Einstein On Investing

Amidst our nation’s obsession with pop celebrities, reality TV “stars” and those who are famous simply for being famous, we wish to briefly focus on someone truly worthy of the respect, adoration and media attention lavished on others – Albert Einstein. Granted, he left this mortal existence over 50 years ago and to our knowledge never sold a hit record, yet his theories about the nature of energy, light, matter and, indeed, the entire universe continue to profoundly impact our world. For example, the recent discussion between President Obama and Russian President Medvedev about reducing their nations’ stockpiles of nuclear weapons has at its heart a paper Einstein published in 1905. Although we have no hard evidence regarding Albert Einstein’s investment prowess, we suspect that he might have been pretty good at the “big picture” part of the process.


Albert is Smart, He’s a Genius

He is known as a theoretical physicist. Those of us who struggled through high school physics may remember that physics is the study of how things work – from the sub-atomic level up to the interaction among the stars and galaxies which populate the universe. A theoretical physicist would try to explain how things work with theories, formulas and ideas, rather than measurements and observations. This makes this kind of physics even harder for the average person to understand. This suggests that Einstein was not only incredibly smart, but super smart in a very challenging field.


He’ll Be Scribbling Things, Genius Things

Einstein published his first paper in 1902, trying to prove that atoms exist and that they have a finite, non-zero size (something that was still uncertain in the physics world at the time). Although his work did not receive immediate praise, this early work did show the promise which was to blossom in a spectacular fashion within the next few years. For Einstein, 1905 is considered his Annus Mirabilis (extraordinary year) and his work in this year propelled him into the elite circle of great scientific minds where the likes of Newton, Galileo and Aristotle reside. He also won a Nobel Peace Price for his efforts.

In 1905, Einstein published four major papers which revolutionized the physics community and ultimately led to the development of nuclear energy. A brief review of basic findings of these papers can provide some valuable insights into the physics of the investment world.

Photoelectric Effect. – Light, the “stuff” that makes our crops grow, allows us to see colors and most importantly, makes life itself possible on our planet, seems pretty straightforward. Any child can tell you what light is, why it’s good and what it’s good for. But to an early 20th century physicist, light was an enigma. Many thought that light traveled in waves, like sound. Some, like Einstein, thought that light was actually made up of some kind of particles. His paper on the photoelectric effect “proved” (at least in a theoretical way) that light is comprised of discrete packages which he called “quanta.” Modern physicists have refined Einstein’s pioneering work here, and we now know that light is comprised of things called “photons,” but light also continues to display wave-like properties. Einstein was able to prove something that no one could see.

Investment implications. Some things in the investment world are ubiquitous and simple to observe, like stock prices. Anyone, at any time, can measure the price of a stock. But what a stock price really, truly represents; what forces are impacting a stock price at any given time; or why a stock trades as it does are issues much more complicated than the casual observer can truly understand. And understanding these complex forces and their impact on stock prices is the most basic and important step to understanding how to invest. Without this understanding, stock investing becomes nothing less than an exercise in randomness.

Brownian Motion. – Atoms are very small; invisible to the naked eye. Yet, their existence was posited by Indian and Greek philosophers as early as 2,000 years ago. In Einstein’s day, the grand atomic debate centered on whether atoms were real or simply a nice idea, something which helped explain lots of things physicists care about. Einstein was able to prove their existence by postulating what the motion of an atom that had a non-zero finite size would look like and then actually measuring and showing that exact motion. He also devised an experiment whereby one could see this effect (and thus “see” atoms) under a microscope.

Investment Implications. Some important factors which impact our investment decision are hard to see (monetary policy or investor sentiment, for example), but can be measured in one way or another. By accurately measuring and understanding them, one can gain better insight on how the markets operate. Just because something seems small and hard to grasp does not mean it cannot have a big impact on the price of a security or the capital markets at large.

Special Relativity – This theory is a little more complicated, but in simple terms it suggests that all uniform motion is relative and that there is no well-defined state of rest. A simple way to explain this is to consider a person bouncing a tennis ball on a train. To a person in the train, the ball goes down and then comes right back up. To someone watching this from a distance (assuming this person could indeed see the ball), the ball’s trajectory would look like a wide “V” pattern, the horizon movement of the ball being a function of the train’s movement. So what is the “real” motion of the ball? Einstein proved that it would be relative to the point of view of the observer. Another important result of this paper was the notion that the speed of light is constant in all frames of reference.

