Heed the Wisdom of Crowds

08/15/2011 7:00 am EST

Focus: STOCKS

Paul Winkler, an advisor, coach, and TV and radio host in Nashville, says things usually end badly for investors who try to outsmart the market. He adds that keeping emotions in check is of utmost importance, because panic-driven decisions are generally counterproductive.

Kate Stalter: We are speaking today with Paul Winkler, who is the head of Paul Winkler Inc., in Nashville, and he is also the host of the Investor Coaching Show on radio and TV in Nashville. Thanks Paul for joining us today.

Paul Winkler: Well, Kate, thanks for having me on.

Kate Stalter: I want to start out by asking you about what is perhaps the obvious thing on everybody’s mind: With all the market volatility that we have been seeing in recent sessions, give us some context on the market action. What is crucial for individual investors to keep in mind right now?

Paul Winkler: One of the things that investors have got to keep in mind is that market volatility comes with the territory. Really!

We look at long-term return in stocks—the equity premium, as we like to call it in the investment industry. Stocks have a higher return than bonds. You have to pay for that, and you pay for that by putting up with volatility.

If you look at volatility, it is the norm; it is something that happens all the time. Two-thirds of the time, markets go up. But that means that one-third of the time the market goes down, and the problem is that you can’t predict either one of them.

A lot of times people try to figure out, “Hey, when is this thing going to go back up?”

There was a University of Michigan study that was pretty interesting about market volatility, and where returns come from, and when they happen. It was from 1963 to 2004. They actually found that 96% of market returns occurred in less than 1% of trading days.

So the challenge that people have is they say, “Well, you know when things get better, I am going to get back into the market.” They think that when they can see things getting better, they’ll get back in, and then they realize you can’t get in front of that train. It isn’t going to work.

Kate Stalter: So it is just a matter of hanging in there, essentially. Is that what you are saying?

Paul Winkler: Well yeah, really. Because what happens is, new information drives this.

For example, here is a big mistake that people make: They try to tie the economy with the stock market. What I mean by that is, they say, “I think that the economy going forward is going to be lousy. It is going to be a two on a scale of one to ten. I think it is going to be horrible.”

But let’s say that new information comes out, that shows the economy is going to be horrible, it is going to be a 2.1.

Stocks actually adjust upward when that information comes out, because it is better than what was expected. You always hear that when you watch TV. You know, they have better-than-expected earnings or you know, this stock went up 47 cents.

And you say, “They just lost 20 cents a share. Why did their stock go up that much?” Well, we expected that they were going to lose 50 cents, or whatever, so it was better than expected. They lost less than we thought they were going to lose.

So that is the problem with it. You are basically trying to outguess the market…and any time you trade stocks, if you think about how stocks are traded, you have market makers out there. A lot of people don’t even think about how stocks are traded. These market makers hold inventories of stock.

I use the example with my clients, and on my radio show and TV show. Let’s say we are talking about Crest toothpaste. Well, you have Walgreens (WAG), then you’ve got Wal-Mart (WMT), and Kroger (KR), and Price Chopper, and all these different grocery stores that hold an inventory of Crest toothpaste.

They all go to Crest [actually Procter & Gamble (PG)—Editor] to buy the stuff, and they try to keep their prices as low as they can and sell it to the next person.

Well, they are all competing against each other when they buy that toothpaste. They don’t want to overpay for it. When they sell it, they don’t want to sell it for too little.

It is the same thing with stocks. So, when you are trying to figure out where the market is going, and which stocks are overpriced and underpriced, you are competing against the most brilliant minds in the industry that do nothing but buy Crest toothpaste—or that stock. So it is just very, very challenging.

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Kate Stalter: Regardless of any market condition, people are always interested in knowing what areas appear to be showing some strength, or at least some potential, at this juncture. Can you talk a little bit about that, Paul?

Paul Winkler: Well, look around and say, “OK, where do returns come from?” They come from this concept called cost of capital, and I am going to answer your question kind of in a roundabout way, because I think it will be instructive.

