Getting Behavioral Coaching Right

July 23, 2015

Interesting analysis by Vanguard estimating that a good financial advisor has the potential to add 3% annually (net) to their client’s portfolios.  See below for the breakdown of their estimate:

Vanguard Study Getting Behavioral Coaching Right

By their estimation, the area where a financial advisor has the most potential to add value for their clients is in Behavioral Coaching.  I would agree that “providing support to stay the course in times of market stress” is among the areas of greatest opportunities for advisors to add value.  I am sure we all know clients that made drastic asset allocation changes towards equities in the late 1990′s, arriving just in time for a bear market, or away from equities following the 2008-2009 financial crisis, and have been very slow to return.  Such changes can cripple the financial health of an individual and family.

There are all kinds of ways that an advisor could attempt to help their clients stay the course in times of market stress.  They could show their clients the data on historical returns of the stock market.  They could show their client data with the percentage of rolling 3, 5, and 10 year periods where the stock and bond markets have produced positive returns.  They could give reasons why they personally believe that it makes sense to be bullish over the coming year.  They could cite the views of a well-known “expert” who believes that the market is going to rise from here.  They could share behavioral finance research with the client to try to persuade them that they are being irrational.

Some of the above approaches may have their time and place, but ultimately, I believe they are insufficient to keep clients from making the big mistakes—the types of mistakes that alter their standard of living in retirement.

In my view, an absolutely critical component to helping clients stay the course in times of market stress is to have an asset allocation that can adapt to different, even scary, market environments.  Most strategic asset allocations won’t cut it.  They are too static and too dependent upon bull markets in the stock and bond markets.  I will be the first to admit that being a perma-bear has been a losing proposition over time.  However, there must be some portion of a client’s allocation invested in a tactical strategy that can play defense.   Take the following as a sample allocation:

  • 25% in fully-invested global equities
  • 25% in fixed income
  • 50% in a Global Tactical Allocation strategy driven by relative strength

What if that 50% in Global Tactical Allocation had the ability to be heavily focused on equities in favorable equity markets.  Then, the majority of the time the client is going to have a moderately aggressive allocation in order to participate in good markets.  However, the client has the peace of mind that a meaningful portion of their overall allocation can deal with major bear markets.  This peace of mind will minimize the chance that they will demand wholesale changes to their overall asset allocation at exactly the wrong time (because a portion of their asset allocation is already shifting as dictated by relative strength) .  The last two bear markets are always going to be top of mind for this generation of investors.  Permanently defensive strategies (like a constant allocation to gold) are not the answer.  Strategic asset allocation falls short.  However, a relative strength-driven global asset allocation strategy does a much better job at providing a robust long-term solution for clients.

The relative strength strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value. 

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The Disposition to be a Successful Investor

July 9, 2015

Words of wisdom from Morgan Housel:

One summer in college I interned at an investment bank. It was the worst job I ever had.

A co-worker and I survived our days by bonding over a mutual interest in the stock market.

My co-worker was brilliant. Scary brilliant. The kind of guy you feel bad hanging out with because he makes you realize how dumb you are. He could dissect a company’s balance sheet and analyze business strategies like no one else I knew or have known since. He was the smartest investor I ever met.

He went to an Ivy League school, and after college he landed a high-paying gig at an investment firm. He went on to produce some of the worst investment results you can imagine, with an uncanny ability to pile into whatever asset was about to lose half its value.

This guy is a genius on paper. But he didn’t have the disposition to be a successful investor. He had a gambling mentality and couldn’t grasp that his book intelligence didn’t translate into investing intelligence, which made him wildly overconfident. His textbook investing brilliance didn’t matter. His emotional faults led him to be a terrible investor.

He’s a great example of a powerful investing truth: You can be brilliant on one hand but still fail miserably because of what you lack on the other.

There is a hierarchy of investor needs, in other words. Some investing skills have to be mastered before any other skills matter at all.

Here’s a pyramid I made to show what I mean. The most important investing topic is at the bottom. Each topic has to be mastered before the one above it matters:

hierarchy large The Disposition to be a Successful Investor

Every one of these topics is incredibly important. None should be belittled.

But you can be the best stock-picker in the world, yet if you buy high and sell low – the epitome of bad investing behavior – none of it will matter. You will fail as an investor.

