THE FINANCIAL PHILOSOPHER

The Financial Fallacy of Patterns, Causation & Correlation

"Nobody goes there anymore.  It's too crowded." ~ Yogi Berra

Is last week's Yankees win a bullish indicator for stocks?  Stock prices are at a 13-month high, does that mean that the market will continue to go up in the short-term?  Or are stocks due for a correction?  Do the answers to these questions really matter to your investment strategy?

Perhaps the greatest strength and simultaneous weakness of the human brain is its hard-wired tendency for pattern recognition.  Certainly this heuristic wiring aided in pre-historic man's search for food and avoidance of danger but does it translate to prudent financial decisions?  Not necessarily. 

In fact, pattern recognition might be the root cause of most economic and market bubbles (and bursts), including those leading to the current financial crisis. 

Those of you readers who are traders might counter my point by saying that momentum trading is real and can be quite foolish to ignore.  Nothing attracts a crowd like a crowd!  While this is true -- the crowd is "right" more often than it is "wrong" -- it also opens the door to peril -- to the confusion between causation and correlation and to the illusion of control.

"Death is caused by swallowing small amounts of saliva over a long period of time." ~ George Carlin

Humor, which I believe to be a form of philosophy, sure does have a way of illuminating the folly of human thought and behavior, doesn't it?

At root of searching for patterns and confusing causation with correlation is the philosophic term, fallacy, which is simply an instance of poor reasoning. 

Perhaps the most common fallacy, with regard to investing, is the gambler's fallacy.  For example, if a coin is tossed three times and it lands on heads each time, a large majority of people will detect a pattern and reason that the fourth toss will also be heads.  Perhaps a smaller group might reason that it will land on tails, citing that the odds are against another toss landing on heads.  Reasoning for both of these bets is fallacious because the chance of a coin landing on heads or tails is always 50%, regardless of the outcome (or number of) previous tosses.

With regard to investing, do Summer months cause stock prices to fall or is it just a period of time during most calendar years that is coincidental with weak stock market conditions?  For example, the "sell in May and go away" phrase is based upon historical stock price movement (patterns) and suggests an investor avoid stocks from May through October.  This year, however, the market, as measured by the S&P 500 jumped more than 18 percent from May 1 to November 1.

Of course, daily movement of the stock market is no toss of the coin and there are certainly times where technical analysis is more prudent than fundamental analysis.  Furthermore, there is another counter-argument to be made, with investing and trading, that there is no real reason to distinguish between causation and correlation. 

Essentially, the investor is looking for probability of an outcome. Regardless of how irrational the behavior may appear, all data must be considered because crowds often act irrationally.  If the crowd anticipates higher stock prices because the Yankees win the world series, then this event may feed more of an illusion that conditions are favorable to buy stocks, thus becoming a self-fulfilling prophecy of sorts.

"Too keen an eye for pattern will find it anywhere." ~ T.L. Fine

In summary, and as with everything, there is a balance to be found but this balance is only accomplished through self-knowledge and self-awareness.  To prevent a fallacious inference, one must be aware of the brain's tendency to find patterns; to take action on the pattern-based decision; and then to be given the illusion of control if the action is affirmed or "proves to be correct."

Put simply, do not be fooled by patterns!  In fact, don't even look for patterns because you'll find one every time and everywhere you look!

Contrarian View: V-Shaped Recovery

"Excess generally causes reaction, and produces a change in the opposite direction." ~ Plato

Humans like to watch for (and make decisions based upon) patterns.  This behavioral trait is certainly no exception in the world of capital markets and economics.  The most watched pattern at the moment might be the current and projected shape of the recession.

Economists like to describe the shape of economic recessions as V-shaped, U-shaped, W-shaped or L-shaped, the letter shapes of which reflect the respective form taken in a graphical illustration.  It is important to note that economists have not proven to be forecasters by nature and that traders and investors in capital markets often believe the consensus view of economists to be more wrong than right.

A recent BusinessWeek article, The Recovery: It's The Herd Vs. History, noted that the average forecast of economists calls for modest growth in real gross domestic product of 2.7% over the next year.  In fact, the NY Fed President, Bill Dudley, says there will be no V-shaped recovery. 

