One round of polio vaccination will keep you immune for life. But the flu shot is an annual ordeal.
Because the polio virus doesn't change that much – or at least the part of the virus our immune systems recognize does not. An immune system that sees polio once can recognize it for life. Influenza is different. It's always adapting and morphing into something it didn't look like before. We need an annual flu shot because this year's virus doesn't look like the one our immune system learned to attack last year. That's why polio is mostly eradicated while the flu kills hundreds of thousands of people each year.
There's an investing lesson here: Too many investors treat investing like polio when it's actually like the flu.
We want to think investing is like polio in the sense that once we find a solution – an investment technique, a formula, a pattern -- we expect it will work forever. But solutions rarely do because markets are always adapting and morphing into something they didn't look like before, like the flu. If we expect our investment solutions to work, they need to be updated and revised to keep up with how the market adapts.
It's intuitive to look for investing patterns that have worked for decades or centuries. But there's a balance between using enough market history to ensure you're not cherry-picking ideas while not using so much that you're relying on outdated trends markets have adapted to. Blogger Jesse Livermore explained this well:
Some investors like to poo-poo this emphasis on recency. They interpret it to be a kind of arrogant and dismissive trashing of the sacred market wisdoms that our investor ancestors carved out for us, through their experiences. But, hyperbole aside, there's a sound basis for emphasizing recent performance over antiquated performance in the evaluation of data. Recent performance is more likely to be an accurate guide to future performance, because it is more likely to have arisen out of causal conditions that are still there in the system, as opposed to conditions that have since fallen away.
Take dividends. They're the bedrock of investing. But it's dangerous to study the long history of dividends, because the way companies use them have changed over time. In 1973, Benjamin Graham wrote about how using dividends as a signal of business health morphed over time:
Years ago it was typically the weak company that was more or less forced to hold on to its profits, instead of paying out the usual 60% to 75% of them in dividends. The effect was almost always adverse to the market price of the shares. Nowadays it is quite likely to be a strong and growing enterprise that deliberately keeps down its dividend payments.
If we treated dividends like the polio vaccine, we might think we can look at the past, figure out what's worked, and apply it to today's market. But dividends change like the flu virus. The dynamos Facebook and Google pay no dividends, but are some of the healthiest businesses in the world. High dividends are now the refuge of utility companies and struggling oil pipelines – the opposite of how market operated for most of history. So recent dividend performance may be a better guide to the future than the long guide of history. Compared with the famous investors of a generation ago, our views need to be updated.
Graham wrote the most popular investment book of all time, The Intelligent Investor. It inspired every serious investor, and is full of practical investment formulas investors could implement in real life. Graham recommended buying stocks for less than 1.5 times book value. He recommended buying stocks for less than their net working capital. He suggested a quick way to value a company was multiplying its earnings per share by 8.5 plus two times its growth rate.
Do any of these formulas still work? I doubt it. But not because Graham was wrong. They don't work today because markets adapt, so the formulas Graham wrote 80 years ago may now be hopelessly outdated.
Graham knew this. He was one of the rare investors who treated investing like a flu shot. Columnist Jason Zweig once explained Graham's approach to solutions:
In each revised edition of The Intelligent Investor, Graham discarded the formulas he presented in the previous edition and replaced them with new ones, declaring, in a sense, 'that those do not work any more, or they do not work as well as they used to; these are the formulas that seem to work better now.'
One of the most common criticisms made of Graham is that all the formulas in the 1972 edition are antiquated. The only proper response to this criticism is to say: "Of course they are! Those are the ones he used to replace the formulas in the 1965 edition, which replaced the formulas in the 1954 edition, which, in turn, replaced the formulas in the 1949 edition, which were used to augment the original formulas ..
The paradox is that we associate Graham with timeless wisdom – for good reason, as most of his work is just that – but part of the reason he succeeded as an investor is because he adapted to what worked. Just before his death in 1976, Graham was asked whether detailed analysis of individual stocks – his original bread and butter – was still a viable strategy. He answered:
In general, no. I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook "Graham and Dodd" was first published; but the situation has changed a great deal since then.
Here, too, he adapted to a market that changes. (Graham went on to advocate owning a basket of stocks selected by a few criteria.)
Contrast this with what I call "polio investors". They dig through centuries of data, hoping – usually to the detriment of their shareholders – that stocks will revert to market patterns established a century ago. For example, there are those who expect valuation ratios to revert to their 150-year average, unaccepting that anything from accounting rules to the level of foreign sales to the makeup of industries has changed since the Civil War.
The hard part is that these investors use more data than anyone else, so they appear to be the noble ones digging for truth where others scratch the surface of superficiality. Nothing instills more credibility than having a century of data backing you up. But, in reality, lots of data must be discounted by the degree things changed over time, which is very hard to do.
How does an investor deal with this problem?
I see two solutions.
One is to constantly tweak your strategies while remaining guided by broad principles. A mutated flu virus is still a flu virus; parts of it just change around the edges. Investing techniques can be the same. Being guided by the idea that expensive stocks produce low future returns is a timeless philosophy. But assuming the market's P/E ratio will always revert to its 150-year average of 15 is the kind of stuff that gets you into trouble, as it may morph over time.
The second is focusing your effort on strategies so integral to how investing works that they likely won't go out of style. Having a long time horizon is one. Keeping fees low is another. Broad diversification is likely timeless. It's hard to think of a world where dollar-cost averaging stops working.
Leo Szilard, a physicist, said the difference between physics and biology was that physics appealed to logic and reason while biology was governed by change and adaptation. A physicist can work out a problem in his head, because everything has to obey timeless laws. Biology is different. Since living things change, old theories had to be adapted to a current starting point. A physicist can ask, "does this work?" while I biologist has to ask, "does this work today?"
Explaining Szilard's frustration with biology, author John Barry wrote: "Life does not choose the logically best design to meet a new situation. It adapts what already exists."
Same thing in investing.