Why Investors Fail

October 5, 2010

My earlier post about passive investing does bring up an interesting point. Even though investors are, by and large, buying decent funds, they’re not making much money. As a class, DALBAR’s QAIB has shown pretty conclusively that retail mutual fund investors underperform-and the onus should really be where it belongs-on investor behavior. It’s not active management that is the problem. As Morningstar shows, investors are making good fund choices, but their emotional asset allocation decisions are killing them. Owning an index fund, unfortunately, does not make you emotionally numb. Index fund investors may be just as likely to fall prey to behavioral issues as active fund investors. Finding winning strategies is clearly possible, but that’s not the whole story. Good investor behavior is probably the best ticket to better returns.

We see the same thing here as every other money management shop with a good long-term strategy: a decent percentage of clients bail out after a period of short-term underperformance. What really makes for good returns is good clients. Seth Klarman, the legendary hedge fund manager, said exactly that in a recent interview with Jason Zweig:

…ideal clients have two characteristics. One is that when we think we’ve had a good year, they will agree. It would be a terrible mismatch for us to think we had done well and for them to think we had done poorly. The other is that when we call to say there is an unprecedented opportunity set, we would like to know that they will at least consider adding capital rather than redeeming.

You can’t say it more clearly than that. Imagine how much money clients would make if 1) they understood a strategy well enough to know when it had performed well, when it had performed poorly, and why, and 2) they added money during periods when the strategy was temporarily out of favor.

Relative strength trend following is an excellent strategy that has historically afforded investors large excess returns, along with periodic episodes of underperformance (i.e., good entry points). The inherent volatility keeps most investors away so that returns do not appear to have been arbitraged away over time. Unless human nature changes, the relative strength return factor is likely to continue to work extremely well over time. Have we mentioned this before? Yes-but the reason we are mentioning it again is because relative strength has had a significant period of underperformance which may be in the process of ending. (Check out the short-term and long-term views here.)

1 Comment | From the MM, Investor Behavior, Thought Process | Permalink
Posted by Mike Moody

$170 Billion Down the Tubes

October 5, 2010

That’s the conservative estimate of how much money institutional pension managers cost their participants in lost investment returns, according to the Stewart et al. article that appeared in the Financial Analysts Journal. Stewart examined the PSN database of pension funds from 1984 to 2007 and cleverly constructed flow portfolios based on what asset classes were reduced and which were increased. It turns out that institutions are just as bad as retail investors in knowing when to enter or exit an asset class or style. Stewart’s conclusion:

The preceding analyses show that plan sponsors are not acting in their stakeholders’ best interests when they make rebalancing or reallocation decisions concerning plan assets. Portfolios of products to which they allocate money underperform compared with the products from which assets are withdrawn. Performance is lower over one- and three-year periods and shows no signs of reversal even after two more years.

It’s kind of sad. Institutions have access to top-tier consulting firms to help them select managers and make allocation decisions, yet still they struggle to do it properly. Volatility is the culprit. If institutions were cleverly buying when a strategy was out of favor, their results would be best with the high volatility products. Instead, their results were negative across the board-and worst of all in the high volatility products. They are practicing emotional asset allocation in the same way as retail investors! Patience is clearly an undervalued asset. Stewart points out:

Clearly, plan sponsors could have saved hundreds of billions of dollars in assets if they had simply stayed the course.

I think there are at least two important take-aways from this paper. 1) Measure twice, cut once. That’s something my junior high shop teach taught everyone. Do your due diligence carefully. Make sure you have data backing the effectiveness of the strategy. Once you cut, you’re done-leave it alone. 2) Be suspicious of where the asset flows are going. As Stewart shows, the flow-weighted portfolios performed terribly. The assets and products that no one wanted are what performed the best. In other words, buy into your strategies when they are out of season. (And maybe think twice about mimicking the huge flows into bonds that have been happening recently. What asset are people dumping? Domestic equities…hmmm.)

For a link to the complete paper that appeared in the Financial Analysts Journal, click here.

Leave a Comment » | Investor Behavior, Markets, Thought Process | Permalink
Posted by Mike Moody

Relative Strength Spread

October 5, 2010

The chart below is the spread between the relative strength leaders and relative strength laggards (universe of mid and large cap stocks). When the chart is rising, relative strength leaders are performing better than relative strength laggards. As of 10/4/2010:

There were no major changes this week in the RS Spread. The top quartile and the bottom quartile of relative strength stocks continue to generate similar performance–as they have for over a year now. A long-term view of the relative strength spread reveals the strong upward bias of the spread over time.

The RS Spread has seen other transitions from declining spreads to flat spreads to rising spreads (notably following the 2000-2002 bear market).

1 Comment | Markets | Permalink
Posted by JP Lee