I'll never forget it. It was cold that morning....36 degrees. Damn it. January 28th, 1986 at 11:39 AM eastern time. That's when it happened. The space shuttle Challenger exploded and all on board were killed.
I was a senior in high school then, living in Longwood, Florida, a suburb of Orlando. I was picking up my girlfriend (now my wife) from her parents' house that morning and I watched the Challenger launch from her backyard. And yes, you could see it from there. Easily. 73 seconds after lift-off, something went wrong. It was ten miles in the air when the shuttle split in two, then three, and then into more pieces than you could count. And everything fell into the ocean. Christa McAuliffe, the first teacher to go into space, was dead. So were the other members of the crew.
Over the next four months, there was a major investigation to try to understand what had happened. It turns out that the O-rings in the shuttle's rocket booster became brittle when the temperature dropped below 53 degrees. Who was to blame? The manufacturer of the O-rings was a defense contractor by the name of Morton Thiokol. Interestingly enough, the company's engineers were concerned about how the O-rings would perform in cold weather and thought there might be a disaster if the launch occurred. In the days preceding the launch, several of those engineers approached Morton Thiokol's management and explained the situation and management seemed to agree. Management then went to NASA to tell them of the concern and guess what...NASA didn't want to stop the launch unless Morton Thiokol could prove that a disaster would happen. NASA wanted to maintain its time table and didn't want the delay. Because of the push back from NASA, management at Morton Thiokol caved. We know what happened next.
While I didn't know it then, what happened on the stock market that fateful morning is an example of pricing in action. And it's an example of why I hold the investment philosophy I do. You see, by 11:52 AM that morning - just 13 minutes after the Challenger explosion - the New York Stock Exchange called a halt to the trading of Morton Thiokol's stock because it started to fall in value so quickly. When the stock resumed trading at 12:36 PM that afternoon, the stock continued its downward fall. By the day's end, it was down nearly 12%. Lockheed, Martin Marietta, and Rockwell International's stock also fell. Unlike Morton Thiokol however, the stocks of those other companies were mostly back up in value by the day's close.
nobel prize winning research
So how did things move so fast? To answer that question, let me introduce you to Nobel Prize winning economist Frederick Von Hayek. The man was brilliant and was friends with many of the great economists of the 20th century. His big insight is on the importance of price as a conveyor of information. Price, Hayek observed, is a powerful and incredibly subtle thing. No one knows everything...and they don't have to. You may know a little, I know a little, and thousands, millions, maybe billions of people know a little more. I don't need to know what you know and you don't need to know what I know....because at the end of the day, it's all about price. And price captures the information that we collectively know....including the price of a stock. In a weird way - and yes I know I used the word "collectively" - it's a celebration of capitalism over a planned economy kind of idea.
In the case of Morton Thiokol, by the actions of a few and their effect on price, others got the message and started behaving in a way that drove the stock price down. Within minutes...although David Harrelson, a friend of mine from Rotary, tells me it happened in seconds. And remember, this was a time prior to the internet. Cell phones were selling for $4,000 a phone back then and I'm pretty sure I never saw one in 1986...so they weren't being used by the masses either. The only thing we had - and it was big at the time - was 24 hour news from CNN.
Information, conveyed by price, moves incredibly fast!
Active manager's delima
Now think about it. Do you think that many, if any, Wall Street traders knew much about O-rings? Did they know enough to make the stock of the guilty company fall within a few minutes of the Challenger explosion? And then did they also know that three other companies weren't responsible for the explosion by the end of the day? There was a great research paper by a couple of professors looking into this and they didn't find evidence of Wall Street knowledge this definitive. Remember too that the investigation laying the blame primarily on Morton Thiokol wasn't complete until 4 months after the disaster.
Yet "the market" was moving in the right direction within minutes, if not sooner.
I like theories that make sense. But I take action based on data. And both lead me to believe in evidenced-based indexing strategies when it comes to investing. Active managers can't know it all and they often can't move fast enough to take advantage of what they know. Indexing costs are lower than active management costs and the tax benefits of investing are more easily obtained with indexing strategies. Benjamin Graham, the mentor to Warren Buffet, used to compare two amateurs playing tennis with investing. He observed that those tennis players don't win by making great shots. They win by making the fewest unforced errors. Indexing strategies are like that.
Am I saying that active management can't work? No, I'm not. Active management can work ...although the statistics seem to show it's more luck than skill. Nevertheless, I believe that some people have a gift that is beyond pure intellect and reason. You can look back in time and identify who those people were. Using their past performance as a guide to their future performance is not such a good way to identify them though. Picking them in advance is what you want and I don't know how you do that. Study after study shows that that last year's hot shots are this year's under performers. And if past performance isn't really a good guide, then what is?
Given that we're speaking of the 80's, remember that there was a great money manager back then by the name of Peter Lynch. He ran the Magellan Fund for Fidelity and he absolutely crushed the index during his tenure as the fund manager. And then he retired. His last task was to find the next great and brilliant fund manager to take his place at Fidelity Magellan. Who was that manager? Yeah, I understand. I don't remember either.
Entrepreneur, financial guy, husband and father of two great kids.