Click here for our quarterly DWA webinar with Tom Dorsey, Tammy DeRosier, and John Lewis.
Click here for our review of the first quarter and for our market outlook.
Relative strength strategy is NOT a guarantee. There may be times where all investments and strategies are unfavorable and depreciate in value. Relative Strength is a measure of price momentum based on historical price activity. Relative Strength is not predictive and there is no assurance that forecasts based on relative strength can be relied upon.
Posted by: Andy Hyer
Investor behavior has a lot to do with how markets behave, and with how investors perform. To profit from a long mega-bull market, investors have to be willing to buy stocks and hold them through the inevitable ups and downs along the way. Risk tolerance greatly influences their willing to do that—and risk tolerance is greatly influenced by their past experience.
From an article on risk in The Economist:
People’s financial history has a strong impact on their taste for risk. Looking at surveys of American household finances from 1960 to 2007, Ulrike Malmendier of the University of California at Berkeley and Stefan Nagel, now at the University of Michigan, found that people who experienced high returns on the stockmarket earlier in life were, years later, likelier to report a higher tolerance for risk, to own shares and to invest a bigger slice of their assets in shares.
But exposure to economic turmoil appears to dampen people’s appetite for risk irrespective of their personal financial losses. That is the conclusion of a paper by Samuli Knüpfer of London Business School and two co-authors. In the early 1990s a severe recession caused Finland’s GDP to sink by 10% and unemployment to soar from 3% to 16%. Using detailed data on tax, unemployment and military conscription, the authors were able to analyse the investment choices of those affected by Finland’s “Great Depression”. Controlling for age, education, gender and marital status, they found that those in occupations, industries and regions hit harder by unemployment were less likely to own stocks a decade later. Individuals’ personal misfortunes, however, could explain at most half of the variation in stock ownership, the authors reckon. They attribute the remainder to “changes in beliefs and preferences” that are not easily measured.
The same seems to be true for financial trauma. Luigi Guiso of the Einaudi Institute for Economics and Finance and two co-authors examined the investments of several hundred clients of a large Italian bank in 2007 and again in 2009 (ie, before and after the plunge in global stockmarkets). The authors also asked the clients about their attitudes towards risk and got them to play a game modelled on a television show in which they could either pocket a small but guaranteed prize or gamble on winning a bigger one. Risk aversion, by these measures, rose sharply after the crash, even among investors who had suffered no losses in the stockmarket. The reaction to the financial crisis, the authors conclude, looked less like a proportionate response to the losses suffered and “more like old-fashioned ‘panic’.”
I’ve bolded a couple of sections that I think are particularly interesting. Investors who came of age in the 1930s tended to have an aversion to stocks also—an aversion that caused them to miss the next mega-bull market in the 1950s. Today’s investors may be similarly traumatized, having just lived through two bear markets in the last decade or so.
Bull markets climb a wall of worry and today’s prospective investors are plenty worried. Evidence of this is how quickly risk-averse bond-buying picks up during even small corrections in the stock market. If history is any guide, investors could be overly cautious for a very long time.
Of course, I don’t know whether we’re going to have a mega-bull market for the next ten or fifteen years or not. Anything can happen. But it wouldn’t surprise me if the stock market does very well going forward—and it would surprise me even less if most investors miss out.
Posted by: Mike Moody
Morgan Housel at Motley Fool has a wonderful article on how investors can learn from failure. He sets the tone with a few different quotes and anecdotes that point out that a lot of being a success is just avoiding really dumb mistakes.
At a conference years ago, a young teen asked Charlie Munger how to succeed in life. “Don’t do cocaine, don’t race trains to the track, and avoid all AIDS situations,” Munger said. Which is to say: Success is less about making great decisions and more about avoiding really bad ones.
People focus on role models; it is more effective to find antimodels—people you don’t want to resemble when you grow up. Nassim Taleb
I’ve added the emphasis, but Mr. Housel makes a good point. Learning from failure is equally important as learning from success. In fact, he argues it may be more important.
If it were up to me, I would replace every book called How to Invest Like Warren Buffett with a one called How to Not Invest Like Lehman Brothers, Long-Term Capital Management, and Jesse Livermore. There are so many lessons to learn from these failed investors about situations most of us will face, like how quickly debt can ruin you. I’m a fan of learning from Buffett, but the truth is most of us can’t devote as much time to investing as he can. The biggest risk you face as an investor isn’t that you’ll fail to be Warren Buffett; it’s that you’ll end up as Lehman Brothers.
But there’s no rule that says you have to learn by failing yourself. It is far better to learn vicariously from other people’s mistakes than suffer through them on your own.
That’s his thesis in a nutshell. He offers three tidbits from his study of investing failures. I’ve quoted him in full here because I think his context is important (and the writing is really good).
1. The overwhelming majority of financial problems are caused by debt, impatience, and insecurity. People want to fit in and impress other people, and they want it right now. So they borrow money to live a lifestyle they can’t afford. Then they hit the inevitable speed bump, and they find themselves over their heads and out of control. That simple story sums up most financial problems in the world. Stop trying to impress people who don’t care about you anyways, spend less than you earn, and invest the rest for the long run. You’ll beat 99% of people financially.
2. Complexity kills. You can make a lot of money in finance, so the industry attracted some really brilliant people. Those brilliant people naturally tried to make finance more like their native fields of physics, math, and engineering, so finance has grown exponentially more complex in the last two decades. For most, that’s been a disservice. I think the evidence is overwhelming that simple investments like index funds and common stocks will demolish complicated ones like derivatives and leveraged ETFs. There are two big stories in the news this morning: One is about how the University of California system is losing more than $100 million on a complicated interest rate swap trade. The other is about how Warren Buffett quintupled his money buying a farm in Nebraska. Simple investments usually win.
3. So does panic. In his book Deep Survival, Laurence Gonzalez chronicles how some people managed to survive plane crashes, getting stranded on boats, and being stuck in blizzards while their peers perished. The common denominator is simple: The survivors didn’t panic. It’s the same in investing. I’ve seen people make a lifetime of good financial decisions only to blow it all during a market panic like we saw in 2008. Any financial decision you make with an elevated heart rate is probably going to be one you’ll regret. Napoleon’s definition of a military genius was “the man who can do the average thing when all those around him are going crazy.” It’s the same in investing.
