They think that intelligence is about noticing things are relevant (detecting patterns); in a complex world, intelligence consists in ignoring things that are irrelevant (avoiding false patterns)
Nassim Nicholas Taleb
Mathematician and Author, Fooled by Randomness and The Black Swan
We are biased toward finding patterns and we are biased toward finding simple patterns, and so we tend to create patterns from too little information. We tend to create patterns from unreliable information, but that provides some kind of interpretation of whatever information there is. We are not wired to wait for a lot of information before making up our mind; that’s not the way the system works
Daniel Kahneman
Psychologist, Nobel Prize Winner in Economics
The empirical evidence to date provides strong support for the random-walk model. In this light the only way the chartist can vindicate his position is to show that he can consistently use his techniques to make better-than-chance predictions of stock prices. It is not enough for him to talk mystically about patterns that he sees in the data. He must show that he can consistently use these patterns to make meaningful predictions of future prices.
Eugene Fama
Nobel Prize Winner in Economics
Market Performance
Below are the indices I track.
| Data Series Indices USD % | 3 Months | 6 Months | 1 Year | 3 Years | 5 Years | 10 Years |
| S&P 500 | 2.46 | 3.84 | 3.99 | 11.66 | 12.10 | 7.42 |
| Russell 2000 | 3.79 | 2.22 | -6.73 | 7.09 | 8.35 | 6.20 |
| Russell 2000 Value | 4.31 | 6.08 | -2.58 | 6.36 | 8.15 | 5.15 |
| MSCI World ex USA (net div.) | -1.05 | -2.98 | -9.84 | 1.88 | 1.23 | 1.63 |
| MSCI World ex USA Small Cap (net div.) | -1.28 | -0.69 | -3.35 | 6.34 | 3.61 | 3.33 |
| MSCI Emerging Markets (net div.) | 0.66 | 6.41 | -12.05 | -1.56 | -3.78 | 3.54 |
| Barclays Treasury Bond 1-5 Years | 0.82 | 2.41 | 2.44 | 1.62 | 1.42 | 3.24 |
| BofA Merrill Lynch 1-Year US Treasury | 0.29 | 0.65 | 0.59 | 0.38 | 0.34 | 1.69 |
Value is starting to perform again. In addition, it appears that emerging markets have rebounded after a dismal period of performance.
Pattern Seeking and Randomness
It has been an interesting first half of 2016 regarding both markets and the news. After the first 2 months of the year, there were many nervous investors extrapolating those results forward. Headlines such as Risk Grows of Markets Sparking Recession were common. In the interim, we have had a never ending soap opera of election news, as well as a somewhat surprising vote in the United Kingdom regarding Brexit. (Both news issues, as well as ISIS related attacks, will likely increase volatility a bit. Please see my piece on volatility that I sent last September. http://goo.gl/TQCUUb)
However, from March 1 through the end of June, the S&P 500 has returned 9.41%, the MSCI World ex USA 5.66% and the MSCI Emerging Markets Index a whopping 13.98%. If you had listened to the headlines, you may have made a bad short term decision.
This is an important lesson in ignoring short term patterns in the stock market (and maybe to other areas of life as well). In the short term, stock prices exhibit a much more random pattern than humans want to acknowledge. As a reminder, here are daily stock market returns for the S&P 500 in 2016.
As you can see, there is no discernible pattern in the short term and stock prices exhibit much more of a random walk in the short term as Gene Fama has stated above. The same message applies to other equity markets both domestically and internationally.
Trying to guess is really a fool’s game, although many in the industry want you to believe differently, as there are monetary incentives for such firms to get you to trade more often. Further, the mind wants to see correlation or causation where none exists, which also compounds the tendency to trade more often to an investor’s detriment.
However, if one takes a longer term view and waits for more information as Danny Kahneman suggests above, odds are he or she will be rewarded. I just downloaded the daily S&P 500 closing prices from 1950 until the end of 2015, and then ran the numbers through an Excel spreadsheet. As you can see below, daily stock prices have been positive about 53% of the time, or a bit ahead of a coin flip.
| Time Period | % of Periods That Are Positive |
| Daily | 53% |
| Monthly | 59% |
| Yearly | 79% |
| Rolling 10 Year | 97% |
| Rolling 15 Year | 100% |
However, as you lengthen your time horizon, the percentage of positive outcomes becomes ever greater. At 15 year rolling returns, every single 15 year calendar year period since 1950 has been positive. The compounded average annual return since 1950 through the end of 2015 was over 11%. I am not promising those returns in the future. However, the message is crystal clear. Long term discipline is the key to successful investing. As Nassim Taleb advises, ignore the things that are irrelevant, including false short term patterns or trends.
Brexit
Speaking of volatility, the Brexit vote caught markets by surprise. Both betting markets and bookmakers had odds that Britain would vote to remain in the EU. Some odds were as high as 85%. Many people fail to realize that probabilities are not a guarantee, and that although the odds were less than 50% that they would vote to leave, those odds were not zero.
After results were released, stock markets around the world tanked. However, after several days passed, markets staged a rebound, recovering most if not all of their losses.
What is interesting is US ten year yields have fallen by about 25 basis points, and they have remained there. When comparing 10 year yields to 10 year TIPs (treasury inflation protected securities), one can calculate the market’s estimate today of the future inflation rate over the next 10 years. Since Brexit, US expected inflation has fallen from 1.5% to 1.4% annualized. It appears the US market is expecting the Federal Reserve’s job of getting to its 2% inflation target to be a bit tougher since the British vote.
Other Links
Bloomberg Video Interview With David Booth on Investing
Another Problem With Hedge Funds – They Don’t Even Hedge
Estate Planning for Your Digital Assets
Please let me know if you have any questions. FYI, I am working on a paper discussing the issues with private equity. I hope to have something finished in the next quarter.
Thanks for reading! Please share with your friends and family.
Until next time,
Mike