Quote for the Week

Volatility is noise. The short-term trader bets on the noise; the long-term investor listens to the signal. But the long-term investor who thinks that the main trend will even out volatility over time is in for a shock. Volatility is the central concern of all investors, but it matters more in the long run than in the short run.

Volatility matters, because it defines the uncertainty of the price at which assets will be liquidated. The Ibbotson Associates data tells us that the expected total return of the S&P 500 for a one-year holding period is about 12.5 percent, but you should not be surprised if you come out somewhere between -8 percent and +32 percent, a spread of 400 basis points. The range for individual stocks is much wider. So volatility appears to matter a lot if you are going to hold for only a year.

Stretch your holding period out from one year to ten years, and the range of the expected return narrows to between about +5 percent to +15 percent a year, a spread of only 100 basis points and implying very little chance of loss over the ten-year period. Although volatility now seems much less troublesome than it did in the one-year horizon, and although the odds on the losing money when you liquidate are now greatly reduced, do not be lulled by that relatively narrow range of annual rates of return. What matters is not the annual rate of return but the final liquidating value at the end of ten years.  A dollar invested for ten years at 5 percent compounds to $1.63; at 15, it compounds to $4.05. As a dollar invested for one year is likely to end up at the end of the year between $0.92 and $1.28, the spread in liquidating value over one year is far narrower than the probable outcomes over a ten-year holding period, despite the greater standard deviation of returns. So where is the uncertainty greater — in the short run or the long run? — Peter Bernstein (source)

Quote for the Week

Who picked a quarter past eleven, October 24, 1929, to tell that quotation clerk, and me, and all the world, that it now looked as though the whole thing had been a disastrous mistake?

There is an old saying to the effect that you can get used to anything if you stick at it long enough. That is why people can tend their vineyards on the slopes of Vesuvius for generations and still sleep nights. This is also strikingly true of booming economic conditions. Back in 1927, wise heads had been shaken dubiously when brokers’ loans reached the starry figure of nearly $4,000,000,000. (These years they rarely approach $1,000,000,000.) But when, in ’29, they topped $8,500,000,000 and yet nothing seemed to come of it save more of those delectable profits in common stocks, even the wise heads were seduced into becoming more philosophical about it all.

When the common stock of Radio — the old stock — a small earner and a stingy payer, crossed 200, it made some of us gasp, but when in the ensuing months, it crossed, like an army with banners, 300 and 400 and 500, it all began to seem more natural. We tended to become used to it. It began to appear that the market advance resembled some surprising fact of nature, which, though very surprising, was an observable fact, like the tides in the Bay of Fundy. It is clearly unreasonable that trillions of tons of water should race uphill in a Fundy tide, for sixty or seventy feet, when the tides we have usually observed amount to only a yard or two. But anyone can go to Fundy and see it happen twice a day, every day, so why argue?…

What put them up — it would appear now — was a certain proportion of fantasy, resembling the Holland tulip craze, and a certain proportion of hard fact which had to do realistically with our expanding economy. It becomes more and more evident that stock prices are not alone determined by high or low credit, earnings or carloadings. There is another mighty factor which cannot be charted along with the various business indices. It is how high or how low are the hearts of men and women during the given period. — Fred Schwed Jr (source)

Quote for the Week

One of the studies that I did for my first book, Pioneering Portfolio Management, looked at the behavior of endowments and foundations around the crash in October 1987. I used to talk about the crash in October 1987 without explaining what it was and I do still teach a seminar in the economics department in the Fall. I started talking about what happened in October 1987 and I looked around the room and I realized that I think the students were three or four years old in 1987 and weren’t yet reading The Wall Street Journal.

So, just to give you a little bit of context, the crash was really an extraordinary event. According to my calculations it was a twenty-five standard deviation event. One standard deviation happens one draw out of three, two standard deviations one out of twenty, three standard deviations is one out of one hundred. An eight standard deviation event happens once out of every six trillion trials. You can’t come up with a number to describe the twenty-five standard deviation event; it’s just too large a number, I think, for any of us to really comprehend. In essence, this collapse in stock prices — the one-day collapse in stock prices — I think in the U.S. the price was, depending on which index you were looking at, were down 21-22% in a single day. Interestingly, most major markets around the world were off by a similar magnitude. This one-day collapse in stock prices was a virtual impossibility. Of course, this was just a change in stock prices; it wasn’t related to any fundamental change in the economy or any fundamental change in corporate prospects. It was just a financial event. — David Swensen (source)

Here’s what I’ve been reading for the past three months:

• Medici Money — The Medici Bank lasted five generations but less than a century. The book details the founding, rise, and decline of the Medici Bank. The power, influence, and complexity that came with building a bank that spanned most of Europe is explained.
• A Brief History of Panics — This old book covers financial panics in the U.S., starting with 1814 and ending with 1913. Brief accurately describes the writeup on each panic. The author breaks the panics into four causes banking, credit, capital, and tariff changes. It’s data heavy on money in circulation, loans issued, deposits, etc. The lesson is that financial panics have been a recurring theme in the U.S. for over 200 years.
• Tales of National Indemnity Company — Jack Ringwalt founded National Indemnity and wrote this book to commemorate its 50th anniversary. He covers his early insurance career, founding the company, the challenges, growth, and eventual sale to Berkshire Hathaway and Warren Buffett. The book spans a total of 50 pages. PDF copies can be found online.
• The Pleasure Was All Mine — I bought this book several years ago, forgot about it, and just rediscovered it on my shelf. Fred Schwed Jr’s autobiography comes with a catch. It’s more about the people in his life, and their influence on him, then his life itself. It’s filled with humor, a bit of wisdom, and not much finance.