I think these are really good points. It’s true that uncontrolled leverage accompanies most real blowups. Having patience in the investing process is indeed necessary; we’ve written about that a lot here too. The panic, impatience, and insecurity he references are really all behavioral issues—and it just points out that having your head on straight is incredibly important to investment success. How successful you are in your profession or how much higher math you know is immaterial. As Adam Smith (George Goodman) wrote, “If you don’t know who you are, the stock market is an expensive place to find out.”
Mr. Housel’s point on complexity could be a book in itself. Successful investing just entails owning productive assets—the equity and debt of successful enterprises—acquired at a reasonable price. Whether you own the equity directly, like Warren Buffett and his farm, or in security form is immaterial. An enterprise can be a company—or even a country—but it’s got to be successful.
Complexity doesn’t help with this evaluation. In fact, complexity often obscures the whole point of the exercise.
This is actually one place where I think relative strength can be very helpful in the investment process. Relative strength is incredibly simple and relative strength is a pretty good signaling mechanism for what is successful. Importantly, it’s also adaptive: when something is no longer successful, relative strength can signal that too. Sears was once the king of retailing. Upstart princes like K-Mart in its day, and Wal-Mart and Costco later, put an end to its dominance. Once, homes were lit with candles and heated with fuel oil. Now, electricity is much more common—but tomorrow it may be something different. No asset is forever, not even Warren Buffett’s farmland. When the soil is depleted, that farm will become a lead anchor too. Systematic application of relative strength, whether it’s being used within an asset class or across asset classes, can be a very useful tool to assess long-term success of an enterprise.
Most investing problems boil down to behavioral issues. Impatience and panic are a couple of the most costly. Avoiding complexity is a different dimension that Mr. Housel brings up, and one that I think should be included in the discussion. There are plenty of millionaires that have been created through owning businesses, securities, or real estate. I can’t think of many interest rate swap millionaires (unless you count the people selling them). Staying calm and keeping things simple might be the way to go. And if the positive prescription doesn’t do it for you, the best way to be a good investor may be to avoid being a terrible investor!
Posted by: Mike Moody
That’s the title of a Marketwatch article by mutual fund columnist Chuck Jaffe. I have to admit that usually I like his columns. But columns like this make me nuts! (See also The $ Value of Patience for an earlier rant on a similar topic.)
Here’s the thesis in a nutshell:
…safe driving comes down to a mix of equipment and personnel.
The same can be said for mutual funds and exchange-traded funds, and while there is growing consensus that ETFs are the better vehicle, there’s growing evidence that the people using them may not be so skilled behind the wheel.
The article goes on to point out that newsletters with model portfolios of mutual funds and ETFs have disparate results.
Over the last 12 months, the average model portfolio of traditional funds—as tracked by Hulbert Financial Digest—was up 20.9%, a full three points better than the average ETF portfolio put together by the same advisers and newsletter editors. The discrepancy narrows to two full percentage points over the last decade, and Hulbert noted he was only looking at advisers who run portfolios on both sides of the aisle.
Hulbert posited that if you give one manager both vehicles, the advantages of the better structure should show up in performance.
Hulbert—who noted that the performance differences are “persistent” — speculated “that ETFs’ advantages are encouraging counterproductive behavior.” Effectively, he bought into Bogle’s argument and suggested that if you give an investor a trading vehicle, they will trade it more often.
Does it make any sense to blame the vehicle for the poor driving? (Not to mention that DALBAR data make it abundantly clear that mutual fund drivers frequently put themselves in the ditch.) Would it make sense to run a headline like “The Growing Case Against Stocks” because stocks can be traded?
Mutual funds, ETFs, and other investment products exist to fulfill specific needs. Obviously not every product is right for every investor, but there are thousands of good products that will help investors meet their goals. When that doesn’t happen, it’s usually investor behavior that’s to blame. (And you’re not under any obligation to invest in a particular product. If you don’t understand it, or you get the sinking feeling that your advisor doesn’t either, you should probably run the other way.)
Investors engage in counterproductive behavior all the time, period. It’s not a matter of encouraging it or not. It happens in every investment vehicle and the problem is almost always the driver. In fact, advisors that can help manage counterproductive investor behavior are worth their weight in gold. We’re not going to solve problems involving investor behavior by blaming the product.
A certain amount of common sense has to be applied to investing, just like it does in any other sphere of life. I know that people try to sue McDonald’s for “making” them fat or put a cup of coffee between their legs and then sue the drive-thru that served it when they get burned, but whose responsibility is that really? We all know the answer to that.
Posted by: Mike Moody
As sector ETFs have proliferated, more and more investors have been attracted to sector rotation and tactical asset allocation strategies using ETFs, whether self-managed or implemented by an advisor. Mark Hulbert commented on sector rotation strategies in a recent article on Marketwatch that highlighted newsletters using Fidelity sector funds. All of the newsletters had good returns, but there was one surprising twist:
…you might think that these advisers each recommended more or less the same basket of funds. But you would be wrong. In fact, more often than not, each of these advisers has tended to recommend funds that are not recommended by any other of the top five sector strategies.
That’s amazing, since there are only 44 actively managed Fidelity sector funds and these advisers’ model portfolios hold an average of between five and 10 funds each.
This suggests that there is more than one way of playing the sector rotation game, which is good news. If there were only one profitable sector strategy, it would quickly become so overused as to stop working.
This is even true among those advisers who recommend sectors based on their relative strength or momentum. Because there are so many ways of defining these characteristics, two different sector momentum strategies will often end up recommending two different Fidelity sector funds.
Another way of appreciating the divergent recommendations of these top performing advisers is this: Of the 44 actively managed sector funds that Fidelity currently offers, no fewer than 22 are recommended by at least one of these top five advisers. That’s one of every two, on average, which hardly seems very selective on the advisers’ part.
