Consumer Confidence

July 29, 2010

It’s very difficult to maintain conviction in the stock market as an investment vehicle when the economy is so rotten.  (Frankly, it’s never very easy!)   The market was rattled a little bit this week when it was reported that one of the consumer confidence indexes was down again.  The bears aggressively took to the airwaves, discussing how the economy could not recover unless and until consumers felt better about things.

This made me curious.  What actually happens to the stock market when consumer sentiment is poor? J.P. dug up all of the data from the University of Michigan’s Consumer Sentiment Index, which runs back to 1978.  He broke all of the monthly observations into deciles and examined stock market returns over the subsequent five years.

(click to expand image)

Interesting, isn’t it?  When consumer sentiment was low–in the bottom three deciles–subsequent five-year returns in the S&P 500 were over 12% per year, significantly higher than the 9.3% average over the entire sample period.  When consumers felt absolutely fantastic about things and sentiment was in the top decile, subsequent five-year returns were actually negative!  Confident consumers engage in reckless behaviors that sow the seeds for the next downturn.  Fearful consumers engage in behaviors that build the foundation for the next upturn.

Right now, consumer sentiment resides in the second decile.  Based on historical precedent, subsequent five-year returns are likely to be above average from here.

It is well-known that advisory sentiment indexes can be interpreted in a contrary fashion, and it seems that consumer sentiment may fall into the same category, at least over the longer term.  This is one of the many reasons investing is difficult–it is an uphill climb against human nature to be bullish when conditions are poor.  To buy when the outlook is dim takes a real leap of faith–and a steadfast optimism that things will improve over time.  When things seem like they can’t get any worse, it just might be because they really can’t get any worse–and are about to get better.

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

Dorsey, Wright Sentiment Survey – 7/19/10

July 19, 2010

Last survey’s readings were the most extreme we’ve seen.  Thanks for participating.

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

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

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

Leave a Comment » | Investor Behavior, Markets | Permalink
Posted by JP Lee

Retail versus Institutional

July 12, 2010

Are retail or institutional investors better at getting performance out of their funds?  The answer turns out to be neither!  After an examination of investor returns versus NAV returns for various share classes, Morningstar comments:

One thing is clear: Across the board, investor returns are lower than total returns. Regardless of sales channel, the data don’t provide evidence that advisors and institutions do an excellent job timing their moves while other channels are rife with fickle investors. In aggregate, they’re all losing money to poor timing.

Thrashing around doesn’t help.  Study the various available return factors and then stick with your program.  We like relative strength because of its historical performance and great adaptability, but other factors work as well.  In particular, deep value mixes nicely with relative strength.

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

Fluidity of Fund Rankings

July 9, 2010

The more commentary I read from Morningstar, the more sensible I think they are.  Yet I suspect many advisors are misusing the tools that Morningstar provides, or certainly not using the tools in a nuanced way as Morningstar recommends.

For example, a recent article discussed a very topical issue: how to determine if your slumping fund or advisor has permanently lost their touch.  Clients grapple with this issue all the time and, most frequently, get it wrong.  Studies show that both retail and institutional investors tend to terminate advisors after a period of poor performance and to hire advisors after a period of good performance.  Most often, this period tends to be temporary and the studies have demonstrated that investors cost themselves an enormous amount of money by doing so.

On the other hand, no client wants to be permanently stuck with a lousy manager.  So how can you differentiate?

There are a couple of different conditions in which Morningstar suggests you not act too impetuously.

1. Funds that don’t follow the crowd often have very different performance profiles than the broad market.  Their ranking can zig when the market zags.  (Our Systematic portfolios tend to visit both the top and bottom deciles with regularity.) 

2. Sometimes an anomalous time period can make a fund look worse than it is.  Relying on the ranking of a value fund at the end of a growth cycle, or vice versa, would probably be a significant mistake.

In both cases, the fund’s peer ranking can suffer, but as Morningstar points out, the ranking often comes roaring back.  The rankings are exceptionally fluid because the returns are often tightly clustered.  For example:

…most category rankings are based on a tightly constrained range. In the large-value category, a 10-year annualized gain of 1.6% lands a fund in the group’s worst third, but a 3.1% gain puts it in the top third. Neither is good on an absolute basis. It is easy to see how a good month or two is all it would take to vault a fund from the group’s basement to its penthouse, and vice versa.

I’ve added the emphasis because I don’t think the fluidity in ranking is generally understood by the investing public.  If a good month or two can swing your 10-year ranking significantly, it seems to me that it is much more important to understand the manager’s process than it is to worry about the temporary ranking.  Rankings can be unstable; process is permanent.

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

Dorsey, Wright Sentiment Survey 7/2/10

July 2, 2010

Our last survey’s participation rate fell off its highs.  Hopefully we’ll be right back up there this week!

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

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

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

Leave a Comment » | Investor Behavior, Markets | Permalink
Posted by JP Lee

Dorsey, Wright Sentiment Survey Results – 6/18/10

June 28, 2010

Our latest sentiment survey was open from 6/18/10 to 6/25/10.  The response rate fell off its all-time highs, clocking in at 139 respondents.  Your input is for a good cause!  If you believe, as we do, that markets are driven by supply and demand, client behavior is important.  We’re not asking what you think of the market—since most of our blog readers are financial advisors, we’re asking instead about the behavior of your clients.  Then we’re aggregating responses exclusively for our readership.  Your privacy will not be compromised in any way.

After the first 30 or so responses, the established pattern was simply magnified, so we are comfortable about the statistical validity of our sample.  Most of the responses were from the U.S., but we also had multiple advisors respond from at least two other countries.  Let’s get down to an analysis of the data!  Note: You can click on any of the charts to enlarge them.

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

Chart 1: Greatest Fear.  85.6% of clients were fearful of a downturn, as the bounce off recent lows seems to have alleviated some of the hair-pulling we’ve noticed lately.  The market action of the last two months has pushed investor sentiment to very bearish, pessimistic levels, but the modest bounce has taken the edge off; last survey’s fear reading was at 89.1%.  Only 14.4% of clients were concerned about missing an up-move, a slight push higher from last survey’s reading of 10.9%.  Overall, we are still seeing a strongly pessimistic outlook in client sentiment.

Chart 2. Greatest Fear Spread.  Another way to look at this data is to examine the spread between the two groups.  The spread remains significantly skewed towards fear of losing money this round.  This survey’s reading was 71%, down from last survey’s 78%.  Chart 2 is constructed by subtracting the percentage of respondents reporting clients fearful of missing an upturn from the clients reported as fearful of a market downdraft.

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

Chart 3: Average Risk Appetite.  The average risk appetite for this survey moved in-line with the other stats we’ve gone over thus far.  With a modest bounce in the market, client fear has abated slightly, while the average risk appetite has also ticked higher.  This survey’s average risk appetite was 2.29, up from last week’s reading of 2.18.

Chart 4: Risk Appetite Bell Curve.  This chart uses a bell curve to break out the percentage of respondents at each risk appetite level.  Right now the bell curve is biased to the low-risk side, as it has been for the last two months or so.  What we see in the bell curve is just more evidence that clients are afraid of losing money in the market.  Just as in last survey, we have absolutely zero 5’s, which points towards a market dominated by fear.

Chart 5: Risk Appetite Bell Curve by Group.  The next three charts use cross-sectional data.  This chart plots the reported client risk appetite separately for the fear of downdraft and for the fear of missing upturn groups.  We would expect that the fear of downdraft group would have a lower risk appetite than the fear of missing upturn group and that is what we see here.

Again we have a total of zero responses with a risk appetite of 5, indicating pervasive fear in the marketplace.  Only time will tell if these “oversold” emotional conditions will lead to a market rally.