History, however, suggests that deep recessions are followed by strong short-term recoveries -- stronger than economists are now forecasting.  Additionally, the stock market and other indicators of future economic activity seem to be forecasting a V-shaped recovery:

As you can see, at least at the moment, the stock market, along with other leading economic indicators, is pointing toward a V-shaped recovery, which contradicts most of what conventional wisdom has been saying for several months.  The same BusinessWeek article, by James C. Cooper, goes on to make a few other observations that counter current and recent expectations of economists:

...in the first year after the severe slumps in 1973-75 and 1981-82, real GDP grew 6.2% and 7.7%, respectively.

The average number of quarters for GDP to regain its business-cycle peak in the past nine recoveries [is 1.9 quarters].

Like a rubber band, the economy snaps back in proportion to how far it was pulled down, as consumers finally upgrade old laptops and buy new clothes, and businesses replace inventories and worn-out equipment.

The common argument [against a stronger recovery] is that the usual rebound effect will be limited by the aftershock of the financial crisis:  Credit growth is plunging, because households need to unload debt and save more amid lost wealth and tight credit...

Early in recoveries, the growth of household income is a more important impetus to spending than credit.  As job losses fade, pay from wages and salaries, about 60% of aftertax income, will turn up, as it did in July for the first time in nine months.

My non-quantitative/behavioral/philosophical perspective is that one must be careful to look at any economic cycle, especially this one, as "average."  At the same time, one must be careful to make the assumption that consumers, who make up nearly 70% of economic activity, will act according to scientific forecasts.

At present time, consumers appear to be more rational than usual:  They are spending less than they earn and are largely avoiding debt.  This would support the consensus view of economists that the recovery will not be V-shaped.

Complacency, however, must never be underestimated.  As the memory of the financial crisis becomes increasingly replaced by months of economic growth and growing 401(k) balances, consumers will return to their irrational behaviors of spending more than they earn and funding their life today with tomorrow's money.  This would support a V-shaped recovery.

"The difference between what the most and the least learned people know is inexpressibly trivial in relation to that which is unknown." ~ Albert Einstein

Simultaneously, one must consider the unknown and make a conscious effort to resist taking action upon the "easy forecast."    When an expectation seems obvious or when an answer is easy to come by, the prudent minded person, given that there is time to pause, will make an honest effort to find reasons that they (and/or the herd) could be wrong.  The easy forecast, especially at this time last year, was for an L-shaped recovery, which now is obviously not the case.  Evidence also now reveals that this is no U-shaped recovery either.

A V-shape, however, can always be the beginning of a W-shape!  As history repeatedly reveals, nature likes to hide! 

To conclude, and to reiterate last week's point to resist the temptation to watch for patterns and act upon predictions, the prudent investor does not spend time trying to forecast the future direction of capital markets and the economy. 

One must first consider their own "personal economy" and how to allocate financial resources in a way that supports life pursuits beyond money.  Short-term market fluctuations are fodder for media noise -- not a basis upon which to form sound financial decisions.

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Related:

Know Thy Risk 

Quotes on the Unknown, the Uncertain & the Hidden

Rationality & Prediction: One Year Later

"Those who have knowledge don't predict.  Those who predict don't have knowledge." ~ Lau Tzu

Extending upon the recent discussion here on rationality, let's revisit one year ago today, October 6, 2008.  The stock market was in free fall, declining nearly 10 percent in just five days, and the herd reaction was panic.  As I think back to my own emotional state, I believe mine was also panic... but not for the same reason as the herd!

My panic was that others were panicking!  My attempt to remain rational and orderly amidst irrationality and chaos may just have been, well, irrational!  This hindsight observation begs the question, "When is it best to follow the herd and when is it not?"  This may be the most common question on the minds of almost every investor, trader or asset manager when making investment decisions or giving recommendations, especially during extreme volatility.

If you are interested, feel free to read my blog post from exactly one year ago, Reasons Not to Sell Stocks Now.  If you don't care to read it, here's the synopsis:  As the herd was running for the exits, I was hyper-intentionally resolved to maintain my cool-headed contrarian stance.  I can now admit that, in frustration, disgust and a bit of haste, I made the one and only "prediction" on this blog, which was that stock prices, as measured by the S&P 500 would close higher one year later and would even outpace the average money market fund! 

