Life After Modern Portfolio Theory

August 31, 2012

Michael Kitces, partner and director of research, Pinnacle Advisory Group does an excellent job explaining the problems with Modern Portfolio Theory:

Why is this a problem?  Well, it is a problem because this is the most widely used approach to asset allocation.  I absolutely agree with his main point that “asset allocation has to become more dynamic.”  However,  I disagree that the solution is to find ways to improve your forecasting ability.  It just isn’t going to happen.  Tactical asset allocation driven by relative strength is not discussed in his video, but has been demonstrated to be an effective alternative to modern portfolio theory.

HT: Professional Planner

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Modern Portfolio Theory Implodes: Mean Variance Optimization Bites the Dust

August 31, 2012

Andrew Ang of Columbia Business School has an important new paper out on SSRN.  In it, he discusses mean variance optimization, the cornerstone of Modern Portfolio Theory.  Unlike many other treatments in which portfolio construction through mean variance optimization is taken as gospel, Mr. Ang actually tests mean variance optimization against a wide variety of other diversification methods.  This is the first article that I have seen that actually tries to put numbers to mean variance optimization.  Here’s how he lays out his horserace:

I take four asset classes: U.S. government bonds (Barcap U.S. Treasury), U.S. corporate bonds (Barcap U.S. Credit), U.S. stocks (S&P 500), and international stocks (MSCI EAFE), and track performance of various portfolios from January 1978 to December 2011. The data are sampled monthly. The strategies implemented at time t are estimated using data over the past five years, t-60 to t. The first portfolios are formed at the end of January 1978 using data from January 1973 to January 1978. The portfolios are held for one month, and then new portfolios are formed at the end of the month. I use one-month T-bills as the risk-free rate. In constructing the portfolios, I restrict shorting down to -100% on each asset.

He tests a wide variety of diversification methods.  As usual, simple is often better.  Here’s his synopsis of the results:

Table 14 reports the results of the horserace. Mean-variance weights perform horribly. The strategy produces a Sharpe ratio of just 0.07 and it is trounced by all the other strategies. Holding market weights does much better, with a Sharpe ratio of 0.41. This completely passive strategy outperforms the Equal Risk Contributions and the Proportional to Sharpe Ratio portfolios (with Sharpe ratios of 0.32 and 0.45, respectively). Diversity Weights tilt the portfolio towards the asset classes with smaller market caps, and this produces better results than market weights. The simple Equal Weight strategy does very well with a Sharpe ratio of 0.54. What a contrast with this strategy versus the complex mean-variance portfolio (with a Sharpe ratio of 0.07)! The Equal Weight strategy also outperforms the market portfolio (with a Sharpe ratio of 0.41). De Miguel, Garlappi and Uppal (2009) find that the simple 1/N rule outperforms a large number of other implementations of mean-variance portfolios, including portfolios constructed using robust Bayesian estimators, portfolio constraints, and optimal combinations of portfolios which I covered in Section 4.2. The 1/N portfolio also produces a higher Sharpe ratio than each individual asset class position.

That’s a lot to absorb.  If we remove the academic flourishes, what he is saying is that mean variance optimization is dreadful and is easily outperformed by simply equal-weighting the asset classes.  He references Table 14 of his paper, which I have reproduced below.

Table 14 Source: Andrew Ang/SSRN

(click to enlarge to full size)

(He points out later in the text that although risk parity approaches generate a slightly higher Sharpe ratio than equal weighting, it is mostly due to bonds performing so well over the 1978-2011 time period, a period of sharply declining interest rates.  Like most observers of markets, he would be surprised to see interest rates decline dramatically from here, and thus thinks that the higher Sharpe ratios may be unsustainable.  Mr. Ang also mentions in the article that using a five-year estimation period isn’t ideal, but that using 20-year or 50-year data is no better.)

I find it ironic that although mean variance optimization is designed to maximize the Sharpe ratio—to generate the most return for the least volatility—in real life it generates the worst results.  As Yogi Berra said, in theory, theory and practice are the same.  In practice, they aren’t!