Chart 6: Average Risk Appetite by Group.  A plot of the average risk appetite score by group is shown in this chart.  The fear of missing downdraft group had an average risk appetite of 2.18, while the fear of missing upturn group had an average risk appetite of 2.95.  Theoretically, this is what we would expect to see.

In the last survey recap, we highlighted the fact that the missing upturn group seems to have a more volatile risk tolerance – their risk appetite as a group seems to swing more frequently and further than the downdraft group.  We see this again, with the missing upturn average bouncing 20 basis points from 2.75 to 2.95, versus only a 7 basis point move in the downdraft group, from 2.11 to 2.18.

Chart 7: Risk Appetite Spread.  This is a spread chart constructed from the data in Chart 6, where the average risk appetite of the downdraft group is subtracted from the average risk appetite of the missing upturn group.  The spread is currently .77, a modest bounce from last survey’s reading of .63.

This round of sentiment survey is still suffering from the effects of the market mini-meltdown which started in late April.  The last survey was conducted on 6/8/10, near the lows of the latest downturn; this survey was conducted on 6/18/10, which was the most recent high.  The volatility of the last 2 months has put a significant damper on client mood – it seems like the biggest factor in client sentiment is what happened over the last two weeks.  As we like to emphasize, it’s important for the advisor to keep the client’s eye on the prize – long term performance. In two weeks, anything can happen in the markets, and as these surveys point out, a client’s emotional tolerance for pain can swing just as easily.  It’s your job as an advisor to help the client manage his emotional proclivity to shift his long-term investment objectives, based on short-term market action.

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

Leave a Comment » | Investor Behavior, Markets, Sentiment | Permalink
Posted by JP Lee

Your Money or Your Life

June 23, 2010

This used to be just a cliche that muggers would use when relieving you of your wallet.  Apparently Americans headed toward retirement feel like they are being mugged as well.  According to an Allianz Life Insurance study cited in Financial Planning magazine,

…more respondents between the ages of 44 and 49 say they fear outliving their assets more than they fear death (77% versus 23%).

In other words, an overwhelming majority consider running out of money a fate worse than death.  Saving and investing must be far worse than death because Americans really don’t want to do that.

Leave a Comment » | Investor Behavior, Just for Fun, Retirement/Saving | Permalink
Posted by Mike Moody

Global Macro: It’s Not Just for Breakfast Anymore

June 23, 2010

Bloomberg Businessweek has a nice article about how small investors are currently embracing hedge fund-like strategies.  One of the most prominent hedge fund strategies is global macro, in which the manager has the freedom to forage among all kinds of global asset classes.  At Dorsey, Wright we offer exposure to a global macro strategy through both a separate account (Global Macro) and a mutual fund (Arrow DWA Tactical Fund, DWTFX).

Retail investors are intrigued for a couple of reasons.  After large losses in 2008, investors seem to be more willing to explore alternative asset classes and to experiment with a more tactical approach.  There may also be some level of disenchantment with strategic asset allocation, which did not perform as expected during the last bear market.

According to the article, one of the significant attractions of hedge fund-like strategies is this:

Hedge funds as an asset class have a high correlation to equities during bull markets and a low correlation during bear markets…

This is certainly true of our global macro asset class rotation strategy using a systematic relative strength criterion.  If you dig into our recent white paper on asset class rotation, you can see how the portfolio beta ranges up and down in different environments.

[click on the image to enlarge it]

Source: Dorsey, Wright Money Management

The big shift in perspective, though, has to do with the level of allocation to tactical strategies.  In the core-satellite approach, tactical or global macro approaches were typically considered as part of the satellite package and were given small capital allocations.  That has changed rather dramatically.  According to one fund manager interviewed in the article [my emphasis]:

…while the tactical approach is labeled “alternative,” it’s not attracting the typical alternative-asset allocation of 3 percent to 5 percent. “More often, [retail investors] are making this a core allocation. We’re getting a 35% core allocation typically because advisors don’t think they’re getting return expectations or risk [protection] out of traditional strategies.”

We’ve seen much the same thing since the launch of our popular Global Macro separate account last year–very often this portfolio is operating as a core allocation for clients.

What has caused the change in mindset?  Clients appear to be interested in the strategy for multiple reasons.  Some clients gain comfort that it can hold growth assets–but it’s not necessarily locked into holding them in difficult markets.  Other clients seem to be attracted by the fact that the menu is broad and encompasses domestic and international equities, fixed income, currencies, commodities, real estate, and inverse funds.  Like all global macro strategies, that leaves it free to pursue returns wherever they may be.  Other clients focus on the ways in which our portfolio is different: unlike an actual hedge fund, for example, our portfolios do not employ leverage and have a much higher level of transparency than a traditional global macro fund.

Whatever the reasons, it seems that tactical global allocation is increasingly being considered part of investors’ core allocation.

To obtain a fact sheet and prospectus for the Arrow DWA Tactical Fund (DWTFX), click here or call Jake Griffith at 301-260-0163.

Click here for disclosures.  Past performance is no guarantee of future results.

Leave a Comment » | Investor Behavior, Markets, Tactical Asset Alloc | Permalink
Posted by Mike Moody

Dorsey, Wright Sentiment Survey – 6/18/10

June 18, 2010

Our participation rate is hovering near all-time highs; thank you very much for participating.  Let’s keep the momentum going!

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

Click here to take this week’s client survey!

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

Leave a Comment » | Investor Behavior | Permalink
Posted by JP Lee

Gentlemen Prefer Bonds?

June 16, 2010

According to CNBC.com, the world’s largest bond manager, Bill Gross of PIMCO, is shifting toward equities.

Global bonds guru Bill Gross, chief investment officer of Pimco, told CNBC Wednesday that he is making a shift towards equities.

“We are making a move into equities, period,” said Gross.

His rationale was somewhat surprising, but gives some insight into what he thinks of most sovereign credits these days:

“Corporate equities, in terms of valuation, are selling at very low P/E ratios and in some cases might be perceived to be almost as safe, or almost as secure as the sovereigns themselves,” said Gross.

When even the bond guys aren’t excited about owning bonds, you’ve got to scratch your head.  Retail investors, on the other hand, are still piling money into bonds like crazy, I suspect in an effort to reduce their portfolio volatility.  There might be more productive ways to accomplish the same task without taking on the risk of buying bonds at incredibly low yields.  For example, a global allocation fund (like DWAFX or DWTFX) will typically have less volatility than most of the individual asset classes such as commodities or equities, but won’t necessarily lock you into a bond position.  The volatility will clearly be higher than an all-bond portfolio, but the returns over time are likely to be higher as well.

For information about the Arrow DWA Tactical Fund (DWTFX) & Arrow DWA Balanced Fund (DWAFX), click here.

Click here and here for disclosures.  Past performance is no guarantee of future returns.

Leave a Comment » | Investor Behavior, Markets, Tactical Asset Alloc | Permalink
Posted by Mike Moody

Volatility Is Not The Same Thing as Risk!

June 16, 2010

We repeat this to our investors often, so often I probably mumble it in my sleep.  You can imagine, then, how excited I was to read this great article on risk and volatility by Christine Benz, the personal finance writer at Morningstar.  The article makes so many outstanding points it’s hard to know where to start.  I highly recommend that you read the whole thing more than once.

Ms. Benz starts with the “risk tolerance” section of the typical consulting group questionnaire.  They generally ask at what level of loss an investor would become concerned and pull the plug.  (In my experience, many clients are not very insightful; every advisor has seen at least one questionnaire of a self-reported aggressive investor with a 5% loss tolerance!)  In truth, these questionnaires are next to worthless, and she points out why:

Unfortunately, many risk questionnaires aren’t all that productive. For starters, most investors are poor judges of their own risk tolerance, feeling more risk-resilient when the market is sailing along and becoming more risk-averse after periods of sustained market losses.