What are the results of this prognostication?  The S&P 500 closed one year ago, October 6, 2008, at 1056; yesterday (technically one-year later) it closed at 1040; and today, October 6, 2009, the S&P peaked intra-day at 1061 and finally settled at 1055, just a one point below its year-ago mark!

Of course, at the time, I didn't imagine how bold this prediction would appear, especially as the S&P 500 fell another 40 percent lower by March 9, 2009!

"There are no facts, only interpretations." ~ Friedrich Nietzsche

Those of you who have read this blog for long, know that I do not believe in making (or acting upon) predictions. 

Without getting deep into a semantic analysis, one may argue that any action taken based upon an expected future result is a form of prediction.  While this may be true, I should qualify my previous statement against prediction by saying that, in general, I believe it to be foolish to forecast an outcome that may be significantly influenced by the whims of human emotion.

On a lighter note, I can't help but think of some advice someone gave me with regard to emotions and personal relationships:  "Would you rather be right or happy?"

This advice seems to work well with investing and financial markets, wouldn't you agree?

The Rhyme of Irrationality

"Man has the power to act as his own destroyer -- and that is the way he has acted through most of history." ~ Ayn Rand

I recently ran across a few articles that got me thinking about irrational behavior, especially with regard to the key players (politicians, the federal reserve, big business, and the investor herd) in financial markets.  Each article is worth a read; however, I will provide the key takeaways and then follow with a few of my own thoughts, which will hopefully provoke your own:

Predictably Irrational: How Investors Frame Decisions:

• Author of the popular book, Dan Ariely, shares some of his observations from research in the field of behavioral finance at a recent industry conference for investment advisers.
• Ariely says, "Your brains are fooling you in a repeated, systematic way, and they are doing the same for everybody."
• The abundance of choices increases complexity and decreases the brain's ability to make good decisions -- the process of investing (selection, monitoring, buy/sell decisions) is rarely simple, yet decisions are made quickly.
• When decisions affect events further in the future, people act more rationally.  As time frames shorten, temptation plays a greater role and decisions become more irrational.  Ariely calls this "hyperbolic discounting," which explains why people don't save, diet or exercise -- the rewards of immediate temptations are valued too greatly.
• To overcome temptation and other related and irrational behavior, investors (and their advisers) should create binding contracts that anticipate temptation and provide details for rational reactions, such as re-balancing a portfolio in the midst of large swings (up or down) in stock prices.

Can Irrationality Be Rational?:

• Blog author, Barry Ritholtz, of The Big Picture, comments on a recent New Yorker article, titled Rational Irrationality, which discusses "the real reason that capitalism is so crash-prone."
• Mr. Ritholtz's take on the New Yorker article is that the author rationalizes irrationality, for example, on the part of big financial firms having little choice but to participate in financial bubbles or suffer by comparison to others who are profiting.
• This appears to Mr. Ritholtz as overlooking the consequences of a narrow short-term view.  In other words, how can one rationalize irrational behavior simply because others are participating (and profiting at the moment)? 
• Prudent risk management requires that a money manager or CEO go against the crowd at times of irrational exuberance and to exhibit objective judgment rather than herd behavior.

Why Capitalism Fails:

• The article observes recent interest in a somewhat obscure macro-economist, Hyman Minsky, who died over a decade ago, and whose studies predicted exactly the kind of financial meltdown we are experiencing today.
• In true bubble (and human) fashion, Minsky noted that periods of economic stability, as we experienced over the past few decades, would set the stage for monumental crises.  As Minsky observed, "Success breeds a disregard of the possibility of failure."  That success, of course, encourages borrowers and lenders to take on more risk and eventually a "euphoric economy" would develop.  Once this kind of economy develops, any panic, such as the failure of a large firm, would create a sudden economy-wide attempt to shed debt.
• This moment of panic, the watershed moment, would later become known as "The Minsky Moment."  Speculators and Ponzi borrowers would collapse first, followed by the remainder of market participants, even the more stable players.
• Minsky aptly named his idea "The Instability Hypothesis."  In the wake of a depression, he noted, consumers, businesses and financial institutions are all extraordinarily conservative.
• So, what now?  Minsky's solution, put briefly, was for extended programs from the federal government, even more than is currently being implemented.  Understandably, there is much concern today of socialism creeping into our governments so Minsky's solution will not likely be fully implemented.

