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Stock Market Investing for the 21 st Century Steven Thorley and Grant McQueen

Stock Market Investing for the 21 st Century Steven Thorley and Grant McQueen Lesson 1: Invest in stocks for the long-run Lesson 2: Free-ride on the market competition Lesson 3: Avoid the hidden price-tags of trading Lesson 4: Don’t fall into the data-mine

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Stock Market Investing for the 21 st Century Steven Thorley and Grant McQueen

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  1. Stock Market Investing for the 21st CenturySteven Thorley and Grant McQueen • Lesson 1: Invest in stocks for the long-run • Lesson 2: Free-ride on the market competition • Lesson 3: Avoid the hidden price-tags of trading • Lesson 4: Don’t fall into the data-mine

  2. Stock Strategies: Four Important Lessons • Topics not in this presentation • Personal finance • Get-rich-quick schemes • Beating the market • picking stocks • market timing • Hot tips • The things that matter most • family • health • gospel

  3. Stock Strategies: Four Important Lessons • Lesson 1: Invest in stocks for the long-run • Stocks will have higher returns, on average

  4. The Long-term Return on the Stock Market Stock market risk-premium = market return - risk free return 7.13% = 11.88% - 4.75% … but the U.S. in the last half-century has been “lucky” compared to other developed markets and time periods. Going forward, the expected stock market risk-premium is about 5 percent. With the risk-free rate at about 3 percent, the long-term expected return on stocks is about 8 percent per year (standard deviation of 20 percent per year)

  5. Stock Strategies: Four Important Lessons • Lesson 1: Invest in stocks for the long-run • Stocks will have higher returns, on average • Stock market risks are acceptable, if you: • Diversify • Invest for the long-run

  6. Diversify Across Stocks 49% - 24% - 19% - Average annual standard deviation (%) Diversifiable Risk Total Risk Nondiversifiable Risk 1 10 20 25 Number of stocks in portfolio

  7. Based on compounding annual returns from Stocks, Bonds, Bills, and Inflation., 2007 Yearbook, Ibbotson Associates

  8. Based on annual returns from Stocks, Bonds, Bills, and Inflation, 2007 Yearbook, Ibbotson Associates

  9. Stock Strategies: Four Important Lessons • Lesson 1: Invest in stocks for the long-run • Stocks will have higher returns, on average • Stock market risks are acceptable, if you have a long enough time horizon • Question and Answer

  10. Stock Strategies: Four Important Lessons • Lesson 2: Free-ride on the market competition • Most actively managed funds and brokerage accounts will under-perform index funds over the long-run • Choose “total market” index funds

  11. Ten-Year Annualized Return on the 30 Largest Mutual Funds Investor return for calendar years 1995 to 2004 (largest funds as of year-end 1994) Average mutual fund return: 10.78% Vanguard 500 Index fund return: 12.00% Funds outperforming the index: 9 out of 30 (30%) Correlation to prior decade return: -.250

  12. Index Funds Have Low Fees Performance comes and goes, but costs roll on forever.--Jack Bogle Value of $100,000 investment 33% of your retirement to manager

  13. Low Fees or Low Amounts Vanguard is a pioneer in low cost index funds (passively managed diversified mutual funds with fees often below 0.2% per year) www.vanguard.com Homestead Funds is a pioneer in managing small accounts(minimum of $200 for IRA and $500 for regular accounts—NO minimum if automatic scheduled investments) homesteadfunds.com

  14. From: “The Inefficient Markets Argument for Passive Investing"" by Steven Thorley, Marriott School working paper, 1999.

  15. From: “The Inefficient Markets Argument for Passive Investing"" by Steven Thorley, Marriott School working paper, 1999.

  16. Stock Strategies: Four Important Lessons • Lesson 2: Free-ride on the market competition • Most actively managed funds and brokerage accounts will under-perform index funds over the long-run • Choose “total market” index funds • The competition in stock-market research is intense, and will get more competitive going forward • Market indexing or “passive investing” is a free-ride on the competition

  17. Stock Strategies: Four Important Lessons An essential element of profitable economic activity … - Barriers to entry (Porter’s five forces) - Sustainable competitive advantage (Strategic Theory) - Economic Rents (Microeconomic Theory) - A “moat” (Warren Buffet)

  18. Period of Investment NYSE/AMEX/NASDAQ Return Annualized Value of $10,000 Invested in Jan. 1985 January 2, 1985 - December 30, 2005 +12.48% $118,089 Less the 10 biggest days + 9.81% $71,389 Less the 20 biggest days +7.84% $48,827 Less the 30 biggest days +6.13% $34,854 Less the 40 biggest days +4.60% $25,695 Data Source: CRSP Value-Weighted Index with Dividends Trouble with Timing

