Survival of the Fittest for Investors: Using Darwin’s Laws of Evolution to Build a Winning Portfolio - Hardcover

Stoken, Dick

Hardcover

ISBN 10: 0071782281 ISBN 13: 9780071782289

Publisher: McGraw Hill, 2011

Synopsis

The science behind creating portfolios that adapt to market changes

“After ten years of poor stock market returns and yet great bond and gold returns, there is a real thirst for an all-weather portfolio in a high-risk period. Dick Stoken builds that diversified portfolio and also introduces some timing methods to improve returns and lower risks. This is a very timely and useful book.”
―Ned Davis, Senior Investment Strategist, Ned Davis Research, Inc.

“Dick Stoken’s Survival of the Fittest for Investors is a masterful and unique dissection of what makes the market tick. It represents an indispensable and brand-new approach for the serious investor. A must on every investor’s reading list.”
―Leo Melamed, Chairman Emeritus, CME Group

“I selected Stoken’s Strategic Investment Timing as the Best Investment Book of the Year in the 1985 Stock Trader’s Almanac; Survival of the Fittest for Investors will be a leading contender for Best Investment Book of the Year in the upcoming 2013 edition.”
―Yale Hirsch, founder, Stock Trader’s Almanac

About the Book:

Just as the animal kingdom is composed of many species, today’s financial systems are composed of a multitude of independent participants, all over the globe, all influencing the whole. Survival of the Fittest for Investors breaks down the science behind the behavior of these market participants to present a definitive system for building profitable portfolios based on the concept of natural selection.

This advanced guide to the cutting-edge science of complex adaptive systems in financial markets tells you where to find and how to track the evolutionary instability underlying these markets. It shows how, with heightened insight and a powerful algorithm, you can survive and thrive in volatile markets by following the simple principles of evolution.

Award-winning and critically acclaimed author Dick Stoken punches holes in the outdated, Newtonian cause-and-effect paradigm and helps you see financial markets from a Darwinian perspective, where they function as complex systems that have the ability to adapt. By using his state-of-the-art algorithm, Stoken demonstrates how you can use agent-based modeling to assess the actual way markets behave in order to maximize the upside of your asset allocation.

Stoken shows that variation is the key to profitability by using three real-world portfolios, each balancing four major asset classes going back thirty-nine years. Each portfolio clearly demonstrates how to reap consistently impressive profits with lower-than-market risk―regardless of your investment style.

Whether you take conservative, traditional, or leveraged positions, this book helps you create portfolios of equities, debt, gold, and real estate that have proven to beat the S&P 500 by up to 22.5 percent!

After opening your eyes to the science of complex adaptive systems and the vitality of punctuated equilibrium, Survival of the Fittest for Investors helps you implement the know-how into nuts-and-bolts results by equipping you with such practical tools as:

• A 1-year/6-month algorithm for accurately simulating evolutionary fluctuations in markets
• A cutting-edge allocation strategy that takes advantage of our natural “herding” instinct
• Tips for recognizing and enduring “bubbles”

Without Survival of the Fittest for Investors, the evolution of investing may leave your wealth behind.

About this title

About the Author

Dick Stoken is president of Strategic Capital Management. A founding partner of Lind-Waldock (now MF Global), the largest discount commodity brokerage company in the world, he retired at the age of thirty-one to become a full-time financial author. His astounding trading success is chronicled in a variety of media outlets and recognized with various awards.

Excerpt. © Reprinted by permission. All rights reserved.

SURVIVAL of the FITTEST for INVESTORS

USING DARWIN'S LAWS of EVOLUTION to BUILD a WINNING PORTFOLIO

By DICK STOKEN

The McGraw-Hill Companies, Inc.

Copyright © 2012 Dick Stoken
All rights reserved.

