The Catholic Investor Gets Interviewed!

In the Greater Toronto Area, we are very fortunate to have a very vibrant Chinese Catholic community.  There is even a Chinese Catholic television program, called Fountain of Love and Life (FLL), that produces its own TV programs.  I was so very honoured to have been invited to do a little sharing in one of the upcoming episodes on this blog!  I actually just came back from the interview.

On it, I talked about ethical investing and the USCCB investing guidelines.  I also mentioned that one of the biggest pleasant surprises I've had were the readers (yep, that's you!) who have reached out to me and contacted me to say hi.  Among you, there are Catholics, Protestants, and non-Christians, and I felt that this blog was a means of evangelization and ecumenical dialogue.  So, thanks to the Lord's grace and you, I'm still writing on this blog!  Feel free to drop me a line.  You can add me on Google+ (right side of this page) or email me.

If you are interested, you will likely be able to view the episode here: http://fll.cc/index.php/fll-tv/online-tv.  Unfortunately, the program is in Cantonese and has no English subtitles.  But at least you get to see my face!

I also wanted to thank all the staff at FLL for inviting me!  It was a blast!  God bless!

Causality or Simply Correlation: Does the Stock Market React to Real World Events?

When you read the headlines of the day, you'll quickly note that every movement of the stock market or a particular stock can be explained by some thing that is happening in the world.  " Dow drops 237 points as fears of Greek default intensifies," or "stock futures rise as housing market bottoms"...etc.  At times, it appears that the two do correlate.  When the economy is doing well, the stock market goes up.  The questions I would like to pose are: Do real world events cause movements in the stock market?  Or is the reverse true?  Or are they simply correlated without real cause-and-effect?

Bathrooms and SAT Scores

Before I give you my thoughts.  Let me give an example that I read somewhere.  It could have been Freakonomics (interesting book, by the way), but maybe not.  In any case, it was said that SAT scores of highschool students in the US had a high correlation to the number of bathrooms they had in their house.  That seems kind of silly, doesn't it?  Thinking a little deeper, it actually makes perfect sense.  Which kids have many bathrooms in their house?  Kids with a big house.  And who owns big houses?  Those from affluent families.

As further research shows, students from affluent families often perform better than their counterparts from a more modest background.  The causal link is between family affluence (or better yet, the environment provided by an affluent family) and SAT scores.  Since there is high correlation between affluence and number of bathrooms in the home, there is also high correlation between number of bathrooms and high SAT scores. 

One of the dangers in this situation is creating a stereotype that kids with lots of bathrooms in their house will perform better in school.  The larger problem, however, is asserting a causal link between number of bathrooms and high SAT scores.  A parent, learning of this correlation between number of bathrooms and high SAT scores, may mistakenly decide to spend money putting in new bathrooms in the house rather than on tutors, to improve his child's performance in school.  It sounds ludicrous, but it's not entirely unfathomable. 

Headlines Are Mainly Noise

You've probably already guessed where I'm going with this... As with bathrooms and SAT scores, business journalists probably confuse correlation with causality on occasion.

The stock market is really just a reflection of the buying and selling transactions that occurs.  On a day where more people want to sell than buy, the stock market drops, and vice versa.  That is the main causal link between real world events (i.e. people buying/selling) and stock market movement.  One can only guess at what causes people to buy or sell.  Sometimes, the cause of selling may be entirely cyclical.  Fund managers may participate in an activity called, "window dressing", where they will buy up stocks that have recently performed well as it gets closer to the date they disclose their holdings.  This makes it look like they had made great picks.  If enough fund managers do this on a particular day, it could be a market moving event.  But how often do you see this reported by journalists?

The point is that there are so many factors affecting the stock market transactions such that to make the assertion that the market or even a stock moved in a particular direction as a result of a particular event could be wrong.  Therefore, headlines, at many times, are a source of noise.  In short, take it with a grain of salt.

Useful Causal Links
If we can't trust journalists, what can we trust?  The answer may be a little provocative: ourselves!  When it comes to investing, we really should do our own research.  Aside from the ethics side of things, we need to estimate the value of a company.  The causal link between a stock's price and its earnings power is strong in the long term.  A stock may get beaten down due to whatever reason, but if it continues to grow its positive cash flow, its price will eventually reflect that.  High earning power causes higher stock price.  It is that simple!

Therefore, it is key to be able put a value on a company based on the outlook of its earning power.  If the price is sufficiently below the value, then it is time to buy.  Conversely, when the price rises much higher than the value, we should consider selling.  Again, this goes back to doing the right fundamental analysis on a stock.  If you're new to this blog, start by going to Fundamental Analysis or Rule #1 Investing.

Risk vs. Volatility

In the financial industry, the word "risk" gets thrown around quite frequently but its definition is fairly loose.  Today, we will take a look at how it relates to the term "volatility".  We will find that a stock investor should actually like risk as it is traditionally defined (i.e. volatility).