Amazing, isn’t it? It just shows that there are many ways to skin a cat.
Even with a very limited menu of Fidelity sector funds, there was surprisingly little overlap. Imagine how little overlap there would be within the ETF universe, which is much, much larger! In short, you can safely pursue a sector rotation strategy (and, by extension, tactical asset allocation) with little concern that everyone else will be plowing into the same ETFs.
Posted by: Mike Moody
Fourth Quarter Review
After a short dip to start the fourth quarter, the stock market moved strongly higher through the end of November. The marked moved sideways during December, never giving up any substantial ground. What a remarkable year for the stock market! Despite some choppiness, every quarter this year has had positive equity returns!
The S&P 500 finished up over 30% for the year. The last time the S&P accomplished that feat was all the way back in 1997. That was quite a while ago. In fact, it was the longest streak without a 30% up year since the drought from 1959 to 1974. The 10.5% return in the fourth quarter made that possible.
Other asset classes didn’t fare as well as equities in 2013. Continuing to fear tapering by the Federal Reserve, the bond market was lackluster during the final three months of the year. Many broad fixed income indexes finished 2013 with losses. Other asset classes, like commodities, performed poorly as well. Gold, in particular, had a very difficult year after being a darling of the fear mongers for many years. Diversification, which provided improved returns over the past few years, was definitely not the way to go in 2013. It was all about equities.
Economic growth may be starting to pick up. The final estimate for Q3 GDP growth is now 4.1%. That’s stronger annual growth than we’ve seen for at least six quarters. Another positive is the Conference Board’s Leading Economic Index, which is up 3.1% over the past six months. Industrial capacity utilization is still slack and employment still fairly weak, suggesting that there will be little pressure on consumer prices for now.
Although there was some political wrangling about the government healthcare website, the big story for the market this quarter was the December Fed meeting. Would the Fed taper or not? The stock and bond markets both seemed apprehensive that the Fed would decide to reduce bond purchases, especially given the negative market reaction in May. In the end, the Fed decided to taper slightly—and the stock market vaulted upward.
Part of the explanation may have been that the taper was more modest than expected, but a bigger factor was likely the Federal Reserve making it clear that its low interest rate policy would continue even after employment begins to pick up. Although a new Fed chair, Janet Yellen, is scheduled to be installed in January, observers don’t expect significant policy changes. The stock market seems to like quantitative easing and there is no end in sight.
While all of this is good news for equities some people are beginning to wonder if we have reached the end of the bull market. The S&P 500 closed the year at an all-time high. It has only done that five times since 1929, so it is a rare event. The good news is that, according to Standard and Poor’s, equities were up an average of 8.5% in the years following a close at an all-time high. The base rates were also good with equities being up four out of those five years.
We also aren’t seeing the type of euphoria from retail investors that often accompanies major market tops. In a recent survey, Blackrock found that affluent investors were holding 48% of their investable assets in cash! This despite expressing greater confidence about their financial futures. Their allocation to equities was only 18% in the survey. During the late 1990’s stock assets were closer to 40%, so despite reaching all-time highs equities are still not universally loved.
We are heading into the part of the cycle that tends to be very good for relative strength. We believe equities can continue to deliver solid returns, and as the market narrows that should be a major positive for our methodology. As always, we continue to focus on implementing our process in the most disciplined way possible, and if you have any questions we are always happy to speak with you about them.
Posted by: Andy Hyer
According to a recent Gallup Poll, most Americans don’t think much of the stock market as a way to build wealth. I find that quite distressing, and not just because stocks are my business. Stocks are equity—and equity is ownership. If things are being done right, the owner should end up making more than the employee as the business grows. I’ve reproduced a table from Gallup’s article below.
Source: Gallup (click on image to enlarge)
You can see that only 37% felt that the stock market was a good way to build wealth—and only 50% among investors with more than $100,000 in assets.
Perhaps investors will reconsider after reading an article from the Wall Street Journal, here republished on Yahoo! Finance. In the article, they asked 40 prominent people about the best financial advice they’d ever received. (Obviously you should read the whole thing!) Two of the comments that struck me most are below:
Charles Schwab, chairman of Charles Schwab Corp.
A friend said to me, Chuck, you’re better off being an owner. Go out and start your own business.
Richard Sylla, professor of the history of financial institutions and markets at New York University
The best financial advice I ever received was advice that I also provided, both to myself and to Edith, my wife. It was more than 40 years ago when I was a young professor of economics and she was a young professor of the history of science. I based the advice on what were then relatively new developments in modern finance theory and empirical findings that supported the theory.
The advice was to stash every penny of our university retirement contributions in the stock market.
As new professors we were offered a retirement plan with TIAA-CREF in which our own pretax contributions would be matched by the university. Contributions were made with before-tax dollars, and they would accumulate untaxed until retirement, when they could be withdrawn with ordinary income taxes due on the withdrawals.
We could put all of the contributions into fixed income or all of it into equities, or something in between. Conventional wisdom said to do 50-50, or if one could not stomach the ups and downs of the stock market, to put 100% into bonds, with their “guaranteed return.”
Only a fool would opt for 100% stocks and be at the mercies of fickle Wall Street. What made the decision to be a fool easy was that in those paternalistic days the university and TIAA-CREF told us that we couldn’t touch the money until we retired, presumably about four decades later when we hit 65.
Aware of modern finance theory’s findings that long-term returns on stocks should be higher than returns on fixed-income investments because stocks were riskier—people had to be compensated to bear greater risk—I concluded that the foolishly sensible thing to do was to put all the money that couldn’t be touched for 40 years into equities.
At the time (the early 1970s) the Dow was under 1000. Now it is around 16000. I’m now a well-compensated professor, but when I retire in a couple of years and have to take minimum required distributions from my retirement accounts, I’m pretty sure my income will be higher than it is now. Edith retired recently, and that is what she has discovered.