Investor Behavior trumps all other factors.  Our solution to this challenge was to embrace a systematic–or rules-based–investment process that seeks to capitalize on a proven investment factor (momentum) while keeping our emotions from messing things up.  Some may try to develop the right disposition to be a successful investor on their own.  I am skeptical of how much progress can actually be made on that front without the aid of a systematic model, but it is certainly a worthy endeavor.

The relative strength strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value.

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Latest Dalbar Numbers

June 17, 2015

The latest Dalbar numbers, via NYT:

For the two decades through December, Dalbar found, the actual annualized return for the average stock mutual fund investor was only 5.19 percent, 4.66 percentage points lower than the 9.85 percent return for the Standard & Poor’s 500-stock index. Bond investors did even worse, trailing the benchmark Barclays Aggregate Bond index by 4.71 percentage points.

In isolation, these figures, which aren’t adjusted for inflation, may seem small. But they aren’t when they recur year after year. In fact, because of the effects of compounding — in which a positive return in one year adds to your stash and can grow further in subsequent years — those annualized numbers translate into life-changing disparities.

Consider a $10,000 investment in the S.&P. 500 index. Using the Dalbar rates, my calculations show that with dividends, that $10,000 would grow to $65,464 over 20 years, compared with only $27,510 over the same period for the return of the average stock mutual fund investors.

That gap grows over time. At those rates after 40 years, with compounding, the nest egg invested in the plain vanilla stock index would grow to about $428,550, compared with only $75,680 for the average returns of stock mutual fund investors, a $352,870 difference. Disparities of this order have been showing up year after year in the Dalbar numbers. And with so many Americans forced to rely on their own investing acumen because of the decline of traditional pension plans and lax government rules about financial advice, these awful returns really matter.

Keep in mind that those numbers are just average investor returns.  Plenty of people excel in the financial markets and, no, passive cap-weighted indexing is not the only (or perhaps not even the best) solution.  However, succeeding in the financial markets does require an understanding (or use of a professional who understands) what factors work over time and what investor behavior practices are most likely to lead to good outcomes.

HT: Abnormal Returns

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State of the Market With 200 Day Moving Average

May 14, 2015

One well-recognized method of assessing the overall direction of the market is comparing the S&P 500′s current price to its 200 day moving average.  If the S&P 500 is above its 200 day moving average, it suggests a lower risk environment for the broad market.  If the S&P 500 is below its 200 day moving average, it suggests a higher risk environment for the broad market.  As the adage goes, the trend is your friend.  Being prepared to play defense when in a higher risk environment has the potential to help mitigate severe declines for investors.  Consider the following charts of the S&P 500 and its 200 day moving average since 1950 and the second chart showing it since 2000.

sp lt State of the Market With 200 Day Moving Average

sp2 State of the Market With 200 Day Moving Average

Source: Yahoo! Finance.  *10/18/1950 – 5/12/2015.  The performance above is based on pure price returns, not inclusive of dividends or all transaction costs.  Past performance is not indicative of future results.  Potential for profits is accompanied by possibility of loss.  Investors cannot invest directly in an index.  Indexes have no fees.  

Since 1950, the S&P 500 has been above its 200 day moving average 70% of the time.  That means that 30% of the time it was below its 200 day moving average and there were some pretty hairy markets during those times.  Consider the range of trailing 12 month performance of the S&P 500 over this period of time:

12 month State of the Market With 200 Day Moving Average

Source: Yahoo! Finance.  10/18/1950 – 5/12/2015.  The performance above is based on pure price returns, not inclusive of dividends or all transaction costs.  Past performance is not indicative of future results.  Potential for profits is accompanied by possibility of loss.  Investors cannot invest directly in an index.  Indexes have no fees.  

During some 12 month periods, the S&P 500 had spectacular returns—even approaching and exceeding 60%.  However, there were also plenty of trips into negative territory, with a number of them falling 20+%.

What does this mean for your clients?  Well, it depends upon the client.  If a particular client’s time horizon is really long and their tolerance for draw downs is high, then a passive approach to investing may work just fine.  However, most clients would prefer to have the ability to play some defense, especially if they planning on tapping into their nest egg in the near future.

One of the nice features of the 5 Virtus funds that Dorsey Wright was recently hired to provide research for is that they all have the ability to play defense in a meaningful way.  Each of the funds implement defensive measures in a slightly different way, but the 200 day moving average is a key component in all 5 of the funds.

To learn more about each of the funds, please click here to access the fact sheets and accompanying How It Works sheets.