  19. Stock Strategies: Four Important Lessons • Lesson 2: Free-ride on the market competition • Bad reasons to not index • Passive investing is boring • War stories are fun to share with friends • Doing nothing about your portfolio is unnerving • Promotional material on indexing is lacking • Habit and tradition • Good reasons not to index • You are stuck in funds that have a high exit cost • Index funds are unavailable in some plans and foreign markets • Legal proprietary information is routinely available to you • In taxable accounts, complex tax/donation strategies are possible • Reason to index • Superior long-run performance

  20. Stock Strategies: Four Important Lessons • Lesson 2: Free-ride on the market competition • Indexing alternatives • Mutual Funds (Vanguard, Fidelity, etc.) • Easy, no trading costs (commissions or bid/ask spread) • Exchange Traded Funds (SPDRs, WEBs now iShares) • Slightly lower management costs • Potential better tax effects • Trading throughout the day (ouch!)

  21. Stock Strategies: Four Important Lessons • Lesson 2: Free-ride on the market competition • Question and Answer

  22. Stock Strategies: Four Important Lessons • Lesson 3: Avoid the hidden price tags of trading • Transaction costs • Brokerage commissions • Bid-ask spread • Risk • Indexing is optimal diversification • Active funds are more volatile than the market as a whole • Taxes • Income taxes are triggered by buy and sell transactions • Time and energy • Beating the market requires a lot of both

  23. Internal Revenue Service Publication 586A The Collection Process (Income Tax Accounts)

  24. Stock Strategies: Four Important Lessons • Grant’s day-trading buddy • $500,000 in stocks X 2% $10,000 • 250 days X 1 trade X $15 - 3,750 • $0.125 X 100 shares X 250 trades - 3,125 • Gross Trading Profit 3,125 • Tax @ 39.6% - 1,237 • Net Profit $ 1,888

  25. Stock Strategies: Four Important Lessons • Grant’s day-trading buddy • Trading Profit $1,888 • 10 hours/week X 52 weeks 520 hours • Equals $3.63 per hour! • Not to mention the costs of an office, computer, internet fee, real time data fee, and … • …THE FACT THAT HE DIDN’T BEAT THE MARKET.

  26. Stock Strategies: Four Important Lessons • Lesson 3: Avoid the hidden price tags of trading • Question and Answer

  27. Stock Strategies: Four Important Lessons • Lesson 4: Don’t fall into the data mine • Intra-generational

  28. The S&P 5001983-1993 S&P 500 Year Source for all the S&P 500 data mining graphs is: David Leinweber’s “Data-Snooping Biases in Tests of Financial Asset Pricing Models.”

  29. Overfitting the S&P 500Butter in BangladeshR2=.75 S&P 500 Year

  30. Overfitting the S&P 500Butter Production in Bangladesh and the United StatesR2=.95 S&P 500 Year

  31. Overfitting the S&P 500Butter Production in Bangladesh and the United StatesUnited States Cheese ProductionSheep Population in Bangladesh and the United StatesR2=.99 S&P 500 Year

  32. Polynomial Fit to the S&P 500Big Mistake or Bad Idea? S&P 500 Year .25 1016 - .26 1013y + .12 1010y2 - 32000 y3 + 56 y4 - .0064 y5 + .49 10-6y6 - .24 10-10y7 + .69 10-15y8 - .88 10-20y9

  33. Polynomial Fit to the S&P 500Big Mistake or Bad Idea? S&P 500 Year .77 1017 - .88 1014y + .45 1011y2 - .14 108y3 + 2700 y4 - .37 y5 + .000035 y6 - .23 10-8y7 + .99 10-13y8 - .25 10-17y9 + .28 10-22y10

  34. Stock Strategies: Four Important Lessons • Lesson 4: Don’t fall into the data mine • Intra-generational • Inter-generational • No story/no future

  35. Stock Strategies: Four Important Lessons • Lesson 4: Don’t fall into the data mine • Intra-generational • Inter-generational • No story/no future • Out-of-sample testing

  36. From: Investment Strategy Claims: Don’t Fall into the Data Mine, AAII Journal, Feb. 2000, by McQueen and Thorley Dow 30Foolish 4.0 In-sample (73-93) 14.8% 28.8% Out-of-sample (July rebal.) 17.4% 18.9% Out-of-sample (52-72) 12.7% 11.9% Out-of-sample (Twins) 13.9% 14.9% Out-of-sample (since the book) 1994 3.9% -6.1% 1995 37.6% 40.1% 1996 26.1% 37.3% 1997 22.4% 28.1% 1998 16.9% 17.0% 1999 15.8% -8.0% 2000 Opps!

  37. Stock Strategies: Four Important Lessons • Lesson 4: Don’t fall into the data mine • Intra-generational • Inter-generational • No story/no future • Out-of-sample testing • Front runners

  38. From: “Mining Fool’s Gold” by Grant McQueen and Steven Thorley, Financial Analysts Journal, Vol. 55, No. 2, pp. 61-72, (March/April 1999). Figure 1. Foolish Four Event Study, 1994-97

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