Mike Moody and 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
Posted by: Andy Hyer
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
From Barry Ritholz at The Big Picture comes a great article about what he calls “competency transference.” His article was triggered by a Bloomberg story about a technology mogul who turned his $1.8 billion payoff into a bankruptcy just a few years later. Mr. Ritholz points out that the problem is generalizable:
Be aware of what I call The Fallacy of Competency Transference. This occurs when someone successful in one field jumps in to another and fails miserably. The most widely known example is Michael Jordan, the greatest basketball player the game has ever known, deciding he was also a baseball player. He was a .200 minor league hitter.
I have had repeated conversations with Medical Doctors about this: They are extremely intelligent accomplished people who often assume they can do well in markets. (After all, they conquered what I consider a much more challenging field of medicine).
The problem they run into is that competency transference. After 4 years of college (mostly focused on pre-med courses), they spend 4 years in Medical school; another year as an Interns, then as many as 8 years in Residency. Specialized fields may require training beyond residency, tacking on another 1-3 years. This process is at least 12, and as many as 20 years (if we include Board certification).
What I try to explain to these highly educated, highly intelligent people is that they absolutely can achieve the same success in markets that they have as medical professionals — they just have to put the requisite time in, immersing themselves in finance (like they did in medicine) for a decade or so. It is usually around this moment that the light bulb goes off, and the cause of prior mediocre performance becomes understood.
To me, the funny thing is that competency transference mostly applies to the special case of financial markets. For example, no successful stock market professional would ever, ever assume themselves to be a competent thoracic surgeon without the requisite training. Nor would a medical doctor ever assume that he or she could play a professional sport or run a nuclear submarine without the necessary skills. (I think the Michael Jordan analogy is a poor one, since there have been numerous multi-sport athletes. Many athletes letter in multiple sports in high school and some even play more than one in college. Michael Jordan may have been wrong about his particular case, but it wasn’t necessarily a crazy idea.)
Nope, competency transference is mostly restricted to the idea that anyone watching CNBC can become a market maven. (Apparently even talking heads on CNBC believe this.) This creates no end of grief in advisor-client relationships if 1) the advisor isn’t very far up the learning curve, and 2) if the client thinks they know better. You would have the same problem if you had a green medical doctor and you thought you knew more than the doctor did. That is a situation that is ripe for problems!
Advisors need to work continuously to expand their skills and knowledge if they are to be of use to investors. And investors, in general, would do well to spend their efforts vetting advisors carefully rather than assuming financial markets are a piece of cake.
Posted by: Mike Moody
This is a relatively brief document outlining the history of DWA, our investment methodology, and existing products & services. We get frequent requests for this type of material from advisors introducing a tactical strategy or an RS-based product, so feel free to use it in any way that you feel it can help you explain your own investment process and support system.
Posted by: JP Lee
This is the title of a nice article by Brett Arends at Marketwatch. He points out that a lot of our assumptions, especially regarding risk, are open to question.
Risk is an interesting topic for a lot of reasons, but principally (I think) because people seem to be obsessed with safety. People gravitate like crazy to anything they perceive to be “safe.” (Arnold Kling has an interesting meditation on safe assets here.)
Risk, though, is like matter–it can neither be created nor destroyed. It just exists. When you buy a safe investment, like a U.S. Treasury bill, you are not eliminating your risk; you are just switching out of the risk of losing your money into the risk of losing purchasing power. The risk hasn’t gone away; you have just substituted one risk for another. Good investing is just making sure you’re getting a reasonable return for the risk you are taking.
In general, investors–and people generally–are way too risk averse. They often get snookered in deals that are supposed to be “low risk” mainly because their risk aversion leads them to lunge at anything pretending to be safe. Psychologists, however, have documented that individuals make more errors from being too conservative than too aggressive. Investors tend to make that same mistake. For example, nothing is more revered than a steady-Eddie mutual fund. Investors scour magazines and databases to find a fund that (paradoxically) is safe and has a big return. (News flash: if such a fund existed, you wouldn’t have to look very hard.)