ISBN: 978-0-07-178228-9

Contents

ACKNOWLEDGMENTS
PREFACE
PART 1 THE ORIGIN OF A NEW INVESTMENT STRATEGY
CHAPTER 1 The Investment Game
CHAPTER 2 The Investment Environment: An Ever Changing Landscape
CHAPTER 3 The Darwinian Alternative Framework
CHAPTER 4 The Stock Market Is a Living System
PART 2 VARIATION: THE FIRST IMPORTANT DARWINIAN INSIGHT
CHAPTER 5 An Alternative Investment Portfolio: Based on Variation
CHAPTER 6 A Passive Combined Asset Strategy
PART 3 FLUCTUATIONS: THE KEY TO UNDERSTANDING COMPLEX ADAPTIVE SYSTEMS
CHAPTER 7 Trends: The Central Feature of Our Investment and Economic 
World
CHAPTER 8 A Paradox in Our Investment and Economic World
PART 4 SELECTING ASSET CLASS "FITS"
CHAPTER 9 Critical Levels in the Stock Market
CHAPTER 10 Gold and Long-Term Treasuries: Buy and Replace
CHAPTER 11 REIT Estate Investment Trust Trends
CHAPTER 12 An Active Combined Asset Strategy
CHAPTER 13 Risk: Taking On More?
CHAPTER 14 The Twenty-first Century "Real Estate" Bubble
PART 5 A DARWINIAN WORLD
CHAPTER 15 The Agent Role in a Darwinian World
CHAPTER 16 How the Major Components of Search Engines Apply in Today's 
World 209
CHAPTER 17 Conclusion: Don't Sell Evolution Short
NOTES
INDEX

Excerpt

CHAPTER 1

The Investment Game

Ever since 1792, when a group of stockbrokers, meeting under the now famousbuttonwood tree on Wall Street, agreed to form the New York Stock Exchange(NYSE), people have been trying to master the investment game ... but withlittle success.

Sure there have been winners! But in paraphrasing the words of Warren Buffett,head of Berkshire Hathaway and the most quoted investment guru of our time:imagine several million chimpanzees that had been taught to flip a coin,assembled in some immense stadium to participate in a chimp super coin-flippingcontest with the media present. As the field narrowed, anxious media membersbreathlessly interviewed the finalists, asking them, assuming they could speak,what was the basis of their superior coin-flipping skills. And the chimps,honestly believing they possessed some special skill, would credit their successto a particular way of flicking their wrist, or perhaps to repeating some mantrawhile flipping. The public, meanwhile, listening to the commentator's excitedrendition of the chimps' abilities, would believe that practicing such wristflips or chanting magical mantras led to the chimps' success, and then would tryto do the same.

Dear Reader: What if yesterday's and today's acclaimed stock market wizards areno different from a group of chimpanzee finalists?

Sounds silly? Agreed; it flies in the face of the way we Westerners like tothink. We are children of a Newtonian mechanistic worldview. More than 300 yearsago, Sir Isaac Newton excited our ancestors by solving the problem of themotions of the planets and, in doing so, birthed a new way to look at the world.The Newtonian mechanical worldview championed a chain of cause-and-effect logicand it became the blueprint for a large-scale search for knowledge. AsWesterners sought to match cause and effect, identifying a cause for everyeffect and potential effects of any cause, they created a clear pattern ofthinking that allowed us to master problems that had baffled mankind since theancient Greeks. Over the following centuries, men and women vastly increased ourcollective store of knowledge; they figured out how to build spaceships thatwere able to take astronauts to the moon; they invented machines thatspearheaded enormous leaps in our world's material wealth; they found cures fornumerous diseases that had formerly cut short much of human life; and theydesigned a system for citizens of a political entity to govern themselvesthrough representatives.

All this is certainly true, yet, whether or not this same type of knowledge canbe translated into models that will allow us to reliably predict the future isquestionable. Respected observers insist that in the long run the stock marketcannot be beaten. This means that over time the participants, includingso-called experts, will be unable to better an average return obtained frominvesting in an index of stocks, without taking on a greater amount of risk.

IS THE MARKET BEATABLE?

At the beginning of 1970, there was a haystack of 355 equity funds. We canimagine those funds were run by some of the most savvy and highly paid WallStreeters, who were backed up by large and highly educated support staffs andenjoyed a huge information advantage over John Q. Public. At the end of 2005, 36years later, according to John Bogle, founder of the Vanguard Group, 223 ofthose funds no longer existed. There may be a lot of reasons why fundsdisappear, but not many of the reasons are good. Of the 132 survivors, only45—not quite 13 percent—had, even by the tiniest of margins, beatenthe Standard & Poor's (S&P) 500. A lonely nine (2.5 percent) achieved that featby more than a meaningful 2 percent per annum. So an investor's job would be tofind those nine needles of outperformers. But wait! Six of the outperformancespeaked between 1983 and 1993 and have been struggling ever since. Had you waitedmore than 7 years to identify those winners, you would have missed most, if notall, of the outperformances. Okay, chimp, go out and find that 1 percent (thethree remaining outperformances from the 1970 crop) who are going to be, andremain, winners.

