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Welcome to Investing for Beginners podcast this episode 74. Tonight we’re going to talk about potential investor problems when examining the history of the market. Andrew has been on a bit of a history bent lately and I’m a big fan of history and I love learning more stuff about what has happened in the past. Because that can always help us in the future when we make decisions those who fail to learn from the past are bound to fail in the future.

So go ahead and starting off Andrew why don’t you go ahead and talk up to us a little bit about short time periods are valueless.

Andrew: yeah so I think this is a nice kind of follow-up to last week’s because we kind of examines the same type of thing right. a lot of studies academic studies about the stock market are looking at what happened in the past and let’s see if we can find a trend a correlation and maybe use that to have better success in the future.

And so we kind of focus in on like the acted the academic part of the particular problems that can arise when you’re looking at particular studies and then how they’re doing that.

Now we can kind of look also how people like you and I the average investor might do kind of similar things and this is particularly common with beginners if you’re not putting thought into this and how it can affect what kind of decisions you’re making then  you might not even realize you’re making these kinds of mistakes.

I mentioned last week I’m reading this book called bull it’s talking about the history of some of the bull markets right now I’m focused on the bull market of the 90s. And it’s cool to like see the book puts yourself in the shoes of some of these people as they were living it in real time.

You had and I’m blanking on the name of this I believe she was a she was an analyst. basically she this was you have to put yourself again in the 90s you had the internet really kind of coming into the mainstream and it was really changing the whole business world and so she really kind of tied herself to technology she was an analyst who really covered technology stocks.

And as adds a lot of these IPOs a lot of investment bankers are making huge sums I think there was one guy it said something where he made like 300 million dollars a year and he was kind of like a leader of one of the companies like a Morgan Stanley or Goldman Sachs or their these investment banks they’re helping these small companies go public obviously getting the Commission’s off of that.

And so a lot of money was being made and a lot of people like this analysts were good at picking out the winners and really kind of bringing the stocks that were going from IPO to into the market and then having like relative success in the business world which would translate to massive success on Wall Street particularly in this time period because there’s just so much money going around.

And you had the Fed cutting interest rates just flooding the market with liquidity so a lot of different factors that were leading up to everything that you saw in the 90s and that finally bubbled up and crashed in 2000-2001.

But this analyst became like a great expert and she became so bullish with technology stocks she produced this like three hundred page report and the book said that a six or eight page report at  on Wall Street was considered very extensive. So she went crazy with this and I think it said something about the future of the Internet or she was essentially covering like the Internet and new tech so she became very bullish. And became somewhat of a darling to the rest of the investment community and the rest of the mainstream.

And so when she was bullish a lot of people trusted her and she was very good at what she did a lot of people trusted her and went bullish on a lot of these stocks and made money for short period of time.

Where that gets lost is that there was no respect for previous bull markets previous boom periods and the various cycles of the stock market. And I think this can become very easy for any of us to fall trap into like what is the equivalent of that today.

Well I think it’s safe to say that would be the FANG stocks we see these stocks and for sure they dominate everything that we all aspects of our daily life. I mean I know I use Google probably on a daily basis.

I have a lot of my pictures and life stories posted up on Facebook you have people who swear by Apple products and have so many of their different devices they’ve got their music on there they might have their photos on the Apple platform.

All these different things are really a phenomenon that we haven’t seen before however this isn’t an isolated case in the sense that we haven’t seen these type of booms happen in the stock market and so I’m not saying that the business implications of these type of companies are necessarily not unprecedented.

However the way that Wall Street works in the way that the whole community gets so as Robert Shiller calls it irrationally exuberant. There will always be this magnifying effect and understands using the word always it can be troublesome.

But there will always be this magnet this magnifying effect where people will take what’s going on in the business world and just like fear and greed these emotions are part of our nature. and it kind of gets exasperated even further with trend these trend algorithms and all this trading that goes back and forth and and the Internet and how people get so caught up in their little ideas of why stock is bullish.

And so you’ll see that and it’s important to look at long time periods instead of short time periods. so that you don’t fall into the same kind of trap as what we saw with the analysts in the 90s.

Referencing James O’Shaughnessy’s great book again, he talked about the soaring 60s. and  there’s always these cute names for these phenomenon that we see in the stock market that come after the fact right who ever thought up the idea FANG stocks was brilliant and it’s so catchy back in the sixties it was called the soaring sixties and the go-go growth managers.