The relative strength strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value.

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Waiting for the Dust to Settle

April 24, 2015

The Irrelevant Investor kills it with this post:

The Worst Investment Strategy Ever

Sarcasm <GO>

Do you make bad decisions when your portfolio goes down? What if there was a way to automate the decision so that your emotions wouldn’t get in the way. Good news, I found a way!

Here is the strategy, every time stocks drop five percent, you sell and wait for “clarity.” Why would you voluntarily ride out volatility, right? And here is the best part, you don’t get back in until things have stabilized. Repurchase stocks when they are one percent higher than when you sold, just to make sure that the dust has settled. Better be safe then sorry right? Here is what that strategy has looked like since the inception of the S&P 500.

a Waiting for the Dust to Settle

Alright so you didn’t beat the buy and hold investors but you did compound your money at 2.8% with less than a ten percent annualized standard deviation. This is just slightly worse than what the average investor has historically earned, but after adjusting for risk this looks like a great alternative.

End sarcasm <GO>

If you want to suppress volatility it’s likely you’ll suppress your returns as well, it’s just that simple. Here is an idea- if you are uncomfortable with equities, pick a different asset class. Notably, five year treasury notes have compounded at 6.6% a year since 1957 with an annualized standard deviation of just five percent. Unless your looking for an equity strategy with bond-like returns, you might want to rethink jumping in and out every time the market takes a dip.

Comfortable doesn’t work in the financial markets if you want to earn equity-like returns over time.  My simple solution (for typical 55ish-65ish+  year old): Divide your portfolio into three buckets.  Income Bucket, Balanced Bucket, and Growth Bucket.  For your Growth Bucket, don’t try to manage the volatility (that is, in large part, what the other buckets are for).  Don’t do something similar to the strategy described above of selling when you feel uncomfortable and buying when “the dust settles.”  Rather, accept that your Growth Bucket is going to have some volatility to it, some drawdowns, some uncomfortable years.  By all means, spend the necessary time (or seek the appropriate financial advice) to put together a well-thought-out allocation for that Growth Bucket, but once that part is done, don’t look at the Growth Bucket in isolation.  Look at it in the context of your overall asset allocation.  Simple advice, but I believe it would lead to much better outcomes than are typically achieved in the financial markets by investors.

Past performance is not indicative of future results.  Potential for profits is accompanied by possibility of loss.  The relative strength strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value.  Nothing contained herein should be construed as an offer to sell or the solicitation of an offer to buy any security.  This post does not attempt to examine all the facts and circumstances which may be relevant to any product or security mentioned herein.  We are not soliciting any action based on this post.  It is for the general information of readers of this blog.  This post does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients.  Before acting on any analysis, advice or recommendation in this post, investors should consider whether the security or strategy in question is suitable for their particular circumstances and, if necessary, seek professional advice.  

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Fund Flows

August 28, 2014

Mutual fund flow estimates are derived from data collected by The Investment Company Institute covering more than 95 percent of industry assets and are adjusted to represent industry totals.

ici 08.28.14 Fund Flows

This data is presented for illustrative purposes only and does not represent a past recommendation.

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Fund Flows

August 21, 2014

Mutual fund flow estimates are derived from data collected by The Investment Company Institute covering more than 95 percent of industry assets and are adjusted to represent industry totals.

ici 08.21.14 Fund Flows

This data is presented for illustrative purposes only and does not represent a past recommendation.

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Fund Flows

August 14, 2014

Mutual fund flow estimates are derived from data collected by The Investment Company Institute covering more than 95 percent of industry assets and are adjusted to represent industry totals.

ici 08.14.14 Fund Flows

This data is presented for illustrative purposes only and does not represent a past recommendation.

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Quote of the Week

August 13, 2014

Pre-commitment to a rational investment plan is important, because the intuitive impulse to act otherwise is strong. —Shlomo Benartzi

Understated quote by Shlomo Benartzi, but essential for investment success.

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When Ignorance May Not Be Bliss

August 12, 2014

In case there was any question about whether or not investors need advice (Forbes):

The stock market was up 30% in 2013, but if you’re like most investors, that’s news to you.

A new Gallup survey shows that nine out of ten people are unaware that the stock market climbed 30% last year. Most believe that stocks performed well, just not that well — 17% say stocks increased 20% and 37% say stocks increased 10%. Three out of ten people thought stocks stayed the same or decreased.

