In another thread, Pat wrote: 

[quote user="Pat Morgan"]That mess passed; previous messes passed; the current mess is likely to pass, too.[/quote]

Not to pick on him, but this is the epitome of short term thinking. In historical terms, we have had a very good 30-year, and even 100-year, streak. This doesn't mean anything as far as the next 30 years goes, however.

This was a major point made in the Black Swan, and one which most people seem to miss, even if they understand on an intellectual level they just don't get on a gut level. Inductive reasoning of this type (X has happened consistently for 10 years, therefore X will continue to happen for the next 10 years) is just not applicable to certain types of phenomena, of which the stock market is the prime example.  It works great for physical phenomena like the sun rising, which is why we seem to be wired to think that way about everything, but it doesn't work where very nonlinear systems like markets are involved.  The stock market has fairly consistently bounced quickly after dips in the past 20-30 years, and has bounced after dips "eventually" during the past century but that doesn't mean it will continue to do so. There are some historical precedents, look at 1966-1982, for example. But to really understand the Black Swan, you have to consider things that have no historical precedent.

I'll throw a few out, to give you a flavor...

* all existing mortgages rewritten by law to have a fixed 3% interest rate (rather similar to some of the current bailout plans being bandied about, hmm?).

* dollar devaluation, 1 dollar = 100 nubucks for salaries/wages/prices of everything but 1=1 for stocks, mutual funds, savings accounts, or mortgages, or any accounts held by foreigners.

* nationalization of major companies (starting with airlines, hmm?) shareholders paid with special restricted govt bonds, or not paid at all.

These all are black swans produced by the govt, although probably in response to popular demand.  You can readily think of non-govt black swans as well.  Let's try one...

* huge fraud and accounting irregularities at a large US company (I would pick a bank - Goldman Sachs anyone?) is revealed, leading to a market crash, and stocks *stay down* because people now believe all companies are crooked.  "stocks" becomes a dirty word, sort of like "dot-com".

A closing thought... "buy and hold" is a strategy produced by short-term thinking of this type.  The reasoning goes, "over the past X years, stocks have done well in any Y-year period, although they may have underperformed over shorter periods.  therefore I should just buy and hold for a minimum of Y years, and I will do well".  As to whether that is likely to work, well... it will until it doesn't.

Although your thinking may be valid for most on this forum (who are retirees or close to retirement), I would disagree with what you are saying for a general investor.

First of all, I haven't read about Black Swan (the book) but the general concept doesn't strike me as anything revolutionary. Most of the stuff that is happening is not a surprise to some people like me. People like me have been quite bearish on a lot of things for the last few years and the same applies to many others.

For example, consider housing. How many people are actually shocked that housing is collapsing? You can go back several years back and find articles saying that housing makes no sense when mortgage payments are unaffordable to many and are far above comparable rent. Maybe these articles didn't make the front page but they were there (usually in the middle or the back somewhere.)

In fact, if I'm not mistaken, we even had arguments on this board debating how risk was undervalued. Some people have been right and some people have been wrong with their calls on this board. I was always of the opinion that nearly all assets (except US Treasuries, US$-denominated assets and Yen) were overvalued. The most overvalued, I felt, was emergin market bonds. Interestingly EM bonds have not collapsed yet (in fact my call was completely wrong on Brazil) but I believe they will (already some countries who were financially OK are being weakened severely by rampant inflation and their need to provide massive price subsidies.)

 What is a surprise is the details of how everythign is unfolding. I never would have expected the huge pullback in risk appetite. Short-term T-bills were trading at something like 0.5% interest for a short period a few months back. I never would have expected that without rampant deflation. I also wouldn't have expected a top 5 Wall Street investment bank to collapse (Bear Stearns).

Anyway, to get to the point I was going to make...

I don't buy your argument for the following reason (let's limit our discussion to one asset: stocks).

The reason you are wrong (in my opinion) lies in one of the key tenets of value investing that Benjamin Graham etched in stone at the Temple of Value Investing :) Namely, stocks are not just a piece of paper with some fluctuating price; they give you a piece of ownership in a business. Profits that are earned by a business accrues to the stockholder. If you think about it that way, it is extremely difficult for you to argue that stock prices won't go up in the long run. Stocks will only be wealth destroyers if we enter into a prolonged war, disease outbreak, rise of communism (or some anti-private property political system), or something like that. In other words, as long as the GDP grows (even slowly), stocks will create wealth (read my point below about valuation).

But the valuation of stocks matter. If you buy something that is overvalued, it doesn't matter if the company has a profit or not, you can lose money. Present Chinese stocks come to mind but even better examples are the solid tech stocks with growing earnings in the early 2000's (eg. Microsoft, Cisco) or the growth stocks in the early 2000's (eg. Pfizer, Wal-mart). All these companies had good earnings but if you bought them in 1999, 2000, 2001 or 2002, you may have lost money.

In line with what I was saying about valuations, what you are saying may be true for passive investors (eg. indexers). Since they are always in the market and don't pick individual stocks/sectors/businesses, if they buy something they can easily lose money for a long period of time. If you were Japanese investor who bought a broad index of stocks in 1989, you lost money and you will probably never ever break-even within your lifetime!!

One final criticism from me about Black Swan is that it doesn't help you with your investing. Since the whole concept is based on a low probability events that may or may not happen, how are you going to turn that into investing knowledge? Some of the scenarios that you have laid out may happen or they may not! So, apart from barricading oneself into a fortress, what actionable strategy does it provide?