No one goes looking for high-volatility funds on purpose. Yet, according to an article, Risk Rewards: Roller-Coaster Funds Are Worth the Ride at TheStreet.com:
Funds that post big returns in good years but also lose scads of money in down years still tend to do better over time than funds that post slow, steady returns without ever losing much.
The tendency for volatile investments to best those with steadier returns is even more pronounced over time. When we compared volatile funds with less volatile funds over a decade, those that tended to see big performance swings emerged the clear winners. They made roughly twice as much money over a decade.
That’s a game changer. Now, clearly, risk aversion at the cost of long-term returns may be appropriate for some investors. But if blind risk aversion is killing your long-term returns, you might want to re-think. After all, eating Alpo is not very pleasant and Maalox is pretty cheap. Maybe instead of worrying exclusively about volatility, we should give some consideration to returns as well.
—-this article originally appeared 3/3/2010. A more recent take on this theme are the papers of C. Thomas Howard. He points out that volatility is a short-term factors, while compounded returns are a long-term issue. By focusing exclusively on volatility, we can often damage long term results. He re-defines risk as underperformance, not volatility. However one chooses to conceptualize it, blind risk aversion can be dangerous.
Posted by: Mike Moody
Financial Advisor had a recent article in which they discussed a retirement success study conducted by Putnam. Quite logically, Putnam defined retirement success by being able to replace your income in retirement. They discovered three keys to retirement success:
- Working with a financial advisor
- Having access to an employer-sponsored retirement plan
- Being dedicated to personal savings
None of these things is particularly shocking, but taken together, they illustrate a pretty clear path to retirement success.
- Investors who work with a financial advisor are on track to replace 80 percent of their income in retirement, Putnam says. Those who do not are on track to replace 56 percent.
- Workers who are eligible for a workplace plan are on track to replace 73 percent of their income while those without access replace only 41 percent.
- The ability to replace income in retirement is not tied to income level but rather to savings level, Putnam says. Those families that save 10 percent or more of their income, no matter what the income level, are on track to replace 106 percent of their income in retirement, which underscores the importance of consistent savings, the study says.
I added the bold. It’s encouraging that retirement success is tied to savings level, not income level. Everyone has a chance to succeed in retirement if they are willing to save and invest wisely. It’s not just an opportunity restricted to top earners. Although having a retirement plan at work is very convenient, you can still save on your own.
It’s also interesting to me how much working with a financial advisor can increase the ability to replace income in retirement. Maybe advisors are helping clients invest more wisely, or maybe they are just nagging them to save more. Whatever the combination of factors, it’s clearly making a big difference. Given that the average income replacement level found in the study was 61%, working with an advisor moved clients from below average (56%) to well above average (80%) success.
This study, like pretty much every other study of retirement success, also shows that nothing trumps savings. After all, no amount of clever investment management can help you if you have no capital to work with. For investors, Savings is Job One.
Posted by: Mike Moody
Posted by: Andy Hyer
Investment manager selection is one of several challenges that an investor faces. However, if manager selection is done well, an investor has only to sit patiently and let the manager’s process work—not that sitting patiently is necessarily easy! If manager selection is done poorly, performance is likely to be disappointing.
For some guidance on investment manager selection, let’s turn to a recent article in Advisor Perspectives by C. Thomas Howard of AthenaInvest. AthenaInvest has developed a statistically validated method to forecast fund performance. You can (and should) read the whole article for details, but good investment manager selection boils down to:
- investment strategy
- strategy consistency
- strategy conviction
This particular article doesn’t dwell on investment strategy, but obviously the investment strategy has to be sound. Relative strength would certainly qualify based on historical research, as would a variety of other return factors. (We particularly like low-volatility and deep value, as they combine well with relative strength in a portfolio context.)