Moreover, such questionnaires send the incorrect message that it’s OK to inject your own emotion into the investment process, thereby upending what might have been a carefully laid investment plan.

But perhaps most important, focusing on an investor’s response to short-term losses inappropriately confuses risk and volatility. Understanding the difference between the two–and focusing on the former and not the latter–is a key way to make sure your reach your financial goals.

There are three different issues she addresses here, so let’s look at each of them in turn.

1) You’re a crummy judge of your own risk tolerance.  We all are.  That’s because our money is personal to us.  One of my psychologist clients once exclaimed, “Money is my most neurotic asset!”  It’s much easier to take an outside view and look at it with some psychological distance.  An experienced advisor is more likely to be able to gauge your risk tolerance correctly than you are.  There are also good resources like Finametrica for learning more about psychologically appropriate levels of portfolio risk.  But Ms. Benz really gets to the heart of things: your risk tolerance will change depending on your emotions!  That’s something no advisor can calibrate exactly, nor are you likely to guess how powerfully the swell of fear will hit you after a particularly heinous quarterly statement.

2) It’s not okay to panic.  As Ms. Benz points out, discussing loss tolerance in this fashion implies that it is ok to bail out emotionally at some point.  If you have losses that are uncomfortable, perhaps you need to revisit your overall plan, but it’s unlikely that major modifications are needed if you were thoughtful when you put it together in the first place.  Markets, and strategies, go through tough periods and it’s important to be able to persevere.

3) At the height of emotion, volatility and risk get confused.  Volatility is just a measurement of how much your investments are whipping around at the moment.  Risk isn’t the same thing.  Ms. Benz clarifies the difference:

…volatility usually refers to price fluctuations in a security, portfolio, or market segment during a fairly short time period–a day, a month, a year. Such fluctuations are inevitable once you venture beyond certificates of deposit, money market funds, or your passbook savings account. If you’re not selling anytime soon, volatility isn’t a problem and can even be your friend, enabling you to buy more of a security when it’s at a low ebb.

The most intuitive definition of risk, by contrast, is the chance that you won’t be able to meet your financial goals and obligations or that you’ll have to recalibrate your goals because your investment kitty come up short.

Through that lens, risk should be the real worry for investors; volatility, not so much. A real risk? Having to move in with your kids because you don’t have enough money to live on your own. Volatility? Noise on the evening news, and maybe a frosty cocktail on the night the market drops 300 points.

This is one of the best descriptions of risk I’ve ever read, one that puts opportunity cost front and center.  Risk isn’t your portfolio moving around; that’s just volatility—noise, really.  Risk is eating Alpo in retirement, or as she mentions, being forced to move in with your kids.

Source: Purina

Risk is the very real possibility of having a severe investment shortfall if you avoid volatility like the plague.  Low volatility investments earn low returns (or worse if they are Ponzi achemes).

The challenge of every individual investor, hopefully with help from a qualified financial advisor, is how to balance volatility and return–while keeping risk from sneaking up and biting you you-know-where.  Ms. Benz has some thoughts on this as well:

So how can investors focus on risk while putting volatility in its place? The first step is to know that volatility is inevitable, and if you have a long enough time horizon, you’ll be able to harness it for your own benefit. Using a dollar-cost averaging program–buying shares at regular intervals, as in a 401(k) plan–can help ensure that you’re buying securities in a variety of market environments, whether it feels good or not.

Diversifying your portfolio among different asset classes and investment styles can also go a long way toward muting the volatility of an investment that’s volatile on a stand-alone basis. That can make your portfolio less volatile and easier to live with.

Again, she makes several very cogent points, so let’s deal with them one by one.

1) Volatility is inevitable.  Deal with it.  Preferably by constructing your portfolio thoughtfully in the first place.

2)  Better yet, volatility can be your ally.  Buy on dips.  (Easy to say, harder to do.)  In truth, high-return, high-volatility strategies can be tremendous wealth builders because the long-term returns are good and you get plenty of opportunities to add money during the dips.  Toward that end, we publish a High RS Diffusion Index each week to help identify those dips in our particular strategy.

3) Diversify appropriately.  We believe it’s often more fruitful to mix strategies as opposed to asset classes.  For example, relative strength strategies tend to work very well when blended with deep value strategies.

Ms. Benz lays out the real definition of risk: failing to accomplish your goals.

It also helps to articulate your real risks: your financial goals and the possibility of falling short of them. For most of us, a comfortable retirement is a key goal; the corresponding risk is that we’ll come up short and not have enough money to live the lifestyle we’d like to live.

Clearly, the biggest risk for most investors is their own behavior.  They avoid volatility rather than embracing it.  Instead of buying on dips and being patient with proven strategies, they sell during pullbacks and buy only after an extended period of good performance.  When you start to conceptualize risk as shortfall risk, you can also see that another of your big risks is not saving enough in the first place.  At the risk of sounding like my mom, if you don’t have any money, no investment advisor is going to be able to help you retire.  Savings, too, is behavior that can be modified.

What can be done to help clients embrace volatility, or at least deal constructively with it?  Are there any ”nudges” that can be applied in order to increase their patience and their overall good investment behavior?  Ms. Benz makes a suggestion in this regard:

Many financial advisors have begun to embrace the concept of creating separate “buckets” of a portfolio–and in particular, a bucket for any cash the investor expects to need within the next couple of years.  By carving out a piece of your portfolio that’s sacrosanct and not subject to volatility or risk, you can more readily tolerate fluctuations in the long-term component of your portfolio.

Sure, it’s a cheap psychological trick that plays to the mind’s natural tendency to segment things–but if it helps, why not?  We’ve discussed in the past that a portfolio carved into buckets is functionally equivalent to a balanced or diversified portfolio with the same asset allocation, but if it helps clients behave better then it’s worth trying.

Whether you are an advisor or an individual investor, educating yourself about key concepts like the difference between volatility and risk will pay large dividends down the road.

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

Dorsey, Wright Sentiment Survey Results – 6/4/10

June 14, 2010

Our latest sentiment survey was open from 6/4/10 to 6/11/10.  The response rate remained near its all-time highs, right at 183 respondents.  Your input is for a good cause!  If you believe, as we do, that markets are driven by supply and demand, client behavior is important.  We’re not asking what you think of the market—since most of our blog readers are financial advisors, we’re asking instead about the behavior of your clients.  Then we’re aggregating responses exclusively for our readership.  Your privacy will not be compromised in any way.

After the first 30 or so responses, the established pattern was simply magnified, so we are comfortable about the statistical validity of our sample.  Most of the responses were from the U.S., but we also had multiple advisors respond from at least two other countries.  Let’s get down to an analysis of the data!  Note: You can click on any of the charts to enlarge them.

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

Chart 1: Greatest Fear.  89.1% of clients were fearful of a downturn, just a hair lower than last survey’s reading of 92.7%.  The market action of the last month has pushed investor sentiment to very bearish, pessimistic levels.  Investors are exhibiting extremely fearful behavior.  Only 10.9% of clients were concerned about missing an up move, just slightly higher than last week’s readings of 7.3%.  The fear in the market is palpable, indeed!

Chart 2. Greatest Fear Spread.  Another way to look at this data is to examine the spread between the two groups.  Again, we are seeing very high levels of fear evidenced in the size of this spread, which fell slightly from 85% to 78%.  Chart 2 is constructed by subtracting the percentage of respondents reporting clients fearful of missing an upturn from the clients reported as fearful of a market downdraft.