Mr. Ang also asks and answers the question about why mean variance optimization does so poorly.

The optimal mean-variance portfolio is a complex function of estimated means, volatilities, and correlations of asset returns. There are many parameters to estimate. Optimized mean-variance portfolios can blow up when there are tiny errors in any of these inputs. In the horserace with four asset classes, there are just 14 parameters to estimate and even with such a low number mean-variance does badly. With 100 assets, there are 5,510 parameters to estimate. For 5,000 stocks (approximately the number listed in U.S. markets) the number of parameters to estimate is over 12,000. The potential for errors is enormous.

I put the fun part in bold.  Tiny errors in estimating returns, volatilities, or correlations can cause huge problems.  Attempting to estimate even 14 parameters ended in abject failure.  We’ve written numerous pieces over the years about the futility of forecasting, yet this is exactly the process that Harry Markowitz, the father of Modern Portfolio Theory, would have you take!

Good luck with that.

To me, the implications are obvious.  Diversification is always important, as it is a mathematical truism that combining any two assets that are not perfectly correlated will reduce volatility.  But simple is almost always better.  Mr. Ang draws the same conclusion.  He writes:

Common to all these portfolio strategies is the fact that they are diversified. This is the message you should take from this chapter. Diversification works. Computing optimal portfolios using full mean-variance techniques is treacherous, but simple diversification strategies do very well.

The “simple is better” idea is not limited to asset class diversification.  I think it also extends to diversification by investment strategy, like relative strength or value or low volatility.  There’s an underlying logic to it—simple is better, because simple is more robust.

Some investors, it seems, are always chasing the holy grail or coming up with complicated theories that are designed to outperform the markets.  In reality, you can probably dispense with all of the complex theory and use common sense.  Staying the course with an intelligently diversified portfolio over the long term is probably the best way to reach your investing goals.

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Sector and Capitalization Performance

August 31, 2012

The chart below shows performance of US sectors and capitalizations over the trailing 12, 6, and 1 month(s).  Performance updated through 8/30/2012.

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Checking In On PDP

August 30, 2012

So far, 2012 has been an excellent year for the PowerShares DWA Technical Leaders Index (PDP).   Year-to-date, PDP is +14.94%, while the S&P 500 is +12.16%.  PDP, which began trading on March 1, 2007, is a big source of pride for our firm as it has outperformed its benchmark in every year since its inception except for one.  For those unfamiliar with the strategy, the index is comprised of 100 high relative strength stocks and is reconstituted on a quarterly basis.

In every quarterly reconstitution there are stocks that come and stocks that go.  Those that retain their strong relative strength stay, and those that have deteriorated are replaced.  Interestingly, there are a number of stocks that have remained in the index since its inception over five years ago, including Apple Computer.

As shown above, the S&P 500 (red line) has gone nowhere, while Apple Computer (blue line) has powered higher.  Apple is currently the biggest weight in the index:

Obviously, not all of our holdings work out as well as Apple.  However, capturing a few of these big winners can make a big difference.

As we announced just a short time ago, our Technical Leaders Index family was recently expanded to include DWAS, the PowerShares DWA Small-Cap Technical Leaders Index.  Now, it is a family of four: PDP, PIE, PIZ, and DWAS.

See www.powershares.com for more information.  Past performance is no guarantee of future returns.  A list of all holdings for the last 12 months is available upon request.

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The Risks of the “Pay-Day” Approach to Retirement Planning

August 30, 2012

One of the primary reasons that we hold small business owners in such high regard in this country is our admiration for their courage.  It takes real courage to strike out on your own and to invest in yourself and your own idea.  I saw this numerous times with my father while I was growing up.  He succeeded as a small business owner of Chevron gas stations and of a community bank.  He has no shortage of confidence in his ability to succeed by working harder and smarter than the competition.  Investing in himself has paid off nicely over time.