You could even look at what most people consider a longer time period like five years and O’Shaughnessy talks about from 1963 and 1968 you could have done a study where you bought certain stocks with certain characteristics and the one he referenced doubled the S&P; 500 over five years and then he said that same strategy over the next five years lost over half its value while the S&P; 500 gained 2%.

This is something that we definitely want to keep in mind understand that time periods that are that serve as reliable kind of history lessons might be a lot longer than we might think a time period should be.

Also respect the history of the market respect the history of essentially the way the market behaves and the fact that as of today right AI is not as far as we’ve seen as far as what’s been talked about in the mainstream AI is not investing for us for the majority of the market.

And so that means there are humans and humans are emotional and they do a lot of irrational things that might not make sense when you zoom out.

So these are all things to keep in mind and make sure that we’re understanding the history of the stock market but also doing it in the right way. not looking at short-term things understanding that the idea that something is new and different is not a new idea at all that’s been shown over and over and over again with all different types of bull markets.

Make sure you’re not falling into that trap and an easy way to do that is just what we talked about on the podcast all the time invest with a margin of safety emphasis on the safety.

Who knows in five years when the market doesn’t care so much about FANG stocks and FANG stocks become these boring blue chip companies they might become a trading evaluations that are much more reasonable and then that would be a great time to capitalize and hold.

I think a great example of that’s like Microsoft why aren’t they putting Microsoft in the FANG discussion when Microsoft was the FANG stock of the 1999-2000 time period.

And as we’ve talked about Microsoft has been the fantastic investment the last five years so all things to keep in mind I think very very important and something that you might not think about when you’re first starting out. Just make sure you’re checking in and doing that margin of safety being patient and really by investing with a margin of safety you’re protecting yourself against getting caught up in the greed side of a bull market.

Dave: yeah those are great points and I think one thing that I’d like to throw on the fire with this is when you think about how math works.

There’s always a reversion to the mean and again going back to my baseball fantasy baseball love the love of the sport there’s been a trend towards using math in baseball and they talk all the time about reversion to the mean and they talk about players as I mentioned last week.

They talk a lot about players that are doing really well for a short period of time they always talk about how they’re going to revert back to the mean and it’s statistically proven that you can see that. And Tobias Carlisle in his great book the Acquirers Multiple talks a lot about that as well with the stock market and stocks that may be flying high will always revert back to the mean gravity will take effect at some point it always does.

And that’s one of the things that you can learn from studying the history of the stock market and I know Andrew has talked a lot about that and he’s  he bought a book what was the what was the SP book that you bought what year was that from?

Andrew: about several 1996 is one that I’m staring at right now and I bought one OK at the 70s that’s been able to like see the lists of companies.

Dave: yeah and that’s I guess that’s kind of what I was referencing was the one from the 70s you look at the top stocks from that time period and you compare them to 30 30 40 years some time later and they’re not the same stocks they’re not same companies that aren’t going to be in the top 10 so time does change things and.

Andrew: can I name a few of those yeah they have a in the very beginning before they list all the stocks and sp500 they had like an aggressive group. so they said like stocks for potential price appreciation they had a conservative group in an aggressive group so I’m just reading off the top 5 right from the aggressive.

Capital Cities Broadcasting, Sanko Instruments, Dublin Core Fleetwood Enterprises and General Portland Cement, Gimble Brothers. And then from the conservative I see like a bunch that I know are Bank America Corp which is now Bank of America Campbell Soup, General Electric, General Motors, Gillette, Goodyear Johnson & Johnson oh yeah crazy right yeah he’s.

Dave: crazy so although all the first ones were like aggressive growth stocks and the second ones are considered conservative right and those were all still around not to say that those other companies aren’t around but I certainly I personally have never heard of any of them.

Andrew: right you and I know about capital cities broadcasting because I was a Buffett thing that I okay the Disney somebody bought them and then he eventually sold out in that position.

Dave: gotcha okay I’ll admit I was not at I had not heard of any of them and so I think that just kind of illustrates my point about how  a short time period  looking at a high flier and getting super excited about something that’s  rising  greatly very quickly it the history of it is it’s gravity it’s going to take its whole till eventually and it will come back to earth it will revert back to the mean.

And finding great companies and investing in great companies is really what this is all about.

Andrew: yeah hundred percent hopefully we’ve two weeks in a row we found that in your head yeah oh boy.