Morningstar, the leading fund statistical rating service, ranks or categorizesfunds from one to five stars, with five being the best performing funds. MarkHulbert, who keeps tabs on real live investment returns, created a hypotheticalportfolio that was adjusted to hold only Morningstar's five-star funds. Duringthe 11-year test period, 1994 to 2005, the return was 6.9 percent, which fellway short of an 11 percent total market return during that period. The five-starreturns were not even close.

Then there is the story of Bill Miller, star portfolio manager of the Legg MasonValue Trust Fund, who by the early years of the twenty-first century had becomean investment legend. By year-end 2005 he had beaten the S&P 500 for 15 straightyears. Wow! This was such a statistically improbable event that it was comparedto Joe DiMaggio's incredible 56-game hitting streak, a one-in-a-millionlikelihood. During his streak Miller scored a 15.3 percent compounded return,2.4 percent better than the S&P 500. It certainly appeared as if we hadidentified a true investment sage. Magazines, newspapers, and TV commentatorsfell all over themselves in reporting the "Bill Miller" story and, of course,each of them gave their take on how and why he was such a superior investor. InJanuary 2004, Money magazine described Bill Miller as "the country'sgreatest mutual fund manager." Miller, at that time, had beaten the S&P 500 for13 years in a row. Money computed the odds of doing so at 149,012 to 1.In November 2006, Fortune magazine's managing editor, Andy Serwer,seconded Miller's status as "the greatest money manager of our time."

Well what happened? In early 2010, the media's favorite investment "chimp" wasreplaced as Legg Mason Value Trust Fund's manager. Miller's record, which thenincluded a decline of 55 percent in 2008, was so bad that his Value Trust Fundwas ranked by Morningstar close to the bottom for the past 3, 5, and 10 years.The 3-year record was particularly dismal. His fund had an annualized loss of 20percent, compared to a loss of only 9 percent for the S&P 500. Had youidentified "the country's greatest mutual fund manager's" star (!) quality afterseven straight S&P 500 beating returns and just prior to the time that WallStreet was beginning to take notice, and invested at the end of 1997, you wouldhave been a net loser when Miller was benched. On the other hand, thoseinvestors who ignored Miller's cheerleaders and instead purchased the S&P 500 atthe end of 1997 were up approximately 41.5 percent.

CAN WE FORECAST?

Let's now pivot and look at forecasting, which has a lot to do with investingand ask the same question: Can we forecast?

During the 1920s, there was an infectious optimism in the United States. Almostall of the nation's leaders believed there was an enormous pile of new wealthawaiting the middle class—just around the next corner, we were told. In1929, when the eminent John J. Raskob—chairman of the finance committee ofGeneral Motors, vice-president of E. I. DuPont de Nemours & Company, director ofBankers Trust Company, and chairman of the Democratic Party's NationalCommittee—wrote how easy it was to accumulate wealth in a popular articlein the Ladies Home Journal entitled, "Everybody Ought to B Rich,"Americans everywhere nodded their heads in agreement. But when the middle classturned that corner, the goddess of prosperity was nowhere in sight; instead itwas the mugger of a depression waiting for them.

In the late 1970s, a baffling inflation had imbedded itself into Americaneconomic life; it was turning the nation's financial markets upside down, whilea bloated U.S. federal government was encroaching more and more into people'sdaily lives. To further compound worries, Japan's economy was on the march,crippling such stalwart American industries as autos, steel, and electronics,and threatening to uproot much of the rest of the American economy. SeriousAmericans plausibly speculated that the nation was in terminal decline andthought the country was headed toward some sort of state socialism. Whatfollowed instead was a renaissance of American "free-market" capitalism, justthe opposite of what most Americans had been expecting.

Do you remember what the investment world looked like in 1980? The majority ofpeople have long since forgotten, but to refresh memories, the most popular viewwas one of growing energy shortages and mind-numbing inflation. Howard Ruff andDouglas Casey, the fashionable financial gurus of the time whose best-sellingbooks were being read by millions, were prophesying that the world's supply ofoil, the oxygen of industrial economies, was shrinking and oil's price wasdestined to soon top $100 a barrel; furthermore, inflation, already in doubledigits was headed into triple digits. The heavy lifters in their recommendedportfolios were: gold and silver. As for stocks: Forget it! They were a deadasset, with limited upside potential at best. In fact, a year earlier,Business Week magazine, in its cover article, loudly proclaimed, "TheDeath of Equities." So what happened?