If we look at the cost-of-capital concepts, I always tell people: You understand this concept already. If I go down to the bank and I say, “I have $100 and I want to put it in your bank,” and they say, “We will pay you 1% interest,” they are going to pay me $1 for every $100 that I invest.

The stock market is very, very similar. If I look at, for example, large US stocks, they have historically sold for $16 for every dollar of earnings. You have different areas that trade for different prices because of the risk premiums. Small companies typically either sell for a little bit less, or they have higher growth estimates.

So what happens is if you were to say, “Hey Paul, I want you to line up all the different areas of the market, and I want you to guess what is going to have the highest return over the next ten years,” I would tell you, “OK, the highest expected return would be the riskiest area of the market.”

What is that? Well, it might be smaller emerging markets, or value stocks, or something like that.

But the problem is that risk premium doesn’t show up in all situations. If I look at the 80-year return of large US stocks, it has been about ten. If I look at small US stocks, it has been about 12. If I look at small value stocks, it has been about 14.

What happens is, since we don’t know what is going to do well in the future, I can’t tell you that small companies are going to trounce large companies over the next year, because I have no way of knowing that.

The economic train is not certain, and the question almost presupposes that I think that one area of the market is mispriced and not selling for as much as it is actually worth, and it is a bargain right now.

I don’t believe in the idea of a bargain or stocks being a bargain, I believe that they are properly priced. Kind of like that book, The Wisdom of Crowds.

I think it is a really cool book, because for the listeners who don’t know what it is, basically what you had were guys going out to county fairs, and a statistician was buying all the guesses on what is the dressed weight of an ox would be.

The funny thing is, Kate, is that nobody guesses the actual weight of the oxen. But if you took all of the guesses of all these people, educated and uneducated, they were within a fraction of the pound of the actual weight.

Crowds somehow, through their wisdom and knowledge and everybody coming together and putting their minds together, are amazingly good at coming up with a proper weight of the oxen. They are also very good at coming up with the proper price of a stock. To try to beat them is a futile exercise.

You have the Brinson, Hood, and Beebower study too. That was a study done in 1986 and 1991, and they found that all of these pension plans were engaging in stock picking and market timing. They were all trying to figure out where the market was going. They were all trying to figure out which stocks were better than others, and what they found out was that in 100% of the cases, none of them outperformed what markets did on their own. That is pretty daunting.

Kate Stalter: To follow on that, the same would be true of the inverse: Where is the weakness in the market right now?

Paul Winkler: Yeah, it is the same thing. Where is the weakness? I don’t know. If you look at it and say, “What is really doing bad,” we would have to say Europe, wouldn’t we?

And if you look at Europe, it is interesting. If you look at prices of European companies compared to their book value, their assets minus their liabilities, that is where the prices happen to be lowest right now. So that information that it’s weak is already built into the stock price.

So that is what I mean by, markets are really good at figuring this out. So technically, if I look at it and say, “Well, you know, things are really bad over in Europe,” I am not the only person that has picked up on that fact.

Everybody out there has, as well, and they are pricing it appropriately. The buyers and sellers come to an agreement on what they should pay, and quite frankly, I don’t want to pay a whole lot for those stocks right now because I am worried about them.

Kate Stalter: I want to wrap up by asking what you think is the most important thing for an individual who is worried about his or her portfolio. What is the most important thing to remember or to do right now?

Paul Winkler: Well, a couple of things. No. 1, make sure that your investment portfolio mix between stocks and bonds meets your time horizon.

When we talk about bonds, I like keeping my bonds really safe because that is my safety net, my investment portfolio. You know, if I need my money back in three to five years or something like that, putting all your money in stocks isn’t a real good idea. But putting nothing in stocks isn’t a good idea, either.

And make sure that whatever you do, try to tame your emotions. Emotions are the one thing that really kills investors.

They really cause investors to lose more money than anything, because you think you are trying to protect yourself, and you think you are trying to take action for self-preservation. And what ends up happening is you do just the opposite, and you actually reduce your odds of being successful and surviving.

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