However, this inclination to invest in yourself runs some risks.  As detailed in the WSJ article “The Economy Stole My Retirement,” many small business owners have spent decades reinvesting their profits in their businesses—some entirely at the expense of diversifying into other investments.  The plan was to sell their business for a big pay day as they approached retirement.  Then came the Great Recession.

Baby boomers, in many cases, were blindsided by the recession and its effect on their retirement plans, says George Vozikis, director of the Institute for Family Business at California State University in Fresno.

“Boomer entrepreneurs grew up believing in the American dream that you could start a business and eventually sell it for a good return or pass it onto your kids,” adds Aaron Chatterji, associate professor at Duke University’s Fuqua School of Business in Durham, N.C. “Because of the financial crisis and subsequent recession, that is more difficult today.”

Many small business owners are insulted and shocked to find that they can sell their businesses for just a fraction of what they could have prior to the economic malaise of recent years.  Their options are fairly limited at this point; they can keep working and wait it out or they can sell at the discounted prices and adjust to the realities of a more modest retirement.

One piece of advice that my father followed throughout his life, and he instilled in me from an early age, is to save 15% of every dollar you ever earn.  The result of this practice is accumulating sizable financial assets in addition to ownership of the small business.  Following that advice increases the odds of an enjoyable retirement and reduces the stress surrounding the one-time pay day approach to retirement planning.

Source: CNN Money

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Money Goes Where It Is Treated Best

August 30, 2012

Further confirmation of this came in a Wall Street Journal article about corporate behavior.  Companies are moving their corporate headquarters outside the US because they can save money—tens of millions of dollars—by incorporating overseas.  Here’s just one example:

Eaton, a 101-year-old Cleveland-based maker of components and electrical equipment, announced in May that it would acquire Cooper Industries PLC, another electrical-equipment maker that had moved to Bermuda in 2002 and then to Ireland in 2009. It plans to maintain factories, offices and other operations in the U.S. while moving its place of incorporation—for now—to the office of an Irish law firm in downtown Dublin.

When Eaton announced the deal, it emphasized the synergies the two companies would generate. It also told analysts that the tax benefits would save the company about $160 million a year, beginning next year.

I added the bold.  Money talks.  $160 million yells pretty loudly.

Ironically, the goal of the 2004 legislation was to promote companies staying in the US.  However, due to the poor tax treatment in the US relative to many other countries, it has not worked. The WSJ points out:

Since 2009, at least 10 U.S. public companies have moved their incorporation address abroad or announced plans to do so, including six in the last year or so, according to a Wall Street Journal analysis of company filings and statements. That’s up from just a handful from 2004 through 2008.

If the goal of corporations is to make money for their shareholders, of course they are going to take advantage of favorable tax treatment.  If we want businesses—and thus jobs—here in the US, then we have to be competitive.  Money really does go where it is treated best.

Incentives are a pretty important part of economics—some would say the most important part.  It’s critical to get incentives right if we want the US economy to continue to be the strongest in the world.

Source: The Murninghan Post

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Fund Flows

August 30, 2012

The Investment Company Institute is the national association of U.S. investment companies, including mutual funds, closed-end funds, exchange-traded funds (ETFs), and unit investment trusts (UITs).  Flow estimates are derived from data collected covering more than 95 percent of industry assets and are adjusted to represent industry totals.

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The Refrain of the Pessimists

August 29, 2012

Chuck Jaffe wrote a nice article for Marketwatch, pointing out that fund investors are actually more intelligent than they are given credit for.  It’s worth pointing out because nearly every change in the industry is greeted with skepticism by the pessimists.  His article ends with a nice summary:

“The knee-jerk reaction to almost all of the advances we have seen has been ‘Oh my goodness, what is going to happen to the industry?’ and ‘Investors will blow themselves up with this,’” said Geoff Bobroff of Bobroff Consulting, a leading fund industry observer. “Surprise, surprise, the world hasn’t come to an end yet and, in fact, the fund world has gotten better for each of these developments.

