It would be much easier to plan for the future if we knew what stock prices were going to do.  Bank of America has a chart with seemingly solid evidence that stocks will lose a total of about 8% over the next 10 years.  I’m going to show why this evidence is nonsense.  But don’t worry; I’ll do it without making you try to remember any of your high school math. The Bank of America chart looks intimidating to non-specialists, but I’ll summarize the relevant parts in easy-to-understand language.  The basic idea is that for each month since 1987, they looked at how expensive stocks were that month and compared that to stock market returns over the 10 years following that month.  They found that the more expensive stocks were, the lower the next decade of returns tended to be.  The hope is that we can just use the chart to look up today’s stock prices to see what stock returns we’ll get over the next 10 years. In the chart below, each dot represents one month fr...

Imagine you’re in a grocery store looking at apples. You like the look of them, note the price, and decide to grab 5 apples. But something strange happens. Right after you pick up the first apple, the price goes up. You get the first apple for the original price but have to pay more for the other 4. This is an analogy for the complaints against High-Frequency Traders (HFTs). In stock market trading there has always been an advantage for those who can react fastest to new information. It may seem that the criticisms of HFTs by Michael Lewis and others is just the usual moaning by losers about their inability to compete with winners. But there is more to it than this. Let’s get back to the grocery store and the apples. Remembering your first experience with the price of apples rising while you picked them up, you decide to just watch the price. You stand there for a long time and the price doesn’t move. The next day you watch the price of apples for a long time and again i...

Larry MacDonald reported on interesting research into using “robot traders” to prevent market bubbles. Unfortunately, this research ( paper available here ) by Suhadolnik, Galimberti, and Da Silva fails to address some serious real-world constraints. The idea is that based on the researchers’ model of trading patterns, adding some contrarian robot traders that trade against the herd tends to stabilize stock markets and prevent bubbles. This sounds plausible, but it brings up serious questions about how this idea could be implemented. To their credit, the researchers mentioned one of the practical problems (although it is buried on the third to last page): Where will the money for robot trading come from? “Financial resources involved in stabilizing the stock market is not addressed.” I don’t know if contrarian robots would make or lose money over the long run, but contrarian strategies can definitely lose money for very long periods of time. I definitely don’t trust the gov...

Tom Bradley at the Steadyhand blog wrote a piece pointing out that millionaires are bearish right now according to one measure. It turns out that Spectrem Group maintains an index of investment sentiment among millionaires by doing 250 interviews each month. So, do these millionaires know something we don't know? Bradley wasn’t endorsing this index in any way, but it got me thinking. If there is any group that may know something about investing, maybe it is millionaires. Perhaps that’s how many of them came to be millionaires. Perhaps this index has some predictive value. The scale of the index is -100 to +100. Five years ago it was hovering around +20. However, in late 2007 it went negative. This was nearly a year before the market meltdown. This seems like a vote in favour of millionaires having useful insight into short-term stock market moves. The next test is whether this index predicted the huge stock market rebound in 2009. Unfortunately, millionaires were b...

It may seem obvious when you think about it, but the stock market and the economy aren’t exactly the same thing. Some commentators seem to confuse the two. There is no doubt that they are related to each other, but they don’t always move in the same direction. The stock market reflects the going price for businesses that are at least partially owned by the public. The economy includes these businesses plus privately-owned businesses, bond markets, currency markets, governments, jobs, etc. Stock prices are a consensus view of the expected future profitability of public businesses. This makes the stock market forward-looking. Sometimes the crystal ball is cloudy and stock market participants get it wrong, but stock price movements tend to precede changes in the economy. We have seen this lately in media stories. As stock prices dropped, we heard story after story of gloom and doom about the stock market. This has largely given way now to gloom and doom about the economy. Ap...

1. Million Dollar Journey gives us a handy summary of planned TFSA (Tax-Free Savings Account) offerings from the major Canadian banks and brokerages . 2. Have you ever heard of a carry trade, but didn’t know what it was? Preet explains carry trades and the possible ramifications of Yen carry trades . 3. Blunt Money has some useful suggestions for getting out of cell phone contracts .

Reporters are running out of words to describe the drop in stock prices yesterday after the U.S. House of Representatives voted down the $700 billion bailout of the financial system: crash, plunge, carnage, bloodbath. Supporters of the plan said that the bailout is necessary to prevent further financial collapse. Others fear that even $700 billion would not be enough. What is usually left unstated in these discussions is what will happen if government doesn’t act. This part is usually left to our imaginations. In a more fearful moment, I tend to recall images I’ve seen of the homeless and hungry in the swirling dust of the great depression. Maybe others imagine burning buildings and widespread panic. The truth is that supporters of a bailout probably get more mileage out of leaving the consequences unsaid. We imagine much worse outcomes than most commentators would predict. I have little doubt that the U.S. government will ultimately have to do something fairly costly to li...