With regard to these articles, especially the latter, I will avoid the temptation to cast judgment on any particular political view.  What I will opine, however, is that capitalism does not "fail" -- it simply follows a natural cycle that reflects human behavior that happens to go largely unchecked in a free society.

In a free society, individuals, businesses and institutions have an almost limitless capacity to fail, just as they have equal capacity to succeed.

The events in financial markets developing over the past few decades and unfolding within recent years simply speak to my consistent argument that human behavior, which is part of nature, has not fundamentally changed in thousands of years.  Only the environment has changed.

All of these observations underscore my belief that a great understanding of human behavior, combined with a significant degree of self-knowledge, allows for an understanding of all things touched by human behavior, including and especially financial markets.  In other words, knowledge of financial markets and financial instruments is less critical to understanding their cycles than the knowledge of human nature itself.

The only real certainty is that irrationality of participants in financial markets will return again, although it will manifest itself in a different form -- not a "repeat" but a rhyme of irrationality, if you will, that will continue to occur as long as humans populate the earth.

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Link to Don Ariely's book: Predictably Irrational: The Hidden Forces That Shape Our Decisions

Additional Reading on the subject of capitalism and human behavior: Atlas Shrugged by Ayn Rand.

Stocks, Storms & September

"What is to give light must endure burning." ~ Viktor Frankl

As an investment adviser and a resident of coastal South Carolina, two thoughts come to mind every September:  Historically it is the cruelest month for stock investors and it is also the height of hurricane season -- both, to say the least, promise to create some level of anxiety for millions of people -- and this year is certain to be no exception to this annual reflection.

This time last year, the stock market and broader economy had just begun it's most horrific three-month decline (more than 40%) in a generation.  September 2009 also marks the 10-year anniversary of Hurricane Floyd, which is probably best remembered as the largest (and worst planned) evacuation of any kind since World War II.  For those of us in the Charleston, SC area, September 2009 also marks the anniversary of the most devastating hurricane that almost anyone in South Carolina can recall in their lifetime, Hurricane Hugo.

The big storms, whether they are financial or tropical have several commonalities:

• Storms (financial crises/hurricanes) are cyclical in nature.
• Even those with the greatest knowledge, tools and experience (stock traders/meteorologists) can not say with consistency or great certainty when and where the next storm will occur.
• Hindsight is 20/20.
  
• Decisions (investment allocation/evacuation) are best made before the storm arrives -- not during it.
• The worst behavior (complacency/denial) occurs immediately prior to the storm, especially if a long period of time has passed since the most recent big storm.
• The most prudent behavior (financial responsibility/preparedness) occurs following the big storms; however, this behavior shifts to complacency as time passes.
• There are rewards (higher potential gains for stocks/living on the beautiful coast) for taking risk.
• The most devastating storms (largest market downturns/most damaging hurricanes) tend to occur only once per generation (20 to 30 years).
• Investing in stocks and living on the coast have similar risk/reward attributes:  Stocks carry significant risk of short-term price declines but greater potential for higher long-term returns compared to "safer" investments.  Living on the coast presents significant risk of loss due to tropical storms but offers warmer climates and a wonderful quality of life.

"The little reed, bending to the force of the wind, soon stood upright again when the storm had passed over." ~ Aesop

One of the most positive results of these big storms is the emergence (or re-awakening) of great human spirit.  In the wake of the storm, most do not reflect upon what has been lost but choose, instead, to focus on what is still possessed -- all of which has nothing to do with money, material wealth or social status -- it is health, family, a tremendous sense of community and giving, that is colored with shades of hope -- all driving the survivors forward.

One does not ever wish for these big storms and certainly not the devastation they often bring, but they play an important function in nature -- one of cleansing and renewal.

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Related:

Quotes on the Unknown, the Uncertain & the Hidden

Quotes on Worry, Fear, Anxiety & Suffering

Frankl image by Shannon

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.