“Joe Six-Pack is going to do exactly what he has always done,” Bobroff added. “He is not going to change, just because the technology exists for him to do something different. He will adapt, and over time become comfortable with the newer products and newer ways. That doesn’t mean he will always make money; the market won’t always work for Joe Six-Pack, but that won’t be because the fund industry is evolving, it will be because that’s just what the way the market is sometimes.”

The article addresses the concern expressed by many that investors will blow themselves up with ETFs because of their daily liquidity.  (John Bogle has expressed this view frequently and loudly.)  Mr. Jaffe pulls out some data from a Vanguard (!) study that shows, in fact, that’s not how investors are acting.

Over the years, we’ve heard the same refrain about tactical asset allocation: investors will never be able to get it right, they’ll blow themselves up chasing performance, etc., etc.  In fact, tactical allocation funds have acquitted themselves quite nicely over the past few years in a very difficult market environment.  For the most part, they’ve behaved pretty much as advertised—better than the worst asset classes, and not as well as the best asset classes—somewhere in the middle of the pack.  That kind of consistency, over time, can lead to reasonable returns with moderate volatility.

Reasonable returns with moderate volatility is a laudable goal, which probably explains why hybrid funds have seen new assets this year, even as equity funds are seeing outflows.

In markets, pessimism is almost never the way to go.  It’s more productive to be optimistic and to try to find investment strategies that will work for you over the long run.

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High RS Diffusion Index

August 29, 2012

The chart below measures the percentage of high relative strength stocks that are trading above their 50-day moving average (universe of mid and large cap stocks.)  As of 8/28/12.

The 10-day moving average of this indicator is 81% and the one-day reading is 82%.

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Relative Strength Spread

August 28, 2012
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 8/27/2012:
After falling sharply for much of the last couple of weeks, the RS Spread is now showing some signs of finding traction.

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Dorsey, Wright Client Sentiment Survey Results – 8/17/12

August 27, 2012

Our latest sentiment survey was open from 8/3/12 to 8/10/12.  The Dorsey, Wright Polo Shirt Raffle continues to drive advisor participation, and we greatly appreciate your support!  We will announce the winner next Monday!  This round, we had 44 advisors participate in the survey. If you believe, as we do, that markets are driven by supply and demand, client behavior is important.  We’re not asking what you think of the market—since most of our blog readers are financial advisors, we’re asking instead about the behavior of your clients.  Then we’re aggregating responses exclusively for our readership.  Your privacy will not be compromised in any way.

After the first 30 or so responses, the established pattern was simply magnified, so we are fairly comfortable about the statistical validity of our sample. Some statistical uncertainty this round comes from the fact that we only had four investors say that thier clients are more afraid of missing a stock upturn than being caught in a downdraft. Most of the responses were from the U.S., but we also had multiple advisors respond from at least two other countries. Let’s get down to an analysis of the data! Note: You can click on any of the charts to enlarge them.

Question 1. Based on their behavior, are your clients currently more afraid of: a) getting caught in a stock market downdraft, or b) missing a stock market upturn?

Chart 1: Greatest Fear.  From survey to survey, the S&P 500 rose by just under 4%, but the overall fear numbers did not perform as expected.  The fear of downturn number rose from 76% to 79%, while the fear of upturn group fell from 24% to 21%.

Chart 2: Greatest Fear Spread. Another way to look at this data is to examine the spread between the two groups.  The spread rose slightly from 51% to 58%.

Question 2. Based on their behavior, how would you rate your clients’ current appetite for risk?

Chart 3: Average Risk Appetite.  Unlike the overall fear numbers, overall risk appetite performed exactly as expected, in a big way.  Overall risk appetite rose from 2.4 to 2.9, the highest we’ve seen since March 2012.  We’ve noticed over time that this indicator performs as we’d expect it to.

Chart 4: Risk Appetite Bell Curve.  This chart uses a bell curve to break out the percentage of respondents at each risk appetite level.  This round, we saw a big shift towards more risk, and that is reflected in this bell curve.  Currently, over 50% of all respondents would like a risk profile of 3 or higher.