Fast-forward 19 years later, to early 1999:

• Oil was trading at about $11 a barrel, almost 75 percent below its 1980 priceand nearly 90 percent beneath its $100 forecasted price.

• Gold was changing hands at $290 an ounce, down about 65 percent from its19-year earlier price.

• Silver was trading at about $5 an ounce, nearly 90 percent below its 1980 peakprice.

• The "dead" asset class equities, the S&P 500, was trading at about 1,275, orup about 1,175 percent from its 1980 low.

These widely accepted forecasts achieved a perfect score; dead wrong on allfour counts.

Japan's economy continued to thrive throughout the 1980s, in fact, so much sothat, almost daily, new books were being published, shouting that Japan's"miracle" economy was about to grind the American and Western economies into thedust. As Clyde Prestowitz, president and founder of the Economic StrategyInstitute, wrote in 1988, "Japan has created a kind of automatic wealth machine,perhaps the first since King Midas." However, most authors were kind enough toexplain the Japanese economic-business model, which was quite different from theWestern model, and urged America to hurriedly adopt Japanese business methods.

How did the highly touted Japanese model do? In early 1999, while world stockmarkets were trading at more than three times their early-1990 levels, stocks inJapan were trading nearly two-thirds below their 1989 year-end prices.In Japan, the 1990s had become the "lost decade." It was a 10-year period ofeconomic stagnation, during which time real estate markets collapsed, bad loanscrippled the Japanese banking system, and pension funds began running short ofmoney to pay retirees. To say the least, there was a clear lack of interest inwriting or talking about Japanese business savvy by the century's end.

In the mid-1980s, Americans were caught up in a budget deficit mania. Worrywartcommentators were talking about a sea of red ink, stretching out as far as theeye could see, that would surely bankrupt the United States ... unless theReagan tax cuts were reversed. During a 1984 presidential debate, Walter Mondaletold cheering Democrats that there had to be a "new realism" in government."Let's tell the truth," he challenged. "Mr. Reagan will raise taxes and so willI. He won't tell you. I just did." Reagan won that election and did not raisetaxes. In fact, he lowered them ... again.

Taxes would not be raised (meaningfully) until the 1990s, and then the upwardadjustment would offset only a small portion of the prior Reagan tax cuts. Whilegovernment debt did quadruple from 1980 until 1992, the American economy did notbuckle. Rather, it surged to unprecedented heights, far surpassing Japan's"miracle" economy. And who would have thought that from late 1982 until the endof 2000, a period of 18 years, the nation's economy would experience only one 8-month recession? Never before had an industrial economy experienced such a longrun of nearly uninterrupted economic good fortune. As for government deficits asfar as the eye could see, well, by the turn of the century, they had becomesurpluses as far as the eye could see. (The red ink of the early twenty-firstcentury is a new matter—not a direct causality of the Reagan tax cuts.)

Oh yes. Let's not forget the widely predicted post–World War IIdepression. Sewell Avery, head of US Gypsum, had retrenched on the eve of theGreat Depression, allowing his company to sidestep the troubles that werebattering most American businesses. Two years later he was anointed to headMontgomery Ward by John Pierpont (J.P.) Morgan, the largest shareholder of thefloundering catalog merchandiser. Avery, the poster boy of inflexibility,hunkered down after World War II, attempting once again to ride out thepredicted storm. But there was no depression. Instead the country began a25-year period of unprecedented prosperity and soaring share prices. And Avery,waiting for hard times that never came, sat on the sidelines while MontgomeryWard shrank to a third-rate company.

These consensus "forecasts" were ALL laughingly wide off the mark. No wonder thelate Peter Drucker, who by general consensus had been considered America'sforemost business management authority, threw up his hands and said,"Forecasting is not a respectable human activity."

USING NEWTONIAN THOUGHT TO BEAT THE MARKET

So how do we square this "nothing seems to work in trying to best the market"view with our Newtonian mental construct? We don't!

As far as helping to predict market outcomes, the Newtonian "cause-and-effect"logic appears to have been worthless and perhaps even somewhat harmful. Perhapsthe best we can do, according to John Bogle, who thinks the market is smarterthan us all, is merely mimic the market.

