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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Quote of the Week

March 27, 2014

From Meb Faber:

 Most of the alpha out there (or smart beta or whatever it is being called these days) is either hard to find or hard to DO.  And by do, I mean it goes against everything your behavioral instincts tell you to do.  Buying a stock at all time highs is hard to do, and one reason momentum and trend work.  Buying a value investment is hard for many reasons.

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Picking the Winners: NCAA Office Pool Edition

March 18, 2014

The WSJ this morning on how to win your NCAA Office Pool:

Pick the favorites. This is the only foolproof way to guarantee you won’t embarrass yourself.

For all of the attention paid to underdogs—is there any other reason you know Florida Gulf Coast University exists?—the better team still wins most round-of-64 games. Over the last 10 seasons, the average number of double-digit seeds beating favorites was six per tournament. Meanwhile, a bracket with favorites winning every game last year would have placed in the 91st percentile of entries to ESPN’s contest, a company spokeswoman said. In other words, your bracket can only be so contrary until it’s cuckoo.

Part of the fun of NCAA Office Pools is bragging rights of picking the underdogs (even if it’s a statistical unlikelihood).  However, this same principle applies to investing.  When it comes to the financial markets, rather than shoot for bragging rights, go for the money!

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The Coming Mega-Bull Market?

March 2, 2014

Investor behavior has a lot to do with how markets behave, and with how investors perform.  To profit from a long mega-bull market, investors have to be willing to buy stocks and hold them through the inevitable ups and downs along the way.  Risk tolerance greatly influences their willing to do that—and risk tolerance is greatly influenced by their past experience.

From an article on risk in The Economist:

People’s financial history has a strong impact on their taste for risk. Looking at surveys of American household finances from 1960 to 2007, Ulrike Malmendier of the University of California at Berkeley and Stefan Nagel, now at the University of Michigan, found that people who experienced high returns on the stockmarket earlier in life were, years later, likelier to report a higher tolerance for risk, to own shares and to invest a bigger slice of their assets in shares.

But exposure to economic turmoil appears to dampen people’s appetite for risk irrespective of their personal financial losses. That is the conclusion of a paper by Samuli Knüpfer of London Business School and two co-authors. In the early 1990s a severe recession caused Finland’s GDP to sink by 10% and unemployment to soar from 3% to 16%. Using detailed data on tax, unemployment and military conscription, the authors were able to analyse the investment choices of those affected by Finland’s “Great Depression”. Controlling for age, education, gender and marital status, they found that those in occupations, industries and regions hit harder by unemployment were less likely to own stocks a decade later. Individuals’ personal misfortunes, however, could explain at most half of the variation in stock ownership, the authors reckon. They attribute the remainder to “changes in beliefs and preferences” that are not easily measured.

The same seems to be true for financial trauma. Luigi Guiso of the Einaudi Institute for Economics and Finance and two co-authors examined the investments of several hundred clients of a large Italian bank in 2007 and again in 2009 (ie, before and after the plunge in global stockmarkets). The authors also asked the clients about their attitudes towards risk and got them to play a game modelled on a television show in which they could either pocket a small but guaranteed prize or gamble on winning a bigger one. Risk aversion, by these measures, rose sharply after the crash, even among investors who had suffered no losses in the stockmarket. The reaction to the financial crisis, the authors conclude, looked less like a proportionate response to the losses suffered and “more like old-fashioned ‘panic’.”

I’ve bolded a couple of sections that I think are particularly interesting.  Investors who came of age in the 1930s tended to have an aversion to stocks also—an aversion that caused them to miss the next mega-bull market in the 1950s.  Today’s investors may be similarly traumatized, having just lived through two bear markets in the last decade or so.

Bull markets climb a wall of worry and today’s prospective investors are plenty worried.  Evidence of this is how quickly risk-averse bond-buying picks up during even small corrections in the stock market.  If history is any guide, investors could be overly cautious for a very long time.

Of course, I don’t know whether we’re going to have a mega-bull market for the next ten or fifteen years or not.  Anything can happen.  But it wouldn’t surprise me if the stock market does very well going forward—and it would surprise me even less if most investors miss out.

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How Not to be a Terrible Investor

February 27, 2014

Morgan Housel at Motley Fool has a wonderful article on how investors can learn from failure.  He sets the tone with a few different quotes and anecdotes that point out that a lot of being a success is just avoiding really dumb mistakes.

At a conference years ago, a young teen asked Charlie Munger how to succeed in life. “Don’t do cocaine, don’t race trains to the track, and avoid all AIDS situations,” Munger said. Which is to say: Success is less about making great decisions and more about avoiding really bad ones.

People focus on role models; it is more effective to find antimodels—people you don’t want to resemble when you grow up.    Nassim Taleb

I’ve added the emphasis, but Mr. Housel makes a good point.  Learning from failure is equally important as learning from success.  In fact, he argues it may be more important.