Investors Estimates of 2013 When Ignorance May Not Be Bliss

The bull market is well into its fifth year, but many Americans haven’t reaped the gains.

Just 52% of Americans were invested in the stock market last year, down from 62% in 2008, according to a previous Gallup survey.  Another study pegs equity allocations at their lowest levels over the last half century. This includes workers who own equities through money invested in a 401(k) or other retirement account.

“Every bull market, such as the one the country is now experiencing, has the bear’s shadow hanging over it. And that shadow tends to grow bigger and darker with every additional month of market gains,” notes Gallup.

What if investors were handed $10,000 to save or invest now?  Just 41% would put it in the stock market, while 36% would keep it in cash and 20% would buy a CD.

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Bullish Sentiment Dissipates–Again

August 7, 2014

From Bespoke Investments Group comes a reminder of the continuing skittishness of investors:

One thing that investors have been able to count on during this bull market is that whenever equities run into trouble bulls scatter and bears come out of the woodwork.  Given the recent market weakness, that has once again been the case this week.  Following the worst week for equities in over two years, bullish sentiment on the part of individual investors dropped and bearish sentiment spiked.  According to the weekly survey of investor sentiment from the American Association of Individual Investors (AAII), bullish sentiment dropped from 31.12% down to 30.89%.  While that was just a marginal decline, as you can see in the chart, it is still down sharply from where it was in early July.

a Bullish Sentiment Dissipates  Again

Meanwhile, the magnitude of the move in bearish sentiment was much greater.  Compared to last week’s reading of 31.12%, bearish sentiment rose over 7 percentage points this week to 38.23%.  That is the highest level of bearish sentiment in nearly a year (8/22/13).  With bullish sentiment now exceeding bullish sentiment by 7.34 percentage points, this is only the second time this year that bears have outnumbered bulls.

b Bullish Sentiment Dissipates  Again

It seems that every time the market drops a few percent, bullish sentiment dissipates.  In a secular bull market, which we may very well be in, that type of knee-jerk reaction can be costly.

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Fund Flows

August 7, 2014

Mutual fund flow estimates are derived from data collected by The Investment Company Institute covering more than 95 percent of industry assets and are adjusted to represent industry totals.

ici 08.07.14 Fund Flows

This data is presented for illustrative purposes only and does not represent a past recommendation.

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Risk Aversion in Squirrels (And Humans)

August 4, 2014

Who knew we had so much in common with squirrels!  Bob Seawright has a fun summary of a study of squirrels that tried to find out what causes a squirrel to flee.  After all, we’ve all had the experience of walking right by a squirrel and they don’ t seem to be the least bit bothered.  However, make eye contact with a squirrel and off they go.  Read his whole article for the methods of the study, but the key conclusion are as follows:

The key point is that it makes a big difference whether or not people are looking at the squirrels, although staying on the footpaths also keeps them calmer. In truly dreadful scientific prose that tries desperately to sound authoritative, the researchers conclude as follows:

“We have identified cues that are likely to be important for risk perception by an urban animal species monitoring its environment. Together with direction of attention of people, urban squirrels were more reactive to pedestrians that showed a divergence from ‘usual’ behaviour (e.g. pedestrians entering areas which are usually human-free), even when not associated with closer approach or changes in speed. In addition to being arboreal (which can include use of anthropogenic structures), which minimizes vulnerability to diurnal terrestrial ‘predators’ (see Herr, Schley & Roper, 2009), general trophic and social flexibility (Baumgartner, 1943; Don, 1983; Koprowski, 2005) may help explain why eastern grey squirrels are successful urban adapters.”

What they mean is that squirrels pay attention to unusual human behavior and eye contact. When they see them, they bolt.

Seawright then skilfully makes the connection to investor behavior:

These squirrels are a pretty good metaphor for us, but perhaps not in the way we might expect. Squirrels, like humans, are highly risk averse. We humans feel a loss two to two-and-a-half times more strongly than we feel a comparable gain. In the wild, that makes perfect sense. If the squirrels run away too readily, they may lose a nut or two, but little else. But if the varmint sticks around too long, it can get eaten by a predator. That’s a loss that is permanent and unrecoverable.

We are remarkably like squirrels. If markets are behaving as we expect, we’re fine. When they deviate from what we expect, we get concerned and pay special attention, ready to flee. And when we spend too much time looking head-on at what’s going on (as when the squirrels’ and the observers’ eyes meet in sweet communion)—perhaps checking our accounts online every day or, heaven forbid, watching one of the “business” channels, we tend to trade (read “bail”) far too often.

