Couch potato investing: better that betting on a horse race

In Financial Bull Riding I wrote that annual percentage returns is the wrong measure of investment performance. The better metric is absolute dollar return. Naive investors, and most financial journalists, assume the two will produce the same results, but they don't. 

Josh Peters, Director of Equity Income Strategy for Morningstar and the author of The Ultimate Dividend Playbook, calls chasing percentage returns a horse race: 

Almost all of Wall Street is geared around this idea of a horserace. That it’s all about trying to beat your benchmark, beat the S&P 500 — to do it every quarter regardless of whether that quarter is up or down. That’s not what most people are looking to do. That’s only how money managers evaluate each other, maybe. But that’s not necessarily what’s going to serve the actual financial requirements or financial needs of people who are out there. The biggest demand out there is for income and it’s not just because interest rates are low, it’s because baby-boomers are retiring and most of them don’t have those defined benefit pension plans to count on.

Buffet's Investing Advice

Fortune magazine recently published an excerpt from Warren Buffet's annual letter to investors in which Buffet offers advice for the average investor. He starts by telling two investing stories:

This tale begins in Nebraska. From 1973 to 1981, the Midwest experienced an explosion in farm prices, caused by a widespread belief that runaway inflation was coming and fueled by the lending policies of small rural banks. Then the bubble burst, bringing price declines of 50% or more that devastated both leveraged farmers and their lenders. Five times as many Iowa and Nebraska banks failed in that bubble's aftermath as in our recent Great Recession.

Popping Bubbles

Mainstream economists buried the business cycle in the last decade of the 20^th century. Having discovered that pronouncement of its death to be premature in 2008, they have suddenly rediscovered asset markets and cast them in the role of villain in the business cycle melodrama. They think that the popping of asset bubbles triggers recessions so they have been searching for ways to identify bubbles in fetus stage and abort them.

Last week Bloomberg featured an article about Finnish economist Katja Taipalus and her model for detecting asset market bubbles which she explains in her paper, “Detecting asset price bubbles with time-series methods.” Boiling down the 217 page paper to its essentials, she is trying to determine when stock market and housing prices diverge from their “fundamental” value.

Along with most mainstream economists she errs in thinking that assets have an objective value determined by the net present value (NPV) of future income. However, as Austrian economists know there is no objective NPV. Earnings forecasts and the discount rate used to calculate NPV are subjective. Future earnings will vary depending on the optimism of the forecaster. The discount rate changes according to each forecaster’s tolerance for risk.

Taipalus’ model uses the log of the yield of a stock market index to identify bubbles. If the yield falls at a rate set by her test statistics, then the model signals a bubble alarm. Tests of the model show that collapses in asset prices follow within a year of the alarm and recessions follow the collapse.

Experienced investors know that dividend yield is the inverse of the price-earnings (PE) ratio if all profits were distributed as dividends. Yield is E/P whereas price-earnings is P/E. So yield can fall if prices rise faster than earnings and yield will rise if prices rise slower than earnings. Economists love dividend yields for some reason while most investors tend to follow PE, but they tell us essentially the same story.