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2023 | Book

Investing 1.0—Blind Faith and Speculation Read chapter Read first chapter

The Power of Modern Value Investing

Beyond Indexing, Algos, and Alpha

Authors: Gary Smith, Margaret Smith

Publisher: Springer Nature Switzerland

Part of: Springer Professional "Wirtschaft+Technik" , Springer Professional "Wirtschaft"

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About this book

The stock market is a wild and scary roller coaster ride that investors have tried to tame with superficially appealing but ultimately flawed strategies—technical analysis, modern portfolio theory, CAPM, factor models, and algos. Many have simply given up and settled for indexing. This book explains the fundamental flaws that make so many strategies hazardous to our wealth.

There is a better way—what the authors call Investing 6.0—that is simple enough for anyone to use. No fancy math, complicated computer algorithms, or long days are required. This book offers a strategy with a few key principles that all investors and the financial advisors and planners who serve them can use with ease

Table of Contents

Frontmatter
Chapter 1. Investing 1.0—Blind Faith and Speculation
Abstract
The early days of stock investing were characterized by little more than speculative guesses about whether stock prices were about to go up or go down—a fertile field for bubbles, including the South Sea Bubble, Tulipmania, the British Bicycle Bubble, and the Roaring Twenties. The enthusiastic purchase of dubious investments is encouraged by the Greater Fool Theory: “Buy something at an inflated price with the hope that you can sell it to an even bigger fool at an even higher price.” A focus on predicting short-term price movements also encourages Ponzi schemes and market manipulation such as the “Radio Pool” in the 1920s that pumped and dumped RCA stock.
Gary Smith, Margaret Smith
Chapter 2. Investing 2.0—The Birth of Value Investing
Abstract
The carnage left by the Great Crash gave rise to two visionaries, John Burr Williams and Benjamin Graham, who moved investment analysis from Investing 1.0 to Investing 2.0 by arguing that investors can estimate what stocks are really worth by considering a company’s assets, earnings, and dividends. The intrinsic value of a stock is what investors are willing to pay to receive the anticipated income from the stock—with no expectation of ever selling. There are a variety of value-investing benchmarks for assessing whether stock prices are reasonable, including the dividend yield, price/earnings ratio, earnings yield, and Shiller’s CAPE.
Gary Smith, Margaret Smith
Chapter 3. Investing 3.0—(Mis)measuring Risk
Abstract
In the 1950s Harry Markowitz and James Tobin developed mean–variance analysis (or Modern Portfolio Theory). There are several valuable insights, including that a diversified stock portfolio may be safer than any stock in the portfolio and that the gains from diversification depend on the correlations among the stock returns. However, there are debilitating problems, including the fact that stock returns are not normally distributed, and past returns are not a reliable guide to the future. Even more damning is that mean–variance analysis focuses on price volatility, which should be of little concern to most investors.
Gary Smith, Margaret Smith
Chapter 4. Investing 4.0—Efficient Markets and Value-Agnostic Indexing
Abstract
The efficient market hypothesis states that stock prices take into account all relevant information. If changes in stock prices depend solely on new information, which is unpredictable, then stock prices follow a random walk and trying to predict changes in stock prices is a waste of time: the stock market doesn’t leave $100 bills on the sidewalk. The popularity of the efficient market hypothesis underlies the growth of index funds that do not try to beat the market. There is, however, plenty of evidence that stock prices do sometimes depart from intrinsic values—most obviously during bubbles, including the recent dot-com and cryptocurrency bubbles.
Gary Smith, Margaret Smith
Chapter 5. Investing 5.0—Factor Models, Algorithms, and Chasing Alpha
Abstract
The Capital Asset Pricing Model (CAPM) is an extension of mean–variance analysis that distinguishes between risk that can be diversified away and market risk, which cannot. Shortly after the efficient market hypothesis became popular, researchers began accumulating evidence of so-called anomalies—investment strategies that beat the market—and incorporating these anomalies into CAPM as additional factors. A well-known example is the Fama–French factor model. This ransacking of data for anomalies has been facilitated by the use of computer algorithms (algos). CAPM, factor models, and black-box algorithms all lure investors away from value investing because they focus on short-term price movements.
Gary Smith, Margaret Smith
Chapter 6. Investing 6.0—Modern Value Investing
Abstract
A modern value-investing approach—Investing 6.0—returns to the insights of value investing by arguing that investors should look forward, not backward, and estimate the income from their investments and their uncertainty about those estimates. One profitable consequence of focusing on long-term income uncertainty instead of short-term price uncertainty is the shunning of 60/40 portfolios that hobble long-run returns by investing too heavily in low-return bonds in order to reduce short-run price volatility that many investors should not care about.
Gary Smith, Margaret Smith
Chapter 7. A Case Study—Stocks
Abstract
The different investing approaches can be compared by analyzing a potential investment in Apple and JPMorgan Chase. Investing 1.0 tries to predict which direction these two stock prices will go next. Investing 2.0 estimates intrinsic values without an explicit consideration of risk. Investing 3.0 uses historical returns to estimate mean–variance portfolios. Investing 4.0 assumes an efficient market and invests in an S&P 500 index fund that holds modest amounts of Apple and JPM. Investing 5.0 uses historical data to estimate beta coefficients for CAPM and other factor models. Investing 6.0 estimates the future income from these two stocks and measures risk by the uncertainty in these income projections.
Gary Smith, Margaret Smith
Chapter 8. A Case Study—Homes
Abstract
The Investing 6.0 value-surplus approach can be applied to real estate. If you buy a home and rent it to someone else, the income is the rent you receive (net of expenses). If you live in the house you bought, the implicit income is the money you save by not having to pay rent, net of expenses like home insurance, property taxes, mortgage payments, and maintenance. To make clear the analogy to stocks, we call this net income the “home dividend.” Specific applications of this approach indicate that there was no real-estate bubble in Fishers, Indiana, in 2005 but there was one in China’s two largest cities, Beijing and Shanghai, in 2019.
Gary Smith, Margaret Smith
Chapter 9. The 9 Pitfalls of Investing
Abstract
The arguments made throughout this book can be summarized by a “don’t do list” of pitfalls investors should try to avoid: (1) don’t follow the crowd or chase prices; (2) don’t be seduced by fads, follies, and hot tips; (3) don’t try to time the market’s zigs and zags; (4) don’t measure risk by price volatility; (5) don’t be bedazzled by math; (6) don’t be duped by AI; (7) don’t be deceived by backtesting; (8) don’t torture data; and (9) don’t trust things too good to be true.
Gary Smith, Margaret Smith
Backmatter
Metadata
Title
The Power of Modern Value Investing
Authors
Gary Smith
Margaret Smith
Copyright Year
2023
Electronic ISBN
978-3-031-45900-9
Print ISBN
978-3-031-45899-6
DOI
https://doi.org/10.1007/978-3-031-45900-9