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

Chart 3: Average Risk Appetite.  The average risk appetite for this survey round moved even lower, from 2.34 to 2.18.  Again, we are seeing clients’ fear trumping any type of opportunity cost, as the average risk appetite moves lock-step with the market lower.  The question to ask here is how low is too low?  Using only the data inputs in this survey (discounting any daily noise), the market is down about -12.5% from the recent peak.  That’s not particularly unusual.  Our data shows that since 1950, only one out of four -10% market corrections become full-blown bear markets (-20%).  The historical record suggests that a correction is the more likely scenario.  This question is designed to validate the first question, but also to gain more precision and insight about the reported risk appetite of clients.

Chart 4: Risk Appetite Bell Curve.  This chart uses a bell curve to break out the percentage of respondents at each risk appetite level.  Right now the bell curve is biased to the low-risk side, even more so than any of our other sentiment surveys.  What we see in the bell curve is just more evidence that clients are afraid of losing money in the market.  The heavy concentration of 2’s and the complete lack of any 5’s both paint a picture of a market dominated by fear.

Chart 5: Risk Appetite Bell Curve by Group.  The next three charts use cross-sectional data.  This chart plots the reported client risk appetite separately for the fear of downdraft and for the fear of missing upturn groups.  We would expect that the fear of downdraft group would have a lower risk appetite than the fear of missing upturn group and that is what we see here.  Something stands out in this bell curve compared to last week’s (link here) – note the swing of the missing upturn group from high risk appetite to low risk appetite.

Theoretically, the missing upturn group is going to have a higher risk appetite, but this survey’s chart shows an extreme move from higher risk to lower risk.  It’s a bit of a disconnect, because if you report that you are more concerned about missing an upturn, you would theoretically want more risk.  However, we are seeing zero 5’s and a high concentration in 2′s and 3’s in that group.

Chart 6: Average Risk Appetite by Group.  A plot of the average risk appetite score by group is shown in this chart.  The fear of missing downdraft group had an average risk appetite of 2.11, while the fear of missing upturn group had an average risk appetite of 2.75.  Theoretically, this is what we would expect to see.  However, you can see that the missing upturn group’s risk appetite has fallen significantly since the last survey.  It seems like the missing upturn group has a much more volatile risk appetite, which is evidenced in the swings of their average as a group.  Does this group change their mind more than the other group?  Maybe market sentiment swings are powered by only a portion of the participants.  Something to think about.

Chart 7: Risk Appetite Spread.  This is a spread chart constructed from the data in Chart 6, where the average risk appetite of the downdraft group is subtracted from the average risk appetite of the missing upturn group.  The spread is currently .63, a significant move from last week’s reading of 1.26.  This major move in the spread is a direct result of the missing upturn group’s shifting risk appetite.  Two weeks ago, this group had a smattering of 5’s and 4’s with a concentration of 3’s.  This week, we see 1’s and 2’s, with a concentration of 3’s.   What does this mean??  It means that the missing upturn group has a more volatile risk appetite  – they jump around and are conflicted about being in or out of the market.

May was a brutal month for client sentiment.  We’re hovering near the all-time highs of fear since this survey began in March.  The big story for this round of the survey can be found in the missing upturn group’s volatile risk appetite average.  Is this upturn group just more emotional than the downturn group?  Or is the downturn group more self-aware, and therefore less prone to change risk outlooks?  When you consider that this survey is conducted twice a month, it seems like the risk appetites should remain more stable than what we have seen so far.  The shift in the spread represents a significant change in client sentiment, but for long term investors, these types of emotional swings can lead to poor decisions and harmful results.

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

1 Comment | Investor Behavior, Markets, Sentiment | Permalink
Posted by JP Lee

Are ETFs Better Than Mutual Funds?

June 11, 2010

Index Universe contributor Matt Hougan contends that they are.  He suggests that the advantage for long-term investors is that ETF consequences are driven entirely by your own actions:

When you buy a mutual fund, you’re exposed to the actions of others. For instance, if you buy shares in the Growth Fund of America, and then half of the investors in the fund decide to redeem out of their positions, you will bear the brunt of the trading costs as the fund sells stocks to meet those redemptions. If any capital gains are incurred, you will pay those gains, even though you didn’t sell a share and had no intention of exiting your position.

If, on the other hand, no one sells, but another $10 billion in investor cash comes into the fund, you have to pay your share of the costs of putting that money to work: the commissions, the trading spreads, the market impact, etc.

With ETFs, the only thing that matters is you. Outside of a small number of bond funds and a few alternative asset products—such as Vanguard’s ETFs, which share classes of broader mutual funds— existing investors are completely shielded from the actions of others either entering or exiting the ETF. No paying for other people’s commissions, no paying for other people’s market impact and, by and large, no capital-gains distributions driven by the actions of others.

Your investment return and tax profile are driven by your actions, and that’s it.

ETFs are great.  We love them, but I don’t think the issue is quite so black and white.  First of all, I’m not sure ETF investors are entirely shielded from other people’s market impact.  Creation and redemption of new units could put unseen pressure on the underlying securities and might have some impact that way.  The tax efficiency of most ETFs is certainly a plus, but they aren’t nearly as efficient for dollar-cost averaging as mutual funds are.  Automatic investment plans–something a lot more investors should probably be using–where a fixed amount goes into a fund each month is one area in which mutual funds really shine.  As with most investment products, it really depends on their use and your needs.

And then there is Mr. Hougan’s mention of the nearly mythical long-term investor!  This failing obviously can’t really be attributed to the ETFs or the funds themselves.  It’s a mistaken belief on his part that lots of investors like this exist.  There is a marked tendency in both vehicles for investors to buy near the highs, sell near the lows, and have a holding period that is far too short. 

DALBAR’s research suggests that the average mutual fund holding period is only 3-4 years, even for bond funds!  Every advisor has a tale of the self-reported ”long-term investor” with a 7-10 year time horizon (on the consulting department paperwork) that pulled the account after the first down quarter.  The truth is that almost any winning stategy will deliver great rewards over a long time horizon, regardless of the investment vehicle, whether it’s an ETF, mutual fund, or separate account.  Find a manager that exposes a portfolio to a reputable return factor, executes the strategy in a discplined fashion, and hang on for dear life.

1 Comment | Investor Behavior, Markets, Thought Process | Permalink
Posted by Mike Moody

Volatility and Subsequent Returns

June 9, 2010

CXO Advisory has an excellent piece on volatility clusters and subsequent returns in the stock market.  One thing that makes investors incredibly nervous is volatility.  According to the DALBAR studies, price declines often cause investors to bail out, but my experience suggests that bouts of high volatility often have the same effect.  Even if prices are relatively stable, volatility scares the heck out of everyone.  The media has a tendency to attach an explanatory story to each day’s trading, so during periods of high volatility, the news background can seem particularly unsettling.

CXO was responding to an article that suggested that periods of high volatility were bear market signals, but CXO had a different read on the data.  They defined a volatility as a close-to-close spread of more than 1% in the S&P 500 and looked for volatility clusters where there were more than 20 such days in a 40-day period.  Taking the data back to 1950, they found that volatility clusters were typically followed by better-than-average returns.

Source: CXO Advisory

The graphic above is from the CXO article.  As you can see, returns after bouts of high volatility were pretty good.  The returns after 30 volatile days within a 40-day period were especially noteworthy.

It makes sense that volatility and returns are connected in this way.  No investor should expect to get something for nothing, and viewed in that light, volatility is simply the price to be paid for decent results.  The implication that investors who suffer through extended periods of volatility will eventually be rewarded with good returns is comforting!