Where is the pendulum now?

"Excess generally causes reaction, and produces a change in the opposite direction." ~ Plato

Do recent gains in the stock market reflect reality?  This is somewhat of an oversimplification but the stock market is a forward-looking, "discounting mechanism," which essentially means that today's prices reflect investors' expectations for corporate cash flows several months from now.

The price movement on the broader indexes, since the most recent lows on March 9, 2009, is up roughly 50%, which would suggest that the collective expectation of investors is that the worst is behind us and we are quite likely climbing our way out of recession now. 

What if this sharp rise in stocks proves to be a result of a premature and unjustifiable assessment of the current economic environment?  Have stock prices gone up too far, too fast?  Are we due for a "correction?"

Where is the pendulum now?

"The markets can remain irrational longer than you can remain solvent." ~ John Maynard Keynes

Irrationality exists at both ends of the sentiment spectrum: Stock prices can be pushed far too low by fear and uncertainty (as one may easily recollect from the recent past), just as stock prices can be pushed far too high by complacency and over-confidence.  The investor herd is "right" most of the time but eventually stock prices return to the mean or some reflection of "fair value."

Consider just a few observations that may suggest that stock prices have either pushed ahead of fair value or are "priced to perfection," setting the stage for a fall in stock prices if (and when) investors discover that their expectations may be too high:

• Consumers represent roughly two-thirds of the US economy and they are saving more and spending less.  In the short-term, this trend will not support the economy.
• Unemployment remains historically high and does not show signs of improvement in the short-term.
  
• Credit card companies are squeezing consumers by lowering credit limits and increasing interest rates, further constricting consumer spending.
• Federal stimulus is ending and it may be time for investor caution as recent strength in home and auto sales may prove to be fleeting:  The $8,000 tax credit for first-time buyers ends in November and the "cash for clunkers" programs ended this week.
• Stock mutual funds and Exchange Traded Funds (ETF's) had record inflows in July.  Record inflows (or record outflows) are often contrarian signals of unsustainable stock price movement.

"Bad reasoning as well as good reasoning is possible; and this fact is the foundation of the practical side of logic." ~ Charles Sanders Peirce

As with any logical observations, they are just that -- logical observations!  Any knowledgeable person could find supporting data for either side of the argument (stocks going up or stocks going down).  Knowledge, therefore, does not by default translate to good judgment.

Furthermore, media noise is concentrated on the short-term (using information from the immediate past) and leverages emotion to sell advertising.  This noise is not suited for the long-term investor, who is best served by tuning out the noise and investing according to their own objective and risk tolerance.

For now, investors may at least find comfort in observance of the pendulum's swing in the positive direction -- a stark contrast to this time last year.

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Plato image by Shannon

Related Posts:

Beware of Confirmation Bias

Recession is Official: Is it Time to Look Forward?

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.

How the Buying & Selling of 'Pre-Owned' Goods Can Save the Economy

"Thus Something and Nothing produce each other..." ~ Lau Tzu

As I was recently (and reluctantly) doing some routine organizational work around my office, I ran across a business software program that I bought a few years ago when I first started my investment advisory firm.

What makes this business software program noteworthy is that I never used it!  Fully confident in my simple, yet effective, means of organizing electronic files and generating financial reports (and admitting to myself that I had made a hasty purchase) I decided to place an ad in the classified section of a local newspaper to sell it.

To my surprise and delight, someone called with interest in buying the business software program at my full asking price!  My delight, however, began shifting toward disgust as I sat and waited for the buyer (he was an hour late) to meet me at the agreed upon place to make the exchange of software for money.  Disgust started shifting back to delight as I sat in a quiet car with nothing to do but think, which produced this post!

I began thinking of how this business software program was just sitting in my office, producing nothing.  My thoughts soon expanded to how many other people likely have things of value just sitting in their office or home, producing nothing, and how many more people are looking for a particular means of producing something but they don't have much money to spend at this time.

As you may have guessed by now, my thoughts expanded further to the idea of...

How the buying and selling of pre-owned goods can save the economy:

Pre-owned goods are assets that produce a "return:" Most people don't see things laying around their office or home as "assets" that produce a "return."  If you have something that provides some form of utility (whether in the form of a financial return or in the form of simple enjoyment of the thing), then it is an asset producing a positive return.  If this asset is sitting there doing nothing, it is producing nothing -- a zero return.

