As in Murakami’s novel, reality can be ambiguous. Make sure you can find your way back – or forth – to the one you want.

In 1989, Robert Shiller – the same Shiller of Irrational Exuberance fame – wrote a much less accessible book, Market Volatility. In it, he makes the case that market prices tend to move with much higher volatility than the underlying fundamentals would justify. It is interesting how most investors and their advisors regularly ignore this fact, reducing the act of investing to one of trading and pricing pieces of paper (or their electronic equivalent). Understanding and tracking the cash flows associated to those investments is at best an abstraction.

Suppose at the end of 1970 you purchased the US S&P 500 Index. The following graph is the evolution (normalized, with 100 = December 1970) of the quarterly price of that Index; this series exhibits an arithmetic average return of 2.1% with a standard deviation of 8.2% (a ratio of 3.9 times the return):

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If we look at the underlying earnings during the same period – a rough equivalent of the economic cash flows you purchased when you invested in the index – we get the following normalized graph (average return: 1.9%; standard deviation: 5.4%; ratio: 2.9):

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As another form of underlying cash flow – perhaps more tangible but not necessarily more valuable – we can look at dividends paid during the period; here’s the graph (average return: 1.5%; standard deviation: 2.0%; ratio: 1.4):

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A cursory look at the three graphs above will tell you the series represented are shown in order of broadly decreasing volatility. For confirmation, here’s one graph with all three of them:

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It is evident that the price dimension (blue line) is only one of at least three alternatives you can use to value your holdings. Cash flows (orange and grey lines) – however defined – produced from those investments are another. By observing the periodic divergence and convergence of the lines in the last graph you realize there are times when those same cash flows are more accessible (or cheaper) than otherwise. Finally, for the nervous among you it should come as great comfort to know that the market price on any tradable security may be meaningless if you have access to real benefits of another nature.

Why don’t we see more of this type of analysis on portfolios when meeting advisors? I can suggest a few possibilities:

  1. None of it is relevant to the task at hand;
  2. It costs too much to program advisors’ systems to produce the data;
  3. Investors focus on investment results and not the process of investing: “as long as something goes up I’m happy”;
  4. Investors are not investors but traders at heart;
  5. Cognizant of numbers 3 and 4, advisors focus on more “useful” things: research, market advice, timing, economic forecasts, etc.

Take your pick, or add your own reasons. As in 1Q84, unless you like the Little People and their world, you need Aomame’s memory to know your way out.

Photo source: Wikipedia. Graph sources: Bloomberg; own analysis.