Chart 5: Risk appetite Bell Curve by Group.  The next three charts use cross-sectional data.  The chat plots the reported client risk appetite separately for the fear of downdraft and for the fear of missing upturn groups.  This chart sorts out as expected, with the downturn group wanting less risk and the upturn group looking to add risk.

Chart 6: Average Risk Appetite by Group.  The average risk appetite of both groups decreased this week, even as the market did well.  Both groups want to add more risk relative to last survey.

Chart 7: Risk Appetite Spread.  This is a chart constructed from the data in Chart 6, where the average risk appetite of the downdraft group is subtracted from the average risk appetite of the missing upturn group.  The spread is now back in its normal range.

The S&P 500 shot nearly 4% higher from survey to survey, and the risk appetite indicators responded in-kind.  The overall fear numbers pulled back after a big move last round despite the strong market move.  As usual, the overall risk appetite indicator maintained the most consistent relationship between market action and client sentiment.

No one can predict the future, as we all know, so instead of prognosticating, we will sit back and enjoy the ride.  A rigorously tested, systematic investment process provides a great deal of comfort for clients during these types of fearful, highly uncertain market environments.  Until next time, good trading and thank you for participating.

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High RS Diffusion Index

August 24, 2012

The chart below measures the percentage of high relative strength stocks that are trading above their 50-day moving average (universe of mid and large cap stocks.)  As of 8/23/12.

The 10-day moving average of this indicator is 81% and the one-day reading is 73%.

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The Disciplined Pursuit of Less

August 23, 2012

Greg McKeown’s “The Disciplined Pursuit of Less” in the Harvard Business Review is thought-provoking on so many levels.  The article must be read in full  to really appreciate his point, but the concluding paragraph is a nice summary.

If success is a catalyst for failure because it leads to the “undisciplined pursuit of more,” then one simple antidote is the disciplined pursuit of less. Not just haphazardly saying no, but purposefully, deliberately, and strategically eliminating the nonessentials. Not just once a year as part of a planning meeting, but constantly reducing, focusing and simplifying. Not just getting rid of the obvious time wasters, but being willing to cut out really terrific opportunities as well. Few appear to have the courage to live this principle, which may be why it differentiates successful people and organizations from the very successful ones.

While this principle can be applied to nearly every aspect of our lives, it has a clear application to portfolio construction and financial planning.  Some variation of the following story is common: An individual succeeds at earning a high income.  Either on his own or with the help of a financial advisor, investments are made.  The years pass.  Additional investments are made.  Money with a money manager here, a group of mutual funds there, positions in some individual stocks here…  Pretty soon, this person has become a collector as opposed to an investor.  In the collector scenario, it is just possible that everything works out okay.  Perhaps there will be big enough winners in the mix to cover any losers.  However, it is possible that some of those investments were ill-conceived and will be a major drag on the overall portfolio over time–all while not being carefully watched.

Contrast that approach with the investor who purposely employs an asset allocation with more limited, but thoroughly researched investment strategies (we have written many times before about the rationale for mixing relative strength, value, and low volatility strategies).  It is quite possible that this more disciplined investor will be able to earn greater returns and amass greater wealth over time than the collector and still retain the benefits of diversification.

No realistic person has the expectation of a perpetual state of success.  Setbacks are just part of life and investing.  However, the investor who purposefully, deliberately, and strategically eliminates the nonessentials and focuses their resources on the areas where they are likely to achieve the greatest rewards has taken a big step towards putting the odds in their favor.

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Fund Flows

August 23, 2012

The Investment Company Institute is the national association of U.S. investment companies, including mutual funds, closed-end funds, exchange-traded funds (ETFs), and unit investment trusts (UITs).  Flow estimates are derived from data collected covering more than 95 percent of industry assets and are adjusted to represent industry totals.