Converting zero returns into positive:  One man's trash is another man's treasure.  Get some cash for your trash!  Your "asset" may be worthless to you but it just might be exactly what someone else wants or needs.  It's almost irresponsible to keep something you're not using when someone else can receive and/or produce a return from it.  Sell the item and convert a zero return into a positive one! 

Preventing the expensive (and often overlooked) opportunity cost:  If the pre-owned good is worth something to someone else then, not only do you have an asset producing a zero return, you possess an asset that has potential to produce something for you and to produce something for someone else!  Foregoing an opportunity -- this potential for gain -- actually has a cost -- opportunity cost.  Don't overlook these costs!

Creating a type of multiplier effect:  Let's say the pre-owned good sells for $100 but a new one sells for $200.  The $100, to the seller, represents a cash in-flow of $100 from an asset that was previously generating zero return and can now be reinvested and go back into the economy in some shape or form.  The $100, to the buyer, represents an expense -- a cash out-flow; however, the buyer "saved" $100 by buying a pre-owned good that can produce a return potentially greater than the cash alone could generate. 

As you one may easily deduce, this simple exchange of a pre-owned good for cash enables both the buyer and seller the potential to earn a greater return than if the exchange never took place. 

My anecdotal observation is quite simple; however, I am confident that there are thousands of transactions like this taking place every day -- significantly more than even one year ago -- and that the cash produced for the seller and the utility produced for the buyer combine to make opportunities for both sides... and to make this economy stronger (or at least more sound) than it has been in a generation. 

Now go find those "assets" laying around your house, sell them for a reasonable price to a worthy buyer and use your newfound cash to produce a return!  You just might aid in saving the economy!

New Bull Market or 'Bear Market Rally': Why Make Predictions?

"Even if someone knew the entire physical history of the world, and every mental event were identical with a physical, it would not follow that he could predict or explain a single mental event (so described, of course)." ~ Donald Davidson

Now that the rally appears to be losing steam, the predictions for a "retest" of the March 9 low (or even a plunge below that mark) are gaining in velocity.  Perhaps these people making predictions are more brave, more knowledgeable or more foolish than I; but what good does it do to make such predictions anyway?  Will those making the predictions act on them?  Do they manage money?  Are they trying to sell books/newsletters/advertising?

To affirm my own thoughts on prediction, I looked through some of my favorite philosophy books for some support.  I thought you might like to read some of them and form your own conclusions with regard to making predictions (of course you will notice that my bias is against making and acting upon predictions).

"It is clear, then that the idea of a fixed method, or of a fixed theory of rationality, rests on too naive a view of man and his social surroundings.  To those who look at the rich material provided by history, and who are not intent on impoverishing it in order to please their lower instincts, their craving for intellectual security in the form of clarity, precision, 'objectivity', 'truth', it will become clear that there is only one principle that can be defended under all stages of human development.  It is the principle: anything goes." ~ Paul Feyerabend

"Too keen an eye for pattern will find it anywhere." ~ T.L. Fine

 

"The supreme paradox of all thought is the attempt to discover something that thought cannot think." ~ Soren Kierkegaard

"We must not, therefore, wonder whether we really perceive a world, we must instead say:  the world is what we perceive. . . . To seek the essence of perception is to declare that perception is, not presumed true, but defined as access to truth." ~ Maurice Merleau-Ponty

"A likely impossibility is always preferable to an unconvincing possibility." ~ Aristotle

"Until a man has expressed his emotion, he does not yet know what emotion it is.  The act of expressing it is therefore an exploration of his own emotions.  He is trying to find out what these emotions are." ~ R.G. Collingwood

"Those who have knowledge, don't predict.  Those who predict, don't have knowledge." ~ Lau Tzu

"The difference between what the most and the least learned people know is inexpressibly trivial in relation to that which is unknown." ~ Albert Einstein

"A hidden connection is stronger than an obvious one." ~ Heraclitus

"It is the mark of an educated mind to rest satisfied with the degree of precision which the nature of the subject admits and not to seek exactness where only an approximation is possible." ~ Aristotle

"Men in the game are blind to what men looking on see clearly." ~ Chinese Proverb

De-bunking the Case for Hyper-Inflation

"Money often costs too much." ~ Ralph Waldo Emerson

With massive government spending and rising food and energy prices, imagining a not-too-distant future of extreme inflation is quite an easy undertaking, which may be part of the reason I do not participate in the popular forecasts for hyper-inflation.