Not everyone has the means to start their own business, but they can participate in thousands of existing great businesses through the stock market! Richard Sylla’s story is fascinating in that he put 100% of his retirement assets into stocks and has seen them grow 16-fold! I’m sure he had to deal with plenty of volatility along the way, but it is remarkable how effective equity can be in creating wealth. His wife discovered that her income in retirement—taking the required minimum distribution!—was greater than when she was working! (The italics in the quote above are mine.)
Equity is ownership, and ownership of productive assets is the way to wealth.
Posted by: Mike Moody
…talk about the best advice they have even gotten in a short piece from Fortune. I think it clarifies the difference between a blind value investor and an investor who is looking for good companies (not coincidentally, many of those good companies have good relative strength). Warren Buffett and Charlie Munger have made a fortune implementing this advice.
Buffett: I had been oriented toward cheap securities. Charlie said that was the wrong way to look at it. I had learned it from Ben Graham, a hero of mine. [Charlie] said that the way to make really big money over time is to invest in a good business and stick to it and then maybe add more good businesses to it. That was a big, big, big change for me. I didn’t make it immediately and would lapse back. But it had a huge effect on my results. He was dead right.
Munger: I have a habit in life. I observe what works and what doesn’t and why.
I highlighted the fun parts. Buffett started out as a Ben Graham value investor. Then Charlie wised him up.
Valuation has its place, obviously. All things being equal, it’s better to buy cheaply than to pay up. But Charlie Munger had observed that good businesses tended to keep on going. The same thing is typically true of strong stocks—and most often those are the stocks of strong businesses.
Buy strong businesses and stick with them as long as they remain strong.
Posted by: Mike Moody
Mike Moody and Andy Hyer
Posted by: Andy Hyer
I’m still getting back into the swing of things after having the flu most of last week. In the midst of my stock market reading, I was struck by an article over the weekend from Abnormal Returns, a blog you should be reading, if you aren’t already. The editor had a selection of the blog posts that were most heavily trafficked from the prior week. Without further ado:
- Chilling signs of a market top. (The Reformed Broker)
- Ray Dalio thinks you shouldn’t bother trying to generate alpha. (The Tell)
- Ten laws of stock market bubbles. (Doug Kass)
- How to teach yourself to focus. (The Kirk Report)
- Are we in a bubble? (Crossing Wall Street)
- Josh Brown, “If the entities in control of trillions of dollars all want asset prices to be higher at the same time, what the hell else should you be positioning for?” (The Reformed Broker)
- Guess what stock has added the most points to the S&P 500 this year? (Businessweek)
- Everything you need to know about stock market crashes. (The Reformed Broker)
- Jim O’Neil is swapping BRICs for MINTs. (Bloomberg)
- How to survive a market crash. (Your Wealth Effect)
I count five of the top ten on the topic of market tops/bubbles/crashes!
Markets tend to top out when investors are feeling euphoric, not when they are tremendously concerned about the downside. In my opinion, investors are still quite nervous—and fairly far from euphoric right now.
Posted by: Mike Moody
Posted by: Andy Hyer
Gary Antonacci has a very nice article at Optimal Momentum regarding long-only momentum. Most academic studies look at long-short momentum, while most practitioners (like us) use long-only momentum (also known as relative strength). Partly this is because it is somewhat impractical to short across hundreds of managed accounts, and partly because clients don’t usually want to have short positions. The article has another good reason, quoting from an Israel & Moskowitz paper:
Using data over the last 86 years in the U.S. stock market (from 1926 to 2011) and over the last four decades in international stockmarkets and other asset classes (from 1972 to 2011), we find that the importance of shorting is inconsequential for all strategies when looking at raw returns. For an investor who cares only about raw returns, the return premia to size, value, and momentum are dominated by the contribution from long positions.
In other words, most of your return comes from the long positions anyway.
The Israel & Moskowitz paper looks at raw long-only returns from capitalization, value, and momentum. Perhaps even more importantly, at least for the Modern Portfolio Theory crowd, it looks at CAPM alphas from these same segments on a long-only basis. The CAPM alpha, in theory, is the amount of excess return available after adjusting for each factor. Here’s the chart:
(click on image to enlarge)
From the Antonacci article, here’s what you are looking at and the results:
I&M charts and tables show the top 30% of long-only momentum US stocks from 1927 through 2011 based on the past 12-month return skipping the most recent month. They also show the top 30% of value stocks using the standard book-to-market equity ratio, BE/ME, and the smallest 30% of US stocks based on market capitalization.
Long-only momentum produces an annual information ratio almost three times larger than value or size. Long-only versions of size, value, and momentum produce positive alphas, but those of size and value are statistically weak and only exist in the second half of the data. Momentum delivers significant abnormal performance relative to the market and does so consistently across all the data.
Looking at market alphas across decile spreads in the table above, there are no significant abnormal returns for size or value decile spreads over the entire 1926 to 2011 time period. Alphas for momentum decile portfolio spread returns, on the other hand, are statistically and economically large.
Mind-boggling right? On a long-only basis, momentum smokes both value and capitalization!
Israel & Moskowitz’s article is also quoted in the post, and here is what they say about their results:
Looking at these finer time slices, there is no significant size premium in any sub period after adjusting for the market. The value premium is positive in every sub period but is only statistically significant at the 5% level in one of the four 20-year periods, from 1970 to 1989. The momentum premium, however, is positive and statistically significant in every sub period, producing reliable alphas that range from 8.9 to 10.3% per year over the four sub periods.
Looking across different sized firms, we find that the momentum premium is present and stable across all size groups—there is little evidence that momentum is substantially stronger among small cap stocks over the entire 86-year U.S. sample period. The value premium, on the other hand, is largely concentrated only among small stocks and is insignificant among the largest two quintiles of stocks (largest 40% of NYSE stocks). Our smallest size groupings of stocks contain mostly micro-cap stocks that may be difficult to trade and implement in a real-world portfolio. The smallest two groupings of stocks contain firms that are much smaller than firms in the Russell 2000 universe.
What is this saying? Well, the value premium doesn’t appear to exist in the biggest NYSE stocks (the stuff your firm’s research covers). You can find value in micro-caps, but the effect is still not very significant relative to momentum in long-only portfolios. And momentum works across all cap levels, not just in the small cap area.