The research bears this tendency out. And, sadly, the professionals tend to flee as readily as their clients. The metaphor is a bit mixed, but if we have a good plan in place (a crucial “if”) and when the markets are wild, we’d be wise to “avert our eyes” and stay calm.

In the investment world, being too skittish—bailing out of the markets too readily—is generally much more dangerous to our success than holding on too long, especially when the applicable time horizon is a relatively long one. Staying the course through tough times requires that we deal with immediate pain for far-off gain, which is always very difficult for us. That makes this sort of situation that much tougher.

“Averting our eyes” only makes sense if we have a good plan in place.  That is the value of consulting with a competent financial advisor.  But, if that is in place, behaving like a squirrel is likely to end in disappointment.

squirrel Risk Aversion in Squirrels (And Humans)

Source: ThinkAdvisor.com

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Fund Flows

July 31, 2014

Mutual fund flow estimates are derived from data collected by The Investment Company Institute covering more than 95 percent of industry assets and are adjusted to represent industry totals.

ici 08.01.14 Fund Flows

This data is presented for illustrative purposes only and does not represent a past recommendation.

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Fund Flows

July 24, 2014

Mutual fund flow estimates are derived from data collected by The Investment Company Institute covering more than 95 percent of industry assets and are adjusted to represent industry totals.

ici 07.24.14 Fund Flows

This data is presented for illustrative purposes only and does not represent a past recommendation.

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Unrealistic Paradigms

July 21, 2014

The NYT unintentionally gives a great example of how NOT to analyze active equity strategies:

A new study by S.&P. Dow Jones Indices has some fresh and startling answers. The study, “Does Past Performance Matter? The Persistence Scorecard,” provides new arguments for investing in passively managed index funds — those that merely try to match market returns, not beat them.

Yet it won’t end the debate over active versus passive investing, because it also shows that a small number of active investors do manage to turn in remarkably good streaks for fairly long periods.

The study examined mutual fund performance in recent years. It found that very few funds have been consistently outstanding performers, and it corroborated the adage that past performance doesn’t guarantee future returns.

The S.&P. Dow Jones team looked at 2,862 mutual funds that had been operating for at least 12 months as of March 2010. Those funds were all broad, actively managed domestic stock funds. (The study excluded narrowly focused sector funds and leveraged funds that, essentially, used borrowed money to magnify their returns.)

The team selected the 25 percent of funds with the best performance over the 12 months through March 2010. Then the analysts asked how many of those funds — those in the top quarter for the original 12-month period — actually remained in the top quarter for the four succeeding 12-month periods through March 2014.

The answer was a vanishingly small number: Just 0.07 percent of the initial 2,862 funds managed to achieve top-quartile performance for those five successive years. If you do the math, that works out to just two funds. Put another way, 99.93 percent, or 2,860 of the 2,862 funds, failed the test.

Yes, that is right.  Unless a fund was in the top quartile of performance for each of the four years it was considered a failure.  The premise of the article is that investors should employ index funds unless they can find active strategies that outperform every year.  Talk about setting yourself up for failure!  I am aware of a number of investment factors that have generated outperformance over time (momentum, value, low volatility), but I am aware of nothing that outperforms every year.

The returns of those managers who are able to generate outperformance over time is rather lumpy.  Consider the performance profile of the best performing managers of the 1990′s as an example:

Cambridge Associates, a money management consulting firm, did a study of the top-performing managers for the decade of the 1990s. In 2000, they could look back and see which managers had returns in the top quartile for the entire decade. Presumably, these top quartile managers are precisely the ones that clients would like to identify and hire. Cambridge found that 98% of those top managers had periods of underperformance extending three years or more. 98% is not a misprint!  Even more striking, 68% of the top managers ended up in the bottom quartile for some three-year period and a full 40% of them visited the bottom decile during that ten years. Clearly, there are good and bad periods for every strategy.

Investing is challenging enough without setting yourself up for failure by placing unrealistic expectations on active managers.  I have nothing against index funds.  We use them in a number of our strategies and I think many investors can benefit from using them as part of their allocation.  However, they are not a panacea.

This example is presented for illustrative purposes only and does not represent a past recommendation.  A relative strength strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value.