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

Stock Market Investing: Not for Cupcakes

June 7, 2010

Investors are quite skittish these days.  2001-2002 was bad enough, but then 2008 came along.  Most investors lost a boatload of money, in some cases enough to get them to swear off investing altogether.  Although that may be understandable from a certain perspective, it’s probably not the way to go.  The reality is that market volatility is to be expected.  Charlie Munger, Warren Buffett’s investing partner at Berkshire Hathaway, rather unsympathetically expounds on what investors should expect (my emphasis added):

“I think it’s in the nature of long term shareholding of the normal vicissitudes, of worldly outcomes, of markets that the long-term holder has his quoted value of his stocks go down by say 50%. In fact you can argue that if you’re not willing to react with equanimity to a market price decline of 50% two or three times a century you’re not fit to be a common shareholder and you deserve the mediocre result you’re going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations.”

I’ve seen plenty of people react to a 50% decline, but not usually with equanimity!  The always excellent Psy-Fi blog has this further comment:

Munger is, as usual, spot on the money. It turns out that the odds of a 50% drawdown in any investor’s portfolio during an investing lifetime are virtually 100%. Dabble in stocks for long enough and you’re bound to lose half your net worth in a single swoop. In some recent research Guofu Zhou and Yingzi Zhu have set about demolishing the idea that our most recent set of calamities are surprising.

In other words, what markets are going through right now–although it’s clearly the unpleasant part–is just part of the normal cycle of investing.  The problems come when investors  create drama over what should be expected.  It might be healthier to imagine one’s portfolio as having a wide range of possible values, as opposed to taking mental ownership of the equity value reflected on your best monthly statement.  Psy-Fi has a couple of suggestions for reducing the unnecessary drama:

…intelligent investors should mange their holdings with the expectations that they’ll lose 50% of their value at some point. The main aim should be to ensure that such a drawdown is a temporary measure and, if you’re invested in good enough stocks, this should surely prove to be the case over a few years. This is the lesson of behavioural finance: be humble in the face of the markets, diversify wisely and don’t use leverage.

That’s a pretty good prescription: 1) think long term, 2) diversify effectively between strategies, and 3) don’t use leverage.  Patience always helps, because drawdowns in most sound strategies are temporary.  Diversification between strategies (not necessarily just asset classes) can help mitigate drawdowns too.  We find, for example, that high relative strength strategies blend nicely with deep value strategies.  Finally, the absence of leverage gives you the staying power to hold on during a drawdown.  Too much borrowed money, as some overleveraged homeowners are finding out, will cause you to mail in the key to your portfolio to the margin clerk at an inopportune time.

Investing is a rough game; you’ve got to be tough to play.  To paraphrase Yogi Berra, “Investing is 90% mental, the other half is rational.”

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

Dorsey, Wright Sentiment Survey – 6/4/10

June 4, 2010

We had our highest participation rate yet 2 weeks ago; thank you very much for participating.  Let’s keep the streak going!

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

Contribute to the greater good!  You WILL NOT be directed to another page by clicking the survey.  It’s painless, we promise.

Leave a Comment » | Investor Behavior | Permalink
Posted by JP Lee

The Real Efficient Frontier

June 3, 2010

Emotions are the well-documented cause of most problems in investing.  For some reason, it is very difficult for most people to be rational during uptrends, downtrends, or during periods of high volatility–in other words, 90% of the time.

The recent “flash crash,” besides spawning humorous t-shirts, got investors riled up again.

The clever t-shirt took me back to 1987 when it was de rigeur for advisors to own at least one piece of ”I Survived the Crash” apparel.  I thought about a great, great Joe Nocera column in the New York Times as the 20th anniversary of the 1987 stock market crash was looming.  He was interviewing Jason Zweig, who had a priceless anecdote about the father of modern portfolio theory, Harry Markowitz.

“There is a story in the book about Harry Markowitz,” Mr. Zweig said the other day. He was referring to Harry M. Markowitz, the renowned economist who shared a Nobel for helping found modern portfolio theory — and proving the importance of diversification. It’s a story that says everything about how most of us act when it comes to investing. Mr. Markowitz was then working at the RAND Corporation and trying to figure out how to allocate his retirement account. He knew what he should do: “I should have computed the historical co-variances of the asset classes and drawn an efficient frontier.” (That’s efficient-market talk for draining as much risk as possible out of his portfolio.)

But, he said, “I visualized my grief if the stock market went way up and I wasn’t in it — or if it went way down and I was completely in it. So I split my contributions 50/50 between stocks and bonds.” As Mr. Zweig notes dryly, Mr. Markowitz had proved “incapable of applying” his breakthrough theory to his own money. Economists in his day believed powerfully in the concept of “economic man”— the theory that people always acted in their own best self-interest. Yet Mr. Markowitz, famous economist though he was, was clearly not an example of economic man.

This story basically says it all.  Even the theory’s originator was incapable of applying it, due to his emotional hang-ups!

We think this is the very best argument for our systematic relative strength approach.  Relative strength has been shown to work over time and our process is systematic.  There will be no emotional backsliding on the part of the computer when it comes to calculating our relative strength ranks.  I cannot stress enough how much more important the systematic execution of the process is, as opposed to the individual items that might be held in a portfolio.  A recent white paper by one of our portfolio managers, John Lewis, makes this point powerfully by picking portfolios of high relative strength stocks at random.

The point is that our Systematic Relative Strength portfolios keep investors continuously exposed to the relative strength return factor, come hell or high water.  (There’s plenty of both in financial markets.)  Over time, that’s very likely to be a winning strategy.  The coordinates for the real efficient frontier are emotional reactivity and volatility, not risk and return.  If you can suppress your emotions and stay rational, you have a chance.

Jason Zweig, in Joe Nocera’s article, had a nice quip for that too:

As our interview was winding down, Mr. Zweig told me a story — “I think it might even be true” — about Charles T. Munger, the Los Angeles lawyer best known as Mr. Buffett’s sidekick at Berkshire Hathaway. “A woman was sitting next to him at a dinner party in L.A.,” Mr. Zweig said. “She turned to him and said, `You’re Warren Buffett’s partner, and a great investor. Tell me, what is your secret?’”

Mr. Munger looked up at her. “I’m rational,” he said. Then he went back to his dinner.

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

Is This the Beginning of a New Bear Market?

June 1, 2010

Everyone wants to know the answer to this question, and every commentator, it seems, has an opinion.  We examined S&P 500 price data going back to 1950 and this is what it shows:

There were 46 10% corrections since the beginning of 1950.  Out of those 46, 12 of them turned out to be 20% corrections.  About 25% of the time a “correction” turns into a “bear market.”

(This is using the now media-standard 10% drop is a correction and 20% drop is a bear market.)  In any one case, no one really knows whether a drop is just a short-term correction or the beginning of a bear market.  All of the forecasts you have read or seen over the past few days should properly be labeled “guesses.”  We wouldn’t even hazard a guess as to the eventual outcome of the current drop, but it is interesting to note that 75% of the corrections since 1950 did not result in a bear market.  Most of the time, the correction is contained in the 10-20% range and the market bounces back.

Advisors, however, appear to be gambling heavily on the bear market scenario.  Mark Hulbert reports that a rush is on to jump on the bearish bandwagon.  Commentaries like this one from Investment Advisor magazine are pretty common.   Investment News also reports that advisors are making a mad dash to cash.  Based on the historical statistics, there is a certain amount of risk in moving to cash, especially since advisors seem to be driving the change:

Most of the advisers who are moving into cash are doing so on their own, and not as a result of client demand. Just 14.9% of advisers in the InvestmentNews survey who said that they recently moved into cash said they were doing so in response to requests from clients.

In other words, clients are not the ones running to cash.  Clients may be quite unhappy if the move to cash does not work out.  Even if the clients were driving the change, they might end up blaming their advisors for it–but if it was the advisor’s idea, well, that’s pretty cut and dried.