Strategy consistency is just what it says—the manager pursues their chosen strategy without deviation. You don’t want your value manager piling into growth stocks because they are in a performance trough for value stocks (see Exhibit 1999-2000). Whatever their chosen strategy or return factor is, you want the manager to devote all their resources and expertise to it. As an example, every one of our portfolio strategies is based on relative strength. At a different shop, they might be focused on low-volatility or small-cap growth or value, but the lesson is the same—managers that pursue their strategy with single-minded consistency do better.
Strategy conviction is somewhat related to active share. In general, investment managers that are willing to run relatively concentrated portfolios do better. If there are 250 names in your portfolio, you might be running a closet index fund. (Our separate accounts, for example, typically have 20-25 positions.) A widely dispersed portfolio doesn’t show a lot of conviction in your chosen strategy. Of course, the more concentrated your portfolio, the more it will deviate from the market. For managers, career risk is one of the costs of strategy conviction. For investors, concentrated portfolios require patience and conviction too. There will be a lot of deviation from the market, and it won’t always be positive. Investors should take care to select an investment manager that uses a strategy the investor really believes in.
AthenaInvest actually rates mutual funds based on their strategy consistency and conviction, and the statistical results are striking:
The higher the DR [Diamond Rating], the more likely it will outperform in the future. The superior performance of higher rated funds is evident in Table 1. DR5 funds outperform DR1 funds by more than 5% annually, based on one-year subsequent returns, and they continue to deliver outperformance up to five years after the initial rating was assigned. In this fashion, DR1 and DR2 funds underperform the market, DR3 funds perform at the market, and DR4 and DR5 funds outperform. The average fund matches market performance over the entire time period, consistent with results reported by Bollen and Busse (2004), Brown and Goetzmann (1995) and Fama and French (2010), among others.
Thus, strategy consistency and conviction are predictive of future fund performance for up to five years after the rating is assigned.
The bold is mine, as I find this remarkable!
I’ve reproduced a table from the article below. You can see that the magnitude of the outperformance is nothing to sniff at—400 to 500 basis points annually over a multi-year period.
Source: Advisor Perspectives/AthenaInvest (click on image to enlarge)
The indexing crowd is always indignant at this point, often shouting their mantra that “active managers don’t outperform!” I regret to inform them that their mantra is false, because it is incomplete. What they mean to say, if they are interested in accuracy, is that “in aggregate, active managers don’t outperform.” That much is true. But that doesn’t mean you can’t locate active managers with a high likelihood of outperformance, because, in fact, Tom Howard just demonstrated one way to do it. The “active managers don’t outperform” meme is based on a flawed experimental design. I tried to make this clear in another blog post with an analogy:
Although I am still 6’5″, I can no longer dunk a basketball like I could in college. I imagine that if I ran a sample of 10,000 random Americans and measured how close they could get to the rim, very few of them could dunk a basketball either. If I created a distribution of jumping ability, would I conclude that, because I had a large sample size, the 300 people would could dunk were just lucky? Since I know that dunking a basketball consistently is possible–just as Fama and French know that consistent outperformance is possible–does that really make any sense? If I want to increase my odds of finding a portfolio of people who could dunk, wouldn’t it make more sense to expose my portfolio to dunking-related factors–like, say, only recruiting people who were 18 to 25 years old and 6’8″ or taller?
In other words, if you look for the right characteristics, you have a shot at finding winning investment managers too. This is valuable information. Think of how investment manager selection is typically done: “What was your return last year, last three years, last five years, etc.?” (I know some readers are already squawking, but the research literature shows clearly that flows follow returns pretty closely. Most “rigorous due diligence” processes are a sham—and, unfortunately, research shows that trailing returns alone are not predictive.) Instead of focusing on trailing returns, investors would do better to locate robust strategies and then evaluate managers on their level of consistency and conviction.