If we hope to have a chance at outdistancing the S&P 500 in total returns, weneed a better picture of how markets work. But first, let us pause for a shorthistory lesson of the stock market landscape we are operating in.

CHAPTER 2

The Investment Environment: An Ever-Changing Landscape

The year 1926 was the chosen starting point of a study conducted under theauspices of the University of Chicago—now known as the CRISPdatabase—to tabulate complete equity results, encompassing all stocks.From that date on, stock market data has been considered complete and reliable.It is also the most legitimate marker for a beginning to stock market history.

Today, Morningstar keeps the CRISP flame alive in its annual publication,Ibbotson 'SBBI' Classic Yearbook, which updates yearly returns on Stocks(S), Bonds (B), Bills (B), and Inflation (I). Most of the figures we will use inthe coming chapters are from the Ibbotson 'SBBI' Classic Yearbook.Table 2-1 contains a year-by-year compilation of returns for stocks,intermediate government bonds, and 90-day T-Bills.

To follow the contours of an investment through time, I am going to introduce anew concept for many of you: Net Asset Value (NAV). NAV starts with ahypothetical $1000 and adds or subtracts each subsequent year's performance tothe prior year's NAV to derive a total wealth map. Take a look atTable 2-1. In 1926, equities were up 11.62 percent; the original $1000was multiplied by that percent (1.1162 x 1000) and added to the original $1000to get a year-end NAV value of 1116. In the following year, stocks were upanother 37.49 percent; this number was used to multiply the prior year's NAV of1116 and resulted in a 1927 year-end NAV of 1534. A losing year, such as the-8.42 percent in 1929, was used to multiply the prior year's NAV, only this timethe figure, which was 185, was subtracted from 1928's NAV of 2203, resulting ina new 1929 NAV of 2018. This annual NAV wealth map allows us to calculatecompounded (CMPD) returns or drawdowns (DDs) in equity for any calendar-yearinterval.

As we can readily see, during the 85-year period ending on December 31, 2010,the stock market, including reinvested dividends, delivered a generouscompounded annual return of 9.87 percent. An original $1000 investment at thebeginning of 1926 blossomed into $2,982,470 by the period's end. This return wasfar larger than those from bonds—long-term (20-year) Treasuries returned apaltry compounded 5.5 percent, while the return on intermediate (5-year)government bonds was 5.4 percent (see Table 2-2)—and almost anyother asset class that had a sufficiently long enough history to measure.

Furthermore, note that these stock market returns beat a riskless 90-day T-Billin 55 of the 85 years (Table 2-1). That means it paid to take on risk,via equities, approximately 65 percent of the time.

No wonder leading stock market academicians, such as Jeremy Siegel, Professor ofFinance at The Wharton School of the University of Pennsylvania and author ofthe widely read investment classic Stocks For the Long Run, stood onsoap boxes herding investors into equities only, buy-and-hold (B&H) portfolioswith the strict caveat to hang on through thick and thin. But there is anotherside to the stock market equation ...

RISK

Most would answer the risk question by referring you to the standard deviationof stock returns which was 20.39 percent, as shown in Table 2-1.Traditional risk analysis uses standard deviation—the variation inannual returns from its average—as a proxy for volatility, which istranslated to mean risk. A higher standard deviation means more volatility, andis assumed to imply greater risk and vice versa. Increased volatility certainlydoes seem to capture certain aspects of risk. Strategies that use more leverageor higher betas (a measure of the volatility of the asset compared to thevolatility of the financial market as a whole) are, indeed, likely to displayhigher standard deviations.

However, standard deviation suffers from assuming investment returns fall into a"normal" distribution pattern, much like in physics or general statistics. Butwhen applied to investing, that normal distribution vastly underestimates tailrisk. Tail risk refers to outliers on the downside that far exceed whatshould be normal boundaries to a price decline, such as in 2008 or the one-daystock market plunge of 23 percent in October 1987.

(Continues...)

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Excerpted from SURVIVAL of the FITTEST for INVESTORS by DICK STOKEN. Copyright © 2012 by Dick Stoken. Excerpted by permission of The McGraw-Hill Companies, Inc..
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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Edition details

• Publisher: McGraw Hill
• Publication date: 2011
• ISBN 10: 0071782281
• ISBN 13: 9780071782289
• Binding: Hardcover
• Language: English
• Edition number: 1
• Number of pages: 224