All of this is quite important if you are running long-only portfolios for clients, which is what most of the industry does. Relative strength (momentum) is a practical tool because it appears to generate excess return over many time periods and across all capitalizations.
Posted by: Mike Moody
Marshall Jaffe wrote an excellent article on investment process versus investment performance in the most recent edition of ThinkAdvisor. I think it is notable for a couple of reasons. First, it’s pithy and well-written. But more importantly, he’s very blunt about the problems of focusing only on investment performance for both clients and the industry. And make no mistake—that’s how the investment industry works in real life, even though it is a demonstrably poor way to do things. Consider this excerpt:
We see the disclaimer way too often. “Past performance is no guarantee of future results.” It is massively over-used—plastered on countless investment reports, statements and research. It’s not simply meaningless; it’s as if it’s not even there. And that creates a huge problem, because the message itself is really true: Past performance has no predictive value.
Since we are looking for something that does have predictive value—all the research, experience and hard facts say: Look elsewhere.
This is not a controversial finding. There are no fringe groups of investors or scholars penning op-ed pieces in the Wall Street Journal shooting holes in the logic of this reality. Each year there is more data, and each year that data reconfirms that past performance is completely unreliable as an investment tool. Given all that, you would think it would be next to impossible to find any serious investors still using past performance as a guideline. Indeed, that would be a logical conclusion.
But logical conclusions are often wrong when it comes to understanding human behavior. Not only does past performance remain an important issue in the minds of investors, for the vast majority it is the primary issue. In a study I referred to in my August column, 80% of the hiring decisions of large and sophisticated institutional pension plans were the direct result of outstanding past performance, especially recent performance.
The truth hurts! The bulk of the article discusses why investors focus on performance to their detriment and gives lots of examples of top performers that focus only on process. There is a reason that top performers focus on process—because results are the byproduct of the process, not an end in themselves.
The reason Nick Saban, our best athletes, leading scientists, creative educators, and successful investors focus on process is because it anchors them in reality and helps them make sensible choices—especially in challenging times. Without that anchor any investor observing the investment world today would be intimidated by its complexity, uncomfortable with its volatility and (after the meltdown in 2008) visibly fearful of its fragility. Of course we all want good returns—but those who use a healthy process realize that performance is not a goal; performance is a result.
Near the end of the article, I think Mr. Jaffe strikes right to the core of the investment problem for both individual investors and institutions. He frames the right question. Without the right question, you’re never going to get the right answer!
In an obsessive but fruitless drive for performance too many fund managers compromise the single most important weapon in their arsenal: their investment process.
Now we can see the flaw in the argument that an investor’s basic choice is active or passive. An investor indeed has two choices: whether to be goal oriented or process oriented. In reframing the investment challenge that way, the answer is self-evident and the only decision is whether to favor a mechanical process or a human one.
Reframing the question as “What is your investment process?” sidelines everything else. (I added the bold.) In truth, process is what matters most. Every shred of research points out the primacy of investment process, but it is still hard to get investors to look away from performance, even temporarily.
We focus on relative strength as a return factor—and we use a systematic process to extract whatever return is available—but it really doesn’t matter what return factor you use. Value investors, growth investors, or firms trying to harvest more exotic return factors must still have the same focus on investment process to be successful.
If you are an advisor, you should be able to clearly explain your investment process to a client. If you are an investor, you should be asking your advisor to explain their process to you. If there’s no consistent process, you might want to read Mr. Jaffe’s article again.
HT to Abnormal Returns
Posted by: Mike Moody
I’ve long been a fan of portfolio buckets or sleeves, for two reasons. The first reason is that it facilitates good diversification, which I define as diversification by volatility, by asset class, and by strategy. (We happen to like relative strength as one of these primary strategies, but there are several offsetting strategies that might make sense.) A bucket portfolio makes this kind of diversification easy to implement.
The second benefit is largely psychological—but not to be underestimated. Investors with bucket portfolios had better performance in real life during the financial crisis because they didn’t panic. While the lack of panic is a psychological benefit, the performance benefit was very real.
Another champion of bucketed portfolios is Christine Benz at Morningstar. She recently wrote a series of article in which she stress-tested bucketed portfolios, first through the 2007-2012 period (one big bear market) and then through the 2000-2012 period (two bear markets). She describes her methodology for rebalancing and the results.
If you have any interest in portfolio construction for actual living, breathing human beings who are prone to all kinds of cognitive biases and emotional volatility, these articles are mandatory reading. Better yet for fans of portfolio sleeves, the results kept clients afloat. I’ve included the links below. (Some may require a free Morningstar registration to read.)
Article: A Bucket Portfolio Stress Test http://news.morningstar.com/articlenet/article.aspx?id=605387&part=1
Article: We Put the Bucket System Through Additional Stress Tests http://news.morningstar.com/articlenet/article.aspx?id=607086
Article: We Put the Bucket System Through a Longer Stress Test http://news.morningstar.com/articlenet/article.aspx?id=608619
Posted by: Mike Moody
What the heck is fictive learning? Well, I’m glad you asked. Fictive learning refers to our ability to imagine “what if” situations. We learn not only from our actual actions, but from our perceptions of what would have happened if we had done something differently. It turns out that fictive learning has a lot to do with investor behavior too. Here are a few excerpts about relevant experiments discussed in an article in Wired magazine.
To better understand the source of our compulsive speculation, Read Montague, a neuroscientist now at Virginia Tech, has begun investigating the formation of bubbles from the perspective of the brain. He argues that the urge to speculate is rooted in our mental software. In particular, bubbles seem to depend on a unique human talent called “fictive learning,” which is the ability to learn from hypothetical scenarios and counterfactual questions. In other words, people don’t just learn from mistakes they’ve actually made, they’re able to learn from mistakes they might have made, if only they’d done something different.