 

Having said all that, this is not to say that things won't deteriorate or that prices won't drop, or tthat bankruptices won't increase, or whatever. All those, and more, can happen. But it won't be so bad.

 

Anyway good post... even though I disagree with it, it raises thoughtful issues...

Hey Koala, thanks for the response, what I'm saying is that a lot of people seem to think "It's always been this way so it will continue to be this way" and that is what I mean by short term, because (a) their notion of "always" really is quite short in historical terms, and (b) the conclusion doesn't follow in any case because what they're trying to predict does not have that kind of consistency.

What you listed under "stocks will only be a wealth destroyer if..." is actually not a bad list, you're thinking along the right lines, and all of those are not all *that* unlikely in my opinion.  To assume that all of those won't happen is not good risk management.

[quote user="KoalaBear33"]Most of the stuff that is happening is not a surprise to some people like me. People like me have been quite bearish on a lot of things for the last few years and the same applies to many others.  .... For example, consider housing. How many people are actually shocked that housing is collapsing?[/quote]

Oh, to be sure many people may have had some thoughts or suspicions in that direction, or may even have considered it likely from an intellectual perspective, but how many actually *did* short financials or homebuilders in 2006-2007?  It is easy to see something as obvious in retrospect, but much harder to see it (and see it as actionable intelligence) ahead of time.

More to the point, the people who were buying (or not selling) actual houses in 2006-2007 certainly didn't see it, and that's quite a lot of people. 

[quote user="KoalaBear33"]But the valuation of stocks matter. If you buy something that is overvalued, it doesn't matter if the company has a profit or not, you can lose money.[/quote]

Just so.  And valuation depends on estimating future earnings as well as the relative attractiveness of other investments, and both of those estimates (if not the actual numbers) are subject to sudden massive shifts.

If you could somehow buy and sell stocks at a "fair" price, sure you would over a very long term participate in the general growth of the economy, but "fair" price is something that pretty much doesn't exist, stocks are either massively over- or under-valued at any point in time, and that "very long term" would have to be measured in multiple decades or centuries in order to span several over/undervaluation cycles.

[quote user="KoalaBear33"]Since the whole concept is based on a low probability events that may or may not happen, how are you going to turn that into investing knowledge?[/quote]

You need to read the Black Swan book for more details, but, to quote the author "I only need to be right once in a century to make money".   In my somewhat shorter experience I've been seeing about one "surprise" event from the list I've been anticipating roughly every year, which is far, far more often than I would have predicted in advance, and easily enough to make money on.

Basically, I try to make sure that I have leveraged positive exposure to good surprises, and inverse exposure to bad surprises, and by surprises here I mean the once in a decade or once in a century events.   For example: banks and insurers are sometimes subject to huge negative surprises, so being long puts on these (esp when they seem to be doing well) is generally a winning strategy.  There is nothing that can increase the value of a bank 10x, but lots of things that can decrease it 10x, see BSC, and if you happen to have some far out of the money puts in such a situation you can easily get 100x returns.   Now this doesn't happen every year, or perhaps every decade, but it does happen quite a bit more often than the price of the options would seem to suggest.  Some other types of companies are subject to potential huge positive surprises (think: companies that invent things), which you can also leverage to.

How do I think of events/scenarios like that... well, think of something which is generally considered to be just flat out impossible today (perceptual bias), but from a historical perspective is not actually very unlikely.  For example, one of my current favorites is looking at long treasury rates, see http://static.seekingalpha.com/uploads/2007/9/4/rates1.jpg , historically they seem to have ranged between 2 and 14%, and well over 6% for most of the period since we have had a fiat currency.  From that perspective, a return to above 6% is likely, and over 8% possible,  but the options market prices it as being considerably less than 1 in 100 odds over the next year.   Regardless of any sensible reasons that may be given for this, those options almost *have* to be mispriced.  Thinking about that has an additional benefit, which is that you can start from an assumed scenario and think about how it would actually come to pass (foreign dumping of treasuries?), which in turn leads to other ideas for unlikely but not impossible scenarios (what would the dollar index be with treasuries at 8%? how about the S&P dividend yield, and what does that say about the S&P itself?).

This is quite enough to be a workable investment strategy; however even if you choose not to do that but to stick with a more conventional "participating in the growth of the economy" strategy, you still have to make sure you don't have significant exposure to negative surprises. 

 

This thread has intrigued me, I'll have read the Black Swan.

One of the arguements I've heard from the managed funds community, against emerging markets as investments is the lack of finanical accounting rules that are imposed on US markets. Without these rules, or rules that don't fit the US mind set equates to increased risk.

How did these US rules protect investors of an Enron? The current crisis in housing?  US banks?

I've been searching for retirement projection tools, indicating the amount of money one needs for retiring in comfort.  All the models use historical returns for the US economy and projections based on this base.  They don't incorporate how the global economy landscape has changed away from the dollar.  20-30 yrs ago emerging markets had problems due to inflation, currency exchange, politics.

How does one model unexpected paradyme shifts?  I'm betting on the global marketplace is shifting to a new frontier, with significant risks.  As such the only model that works is diversification. A plan to be covered, while dynamically adapting as needed. True wealth builders in the marketplace did it by using a new paradyme.  A number of people have lost trying to play it safe, and maverics (sp?) have lost a fortune.