As long as the Federal Reserve has the ability to print money, the long-term macro-economic trend will be inflationary.  But will inflation really become the large problem that many forecasters predict?  Personally, I don't think so... at least not any time soon...

Here are my logical assumptions that suggest inflation will not be a large problem any time in the near future:

• Supply/Demand:  My simple-minded definition of Inflation is "too many dollars chasing after too little amounts of goods and services."  It's the classic supply/demand balance.  While there are reports of shrinking inventories, there also remains the likelihood of growing unemployment.  In addition, and even as job losses stabilize, consumers must open their wallets for corporate pricing power to return.

• De-leveraging of consumer credit and bank balance sheets may be a multi-year process:  Consumer discretionary money will go towards debt reduction before it goes to spending on products and services that are not absolutely necessary.  Likewise, banks and big business have some cleaning up to do on their balance sheets before their free cash flow is at healthy levels.

• The shifting money perception paradigm:  Consumers are changing the way they see money and, hence, their financial habits.  They are doing more with less and some time will have to pass for complacency to return and for the credit cards to be pulled out again.  There is more of an attitude now that says "Do I need it?" rather than the preceding mind set of "Do I want it?" In the immediate wake of the largest credit crisis since the Great Depression, the appetite for buying new products and services will be lesser than (or equal to) the appetite for debt reduction.  In addition, more and more credit card users will put away the plastic as credit card companies raise rates and fees, even on their best customers.

• Rising Commodities and Food prices will hold down discretionary spending:  Higher prices for oil and food are inflationary but can also put a dent in an already thin consumer wallet, leaving less money remaining for spending elsewhere; therefore keeping a lid on hyper-inflation for the foreseeable future.

• The greatest money tap of all, home equity, is almost non-existent:  More than 20 percent of homeowners are "under water" (owe more than their home is worth).  The remaining 80 percent has little capacity and/or desire to tap into home equity any time soon.  Keep in mind that, as home values fall and debt levels hold steady, home equity gets crushed.  For example, a 40 percent fall in home value represents a 70 percent decline in home equity. 
  

• If consumers spend, it will be on "deals:"  Once again, consumers are changing their habits -- they are "smarter" shoppers than before.  Coupon usage is on the rise and discounts have to be deep for consumers to spend, especially for those non-essential items.  Low prices will be the norm for a long time.

• A rising savings rate:  When consumers reduce debt to a satisfactory level, they are likely to shift discretionary money to savings.  Reducing debt and saving money are generally good but can be bad for the economy when everyone is doing it at once.

"You could not step twice into the same river; for other waters are ever flowing on to you." ~ Plato

As with nature, and ourselves, the financial markets are constantly evolving.  Inflation, as long as the Federal Reserve has the power to print money, is the prevailing long-term macro-economic trend.  In the short-term (less than three-years), however, a logical perspective would expect Deflationary conditions (high supply/low demand, falling prices) possibly evolving into some degree of Stagflation (slow growth, surging inflation). 

"Bad reasoning as well as good reasoning is possible; and this fact is the foundation of the practical side of logic." ~ Charles Sanders Peirce

Beyond three years is difficult and foolish to forecast.  Logic would expect, however, that tremendous government borrowing and spending will almost inevitably lead to high relative inflation... just not any time soon... and not as dramatic as the most extreme forecasters are saying.

"Things do not change; we change." ~ Henry David Thoreau

To conclude my thoughts here, I can not help but add that, as an individual, there is no controlling the economic environment; therefore, the prudent-minded person will focus on those things that are well within their control -- spending, investing, pursuing education, allocating assets, allocating resources, and allocating attention to name a few.

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Related Post: "Can We Help Being Deceived?"