Risk as Volatility
Investopedia.com is usually a pretty good place to obtain conventional wisdom on investing.  So, let's see how it defines risk.   It basically says 2 things.

Risk is:
1) the chance that an investment's actual return will be different than expected, or
2) standard deviation of the historical returns or average returns of a specific investment.

The two actually say the same thing.   The former is a more down to earth language and the latter is just more mathematical.  At first sight, they sound pretty fair.  For an investment to be risk free, we should know what its expected return should be and the chance that it deviates from it should be very, very low.  Sure, that is exactly what volatility means, but does volatility really equate to risk?  I would argue not quite.

Volatility is Not Risk, But Opportunity
First and foremost, this is not exactly the same definition as we understand the word "risk" to mean.  The Webster dictionary tells us that risk is "the chance that an investment (as a stock or commodity) will lose value", when it is dealing with investments, and I would 100% agree with this definition.  But going back to the financial industry's definition of risk as volatility, we see that it falls short.  The definition speaks nothing about the performance of an investment.  If an investment's expected return is -5% per year and it hits that target bang on every year, by this definition, it is a "risk free" investment.  Moreover, it negates the fact that an investor is able to take advantage of volatility to increase his/her returns.  Lastly, an investment is determined solely by its volatility and is independent of what price one had paid when one first buys the investment.

So how did we get here?  Many academics and other smart people use this definition.  Almost every major financial institution will use this definition of risk to calculate the risk in their portfolios.  I believe it all stems from the random walk theory.  The random walk theory posits that the movement of the price of stocks are randomly distributed.  Thus, past price movement do not predict future price movements.  If one subscribes to this theory, it would be natural for one to define risk as we see it defined by the financial industry.  Since we can't know future price movement, the greater the fluctuation an investment has, the greater risk it contains because at any given moment, its price can either go up or down.

Figure 1: Investments with Low and High Volatility

If we look at Figure 1, we can see two investments.  Investment 1 is depicted by the blue line.  It fluctuates very little.  Investment 2, depicted by the red line, fluctuates a lot.  However, in the end of our time horizon, they both reach the same level.  Conventional wisdom tells us that Investment is riskier because it has more volatility.  Since the random walk theory tells us that we can never predict movements, we are as likely to buy at B and sell at C (i.e. lose money) as we are to buy at A and sell at D (i.e. make money).  Along the same line of thought, the theory implies that the stock gurus like Warren Buffet are as successful as they are because they got lucky.  Warren Buffet is as lucky as you would be lucky if you were blindfolded and threw a dart and hit the bullseye.  Since there are so many stock investors out there, there's bound to be a few that get really lucky and outperform the market.

As you have already guessed, I don't buy into this theory.  Warren Buffet and the like do so well because they are able to accurately determine a stock's intrinsic value.  With volatility, the price of a stock would sometimes drop below that of its value.  This is the time when Buffet buys.  When volatility brings the stock price above its intrinsic value, Buffet sells.  Buy low, sell high...it's really that simple!  Even though stock movements may be random, it does not mean that you have to buy or sell the stock at random times!

If we are able to reliably buy at points A, C and E, and sell at points B, D, and F, respectively, the risk of Investment 2 may be even lower than that of Investment 1.  It is, therefore, entirely possible that you are able to have a safer investment with higher returns!

So What is Risk?
So, we are back to square one.  What is risk?  I would go ahead and re-state Merriam-Webster's definition, that risk is "the chance that an investment (as a stock or commodity) will lose value".  It's actually a pretty good definition.  To personalize it a little more, I would like to add your investment goal in there somewhere.  Perhaps the definition should go something like this: risk is "the chance that an investment will not meet your investment goal."  With this definition, an investment's risk becomes much more relevant.  Many new questions surface, such as, "What is the current inflation rate?", "What is the intrinsic value of the stock?", "What was my purchase price relative to that intrinsic value?", "What are my investment goals?", etc.

In the end, you want your investment to give you returns higher than inflation so that you're actually making money!  You also need to have an investment goal so that your portfolio matches that goal.  If you intend to make $1 million in 10 years and you're starting with $10,000, good luck with that CD (or GIC)!  A CD may give you a volatility-free investment, but the risk that you will not meet your investment goal is 100%!

Where Does This Leave Us?
If you buy into what I said above, the obvious question becomes: how do we determine when the price of a stock is below its value?  There are many investing techniques out there that are based on the fundamental analysis of a stock (looking at its intrinsic value).  And if you have followed this blog, you would know that I am a big fan of Phil Town's Rule #1 Investing.  It's a great and easy way to figure out if a company is "investable" and if its price is sufficiently below its value for you to make your purchase.  Go ahead and click on the link above and see what Rule #1 Investing is all about!