Of course, advisors could be right and earn clients’ undying gratitude.  It’s just that sudden swings to bearishness are often signs of a rally rather than an indication of continuing weakness.  Right now the jury is still out.  It’s too early to declare victory either way, but allocation changes in response to market swings ought to be considered carefully.  No advisor wants to cry wolf too often.

1 Comment | Investor Behavior, Markets, Sentiment | Permalink
Posted by Mike Moody

Dorsey, Wright Sentiment Survey Results – 5/21/10

June 1, 2010

Our latest sentiment survey was open from 5/21/10 to 5/27/10.  The response rate continues to tick higher as we roll out more surveys – this week we had 191 responses.  Your input is for a good cause!  If you believe, as we do, that markets are driven by supply and demand, client behavior is important.  We’re not asking what you think of the market—since most of our blog readers are financial advisors, we’re asking instead about the behavior of your clients.  Then we’re aggregating responses exclusively for our readership.  Your privacy will not be compromised in any way.

After the first 30 or so responses, the established pattern was simply magnified, so we are comfortable about the statistical validity of our sample.  Most of the responses were from the U.S., but we also had multiple advisors respond from at least two other countries.  Let’s get down to an analysis of the data!  Note: You can click on any of the charts to enlarge them.

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

Chart 1: Greatest Fear.  92.7% of clients were fearful of a downturn, up significantly from last survey’s 84.0%.  Only 7.3% were afraid of missing an upturn, also much lower than last survey’s 16.0%.  Recent market action has driven market fear to the highest levels we have seen yet in our survey.  This is great news for the purposes of our data-driven survey, but bad news for the respondents’ collective blood pressure readings!

Chart 2. Greatest Fear Spread.  Another way to look at this data is to examine the spread between the two groups.  That spread has continued its surge from 2 weeks ago, moving to 85% from 68%.  Again, these readings indicate that fear is dominating investor emotions at this point.  After 2008, investors seem very afraid to stick to their guns during any type of correction.  Chart 2 is constructed by subtracting the percentage of respondents reporting clients fearful of missing an upturn from the clients reported as fearful of a market downdraft.

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

Chart 3: Average Risk Appetite.  The average risk appetite this week was 2.34, another noticeable move lower from last survey’s average risk appetite of 2.55.  This chart shows that client risk appetite is moving lock-stop downwards with the market.  It will definitely be interesting to see how this major pullback will shake out – and how clients’ risk appetites will react.  This question is designed to validate the first question, but also to gain more precision and insight about the reported risk appetite of clients.

Chart 4: Risk Appetite Bell Curve.  This chart uses a bell curve to break out the percentage of respondents at each risk appetite level.  Right now the bell curve is biased to the low-risk side, even more so than the last five sentiment surveys.  In our office discussions, we’ve talked about what the underlying meaning of this risk appetite might be.  It’s interesting to see how the average risk appetite and the greatest fear don’t seem to correspond.  For example, the Greatest Fear spread right now is huge – 93% versus 7% are worried about getting caught in a  downturn.  It would seem to follow that the average risk appetite would be even more skewed towards 1, but that’s not the case.  Perhaps we have a situation where the clients are extremely fearful of the market, but also don’t want to lose out on an up move…hence a large percentage of conflicted 1′s and 2′s.  Something to think about.

Chart 5: Risk Appetite Bell Curve by Group.  The next three charts use cross-sectional data.  This chart plots the reported client risk appetite separately for the fear of downdraft and for the fear of missing upturn groups.  We would expect that the fear of downdraft group would have a lower risk appetite than the fear of missing upturn group and that is what we see here.

Chart 6: Average Risk Appetite by Group.  A plot of the average risk appetite score by group is shown in this chart.  The fear of missing downdraft group had an average risk appetite of 2.24, while the fear of missing upturn group had an average risk appetite of 3.50.  Theoretically, this is what we would expect to see.  The fear of downdraft group’s risk appetite fell even further from the last survey, while the fear of missed upturn group’s risk appetite actually went up!  This might be because there were so few people in the upturn group that one or two outliers heavily skewed the average.

Chart 7: Risk Appetite Spread.  This is a spread chart constructed from the data in Chart 6, where the average risk appetite of the downdraft group is subtracted from the average risk appetite of the missing upturn group.  The spread is currently 1.26, as the spread continues to grow with a weakening market.  Theoretically, a market bounce will bring that spread lower, while more downward momentum could lead to an even larger spread.  Only time will tell.

The market action in May has been absolutely brutal for client sentiment.  The popular VIX indicator, a measure of fear in the market, spiked to one-year highs on May 21, the date this survey was launched.  It’s very clear that our sentiment survey is matching up fairly well with the VIX indicator, which could be a sign of good things to come in the market.  No one can predict the future, as we all know, so instead of prognosticating, we will sit back and enjoy the ride.  A rigorously tested, systematic investment process provides a great deal of comfort for clients during these types of fearful, highly uncertain market environments.  Until next time, good luck and thank you for participating!

Leave a Comment » | Investor Behavior, Markets | Permalink
Posted by JP Lee

What Explains the Difference?

May 28, 2010

What explains the difference between the calm investor and the scared investor?

With the market correction of the last month has come dramatically rising fear levels among individual investors.  Case in point, the 5/27 AAII Sentiment Survey reveals that over 50% of individual investors are now bearish.  There are only a small number of times in the 23-year history of this particular sentiment survey when there has been more bearish sentiment than now.  Surely, a large part of the fear comes from the realization that many have not adequately prepared for the possibility of bear markets.  Proper preparation comes from constructing an asset allocation with an appropriate amount of the portfolio dedicated to strategies with strong risk management characteristics. Historically, only about twenty-five percent of 10 percent corrections turn into a 20+ percent bear market so it is quite possible that what we are experiencing now is simply a correction.  However, that doesn’t change the fact that investors need to have that strong risk management component of their asset allocation in order to be able to have the intestinal fortitude to stay in the game through all the 10 percent corrections.

Seeking to be adequately prepared for the worst is the very reason that we have included inverse equities in the investment universe for our Global Macro portfolio.

It is with this same logic that Ronald Reagan argued in 1984 for a strong national defense.  Consider his famous “Bear in the woods” commercial.  Click here to view.  The text of the commercial is as follows:

There’s a bear in the woods. For some people, the bear is easy to see. Others don’t see it at all. Some people say the bear is tame. Others say it’s vicious and dangerous. Since no one can really be sure who’s right, isn’t it smart to be as strong as the bear? If there is a bear….

To watch a 15-minute presentation on how we incorporate inverse equities into our Global Macro strategy, click here and then click on “Global Macro Presentation” (Financial Professionals Only.)

What explains the difference between the calm investor and the scared investor?  The level of preparation.

Click here to visit www.arrowfunds.com for a prospectus & disclosures.  Click here for disclosures from Dorsey Wright Money Management.  Past performance is no guarantee of future results.

Leave a Comment » | Investor Behavior, Sentiment, Tactical Asset Alloc, Thought Process | Permalink
Posted by Andy Hyer

Hobo Investing

May 26, 2010

Investing, at its core, is a simple process.  You need to determine if the train is going north or south, or just sitting on a track siding doing nothing.  Once you’ve found a train going north, you need only to hop aboard.  If the train starts to go south, you need to jump off.

The concept is simple, but sometimes investors make the execution more complicated.  For us, relative strength and trend following provide the tools and methodology to find the northbound trains.  The same tools and methodology can be used to tell you when the switch engine has come along and started to move the train south.