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Why Bother With Active?

July 14, 2014

National Geographic makes a provocative claim about longevity on one of its recent covers:

national geographic may 13 600x375 Why Bother With Active?

Our genes harbor many secrets to a long and healthy life.  And now scientists are beginning to uncover them.

While it might be a stretch that life expectancy in the US will be approaching 120 any time soon, what is not a stretch is that life expectancy continues to increase.  Among many other aspects of increased longevity, the financial implications of being a good investor are becoming more pronounced.

To illustrate, consider a simple example.  Suppose that when the baby on the cover of the magazine graduates from high school at age 18 he decides to take a summer job selling alarm systems door-to-door.  This boy is a very good salesman, and is able to pull in $100,000 before he heads off to college.  He decides to take that sum of money and invest it in the stock market.  Suppose that this boy ends up never needing to use that money and so throughout his very long life that money just stays invested and is able to earn 9 percent a year.  Compare that return to a different person who, over the same time frame, invests $100,000 and earns only 6 percent a year.

Table 1 Why Bother With Active?

With this simple example, it becomes easy to see how greater longevity can have an outsized reward for those investors who are able to generate even a couple percent excess return over time.  After only 10 years of investment results, the investor earning 9 percent a year only has 1.3 times more money than the investor earning 6 percent.  However, after 100 years there is an enormous difference of 16.3 more money.

Something to think about next time you hear someone say that it is not worth it to try to find an active strategy that is able to generate a couple percent in annual excess return over time.

This example is presented for illustrative purposes only and does not represent a past recommendation.  A relative strength strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value.

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Fund Flows

July 10, 2014

Mutual fund flow estimates are derived from data collected by The Investment Company Institute covering more than 95 percent of industry assets and are adjusted to represent industry totals.

ici 07.10.14 Fund Flows

This data is presented for illustrative purposes only and does not represent a past recommendation.

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Two Sides of Risk Management

June 24, 2014

How did institutional investors handle their equity allocations in the aftermath of the financial crisis?  Just as a student of behavioral finance would have expected.  As reported by the WSJ:

The average college endowment had 16% of its investment portfolio in U.S. stocks as of the end of June 2013, the most recent academic year, according to a poll of 835 schools conducted by Commonfund, an organization that helps invest money for colleges. That is down from 23% in 2008 and 32% a decade ago. The 18% allocation to foreign stocks didn’t change in that period. Schools in the poll, which collectively manage nearly $450 billion, had 53% of their funds in alternative strategies, up from 33% in 2003.

The average allocation of corporate pension funds to stocks was 43% at the end of last year, down from 61% at the end of 2003, according to J.P. Morgan Chase & Co. The average public pension fund had 52% of its portfolio in stocks at the end of 2013, down from 61% at the end of 2003, J.P. Morgan said.

P1 BQ523 PENSIO G 20140623180315 Two Sides of Risk Management

After going through a traumatic event like the financial crisis, it is only natural to want to dial back the risk.  However, now that the S&P 500 Total Return Index has had an annualized returns of 18.39 percent over the past five years, ending 5/31/14, institutional investors are starting to realize just how costly their risk aversion has been.

Meanwhile, U.S. equity exposure in our Global Macro portfolio has been on the rise in recent years.  This global tactical asset allocation fund is driven by relative strength and as a result it dispassionately overweights those asset classes demonstrating the best performance.

Global Macro Two Sides of Risk Management

This Global Macro strategy is also used to manage The Arrow DWA Tactical Fund, which has outperformed 81 percent of its peers over the past 5 years—no doubt in large part because of its relatively high U.S. equity exposure.

morningstar Two Sides of Risk Management

Source: Morningstar, as of 6/24/14 

After experiencing two major bear markets in the last decade, investors big and small are demanding risk management.  However, it is important to remember that part of risk management is seeking to manage downside risk and part of it is seeking to capitalize in strong equity markets.

The relative strength strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value.  Click here for Appendix A.  This example is presented for illustrative purposes only and does not represent a past recommendation.   Investors cannot invest directly in an index. Indexes have no fees. Past performance is not indicative of future results. Potential for profits is accompanied by possibility of loss. 

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Hoarding Cash

June 15, 2014

I would never argue against holding some cash (say 6-9 months worth of non-discretionary expenses), but holding this much??