Dave: alright so moving on let’s talk about the next one the next one this is one of my favorites it’s different this time Andrew.

Andrew: okay so O’Shaughnessy talks about Isaac Newton who lost a fortune in the South Sea trading company bubble so this was like 1700s he was a fantastically intelligent guy but did not make a good investment decision and I don’t know if he ended up broke or what.

But he had a quote he said he could calculate the motions of heavenly bodies but not the madness of men and so this idea of that there’s bubbles this idea that there’s mania that can even happen outside of the stock market.

Example of that that’s super popular and we’ve referenced a couple times the Tulip Mania right where a single bulb of a tulip became worth more than people’s property and stuff the South Sea trading company a stock where  there’s so much exploration and people saw as this new creation of wealth and never been seen before. Recently we’ve seen it with Bitcoin.

So it’s different this time you could be there’s been plenty of examples of people who are very very smart yet because they don’t respect the emotions of the market they get killed.

Dave: yeah they do in just talking about the bubbles that have burst in the last in our lifetime we look at the last Great Recession and everybody was saying right before that happened it’s different this time it’s different this time and it’s not going to happen we’re not going to have this huge drop-off or things are not going to go sideways and we’re going to lose all of our money and you think about how much the stock market has risen since that period of time.

And there are a lot of perma bears out there that are talking a lot about how things are going to fall off and then you have the enthusiasts to say this will never happen again it’s different this time it’s and things are not going to change.

And the history of the stock market will always come back to bite you in the butt and you have to pay attention to things that have happened to pass so you can learn from the mistakes that people have made in the past. and not just your investing life but in your personal life and it’s so critical to think about  decisions that you make and when you make them and you have to think about why am I making this decision.

And if it’s being based on I think it’s different this time then I would caution you to be hesitant about pulling the trigger on something like that because you look at think about just anything.

that’s  the hot new thing electric cars marijuana is a very popular topic as of recently and I certainly don’t want to go into any of the political debate about that but if you just look at the investing business side of it there is of course potential but who knows if that’s going to happen or play out but there are companies that are  fluctuating  wildly right now because of the rumors and the difference innuendo and the different news reports that you hear about Coca-Cola for example as considering creating a CBD drink and some other things.

And people are trying to hop on the bandwagon to catch the latest greatest craze and I’m sure they’re all saying it’s going to be different this time cannabis or marijuana is going to be the hot thing and it may be I could be wrong I’m not saying I’m right or wrong but it could be the next big thing but you don’t know but I know everybody’s that’s buying is it’s different this time it’s not going to happen like it did with Bitcoin a year and a half ago went from what twenty thousand to like three thousand.

You got to be careful you got to do your due diligence so you got a you got to pay attention to what you’re doing it’s not always going to be different this time.

Andrew: I mean that’s a huge market obviously but when valuations get too high you don’t want to be getting into those type of stocks mm-hmm yeah.

I love the quote I think that just summarizes it so perfectly from O’Shaughnessy he says from the past the future flows history never repeats exactly but the same types of events continue to occur.

Dave: yep I agree that’s awesome all right so moving on.

The next topic is going to be anecdotal evidence is not enough.

Andrew: yep I think most intelligent people can understand that obviously especially if you have like a scientific kind of way of the way your mind works there’s it’s so easy to get wrapped up in something that’s anecdotal so easy to believe  because it makes for great stories.

I mean we have different parts of our brains some of it is really emotional base and then feeds off stories and a lot of people are wired that way and that’s awesome and some people are  a little bit more logical and don’t get swept up in the story. I want to look at maybe like probabilities chances stuff to do with statistics.

So when it comes to the stock market a place that’s dominated with numbers your success or your failure will depend on which way the ticker symbol moves in regards to the numbers. I think it should be blatantly obvious that you don’t want to look at one little thing right what one person who found massive success or one strategy that found massive success.

You want to look at what has statistically and with enough evidence where it’s no longer anecdotal and then and then maybe use that as a as a useful lesson that you can apply to your own decisions and your own decision making. I think a good example of that right if we want to challenge the our faith a little bit Dave with value investing probably Buffett’s the most obvious anecdotal evidence there is specifically the Buffett and Munger kind of duo.

We’ve obviously haven’t seen the way they’ve been able to grow the book value of Berkshire through making these investments and acquisitions has just been unseen and they have this superhuman ability to make amazing investment decisions for a very long time period and they’ve done it consistently.

