular Delusions and the Madness of Crowds" by Charles Mackay / Wikipedia.

The IT bubble was obvious case of pure mania, but even if I knew that I was riding a bubble I could not help to stay out (like Buffett did). On average, I got out pretty clean with a healthy net gain despite of some big losses in the aftermath of the bubble as I came back in too early. All in all, I probably was lucky that I did have only relatively small amount of money to invest back then. I was foolish enough to allocate all my money to single sector (technology/IT).

There are no mistakes or failures, only lessons. - Denis Waitley

I did not have any clue on US housing bubble, but I did start to sell off family stock positions in 2006 because I knew we needed the money for a house within 2 years and wanted to reduce risk by moving all money into short duration time deposits. Thus I completely avoided the crash, but I also lost some profits by hopping out of a very strong bull market that continued until around mid 2007.

Eruption at Eyjafjallajökull April 17, 2010. Source: Árni Friðriksson / Wikipedia. Some rights reserved. Distributed under the terms of the GNU Free Documentation License.

While I was unaware of what was happening in the US, I and plenty of others in Scandinavia suspected that there was something terribly wrong in the banking system of Iceland. Many prominent people in Finnish banking sector warned about Iceland banks that were luring people in with one year time deposit offers yielding whopping 5% or even more. Some people wrote these warnings off as jealousy, but I did not touch any of those offers. It was widely known that the Iceland banking miracle was built with good old leverage using cheap credit in the aftermath of IT bubble and low interest rates. Therefore, it was really a time bomb set to go off if interest rates raise and stock market plunges. When the perfect storm came into Europe from USA Iceland banks started to fall like dominos.

Does it make sense to try to time the market?

I came back into markets late 2008 as I simply could not believe how cheap some companies were selling. For the first time and probably last, I used borrowed money in investing as all of our savings were already spent on a house (our housing market has not crashed – at least not yet). It took a while to convince my wife to agree to this, but eventually she agreed that I can spend less than 5% of the value of the house back then. So off I went. I think I saw what every other value intestor saw back then: low valuations with healthy margin of safety.

Now, given all this bragging you might think that I believe I can time the market. No, I don’t believe I can – I don’t believe anyone can get it all right. However, I believe that a person with better than average knowledge about stock markets can spot the extremes: the lowest of lows and the highest of highs. Most of the time, timing the market is just pure waste of time. For the past two years I have tried to do that and in the process I have lost to the index due to my cash and gold positions. Also, I have deliberately built a defensive portfolio that does not behave well in bull market, but does not have a lot of downside risk either. Still, it is extremely interesting and useful to understand how ones portfolio compares to a suitable index.

How to benchmark your portfolio

First you have to select an index. I would recommend a broad index like “S&P 500” for USA, “MSCI World” for developed markets, “MSCI All Country World index” or “FTSE All World index” for developed markets combined with emerging markets. I have chosen the MSCI All Country World index for me because I am investing also outside the developed countries. It is important to study the index closely as the name does not always tell what it actually tracks (i.e. “MSCI World” really does not represent the world and “MSCI All country world index” does not actually do that to the fullest extent possible either).

After selecting the index, I recommend to find an ETF that tracks the index and reinvests the dividends. Then all you have to do is to compare performance of your portfolio to that of a single ETF. I wasn’t able to find one for my purposes, so then I looked for an ETF that distributes dividends and tracks index similar to “MSCI All Country World”. I found three candidates: “iShares MSCI ACWI Index ETF” (ACWI) tracking “MSCI All Country World Index”, “Vanguard Total World Stock Idx Fd ETF” (VT) tracking “FTSE All World index” and “WisdomTree Global Equity Income Fund” (DEW). However, I find it a bit hard to convert back and forth from USD to EUR and then also to track the dividends. Therefore, I chose to track the index itself and compile own benchmark index “fund”.

How to construct own benchmark index “fund”

It is actually not at all hard. First you need to find the index data. You can download MSCI index data from their web site in Excel format. Before doing so, make sure that you have selected the right index, currency and index level. I used the “Net” as in “With Net Dividends” that takes into account taxes that you would have to pay before you can reinvest back into the fund. “Gross” option reinvests dividends wholly.

Then you should get data from your brokers about your investments, cash position etc. The additions in cash to the brokerage accounts are a bit problematic. I chose track these as if I had purchased my imaginary benchmark index fund on the very same date. By dividing the money with the index, you get “shares in index”. Be sure to take into account the usual expenses in purchasing and owning an ETF. I decided to use 0.5% for yearly expenses and 0.5% for purchase cost and spread. The rest is then just a matter of “small” Excel exercise.

In nutshell: you are comparing your actual investment performance to passive index investing. You don’t have to track the individual trades, dividends or such. You only have to look at cash and stock balances at year end and take into account any additions or removals to/from brokerage accounts. This may sound easy, but actually is not. It may take a while to get hang of it. But believe me, it will be worth the time and next year you have got a template ready!

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