Investors, after all, are constantly engaging in fictive learning, as they compare their actual returns against the returns that might have been, if only they’d sold their shares before the crash or bought Google stock when the company first went public. And so, in 2007, Montague began simulating stock bubbles in a brain scanner, as he attempted to decipher the neuroscience of irrational speculation. His experiment went like this: Each subject was given $100 and some basic information about the “current” state of the stock market. After choosing how much money to invest, the players watched nervously as their investments either rose or fell in value. The game continued for 20 rounds, and the subjects got to keep their earnings. One interesting twist was that instead of using random simulations of the stock market, Montague relied on distillations of data from famous historical markets. Montague had people “play” the Dow of 1929, the Nasdaq of 1998 and the S&P 500 of 1987, so the neural responses of investors reflected real-life bubbles and crashes.
Montague, et. al. immediately discovered a strong neural signal that drove many of the investment decisions. The signal was fictive learning. Take, for example, this situation. A player has decided to wager 10 percent of her total portfolio in the market, which is a rather small bet. Then, she watches as the market rises dramatically in value. At this point, the investor experiences a surge of regret, which is a side-effect of fictive learning. (We are thinking about how much richer we would be if only we’d invested more in the market.) This negative feeling is preceded by a swell of activity in the ventral caudate, a small area in the center of the cortex. Instead of enjoying our earnings, we are fixated on the profits we missed, which leads us to do something different the next time around.
When markets were booming, as in the Nasdaq bubble of the late 1990s, people perpetually increased their investments. In fact, many of Montague’s subjects eventually put all of their money into the rising market. They had become convinced that the bubble wasn’t a bubble. This boom would be different.
And then, just like that, the bubble burst. The Dow sinks, the Nasdaq collapses, the Nikkei implodes. At this point investors race to dump any assets that are declining in value, as their brain realizes that it made some very expensive mistakes. Our investing decisions are still being driven by regret, but now that feeling is telling us to sell. That’s when we get a financial panic.
Montague has also begun exploring the power of social comparison, or what he calls the “country club effect,” on the formation of financial bubbles. “This is what happens when you’re sitting around with your friends at the country club, and they’re all talking about how much money they’re making in the market,” Montague told me. “That casual conversation is going to change the way you think about investing.” In a series of ongoing experiments, Montague has studied what happens when people compete against each other in an investment game. While the subjects are making decisions about the stock market, Montague monitors their brain activity in two different fMRI machines. The first thing Montague discovered is that making more money than someone else is extremely pleasurable. When subjects “win” the investment game, Montague observes a large increase in activity in the striatum, a brain area typically associated with the processing of pleasurable rewards. (Montague refers to this as “cocaine brain,” as the striatum is also associated with the euphoric high of illicit drugs.) Unfortunately, this same urge to outperform others can also lead people to take reckless risks.
More recently, a team of Italian neuroscientists led by Nicola Canessa and Matteo Motterlini have shown that regret is also contagious, so that “observing the regretful outcomes of another’s choices reactivates the regret network.” (In other words, we internalize the errors of others. Or, as Motterlini wrote in an e-mail, “We simply live their emotions like these were our own.”) Furthermore, this empathy impacts our own decisions: The “risk-aptitude” of investors is significantly shaped by how well the risky decisions of a stranger turned out. If you bet the farm on some tech IPO and did well, then I might, too.
If you are an investment advisor, all of this is sounding pretty familiar. We’ve all seen clients make decisions based on social comparison, regret, or trying to avoid regret. Sometimes they are simply paralyzed, trapped between wanting to do as well as their brother-in-law and wanting to avoid the regret of losing money if their investment doesn’t work out.
The broader point is that a lot of what drives trends in the market is rooted in human behavior, not valuations and fundamentals. Human nature is unlikely to change, especially a feature like fictive learning which is actually incredibly helpful in many other contexts. As a result, markets will continue to trend and reverse, to form bubbles and to have those bubbles implode periodically.
While social science may be helpful in understanding why the market behaves as it does, we still have to figure out a way to navigate it. As long as markets trend, relative strength trend following should work. (That’s the method we follow.) As long as bubbles form and implode, other methods like buying deep value should help mitigate the risk of permanent loss. Most important, the discipline to execute a systematic investment plan and not get sucked into all of the cognitive biases will be necessary to prosper with whatever investment method you choose.
Posted by: Mike Moody
At first, you might not think that relative strength and philosophy are related in any way. But they are, because every strategy is based on some philosophy of the market. Different philosophies lead to different strategies. We like relative strength because it is simple, straightforward, and performs well over time. Of course, there are other strategies that work also, including some that are quite complementary to relative strength. A nice encapsulation of philosophy leading to strategy appeared on The Bloodhound System blog. A couple of excerpts from the article are instructive. The first is a quote from Rick Ferri in a Morningstar interview:
“Strategy comes from philosophy. If you don’t have a philosophy, you can develop a strategy, but it’s only going to blow apart the next time it doesn’t work for a month or two. And you are going to go onto another strategy, and that’s the worst thing you can do.”
This is very true. Over my career, I’ve seen many investors careen from strategy to strategy, never sticking long enough with any of them to enjoy success. The author of the blog piece, Bill Moore, I think really cuts to the core of why a deeply held philosophy is so important to success. Having some kind of belief system is necessary to have conviction. With conviction comes discipline—and discipline is the key to everything. I put the good part in bold.
…what’s really important is that you have a philosophy that makes sense to you and that you believe in–and that you then create a strategy which you would execute with discipline. As much as pundits might dogmatically espouse one investing philosophy or another–making it seem like it’s their way or the highway–there are thousands of investment philosophies–and in turn strategies. The reason multiple philosophies can work out well is that inherent in having a philosophy, or belief system, is that you have conviction in it. That kind of discipline, not so much the philosophy itself, is the key to an investment plan.
One of our senior portfolio managers, Harold Parker, likes to say “to the disciplined go the spoils.” He’s right. Even a good strategy that is poorly executed will lead to bad results. Every strategy might be driven by some philosophy, but none of them are worth a darn without conviction and the resultant discipline to execute well.