However when you study other value investors you see that it’s not anecdotal and that there have been enough that have found similar types of outside success where you start to see a correlation for example with the super investor speech that Warren Buffett made.

When you have a group of investors who are all trained from the same sensei if you will  the same mentor all followed Benjamin Graham and his lessons then you start to see that while there are outliers and there will always be people who do better than others just statistically from a purely statistical standpoint.

The fact that they all come from the same school of thought should give you an indication that this probably isn’t just a random chance it’s not just somebody hitting the lottery but there can be a lot of weight behind this.

I think you’ll see countless stories and I’m sure will see them the longer that  with Twitter and the internet and these ways that stories can go viral. I’m sure nothing’s coming to mind right now but I’m sure we had people from getting rich from Bitcoin or people getting rich from day trading that’s been something historically.

Lots of these things can happen and people can think well yeah I can do it as well but if you’re basing it just off that single person and off like a broader picture I think that’s where stock market studies can be really useful like we talked about last week.

At least with us with a study as long as you’re aware of the dangers of that study and your accounting for it well the great thing about studies is you have massive data base and a lot of pieces of evidence that you can stack together to really show you that something’s not anecdotal and something is more reliable when it comes to okay there seems to be some sort of correlation here and we’ve kind of considered.

What could possibly be the reason for this and this seems to be the most reasonable reason that makes sense and that’s the best thing you can do I think and that’s something that’s important when you when you’re looking at the history to is that I don’t know if there’s a quote there’s definitely a quote about like if stocks were all about numbers then accountants would all be the most wealthy people in the world I believe there’s another one that said if if just learning from history was enough to do really well in the stock market then historians would all be the most richest people in the world.

Remember history is a tool it’s something that can teach you a lot but at the same time it’s not panacea and you want to make sure that you’re not falling trap into thinking you can just apply it 100% black and white and so I guess I got off a little bit of a tangent but maybe you can add some thoughts to why you think anecdotal evidence is not enough.

Dave: well I think I guess the only thing that I would really kind of throw out there was you were talking a little bit about the some of the super investors and some of the people of maybe a little more recent time like Mohnish Pabrai Guy Spier some of those people.

They’ve done fantastically well using the same framework that Warren Buffett and Charlie Munger have used and they’ve kind of they’ve taken it to a once a new level but they have taken it from a different slightly different path in that they are learning from Buffett and Munger whereas Buffett a Munger we’re learning directly from the source.

Every time you get a little farther away from the original source there’s going to be some changes to how they do things and I think that that is  an evidence that it’s not just  it’s not just one guy it’s not just Buffett it’s not just Munger. That there’s been so many other people that have done this that it’s you can’t just take the basis of one person has done fantastically well.

You were mentioning Bitcoin I specifically remember that I don’t remember the gentleman’s names but the guys that helped oh I’m going to blame Mark Zuckerberg create Facebook or I don’t I don’t know if he helped created of the two gentlemen that he was went to school with that they had a dispute about who actually started Facebook.

Anyway those the those guys became the first Bitcoin billionaires and I remember that was all over Facebook for a short time period I don’t know what sense has come of that but I know they were trotting that out as evidence that investing in Bitcoin could make you a billionaire.

And using that is just one prime example is certainly not enough for you to invest in something like that is it fair to say that maybe you can combine the idea that we talked about the very beginning where if the time period is too short then it’s more likely to be anecdotal like yeah when you mentioned Buffett we’re talking about a history that goes all the way back to Benjamin Graham which was the 1920s.

Andrew: Right you’re seeing like a pattern over time whereas something’s more likely to be anecdotal if it’s like your example perfectly one person or even maybe a group of people but over such a short time period that it could be more because of the market rather than because it works.

Dave: yeah I would definitely agree with that I think that would be I think a perfect way to kind of tie that all together okay cool. all right so let’s move on to the last thing you wanted to talk about which was the specific in value investing back test pitfalls so we wanted to touch a little bit on something that we were talking about last week.

Andrew: yeah so this one’s tough right because um there’s a lot of great studies out there and particularly in the value investing the quant space a lot of this number based stuff something that I’ve struggled with and kind of seen as a potential problem this is maybe much more advanced than the average beginner or average investor but there’s obviously a lot of evidence of value investing working value investing being able to produce outsized returns and a lot of numbers that back that up however we have to be careful because you want to really see you got to read in and see how applicable is that to you.