According to new research on investors in 16 countries by State Street’s Center for Applied Research, retail investors globally were holding an average of 40 percent of their assets in cash, up from 31 percent two years ago. That’s a compounded annual growth rate of a whopping 13 percent.

The lowest levels of cash holdings were in India, at 26 percent, and China, at 30 percent; the highest was 57 percent in Japan. The United States was in the middle at 36 percent, but that was an increase of 10 percentage points in just two years. The survey, done by State Street, one of the world’s largest asset managers and custodians, was conducted in the first quarter of this year. It considered cash to be money held in savings and checking accounts as well as cash equivalents like money market funds.

Despite the run-up in equity markets, people have resisted rushing into stocks and have instead added to cash. They’ve done this regardless of their age or amount of wealth. The study found that millennials who are under 33 and have the longest time to invest their money were increasing their cash positions at the same rate as baby boomers, who will need to draw on their investments soon.

So, the amount of cash being held has gone up over the past two years even though there has been a rising market…doesn’t really support the position of some that we’re starting to see risk-taking come back in a major way.  It also doesn’t strike me as the type of behavior you might see at a major market top.

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The Case for Tactical Asset Allocation

June 4, 2014

One of the realities for a typical investor preparing for retirement is that they do not have an unlimited time for their investments to work out.  Take, for example, a 55 year old client with $1.5 million in investable assets.  Whether this investor earns a return of 4% or 8% on their portfolio over the next several decades is going to dramatically change their standard of living.  Yet, I think few clients have an appreciation for just how much variability there can be in returns to different asset classes that commonly make up a diversified portfolio.  For example, consider the variation in returns over the last couple of decades in U.S. stocks, commodities, bonds, and real estate as shown in the table below.

asset class 06.04.14 The Case for Tactical Asset Allocation

Source: Global Financial Markets and FactSet.  *Data through 5/28/14.  This example is presented for illustrative purposes only and does not represent a past recommendation.  The performance above is based on total returns, inclusive of dividends, but does not include all transaction costs.   Investors cannot invest directly in an index. Indexes have no fees. Past performance is not indicative of future results. Potential for profits is accompanied by possibility of loss. 

The column in green highlights the dispersion between the best and worst performing decade for that asset class.  There really is no such thing as stability in the financial markets!  Think about the implications that this might have on different approaches to building an asset allocation.  One approach to dealing with the amount of variability in asset class returns could be to simply equal weight exposure to a broad range of asset classes.  That may work out okay over time, but I think is susceptible the behavioral weaknesses of most investors, as pointed out in the quote below.

The problem with the person who thinks he’s a long-term investor and impervious to short-term gyrations is that the emotion of fear and pain will eventually make him sell badly. –Robert Wibbelsman

A tactical approach to asset allocation, driven by a relative strength, has a number of potential performance and client management advantages over many alternative approaches to asset allocation.  As shown in the images below, a trend following approach to asset allocation seeks to identify and overweight those asset classes that are in favor and to underweight those asset classes that are out of favor.

arrow trend following The Case for Tactical Asset Allocation

Source: Arrow Funds

One of the developments over the past decade that has made a tactical approach to asset allocation even more accessible to individual investors is the expansion of the ETF universe to include a broad range of asset classes like U.S. equities, international equities, currencies, commodities, real estate, and fixed income.

To learn more about our “Global Macro” approach to asset allocation, please click here.

A relative strength strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value.

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Recession Babies

May 14, 2014

Bloomberg on the implications of lasting psychological damage inflicted on millennials during the financial crisis:

While investing in equities has dropped across the board since the recession, so-called millennials born after 1980 have continued to forsake the market even as it rebounds, according to a Gallup poll taken April 3 through April 6. Just 27 percent of 18- to 29-year-olds reported owning shares outright or in funds, down from 33 percent in April 2008, the survey found.

The aversion means the group is missing out as major indexes reach records, potentially imperiling their future financial security, especially at a time when these Americans are also shunning investments such as real estate. Instead of plunging into stocks, which can provide better returns over the long run, young people are stashing savings in bank accounts and securities that pay near-zero interest.

“We call them Recession Babies,” said William Finnegan, a senior managing director at MFS Investment Management in Boston, drawing a parallel to “Depression Babies” who avoided banks and investing after the 1929 crash. “If the cumulative return of the past five years didn’t convince you that the stock market might be an OK place to be for a long-term investor, I’m not sure what else is going to. These folks have been scarred.”