Posted by: Mike Moody
Avoiding danger is no safer in the long run than outright exposure. The fearful are caught as often as the bold.—Helen Keller
I doubt that Helen Keller was thinking about bond investors when she wrote this, but she may as well have been. The safe haven trade hasn’t worked out too well since May. Bond investors sometimes think they have an extra measure of security versus stock investors. And it is true that most bonds are less volatile than stocks. Volatility, however, is a pretty poor way to measure risk. An alternative way to measure risk is to look at drawdown—and measured that way, bonds have had drawdowns in real returns that rival drawdowns in stocks.
In truth, bonds are securities just like stocks. They are subject to the same, sometimes irrational, swings in investor emotion. And given that bonds are priced based on the income they produce, they are very vulnerable to increases in interest rates and increases in inflation.
So I think that Helen Keller’s point is well taken—instead of pretending that you are safe, make sure you understand the exposures you have and make sure you take them on intentionally.
Source: Wikipedia (click on image to enlarge)
Posted by: Mike Moody
Every time I read an article about how active investing is hopeless, I shake my head. Most of the problem is investor behavior, not active investing. The data on this has been around for a while, but is ignored by indexing fans. Consider for example, this article in Wealth Management that discusses a 2011 study conducted by Morningstar and the Investment Company Institute. What they found doesn’t exactly square out with most of what you read. Here are some excerpts:
But studies by Morningstar and the Investment Company Institute (ICI) suggest that fund shareholders may not be so dumb after all. According to the latest data, investors gravitate to low-cost funds with strong track records. “People make reasonably intelligent choices when they pick active funds,” says John Rekenthaler, Morningstar’s vice president of research.
The academic approach produces a distorted picture, says Rekenthaler. “It doesn’t matter what percentage of funds trail the index,” says Rekenthaler. “What matters most is how the big funds do. That’s where most of the money is.”
In order to get a realistic picture of fund results, Rekenthaler calculated asset-weighted returns—the average return of each invested dollar. Under his system, large funds carry more weight than small ones. He also calculated average returns, which give equal weight to each fund. Altogether Morningstar looked at how 16 stock-fund categories performed during the ten years ending in 2010. In each category, the asset-weighted return was higher than the result that was achieved when each fund carried the same weight.
Consider the small-growth category. On an equal-weighted basis, active funds returned 2.89 percent annually and trailed the benchmark, which returned 3.78 percent. But the asset-weighted figure for small-growth funds exceeded the benchmark by 0.20 percentage points. Categories where active funds won by wide margins included world stock, small blend, and health. Active funds trailed in large blend and mid growth. The asset-weighted result topped the benchmark in half the categories. In most of the eight categories where the active funds lagged, they trailed by small margins. “There is still an argument for indexing, but the argument is not as strong when you look at this from an asset-weighted basis,” says Rekenthaler.
The numbers indicate that when they are choosing from among the many funds on the market, investors tend to pick the right ones.
Apparently investors aren’t so dumb when it comes to deciding which funds to buy. Most of the actively invested money in the mutual fund industry is in pretty good hands. Academic studies, which weight all funds equally regardless of assets, don’t give a very clear picture of what investors are actually doing.
Where, then, is the big problem with active investing? There isn’t one—the culprit is investor behavior. As the article points out:
But investors display remarkably bad timing for their purchases and sales. Studies by research firm Dalbar have shown that over the past two decades, fund investors have typically bought at market peaks and sold at troughs.
Active investing is alive and well. (I added the bold.) In fact, the recent trend toward factor investing, which is just a very systematic method for making active bets, reinforces the value of the approach.
The Morningstar/ICI research just underscores that much of the value of an advisor may lie in helping the client control their emotional impulse to sell when they are fearful and to buy when they feel confident. I think this is often overlooked. If your client has a decent active fund, you can probably help them more by combatting their destructive timing than you can by switching them to an index fund. After all, owning an index fund does not make the investor immune to emotions after a 20% drop in the stock market!
Posted by: Mike Moody
Simplicity is the ultimate sophistication.—-Leonardo di Vinci
This quotation doubles as the title of a Vanguard piece discussing the merits of a simple fund portfolio. However, it occurred to me that their guidelines that make the simple fund portfolio work are the same for making any investment strategy work. They are:
- adopt the investment strategy
- embrace it with confidence, and
- endure the inevitable ups and downs in the markets
Perhaps this seems obvious, but we see many investors acting differently, more like this:
- adopt the investment strategy that has been working lately
- embrace it tentatively, as long as it has good returns
- bail out during the inevitable ups and downs in the markets
- adopt another investment strategy that has been working lately…
You can see the problem with this course of action. The investment strategy is only embraced at the peak of popularity—usually when it’s primed for a pullback. Even that would be a minor problem if the commitment to the investment strategy were strong. But often, investors bail out somewhere near a low. This is the primary cause of poor investor returns according to DALBAR.
Investing well need not be terribly complicated. Vanguard’s three guidelines are good ones, whether you adopt relative strength as we have or some different investment strategy. If the strategy is reasonable, commitment and patience are the big drivers of return over time. As Vanguard points out:
Complexity is not necessarily sophisticated, it’s just complex.
Words to live by.
Posted by: Mike Moody
The Arrow DWA Balanced Fund (DWAFX)
At the end of June, the fund had approximately 46% in U.S. Equities, 26% in Fixed Income, 16% in International Equities, and 12% in Alternatives. The U.S. equity markets pulled back in for the first couple weeks of June as the market continues to digest the likelihood of the eventual “tapering” of the Federal Reserve’s quantitative easing program which has served to hold interest rates down. However, the equity markets showed signs of stabilizing towards the end of the month. Most of our U.S. equity holdings held up relatively well in June, with some areas (Consumer Cyclicals) actually showing a small gain for the month. Small and mid-caps, which we own, also held up relatively well and continued to show positive relative strength compared to large caps for the year. U.S. equities continue to be an overweight in the fund. International equities pulled back even more sharply than U.S. equities in June. Developed international markets have been performing better than emerging markets this year and now all five of our current international equity positions are in developed markets (Mexico was replaced with Japan in June). Japanese equities pulled back sharply in May, but were actually positive in June and remain among the strongest international equity markets for the year. We had relatively weak performance in our alternatives (real estate and the currency carry trade). Our exposure to alternatives remains near its lower constraint of 10% of the fund. Interest rates made a pretty strong move higher in June and most sectors of fixed income declined. About half of our fixed income exposure is in short-term U.S. Treasurys and held up relatively well.