'Buy & Hold' is Not Dead (If Properly Defined)

"If I can assign names as well as pictures to objects, the right assignment of them we may call truth, and the wrong assignment of them falsehood." ~ Socrates

If one makes the statement, "Buy and hold is dead," what do they really mean by that?  How do they define the term buy and hold? (Of course, to make this argument, one would also need to define the term, "dead," but I won't get that far into semantics here).

If buy and hold is truly "dead," in my humble opinion, the term must be defined as follows: 

An investment strategy of buying shares of a particular investment and holding the investment for a period of time generally accepted to be "long-term," such as 10 years.

Is that a fair definition of "buy and hold?"  Perhaps it is, but who on the planet actually invests like this? 

Who actually bought, for a simple example, shares of an S&P 500 Index Mutual Fund 10 years ago, let it sit there without buying any new shares or any other asset types for diversification, and sold it today?  I'd love to hear of any examples if any really do exist.

For reference, $10,000 invested in the S&P 500 Index for the ten-year period ending March 31, 2009, would be worth $7,742 at the end of the period -- a total return of -22.58 or -2.47 annualized (An index mutual fund would have returns slightly lower than this when expenses are included).

These are quite sobering numbers and would tend to lead a rational person to conclude that so-called "long-term investing" has gone the way of the Dodo bird. 

In summary, if buy and hold, by the previous over-simplified definition, is dead then it never was living in the first place.

So what is my definition of buy and hold?  There are certainly many acceptable definitions, as it should be, but here is a loose framework of what I would accept:

An investment philosophy of selecting investments, usually as part of a diverse portfolio of other investments and asset types, with the intention of holding (and continuing to purchase shares if applicable) of the investment(s) for at least three years.  The investment(s) will be used as a tool, along with the other investments and asset types, to serve a larger purpose for an objective unique to the individual, which would typically have a time horizon of more than five years.

The key phrases in this definition are "continuing to purchase shares" and "unique to the individual."  

On the "continuing to purchase shares" point, is it not reasonable to expect a buy and hold investor to continue purchasing shares throughout the holding period?  Wouldn't a buy and hold investor, also be a typical user of dollar-cost averaging? 

This same buy and hold investor can certainly also be a net buyer when the herd is running from stocks and a net seller when the herd is running toward stocks without abandoning the buy and hold philosophy.  These practices certainly weaken the argument that buy and hold is dead. 

For reference, the S&P 500 may be lower today than it was 10 years ago, but it currently stands more than 8% higher in price than its low in October of 2002, and more than 30% higher in price than its more recent low in March of this year -- both times included in this 10-year period for which our buy and hold investor would have been buying more shares at lower prices.

If our buy and hold investor diversified into other investments and asset types, their investment philosophy, judging by returns in other sectors, certainly would not be dead.  The 10-year annualized returns ending March 31, 2009, weren't too bad for several common sectors and other asset types used for diversification:  Precious Metals (15.77%), Natural Resources (9.21%), Health Care (3.88%), Multi-Sector Bond (5.15%) and Taxable Money Market (3.65%).  

The "unique to the individual" point in my definition, makes the "buy and hold is dead" argument, well, dead! 

Buy and hold is not some static investment strategy that can only be used in one way.  Buy and hold is more philosophy than strategy and says the investor is not an absolute market-timer.  This investor is not chained down under lock and key to the same investment(s) for a 10 or even 5-year period -- the investor is simply incorporating the idea into their investment selection criteria that they would be willing to hold the investment for a long period of time.

"Words are not (except in their own little corner) facts or things: we need therefore to prise them off the world, to hold them apart from and against it, so that we can realize their inadequacies and arbitrariness, and can re-look at the world without blinkers." ~ J.L. Austin 

In summary, buy and hold, properly defined, is not a static, one-size fits all investment strategy -- it is a philosophy -- one that speaks to the virtues that embody successful financial behavior -- simplicity, moderation and patience -- the same virtues that define the one investor that may embody this buy and hold philosophy more than any other investor -- Warren Buffett. 

As far as I am aware, Mr. Buffett had a difficult 2008 but his buy and hold philosophy has worked well for him more than it has not.  And he is certainly not dead...

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Securities data from Morningstar, Inc, as of March 31, 2009

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