The problems happen when investors deviate from the simple goal-directed hobo mentality and get too clever for their own good.  Can you imagine how irrational some investor behavior must look to a hobo?  Here are the top six dysfunctional hobo sayings:

1. I wanted to go north, so I hopped on an out-of-favor southbound train, hoping it would go north eventually.  (value hobo)

2. I got on a northbound train, but it only went north a few miles.  A switch engine came along and started to take my boxcar south.  How embarrassing!  This train owes me.  I’m not getting off.  (ego-attached hobo)

3. There are so many trains going north.  I want to hop on one eventually, but I’m afraid it will go south right after I get on it.  (failure to launch hobo)

4.  This northbound train is picking up speed.  I’d better get off.  (premature ejection hobo)

5. I want to go north, but my train pulled on to a siding and stopped.  Maybe I’ll just sit here and see what happens.  (buy-and-hold hobo)

6. There are so many trains going north without me.  Eventually they will all have to go south, and then I’ll have my revenge!  (bitter hobo with economics background)

If you want to go north, get on a northbound train.  KISS really applies here.  On our good days, we all know this, but it’s so easy to forget.

4 Comments | From the MM, Investor Behavior, Just for Fun, Markets, Thought Process | Permalink
Posted by Mike Moody

Two Approaches to Retirement Income

May 25, 2010

Research Magazine has a nice piece on building retirement income portfolios.  If you have clients that are aging baby boomers–and most of you do–or you are, like me, an aging baby boomer yourself, you’ll recognize that lots of people are suddenly thinking about this topic.

The two approaches to retirement income that are discussed are the total return approach and the investment pool approach, sometimes called the bucket approach.

Courtesy: Research Magazine

The graphic highlights the differences between the two approaches, although the article points out that advisors are trying to achieve the same end result:

While advisors may differ in the philosophy they follow for retirement clients, there are consistent elements among best-practice advisors that cut across both approaches. These common elements include:

– Generating an annual income or cash flow target of between 3 percent and 6 percent;

– Managing portfolios to support spending on essential needs such as housing, healthcare and other daily living expenses while also looking to maintain long-term purchasing power in light of potential inflationary pressures;

– Seeking to produce competitive returns for the client within agreed-upon risk parameters, but not striving for consistent above-average returns or outperforming market benchmarks;

– Focusing on broad diversification in asset classes, relying on vehicles they are highly familiar with, such as mutual funds, ETFs, individual securities, separately managed accounts and annuities;

– Emphasizing the process of constructing portfolios rather than the products or solutions available.

So which approach is best?  The article doesn’t take a position on that question, but I think two things should be kept in mind when trying to decide.

1. There is no necessary functional difference at all between the two approaches.  In other words, an investment pool approach with six equal 5-year buckets allocated progressively to Treasury bills, short-term bonds, intermediate-term bonds, large-cap value stocks, large-cap growth stocks, and emerging market equities is absolutely the same thing as a 50/50 balanced portfolio that uses the same asset classes.

2. As a result, the only thing that matters is which approach works best psychologically for the client.  If the portfolios are functionally the same, ideally we should gravitate to whatever will help the client achieve their income and investment growth goals.  Twenty years ago, the total return approach was dominant–and it still makes perfect sense from a financial point of view.  However, over the last decade or so, the rise of behavioral finance has generated research that focuses on ways to nudge clients into more productive investment behaviors.  There seems to be an innate tendency of humans to compartmentalize their finances; whether it is rational or not is beside the point.  Even though we can all agree that the two leading retirement income approaches are functionally the same, if the client is more comfortable breaking an account into buckets–and will therefore have less emotional anxiety when the growth buckets bounce around in choppy markets–that’s the way it should be handled.  Lousy emotional asset allocation is the root of most portfolio problems and anything that can improve results by alleviating emotional strain on clients should be encouraged.

Leave a Comment » | Investor Behavior, Retirement/Saving, Thought Process | Permalink
Posted by Mike Moody

Net Worth is a Worthwhile Obsession

May 19, 2010

Ron Lieber wrote an interesting article in the New York Times about a number of websites that allow you to anonymously track and post your net worth and compare it with others in similar circumstances.  Mr. Lieber didn’t say explicitly what he thought about this new trend in social networking, but the title to the article, “Net Worth Obsession,” gives a clue.  A number of pundits were quoted decrying the trend:

But does our almost irresistible urge to rank ourselves against others based on any available data serve as a source of inspiration? Or does it lead to endless striving in search of some ever-elusive achievement? “I think this is a profound problem, this aspect of humans in the West,” said Andrew Oswald, a professor of behavioral science at the Warwick Business School in England. “We’re now extraordinarily rich by almost any standard of human history. But because we are creatures of comparison, it’s harder to get happier and happier.”

It’s certainly possible to pay too much attention to your net worth and ignore your happiness, but most of the actual site participants had very positive things to say.  Perhaps there is something redeeming in tracking assets minus debts!  One user says:

Initially, the idea of laying herself bare on a blog and on NetworthIQ caused a lot of anxiety. “You’re saying I have a secret and here it is for everyone to see,” she says. “But once it’s out there, and especially now that it’s not just a flat line saying ‘negative $23,000,’ and it is moving up a little bit, there’s a sense of pride and accomplishment that goes along with that. I know people are visiting, and it makes me want to pay something else off so I can post another entry that’s something good.” She’s currently putting a third of her monthly take-home pay from her job as a benefits analyst toward debt payments.

All of this has led to some odd reversals in her life. She looks forward to getting her bills in the mail, for instance, because it means it’s time to update her total debt. “Which might be a little bit sick,” she said. “But I know it’s lower than the last month. I know it for a fact.”

Grant often wonders about the people who are far ahead of her in the NetworthIQ standings. Did they get lucky? Are they lottery winners? Or did they get smart about money before she did? She tries not to beat herself up over it. “For people with the same income as me but higher net worth, it tells me that I can get there, too. It just takes discipline,” she says. “I know it has only been a couple of months now, but I kind of feel like I’ve made a life change.”

In other words, most of the participants found tracking their net worth to be motivational.  This is something that I have noticed repeatedly with real clients over the past 25 years.  The clients who track their net worth always do way, way better than clients who have only a vague idea of their finances.  The difference is so dramatic that I routinely suggest the practice to clients.  Before there were social networking websites for net worth, there were spreadsheets.  As far as I know, none of my clients have ever shared their information with anyone but their financial advisor, but like most things, just the fact that it is being tracked makes them pay attention to it.  Most clients do not see updating their spreadsheet each month or each quarter as a joyless activity–they are instead motivated to keep that number moving north.

If competing with your net worth on a social networking website helps push you to save and invest, well, more power to you.  One person interviewed in the New York Times article makes this same point:

She admits that some of her pleasure is fueled as much by competition as self-satisfaction. “I’m not that far off from the person right above me” on the NetworthIQ list, she says. “I can probably catch them this month. And maybe next month I can get to the next one.”

It’s not as if people don’t notice their socioeconomic status anyway.  Even Mr. Osvald, who was quoted earlier in the article lamenting the “profound problem” with humans admits that comparison is actually just human nature:

Oswald, the professor of behavioral science, says the craving for comparison may be rooted in our biology. “It’s easier said than done to break through two million years of evolution,” he says. “A million years ago, you could watch what others were doing and mimic that to get food and resources. Or if you were high up the monkey pack, you could get the best mates.”

Let’s face it: everyone wants to be high up in the monkey pack.  Perhaps we’re not all members of the same monkey pack, but humans always and everywhere are in competition for resources.  Consequently, social and economic signifiers are embedded in everything from the car you drive, the sneakers you wear, the sports you enjoy (polo anyone?), the bling and tats you do (or do not) have.  We have elaborate social ways of interpreting these signifiers:  the same Bentley might be seen as appropriate if the owner comes from ”old money,” but tacky if the owner is “nouveaux riche.”  Most product marketing is based more on the branding–the social signifier–than on the actual product features.

