Futile search for an Investment Formula
In a classic “Margin of Safety”, the author, Seth A. Klarman, writes about the futile search by investors for a winning formula in the stock market. “Many investors greedily persist in the investment world’s version of a search for the hold grail: the attempt to find a successful investment formula. It is human nature to seek simple solutions to problems, however complex. Given the complexities of the investment process, it is perhaps natural for people to feel that only a formula could lead to investment success.
Just as many generals persist in fighting the last war, most investment formulas project the recent past into the future. Some investment formulas involve technical analysis, in which past stock-price movements are considered predictive of future prices. Other formulas incorporate investment fundamentals such as price-to-earnings (P/E) ratios, price-to-book-value ratios, sales or profits growth rates, dividend yields, and the prevailing level of interest rates. Despite the enormous effort that has been put into devising such formulas, none has been proven to work.
One simplistic, backward-looking formula employed by some investors is to buy stocks with low P/E ratios. The idea is that by paying a low multiple of earnings, an investor is buying an out-of-favor bargain. In reality investors who follow such a formula are essentially driving by looking only in the rear-view mirror. Stocks with a low P/E ratio are often depressed because the market price has already discounted the prospect of a sharp fall in earnings. Investors who buy such stocks may soon find that the P/E ratio has risen because earnings have declined.
Another type of formula used by many investors involves projecting their most recent personal experiences into the future. As a result, many investors have entered’ the 1990s having “learned” a number of wrong and potentially dangerous lessons from the ebullient 1980s market performance; some have come to regard the 1987 stock market crash as nothing more than an aberration and nothing less than a great buying opportunity. The quick recovery after the October 1989 stock market shakeout and 1990 junk-bond market collapse provide reinforcement of this shortsighted lesson. Many investors, like Pavlov’s dog, will foolishly look to the next market selloff, regardless of its proximate cause, as another buying “opportunity”.
The financial markets are far too complex to be incorporated into a formula. Moreover, if any successful investment formula could be devised, it would be exploited by those who possessed it until competition eliminated the excess profits. The quest for a formula that worked would then begin anew. Investors would be much better off to redirect the time and effort committed to devising formulas into fundamental analysis of specific investment opportunities.”