Posted by: Mike Moody
Posted by: Andy Hyer
Posted by: Andy Hyer
Index Universe has a provocative article by Rob Arnott and John West of Research Affiliates. Their contention is that 2000-2009 was not really a lost decade. Perhaps if your only asset was U.S. equities it would seem that way, but they point out that other, more exotic assets actually had respectable returns.
The table below shows total returns for some of the asset classes they examined.
click to enlarge
What are the commonalities of the best performing assets? 1) Lots of them are highly volatile like emerging markets equities and debt, 2) lots of them are international and thus were a play on the weaker dollar, 3) lots of them were alternative assets like commodities, TIPs, and REITs.
In other words, they were all asset classes that would tend to be marginalized in a traditional strategic asset allocation, where the typical pie would primarily consist of domestic stocks and bonds, with only small allocations to very volatile, international, or alternative assets.
In an interesting way, I think this makes a nice case for tactical asset allocation. While it is true that most investors–just from a risk and volatility perspective–would be unwilling to have a large allocation to emerging markets for an entire decade, they might find that periodic significant exposure to emerging markets during strong trends would be quite acceptable. And even assets near the bottom of the return table like U.S. Treasury bills would have been very welcome in a portfolio during parts of 2008, for example. You can cover the waterfront and just own an equal-weighted piece of everything, but I don’t know if that is the most effective way to do things.
What’s really needed is a systematic method for determining which asset classes to own, and when. Our Systematic Relative Strength process does this pretty effectively, even for asset classes that might be difficult or impossible to grade from a valuation perspective. (How do you determine whether the Euro is cheaper than energy stocks, or whether emerging market debt is cheaper than silver or agricultural commodities?) Once a systematic process is in place, the investor can be slightly more comfortable with perhaps a higher exposure to high volatility or alternative assets, knowing that in a tactical approach the exposures would be adjusted if trends change.
—-this article originally appeared 2/17/2010. There is no telling what the weak or strong assets will be for the coming decade, but I think global tactical asset allocation still represents a reasonable way to deal with that uncertainty.
Posted by: Mike Moody
You don’t know jack about what the market is going to do. Neither do I. None of us really do. Falling back on investment process is the only way to survive in the long run. Bob Seawright of Above the Market has a great commentary on investment process and randomness:
In what [Daniel] Kahneman calls the “planning fallacy,” our ability even to forecast the future, much less control the future, is extremely limited and is far more limited than we want to believe. In his terrific book, Thinking, Fast and Slow, Kahneman describes the “planning fallacy” as a corollary to optimism bias (think Lake Wobegon – where all the children are above average) and self-serving bias (where the good stuff is my doing and the bad stuff is always someone else’s fault). Most of us overrate our own capacities and exaggerate our abilities to shape the future. The planning fallacy is our tendency to underestimate the time, costs, and risks of future actions and at the same time overestimate the benefits thereof. It’s at least partly why we underestimate bad results. It’s why we think it won’t take us as long to accomplish something as it does. It’s why projects tend to cost more than we expect. It’s why the results we achieve aren’t as good as we expect. It’s why I take three trips to Home Depot on Saturdays. We are all susceptible – clients and financial professionals alike.
As a consequence, in all probabilistic fields, the best performers dwell on process. This is true for great value investors, great poker players, and great athletes. A great hitter focuses upon a good approach, his mechanics, being selective and hitting the ball hard. If he does that – maintains a good process – he will make outs sometimes (even when he hits the ball hard) but the hits will take care of themselves. Maintaining good process is really hard to do psychologically, emotionally, and organizationally. But it is absolutely imperative for investment success.
I flipped Mr. Seawright’s paragraphs around, but that’s just how I think. The emphasis is mine, but I think Mr. Seawright is correct about all of this. We are often attracted by shiny things, by the hedge fund manager that had the big hit last year, but the real winners are the investors with a great process that they stick with through thick and thin. Those investors often sustain good track records for decades. Maintaining good process is really hard to do, but the rewards over time make it worth the effort.
Posted by: Mike Moody