“Keeping up with the Joneses” will always be with us.  Ultimately, I think tracking net worth is a much healthier way of keeping up with the Joneses than accumulating possessions and racking up consumer debt.  After all, most of our personal and national fiscal problems are caused from too much spending and not enough savings and investment.  Tracking your net worth, I suspect, is actually aspirational and motivational rather than pathological.  Instead of sucking the fun out of life, clients end up bonding with their grandkids for the summer at the beach condo they wouldn’t otherwise have had.  Pundits may worry about it, but the public seems to find it practical and valuable.

2 Comments | Investor Behavior, Just for Fun, Retirement/Saving | Permalink
Posted by Mike Moody

How To Get Back on the Bike

May 19, 2010

Most of us learn to ride a bicycle when we are young.  The process, despite the well-meaning frantic coaching of our parents running alongside us, is basically trial and error–including lots of crashes.  As children, we have a “beginner’s mind.”  We are willing to listen to anyone who has a plausible theory about riding a bike because, after all, we know nothing about it.  When we fall down, we are told to immediately get back up and to get back on the bike.  And we do, since most all of us can ride a bike.  But what happens when an experienced rider–who expects to be successful–has a crash? 

Today I read an article in the New York Times about horrific cycling crashes, and how professional cyclists get over their fear and get back on the road.  I noticed a number of parallels between the article and how the capital markets operate. 

Click here to read the NYT article, “Crashes Can Make Even the Best Cyclists Uneasy.”

The article focuses mostly on Jens Voigt, who is one of the older and more experienced riders on the professional circuit.  In the Tour de France of 2009, Voigt crashed so badly that he couldn’t finish the race.  Plenty of people worried he would never race again.

He had a concussion, a litany of bruises and several broken bones in his face.  His orbital bone was broken in two places, his jaw in one.  The wall of one of his sinuses had been punctured and was filling with blood, causing equilibrium problems, Voigt said.  That injury later required the insertion of a titanium plate to hasten healing. 

Sound familiar?  If you were invested in the stock market during 2008, the description of Voigt’s wounds should ring a bell…that’s probably how you felt by the end of the year.  Broken down, beaten up, your face literally smashed in.

A lot of people quit the market after the 2008 meltdown (see this post about money on the sidelines), just like some cyclists never recover from these types of epic crashes.  It’s just human nature – some people just can’t get over that fear of defeat, especially after tasting asphalt.

Jens Voigt on the ground after his crash. Source: NYDailyNews

What separates those who can get back on the bike, and those who just walk away?  The answer is probably different for every person, but I’m going to tie it directly to one of the skills required for success in the capital markets– DISCIPLINE.  The type of person who can get up after a bicycle crash is the same type of person who can recover from a setback in the market.  The determination and willpower necessary to recover and excel professionally after this type of crash is not superhuman–we all do it when we are first learning to ride a bike.  This type of behavior is not to be confused with blind faith or sheer stupidity.  Each time you get back on the bike you try to do things a little better than last time, but you have a strong underlying belief that you can learn to ride successfully because you see others who have learned how to ride. 

Now consider a time-tested investment strategy like relative strength that has outperformed for decades – do you just walk away from your strategy after hitting the pavement?  Or do you shake yourself off, collect your senses, and get back on the road?  The drive to succeed is a matter of temperament and must come from within.  A systematic process can only do so much to help you with this decision…anyone can just quit and go home.

If we’re working on being smart while operating within the capital markets, discipline alone will not carry you to finish line.  It’s the whole package – knowledge, discipline, and patience – that are going to guide you successfully.  Crashes are always just around the corner.  Crashes happen.  It’s your job as an advisor to be ready to deal with them.

Final Thought: One of the more interesting bits in the article highlights how Voigt went back over the tapes again and again to try to figure out “what he did wrong.”  In the end, his tire slipped on road paint and he was face-first on the ground within half a second.  There was literally nothing he could have done to prevent the crash.  That’s often the case in markets as well.  You can’t always prevent it, so you’ve got to be prepared to deal with it and get back on the bike.

Leave a Comment » | Investor Behavior, Markets | Permalink
Posted by JP Lee

Dorsey, Wright Sentiment Survey Results – 5/7/2010

May 17, 2010

Our latest sentiment survey was open from 5/7/10 to 5/13/10.  The response rate was well ahead any of our sentiment surveys so far – 175 responses.  Your input is for a good cause!  If you believe, as we do, that markets are driven by supply and demand, client behavior is important.  We’re not asking what you think of the market—since most of our blog readers are financial advisors, we’re asking instead about the behavior of your clients.  Then we’re aggregating responses exclusively for our readership.  Your privacy will not be compromised in any way.

After the first 30 or so responses, the established pattern was simply magnified, so we are comfortable about the statistical validity of our sample.  Most of the responses were from the U.S., but we also had multiple advisors respond from at least two other countries.  Let’s get down to an analysis of the data!  Note: You can click on any of the charts to enlarge them.

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

Chart 1: Greatest Fear.  84.0% of clients were fearful of a downturn, up significantly from last survey’s 69.3%.  Only 16.0% were afraid of missing an upturn, also much lower than last survey’s 30.7%.  As you can see in the chart, client fear rocketed higher as volatility returned to the market in a big way.

Chart 2. Greatest Fear Spread.  Another way to look at this data is to examine the spread between the two groups.  That spread has soared to 68% from 39% last survey.  Clients are extremely nervous at this point, as Chart 2 illustrates.  Chart 2 is constructed by subtracting the percentage of respondents reporting clients fearful of missing an upturn from the clients reported as fearful of a market downdraft.

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

Chart 3: Average Risk Appetite.  The average risk appetite this week was 2.55, another noticeable move lower from last survey’s average risk appetite of 2.85.  The volatility of the last two weeks has made a significant dent in most clients’ willingness to take on risk in the market.  This question is designed to validate the first question, but also to gain more precision and insight about the reported risk appetite of clients.

Chart 4: Risk Appetite Bell Curve.  This chart uses a bell curve to break out the percentage of respondents at each risk appetite level.  Right now the bell curve is biased to the low-risk side, even more so than the last four sentiment surveys.

Chart 5: Risk Appetite Bell Curve by Group.  The next three charts use cross-sectional data.  This chart plots the reported client risk appetite separately for the fear of downdraft and for the fear of missing upturn groups.  We would expect that the fear of downdraft group would have a lower risk appetite than the fear of missing upturn group and that is what we see here.

Chart 6: Average Risk Appetite by Group.  A plot of the average risk appetite score by group is shown in this chart.  The fear of missing downdraft group had an average risk appetite of 2.40, while the fear of missing upturn group had an average risk appetite of 3.35.  Theoretically, this is what we would expect to see.  Both groups’ risk tolerance fell significantly from the last survey two weeks ago.

Chart 7: Risk Appetite Spread.  This is a spread chart constructed from the data in Chart 6, where the average risk appetite of the downdraft group is subtracted from the average risk appetite of the missing upturn group.  The spread is currently 1.11, a modest move higher from the last survey, and an extreme jump from the .62 spread low from six weeks ago.

The volatility from the last three weeks or so has been great for our Sentiment Survey results.  The dramatic changes we witnessed in the last few weeks in client sentiment have moved exactly as they should have.  With more volatility and fear in the market, we’re seeing clients becoming more risk-averse, and generally more concerned with losing money rather than losing opportunity.   A rigorously tested, systematic investment process provides a great deal of comfort for clients during these types of fearful, highly uncertain market environments. Good luck and thank you for participating!

Leave a Comment » | Investor Behavior, Sentiment | Permalink
Posted by JP Lee

« Previous Entries