Investment Implications. Often a person’s point of reference can influence his or her opinion on a security. Consider Person A, who bought stock XYZ at $10, and Person B, who bought the same stock (at a different time of course) at $30. The stock now trades at $20. Person A is feeling pretty good about XYZ, given the 100% gain Person A has in the stock. Person B on the other hand considers XYZ a “dog,” having lost 50% in it. Yet, XYZ has a valuation, outlook and potential irrespective of where one might have bought it. This concept is at the heart of our equity research – we try to assess value and potential regardless of perspective. Not every stock we buy will appreciate. All along the stock’s trajectory, we try to measure its value and potential. Like the speed of light, some investment principles, like valuation and reducing risk by diversification, are fixed, constant, and independent of point of reference.

Matter and Energy Equivalence. E=mc2. This simple little formula was perhaps Einstein’s greatest achievement. He was able to show (theoretically, of course) that the energy of an object at rest (E) is equal to its mass (m) times the speed of light squared (which, by the way, is a really big number = 8.98755 x 1016 m2 s2). The brilliance of this theory was shown (in very dramatic fashion, by the way) at the scene of the first atomic explosion (July 16, 1945), where a very small amount of plutonium (less than 2 pounds) created an explosion with the power equal to 20 kilotons of TNT. Einstein was right; mass can be converted into energy.

Investment Implications. Other than some weak joke about one’s portfolio “blowing up,” we would suggest that sometimes we see an event or a data point that seems small and inconsequential by itself, but can have a profound impact because of the circumstances in which this event occurs. Sometimes we will see a stock move down a large amount simply by missing its earnings expectation by a penny. A specific example would be the Lehman Brothers bankruptcy. Many companies go bankrupt each year without damaging the economy or the capital markets. Lehman’s failure, on the other hand, led to a near total seizing up of the capital markets and led to much of the angst and trauma all investors experienced last year. In the markets, some little things can have a huge impact.

One does not need to be a genius to be a successful investor (not that it wouldn’t hurt to be one); simply following basic, time-testing rules of investing (diversification, value, etc.) can lead to excess returns for the disciplined and patient investor.

The Outlook

While the debate over the length and severity of the recession continues to play out in the media, most thoughtful and credible economists are calling for positive economic growth by the third quarter of this year. The second quarter (just passed) is likely to show negative growth, but a smaller decline than that of the first quarter. The consensus is suggesting that GDP growth in 2010 could be around 3%. Although I would be the first one to suggest that the correlation between the overall economy and the stock market is less than perfect, rising GDP does imply rising corporate earnings, which is a key driver of the stock market. I find it hard to believe that the stock market would go down in the face of a steadily improving economy (something suggested by the consensus economic forecasts). Thus, I would not be surprised to see higher stock prices into 2010.

Another way to look at the current situation may be to recall the stock market’s action in 2003. By early 2003, the bear market was over 2 years old, and large numbers of widely-held stocks were down 50% or more. The economy had also been struggling for a few years, following the tech bubble of the late 1990s. Global tensions were high in the wake of 9/11, and ironically the stock market bottomed in early March, the day US troops invaded Iraq. The market rallied well from there, but by July many were suggesting the market had run out of steam. Because early signs of improvement were just starting to emerge, many suggested to “buy on weakness.” The market never really corrected, but did flatten out for a few months. The rally resumed by autumn and the stock market return for 2003 came in at +28% or so, the best year in a long time.

Every market and cycle is different, but I see important parallels here. This year the market bottomed in the middle of nothing but bad news. As it rallied, many were calling for caution. Now, many are calling for a pull back, something that would allow investors to buy stocks at better prices. And the consensus outlook is for an improving economy. I do not make forecasts, but I we would not be surprised if the market does not pull back as expected. As so often happens in the early stages of a market recovery, those looking to buy at lower prices may be disappointed. Concern and skepticism about the market right now are two factors that could help propel it higher to the end of the year.

Happy Birthday, United States

"Very many and very meritorious were the worthy patriots who assisted in bringing back our government to its republican tack. To preserve it in that will require unremitting vigilance."

--Thomas Jefferson