The banking crisis continues as Lehman Brothers files for bankruptcy . Most people seem to view banks failing as a sign that the financial crisis is deepening. You won’t be too surprised to learn that I see this differently. The damage to the economy was done when financial institutions made poor choices chasing short-term profits at the expense of the long-term health of their businesses. Lending money to people who can’t pay it back has to cause problems eventually. That banks are failing now is a logical consequence of their actions rather than a sign that things are getting even worse. To maintain a healthy economy, some businesses must fail. Everything would become stagnant if we were to prop up unprofitable businesses. Well-run businesses should see their market share increase as their poorly-run competitors fail. This doesn’t mean that government intervention is always wrong. However, the important test of whether government should step in is whether it is in the public i...

We’ve all heard about market averages. In the US, the big ones are the Dow-Jones Industrial Average, the S&P 500, and in Canada, we have the TSX. There are many other stock market averages as well. However, most investors get significantly worse results than these averages. There are many reasons for this: paying higher brokerage fees, paying high fees to investment advisors, paying high taxes due to overtrading, etc. Even when investors buy index funds that are designed to track a market average, they often underperform the average because of failed attempts to time the market; in trying to avoid market drops, they miss market increases. For these reasons, I think that “market averages” are misnamed. If you buy a stock index and hold on for two decades, you will get much higher than average results. Another problem with the word “average” here is that it turns off investors. Who wants to be average? Who doesn’t think he can do better than average? Maybe we should call the r...

I know I promised a discussion of risk and volatility, but that will have to wait. The stock market is crashing! Shouldn’t we be doing something? Yesterday morning the newspapers and online news sources were nearly unanimous: stocks are headed down and it’s going to be ugly. It can be tempting to sell everything at times like this, and many investors will sell. But if you do sell, when will you jump back in? Maybe you’ll buy once the market rises consistently for a week or two to show that the carnage is over. But this amounts to selling low and buying high. This is the opposite of what you want to do to make money. Any attempt to time the trading of stocks to make more money is called market timing. It can be tempting to try market timing, but be aware that there are others out there who are trying to beat you at this game. Collectively, market timers can’t make more money than those who simply buy and hold their stocks. In fact, on average they have worse results because they...

I intend to review the book Worry-Free Investing by Zvi Bodie and Michael Clowes, but for now I want to discuss one part of the book that reports historical U.S. stock market returns that are higher than I was expecting. In Chapter 6, the authors discuss U.S. stock returns from 1926 to 2000. They actually give real returns, which means the returns after inflation is subtracted out. Based on the historical data, they calculate the average yearly real return on stocks to be 9.3%. But, others say that the long-term real return on US stocks is 7%. This may not look like a big difference, but if you play around with one of the many free retirement calculators available online, you’ll find that an extra percent or two of return on your investments each year makes a big difference over the long term. So, which one is the correct historical average return? It turns out that they are both right because they are talking about different things. The 9.3% figure comes from taking the returns...

Happy new year! I have a few fearless predictions for the upcoming year. 1. Half of all financial prognosticators will correctly guess whether the stock market will go up by more than usual this year. Of course, the other half will get it wrong. Maybe we would be better off if we ignored people who pretend to know what is going to happen to stock prices in the short term. 2. Interest rates will either go up, or down, or stay the same. This is a safe one. Some people will pick just one of these three possibilities, but I don’t believe they know what will happen to interest rates any better than the rest of us. I doubt that even the people who set interest rates know for certain what they will do more than a few weeks in advance. 3. Newspapers will continue to print explanations for what happened in the stock market each day. We see articles with titles like ‘markets jittery amid inflation concerns’ or ‘market rally blunted by corporate earnings pessimism.’ I rarely find these expla...

1. Stock markets in the US and Canada were up this year. The gains were small enough that some would call this a “sideways” market where only stock-pickers can make money. Of course, stock pickers can only make more money by taking it from each other. For every extra dollar that one stock picker made above this year’s average market return, some other stock picker made a dollar less than the average. 2. Apple stock more than doubled. Technical analysts who study patterns in stock price charts could no doubt show you how this could have been predicted by their methods. Personally, I think it has more to do with those little iPod things that everyone is buying. 3. The Canadian dollar overtook the US dollar. Only a few years ago the Canadian dollar was the butt of jokes. (What’s another name for the Canadian twonie? A US dollar.) I think Canadians told these jokes more often than Americans did. The higher Canadian dollar should have caused the price of goods imported into Canada to drop, ...