Market Math...Flunked Again

I promised an update on math and market predictability. I've been taking CE courses for my CFP. Yes, they are annoyingly thorough. Lots of them involve using various formulae for analysing such unpredictabilities as the 'true' value of a stock, and measurement of performance.
I know it makes people feel better to think they have a clue as to the future value of a stock price, or even a hint as to the likelihood of the future value.
The common wisdom says current prices reflect investor expectations about a company's future earnings.
That seems quite ridiculous to me. The same managers do lots of math using past prices, and past earning growth, then, what? Make a pick based on future expectations?
Expectations of what? That the past will repeat? That happens only if you allow for a lot of leeway in your definition of repetition.
Microsoft, as an example was $23.40 five years ago. Today it's $24.15. In between it was $15.27 and $34.33.
Lots of people bought and sold it along the way. The net result of all that guesswork was zero. Nobody 'knew' it would rise to $34, nobody 'knew' it would shrink to $15. Please send along evidence you put actual money on the table to buy at $24, sell at $34, short, then buy back at $15. You don't have it. If I'm wrong, prove it, I'll recant.
Like 'low' PEs? During that period MSFT made scads of money, it has one of the lowest PEs around, not just in the tech sector. Right now it's under 10 times earnings.
How much do you own? Or how much are you going to buy? Money talks, bs walks. Demonstrate your belief in low PE stocks, if you have one.
This is NOT to be in any way construed as a recommendation to buy sell or hold MSFT or any other stock. We don't do that here. I use it to make a point. I could have used Berkshire. 90K 5 years ago, 116k today. Buy and hold netted you 5.25% a year, no dividend either. Did Buffett and Munger get dumb for five years?
Did you buy BRK at 90K, then sell at 148K, then short and cover at 78K, buy again? Then you made a killing percentage-wise. Except nobody did, because nobody makes those kinds of guesses repeatedly.
Even the beloved God of Stocks, Google, returned 5.2% over that time frame. Or did you presciently buy at 400, sell at 699, short, cover at 283 and buy again right away? Sure you did. Just, for the sake of accuracy, post those account statements, redact you name and account number of course, we don't want to know you that well.
You didn't? Don't feel bad, neither did anyone else.
During that same five year period, the S&P 500 (using the ETF proxy SPY) went from 125 to 130, under a 1% annual return, plus a 1 1/2% dividend give or take along the way.
This is the long way of saying, over time, you get what the market gives, no more, no less (except for the percent you give to a manager to pick stocks for you...oops.)

Sucker Punch

I've been reading lots of investment material, I'm a masochist at heart. I was reading about Modern Portfolio Theory, which you have to Capitalize (mixed metaphor.)
It's really a fascinating combo of science fiction and meaningless math.
First, it was foisted on an unsuspecting public 50 YEARS ago, and it's STILL called modern, despite there being nothing like today's derivatives and Warren Buffet was only 30 years old.
Investment Manglers, uh, Managers, are using it to decide how to construct portfolios, which they then foist off on YOU in the form of mutual funds, managed accounts and hedge funds. And YOU buy it, well, lots of you do.
Where are all the customer's yachts anyway?
Here are the general assumptions behind Modern Portfolio Theory, try not to throw up.
-Investors are risk averse.
Comment: It isn't true, as demonstrated by Kahneman and Tversky. The research is too long to go into here, but the truth is...investors are LOSS averse. They will actually seek risk under the right circumstances.
-Investors make decisions based purely on expected return and risk.
Comment: No, you didn't read wrong. He posited an investment theory based on people being rational...???
-Investors have a common one period investment horizon.
Comment: It then explains that the period can cover varied lengths of time. If you can make that sensible, let me know how.
-Investors have free access to all information relevant to investment decision making.
Comment: Having access and using it are not the same thing. And you'll have to explain Bernie Madoff if you believe this.
-I LOVE this one
-There are no transaction costs.
Comment: A portfolio construction model that denies costs. ALERT!!!....This is the founding investment theory your children are learning in the expensive Finance and MBA program you are paying for.
-Capital markets are perfectly competitive, so no one can manipulate the market.
Comment: Duh. It also begs the question of why your government should intervene by plowing borrowed money into financial crises, which is nothing but market manipulation.
Soon, we move to the Capital Asset Pricing Model for Dummies. Stay tuned.

Important Past Post - Read and Understand All

Well, that’s a little exaggerated, you do need to figure out what percentage of your portfolio should be in stocks, how much in bonds, or in money market funds.
But for picking stocks, this formula will guarantee you avoid costly investment mistakes.

A = Total Stock Market
B = Active investors (traders, stock pickers, money managers, hedge funds)
C = Passive Investors (index buyers)
Y = Rate of return for the market
X = what we want to know

If Y, the market rate of return, is 12%, then the rate earned by C, passive investors, must also be 12%.
Let’s say for now that 70% of the investors are active, and 30% are passive index investors. So out of 100, or any number you like, could be a million or a skillion, but 100 will serve for now, there are
70 active investors
30 passive investors
Y is 12%
Plug in the numbers: 12%(A) = X%(B) + !2%(C)
So, given these facts, what did B, active investors, earn?

Let me simplify life for you, no matter what numbers you use for the market return, or the percentages of active versus passive investors, the answer is the same. In this case 12%.
Yes, the % earned by active investors averages the same percentage as both the market and passive investors, and obviously, not all active investors earn the same thing. some earn more, some less. The problem is that year over year, there is no way to predict which active investor will finish ahead, or which one will fall behind. It only looks that way when you look at the single most misleading, portfolio damaging indicator in the world, past performance.
I will discuss the absolute uselessness of past performance data in another section.

Before you challenge me on any of this math as flawed, let me point out it wasn’t me who thought it up. The general topic is discussed in Commentary, and a link to the article can be found in Referenced Articles. It is also referenced below
The formula used here is adapted from The Successful Investor Today, by Larry E. Swedroe,
St. Martin’s Press 2003.
For most equity investors, I believe in passive, index investing. I refer you to The Arithmetic of Active Management by William Sharpe, Nobel Laureate and Professor Emeritus at Stanford University as to the specifics of why. You can find that article in the section of this site called "Referenced Articles."
Essentially, Sharpe demonstrates mathematically why it is impossible for active investors as a group to perform any better than indexes, before costs. After costs, active investors must do worse. Are there active investors who will "outperform" from time to time? Of course, but always at the expense of other active investors who underperformed. Passive investors, by definition, get the market's rate of return, no more, no less. By the way, the active investors who do beat the market in any given year are almost never the same ones who beat it the next year. The simple arithmetic is that some fund manager will beat the market, but it's not likely to be the one you choose, and if it is, it's not likely that he can repeat the following year.