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What’s Hot…and Not

August 22, 2012

How different investments have done over the past 12 months, 6 months, and month.

1PowerShares DB Gold, 2iShares MSCI Emerging Markets ETF, 3iShares DJ U.S. Real Estate Index, 4iShares S&P Europe 350 Index, 5Green Haven Continuous Commodity Index, 6iBoxx High Yield Corporate Bond Fund, 7JP Morgan Emerging Markets Bond Fund, 8PowerShares DB US Dollar Index, 9iBoxx Investment Grade Corporate Bond Fund, 10PowerShares DB Oil, 11iShares Barclays 20+ Year Treasury Bond

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Mexico: The Forgotten Emerging Market

August 21, 2012

Charles Sizemore sings praises for “the forgotten emerging market:”

Mexico gets no love. It’s not quite a developed market, but being next door to the United States it’s not quite remote or exotic enough to be an alluring emerging market either. And starting with the letter “M,” it doesn’t fit into any popular acronyms.

Lest you think I am joking, the four countries that comprise the “BRIC”—Brazil, Russia, India and China—have nothing in common other than the fact that their first letters make a word that sounds good in marketing literature. Mexico, Turkey, and Indonesia would all have been better choices than Russia—all three are promising emerging markets whereas Russia is a decrepit petrostate on the decline—but it’s hard to form an acronym with their first letters. Go ahead. Try. I’m waiting.

Investors who overlook Mexico do so to their own detriment. In addition to being an attractive market in its own right—and the second-largest in Latin America after Brazil—Mexico is also a large investor in other Latin American markets, and some of its multinational companies have a truly global scope.

The Mexican stock market has also been a star performer in 2012. At time of writing, the Mexican IPC Stock Index was up over 10 percent, making it one of the better performing markets in the Americas.

Mexico’s relatively strong performance has not been lost on the PowerShares DWA Emerging Markets Index (PIE).  As shown below, PIE current has 9.27% exposure to Mexico (while VWO, its cap-weighted benchmark only gives 5% weight to Mexico).

Source: PowerShares

See www.powershares.com for more information.  A list of all holding for the last 12 months is available upon request.

HT: Abnormal Returns

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Relative Strength Spread

August 21, 2012

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 8/20/2012:

The RS laggards have had the upper hand in recent weeks.

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Weekly RS Recap

August 20, 2012

The table below shows the performance of a universe of mid and large cap U.S. equities, broken down by relative strength decile and quartile and then compared to the universe return.  Those at the top of the ranks are those stocks which have the best intermediate-term relative strength.  Relative strength strategies buy securities that have strong intermediate-term relative strength and hold them as long as they remain strong.

Last week’s performance (8/13/12 – 8/17/12) is as follows:

The top quartile of the RS ranks lagged the universe last week.

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What You Should Focus On

August 17, 2012

Good advice from Carl Richards:

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Dorsey, Wright Client Sentiment Survey – 8/17/12

August 17, 2012

Here we have the next round of the Dorsey, Wright Sentiment Survey, the first third-party sentiment poll.  Participate to learn more about our Dorsey, Wright Polo Shirt raffle! Just follow the instructions after taking the poll, and we’ll enter you in the contest.  Thanks to all our participants from last round.

As you know, when individuals self-report, they are always taller and more beautiful than when outside observers report their perceptions!  Instead of asking individual investors to self-report whether they are bullish or bearish, we’d like financial advisors to weigh in and report on the actual behavior of clients.  It’s two simple questions and will take no more than 20 seconds of your time. We’ll construct indicators from the data and report the results regularly on our blog–but we need your help to get a large statistical sample!

Click here to take Dorsey, Wright’s Client Sentiment Survey.

Contribute to the greater good!  It’s painless, we promise.

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Sector and Capitalization Performance

August 17, 2012

The chart below shows performance of US sectors and capitalizations over the trailing 12, 6, and 1 month(s). Performance updated through 8/16/2012.