I know there’s a Maryland study that showed that value stocks outperform grow stocks and the market obviously and it was something to the effect of like they the value stocks over 90 years produced returns of 17 percent where growth stocks was somewhere between I think it was 12% and the market was 10%.

And there’s just been countless other studies and a lot of people that we follow and respect who’ve made some really great findings in the field that show just how well value investing does over the long term.

But you have to think about I’m the average investor right I don’t run a hedge fund I’m not managing huge sums of money so how relevant is this particular back test to me and it’s not going to be whether it’s a back test an academic study a study like the Merrill Lynch study there’s not going to be a clear-cut answer that you can just apply across everything.

To say that okay that’s how it applies to me everybody’s situation is different financially the way you are investing is different I love to advocate dollar cost averaging where you invest a specific amount every single month and then really like Buffett trying to hold as long as you can as long as the business looks good so a lot of the studies.

At least today and I hope this changes and I’m sure well as more data more computational power you have so many more people doing these sorts of studies and back tests every single day but this idea of that specifically a lot of the studies I’ve seen will give you a basket of stocks and then at the end of a year you have to rebalance it.

What rebalancing means is you are adding to some positions and you’re taking away from some positions for an investor particularly if you’re investing with smaller amounts of capital let’s say you’re doing one hundred and fifty dollars a month like I advocate that as a recommendation as a start point especially if you don’t have much excess in your budget to be able to do a lot more.

But at least to get started and you’re doing like Ally brokerage like me and Dave use with transaction fee of 495 a trade to rebalance every year you’re looking at probably six to eight to maybe ten trades if not more depending on what your portfolio looks like year after year after year so you’re looking at if you’re only doing one hundred fifty dollars a month and you’re doing the four ninety five transaction fee and you’re stacking a bunch of those you’re almost paying as much or more in transaction fees and you’re actually putting it into the market that’s obviously going to give you really poor results.

Also if you’re holding strategies completely different say you want to have a low turnover portfolio and you’re trying to hold a very long term like a lot of successful investors have done. Rebalancing every year is not going to fit with your strategy as well so can you really take those findings and really apply them a hundred percent.

I think I think it’s a judgement call I think it’s something you just have to be you have to get and then to the feel for and so if you’re looking at the history of the market you’re trying to draw lessons and you’re trying to specifically apply it we talked about last week how a an academic study could be inconclusive or leads you down potentially wrong path.

Today I’m telling you as it specifically relates to the way you take action in the market be careful make sure you’re really putting enough thought into the way you’re investing how much money you are allocating. the stories will be completely different for a hedge fund where transaction fees aren’t a problem where they’re able to rebalance with positions and be completely fine generate alpha in that way.

It might not be applicable to you as the average investor and so you want to keep that in mind and something that I hope becomes more of like a talking point and more of like a goal for people because I really believe in long term investing buy-and-hold investing being part owner of a business and even though there’s so much data out there from the quant side about how stocks have been doing based on price based valuations or other financial characteristics.

You still haven’t seen a lot and maybe I just haven’t stumble upon them if you’ve seen them please send them my way I’d be so interested to read them. but  studies where you’re having time periods that are that are much longer and I realize that’s really hard to do because then how you’re getting into the problem of well if I’m investing once a month how is my how is my study making this decision and you can’t replace a human in that sense too.

So a lot of different pitfalls but I think if you’re aware of it and you understand the limitations of what you’re trying to do and what you’re trying to learn from the history of the stock market then you’ll be fine and you can at least take the broad general themes and apply it to make really great decisions to make sure you’re in general investing with the margin of safety emphasis on the safety.

You are stacking the odds in your favor statistically and just doing everything that you reasonably can as the average investor and then letting the chips fall as they may understanding how the market will generally act over very long time cycles and make sure you’re not trying to split atoms.

Like keep it simple but at the same time be smart about how you’re drawing lessons from the market excellent as buff I would say perfect.

Dave: alright folks well that is going to wrap up our discussion for tonight I hope you enjoyed our discussion on potential investor problems when examining the history of the mark there’s a lot you can learn from history and the more you can learn the better you can make better decisions.

But Andrew has some fantastic points tonight some things you should really keep in mind when you’re considering any sort of investment, so as always go out there and invest with the margin of safety emphasis on the safety you guys have a great week and I’ll talk to you next week

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