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Market Narratives–Oops

May 5, 2014

A Wealth of Common Sense  makes a good point as it relates to sector leadership over the past couple of years:

The best performer over this period was the consumer discretionary sector. One of the narratives following the financial crisis was that the consumer was tapped out from the debt overhang. From 2009-13, consumer discretionary stocks were up nearly 240% versus the S&P’s gain of roughly 130% (Although that trend has finally reversed this year).

sector leadership Market Narratives  Oops

So much for that market narrative!  It sounded good at the time, but the Consumer Discretionary sector has been a strong outperformer over the last couple of years.

Allocations to the PowerShares DWA Momentum ETF (PDP), of course, pay no attention to market narratives.  Rather, allocations to this index are based solely on relative strength.

pdp Market Narratives  Oops

Source: Dorsey Wright

As shown above, the Consumer Discretionary sector has shown some signs of deterioration this year, so it is possible that when PDP goes through its next quarterly rebalance at the end of the quarter that the exposure to Consumer Discretionary stocks will drop (it is also possible that they will rebound from here and regain a leadership position).

However, the broader point is a good one—beware of market narratives.

A relative strength strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value.  Past performance is no guarantee of future returns. Potential for profits is accompanied by possibility of loss. Dorsey Wright & Associates is the index provider for the suite of Momentum ETFs with PowerShares.  See www.powershares.com for more information.  A list of all holdings for the trailing 12 months is available upon request.

HT: Abnormal Returns

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The Case for Rules-Based Models

April 30, 2014

There is a passage in Steven Pinker’s book The Better Angels of Our Nature: Why Violence Has Declined that focuses on self-control which caught my eye:

Researchers Baumeister and his collaborators measured self-control by asking university students to divulge their own powers of self-control by rating sentences such as these:

I am good at resisting temptation.

I blurt out whatever is on my mind.

I never allow myself to lose control.

I get carried away by my feelings.

I lose my temper too easily.

I don’t keep secrets very well.

I’d be better off if I stopped to think before acting.

Pleasure and fun sometimes keep me from getting work done.

I am always on time.

After adjusting for any tendency just to tick off socially desirable traits, the researchers combined the responses into a single measure of habitual self-control.  They found that the students with higher scores got better grades, had fewer eating disorders, drank less, had fewer psychosomatic aches and pains, were less depressed, anxious, phobic, and paranoid, had higher self-esteem, were more conscientious, had better relationships with their families, had more stable friendships, were less likely to have sex they regretted, were less likely to imagine themselves cheating in a monogamous relationship, felt less of a need to “vent” or “let off steam,” and felt more guilt but less shame.  Self-controllers are better at perspective-taking and are less distressed when responding to others’ troubles, though they are neither more nor less sympathetic in their concern for them.  And contrary to the conventional wisdom that says that people with too much self-control are uptight, repressed, neurotic, bottled up, wound up, obsessive-compulsive, or fixated at the anal stage of psychosexual development, the team found that the more self-control people have, the better their lives are.  The people at the top of the scale were the mentally healthiest. (my emphasis added)

Could it also be those with the highest self-control are also better investors?  I suspect the answer is clearly yes.  One can probably easily guess how we feel about the topic of self-control given that the name of this blog is Systematic Relative Strength.  The ups and downs of the financial markets are extremely effective at tempting investors to respond to their emotions and to forget about self-control.  The natural consequence being the tendency to buy when an investor feels good and to sell when an investor feels scared (a recipe for poor investment results).

While there are countless investment and self-help books that claim to be able to train people to develop greater self-control, I think that an even more effective way for investors to reap the rewards that accrue to the self-disciplined in the financial markets is simply to employ systematic investment models.  Our preference at Dorsey Wright is to execute relative strength-driven models, but there are surely also other investment models that can be applied systematically.  My experience in talking to numerous financial advisors on a regular basis is that those advisors who employ rules-based models tend to be more confident in their ability to provide value for their clients, tend to be more relaxed, and tend to be bigger producers than those without such an approach.

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Trepidation About Investing Persists

April 24, 2014

Looks like there may still be a long ways to go in this bull market:

Six years after the financial crisis, most Americans remain unwilling to risk putting money in the stock market, according to a new report.

Research by Bankrate.com found that 73 percent of those surveyed are shying away from investing. This reluctance comes despite the low interest rates being paid on savings and government bonds, and market returns that exceeded 30 percent last year.

Source: CBS News

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