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Biggest Source of Demand For Equities: Corporate Buybacks

August 16, 2012

How is it that the equity markets are moving higher when retail investors continue to pull money out of domestic equity mutual funds ($76 billion in redemptions YTD)?  According to David Kostin, chief U.S. equity strategist at Goldman Sachs Group, the biggest demand for equities this year has come from corporate buybacks.  In fact, there have been $250 billion in corporate buybacks so far this year.  See him address this starting at the 8:15 mark.

As a side note, enjoy the disgust that the hosts display when Kostin tells them that he expects the equity markets to return 8% a year in the coming decade!

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How Your 401k Really Grows: Savings

August 16, 2012

CNBC ran an interesting article on the 401k market today.  Fidelity Investments handles about 12 million 401k accounts which they report on, in aggregate, periodically.  Here’s what I found most interesting from their recent release:

Over the past 10 years, about two-thirds of annual increases in account balances have been due to workers’ added contributions and company matches, with one-third the result of investment returns.

Surprised?  You shouldn’t be.  While investment performance is important, so is savings.  In a very slow decade for the market, the bulk of 401k growth came from new contributions.  Even in a stronger market for financial assets, it would not be surprising to see most of the increase in balances coming from savings since the average 401k balance is only $72,800, according to the article.

The savings rate is another area with plenty of room for improvement.  The article notes:

The average employee contribution in Fidelity-administered 401(k) plans has remained steady at around 8 percent of annual pay for the past three years.

8% is a good start, but most experts recommend something closer to 15%.  Given the current low-yield environment, seeking out investment returns wherever they can be found and saving as much as possible are going to be critical keys to 401k success.

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Emotional Investment and How to Escape It

August 16, 2012

Let’s face it; investors often make bad investment decisions. Commonly, this is due to our emotions getting in the way. BlackRock lists some of the emotional investment tendencies that often cloud our judgment and steer us toward poor decisions:

  • Anchoring: Holding onto a reference point, even if it’s irrelevant. For example, a $1.5 million house, being presented on its own, might sound expensive. But if you were first shown a $2 million house, and afterwards shown the $1.5 million house, it might then sound like a good deal.
  • Herding: Following the crowd. People often pile into the markets when they are doing well and they see “everyone else” doing it.
  • Mental Accounting: Separating money into buckets that are treated differently. Earmarking funds for college savings or a vacation home allows you to save for specific goals. But treating those dollars differently may not make sense when they all have the same buying power.
  • Framing: Making a different decision based on context. In a research study, when a four-ounce glass had 2 ounces of water poured out of it, 69% of people said it was now “half empty.” If the same glass starts out empty and has 2 ounces of water poured into it, 88% of people say it is “half full.”

Emotional investment tendencies can result in all sorts of problems.  Typically these behaviors are so ingrained that we don’t even recognize them as irrational!

One way to combat our emotions is to hire a good advisor. As explained in this previous blog post, one important benefit—maybe even the primary benefit—of having a good advisor is behavior modification. An advisor persuading a client to invest more when the market is doing poorly, instead taking money out, is extremely valuable.

Another option is to invest in a managed product like an ETF or mutual fund (here are some of ours) that will make the decisions for you. For an emotional investor, this may be an easier (and presumably safer) option than picking and obsessively monitoring a few random stocks. Even then, it is important try to avoid the herd mentality. Data shows that it’s most important to avoid panic at market bottoms.  Although it is difficult not to panic if other people around you are fearful, the potential difference in your investment return can be significant.

In short, understanding your emotional tendencies may help keep them from interfering in investment decisions. If that isn’t enough, try enlisting the help of an outside source. With the steady hand of a good advisor, it may be possible to mitigate emotional investment tendencies.

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Fund Flows

August 16, 2012

The Investment Company Institute is the national association of U.S. investment companies, including mutual funds, closed-end funds, exchange-traded funds (ETFs), and unit investment trusts (UITs).  Flow estimates are derived from data collected covering more than 95 percent of industry assets and are adjusted to represent industry totals.

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