DWAFX lost 2.06% in June, but remains up 5.39% through 6/30/13.
We believe that a real strength of this strategy is its balance between remaining diversified, while also adapting to market leadership. When an asset class is weak its exposure will tend to be towards the lower end of the exposure constraints, and when an asset class is strong its exposure in the fund will trend toward the upper end of its exposure constraints. Relative strength provides an effective means of determining the appropriate weights of the strategy.
The Arrow DWA Tactical Fund (DWTFX)
At the end of June, the fund had approximately 90% in U.S. Equities and 9% in International Equities. Historically, it has been pretty rare to have this much exposure to U.S. equities in this strategy. The fact that U.S. equities have had the best relative strength compared to other asset classes is certainly a different picture that we saw for most of the last decade. It has become “normal” to say that the U.S. equity markets are in a structural bear market, but with the breakout to new highs this year it is quite possible that we may have transitioned to more of a structural bull market. Of course, one never knows how long any trend will persist and our methodology is designed to adapt regardless of how the future ultimately plays out. There was a pullback in the equity markets in the first couple weeks of June. Our U.S. equity holdings held up relatively well with Consumer Cyclicals actually showing a small gain for the month and a number of our other positions, including small and mid-caps, holding up better than large caps. We did remove a position to international real estate in June and it was replaced with more U.S. equity exposure. The rise in interest rates has not helped the performance of real estate and fixed income. Although this fund also has the ability to invest in commodities, we currently have no exposure to this asset class due to its weakness. Japanese equities pulled back sharply in May, but were actually positive in June and remain among the strongest international equity markets for the year.
DWTFX was down 0.67% in June and has gained 10.16% through 6/30/13.
This strategy is a go-anywhere strategy with very few constraints in terms of exposure to different asset classes. The strategy can invest in domestic equities, international equities, inverse equities, currencies, commodities, real estate, and fixed income. Market history clearly shows that asset classes go through secular bull and bear markets and we believe this strategy is ideally designed to capitalize on those trends. Additionally, we believe that this strategy can provide important risk diversification for a client’s overall portfolio.
See www.arrowfunds.com for more information.
Posted by: Andy Hyer
Click here (financial professionals only) for the monthly review of our Systematic Relative Strength portfolios.
Posted by: Andy Hyer
Jason Zweig has written one of the best personal finance columns for years, The Intelligent Investor for the Wall Street Journal. Today he topped it with a piece that describes his vision of personal finance writing. He describes his job as saving investors from themselves. It is a must read, but I’ll give you a couple of excerpts here.
I was once asked, at a journalism conference, how I defined my job. I said: My job is to write the exact same thing between 50 and 100 times a year in such a way that neither my editors nor my readers will ever think I am repeating myself.
That’s because good advice rarely changes, while markets change constantly. The temptation to pander is almost irresistible. And while people need good advice, what they want is advice that sounds good.
The advice that sounds the best in the short run is always the most dangerous in the long run. Everyone wants the secret, the key, the roadmap to the primrose path that leads to El Dorado: the magical low-risk, high-return investment that can double your money in no time. Everyone wants to chase the returns of whatever has been hottest and to shun whatever has gone cold. Most financial journalism, like most of Wall Street itself, is dedicated to a basic principle of marketing: When the ducks quack, feed ‘em.
In practice, for most of the media, that requires telling people to buy Internet stocks in 1999 and early 2000; explaining, in 2005 and 2006, how to “flip” houses; in 2008 and 2009, it meant telling people to dump their stocks and even to buy “leveraged inverse” exchange-traded funds that made explosively risky bets against stocks; and ever since 2008, it has meant touting bonds and the “safety trade” like high-dividend-paying stocks and so-called minimum-volatility stocks.
It’s no wonder that, as brilliant research by the psychologist Paul Andreassen showed many years ago, people who receive frequent news updates on their investments earn lower returns than those who get no news. It’s also no wonder that the media has ignored those findings. Not many people care to admit that they spend their careers being part of the problem instead of trying to be part of the solution.
My job, as I see it, is to learn from other people’s mistakes and from my own. Above all, it means trying to save people from themselves. As the founder of security analysis, Benjamin Graham, wrote in The Intelligent Investor in 1949: “The investor’s chief problem – and even his worst enemy – is likely to be himself.”
From financial history and from my own experience, I long ago concluded that regression to the mean is the most powerful law in financial physics: Periods of above-average performance are inevitably followed by below-average returns, and bad times inevitably set the stage for surprisingly good performance.
But humans perceive reality in short bursts and streaks, making a long-term perspective almost impossible to sustain – and making most people prone to believing that every blip is the beginning of a durable opportunity.
But this time is never different. History always rhymes. Human nature never changes. You should always become more skeptical of any investment that has recently soared in price, and you should always become more enthusiastic about any asset that has recently fallen in price. That’s what it means to be an investor.
Simply brilliant. Unless you write a lot, it seems deceptively easy to write this well and clearly. It is not. More important, his message that many investment problems are actually investor behavior problems is very true—and has been true forever.
To me, one of the chief advantages of technical analysis is that it recognizes that human nature never changes and that, as a result, behavior patterns recur again and again. Investors predictably panic when market indicators get deeply oversold, just when they should consider buying. Investors predictably want to pile into a stock that has been a huge long-term winner when it breaks a long-term uptrend line—because “it’s a bargain”—just when they might want to think about selling. Responding deliberately at these junctures doesn’t usually require the harrowing activity level that CNBC commentators seem to believe is necessary, but can be quite effective nonetheless. Technical indicators and sentiment surveys often show these turning points very clearly, but as Mr. Zweig describes elsewhere in the article, the financial universe is arranged to deceive us—or at least to tempt us to deceive ourselves.
Investing is one of the many fields where less really is more.
Posted by: Mike Moody