If it were up to me, I would replace every book called How to Invest Like Warren Buffett with a one called How to Not Invest Like Lehman Brothers, Long-Term Capital Management, and Jesse Livermore. There are so many lessons to learn from these failed investors about situations most of us will face, like how quickly debt can ruin you. I’m a fan of learning from Buffett, but the truth is most of us can’t devote as much time to investing as he can. The biggest risk you face as an investor isn’t that you’ll fail to be Warren Buffett; it’s that you’ll end up as Lehman Brothers.

But there’s no rule that says you have to learn by failing yourself. It is far better to learn vicariously from other people’s mistakes than suffer through them on your own.

That’s his thesis in a nutshell.  He offers three tidbits from his study of investing failures.  I’ve quoted him in full here because I think his context is important (and the writing is really good).

1. The overwhelming majority of financial problems are caused by debt, impatience, and insecurity. People want to fit in and impress other people, and they want it right now. So they borrow money to live a lifestyle they can’t afford. Then they hit the inevitable speed bump, and they find themselves over their heads and out of control. That simple story sums up most financial problems in the world. Stop trying to impress people who don’t care about you anyways, spend less than you earn, and invest the rest for the long run. You’ll beat 99% of people financially.

2. Complexity kills. You can make a lot of money in finance, so the industry attracted some really brilliant people. Those brilliant people naturally tried to make finance more like their native fields of physics, math, and engineering, so finance has grown exponentially more complex in the last two decades. For most, that’s been a disservice. I think the evidence is overwhelming that simple investments like index funds and common stocks will demolish complicated ones like derivatives and leveraged ETFs. There are two big stories in the news this morning: One is about how the University of California system is losing more than $100 million on a complicated interest rate swap trade. The other is about how Warren Buffett quintupled his money buying a farm in Nebraska. Simple investments usually win.

3. So does panic. In his book Deep Survival, Laurence Gonzalez chronicles how some people managed to survive plane crashes, getting stranded on boats, and being stuck in blizzards while their peers perished. The common denominator is simple: The survivors didn’t panic. It’s the same in investing. I’ve seen people make a lifetime of good financial decisions only to blow it all during a market panic like we saw in 2008. Any financial decision you make with an elevated heart rate is probably going to be one you’ll regret. Napoleon’s definition of a military genius was “the man who can do the average thing when all those around him are going crazy.” It’s the same in investing.

I think these are really good points.  It’s true that uncontrolled leverage accompanies most real blowups.  Having patience in the investing process is indeed necessary; we’ve written about that a lot here too.  The panic, impatience, and insecurity he references are really all behavioral issues—and it just points out that having your head on straight is incredibly important to investment success.  How successful you are in your profession or how much higher math you know is immaterial.  As Adam Smith (George Goodman) wrote, “If you don’t know who you are, the stock market is an expensive place to find out.” 

Mr. Housel’s point on complexity could be a book in itself.  Successful investing just entails owning productive assets—the equity and debt of successful enterprises—acquired at a reasonable price.  Whether you own the equity directly, like Warren Buffett and his farm, or in security form is immaterial.  An enterprise can be a company—or even a country—but it’s got to be successful.

Complexity doesn’t help with this evaluation.  In fact, complexity often obscures the whole point of the exercise.

This is actually one place where I think relative strength can be very helpful in the investment process.  Relative strength is incredibly simple and relative strength is a pretty good signaling mechanism for what is successful.  Importantly, it’s also adaptive: when something is no longer successful, relative strength can signal that too.  Sears was once the king of retailing.  Upstart princes like K-Mart in its day, and Wal-Mart and Costco later, put an end to its dominance.  Once, homes were lit with candles and heated with fuel oil.  Now, electricity is much more common—but tomorrow it may be something different.  No asset is forever, not even Warren Buffett’s farmland.  When the soil is depleted, that farm will become a lead anchor too.  Systematic application of relative strength, whether it’s being used within an asset class or across asset classes, can be a very useful tool to assess long-term success of an enterprise.

Most investing problems boil down to behavioral issues.  Impatience and panic are a couple of the most costly.  Avoiding complexity is a different dimension that Mr. Housel brings up, and one that I think should be included in the discussion.  There are plenty of millionaires that have been created through owning businesses, securities, or real estate.  I can’t think of many interest rate swap millionaires (unless you count the people selling them).  Staying calm and keeping things simple might be the way to go.  And if the positive prescription doesn’t do it for you, the best way to be a good investor may be to avoid being a terrible investor!

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The Growing Case Against ETFs

February 21, 2014

That’s the title of a Marketwatch article by mutual fund columnist Chuck Jaffe.  I have to admit that usually I like his columns.  But columns like this make me nuts!  (See also The $ Value of Patience for an earlier rant on a similar topic.)

Here’s the thesis in a nutshell:

…safe driving comes down to a mix of equipment and personnel.

The same can be said for mutual funds and exchange-traded funds, and while there is growing consensus that ETFs are the better vehicle, there’s growing evidence that the people using them may not be so skilled behind the wheel.

The article goes on to point out that newsletters with model portfolios of mutual funds and ETFs have disparate results.

Over the last 12 months, the average model portfolio of traditional funds—as tracked by Hulbert Financial Digest—was up 20.9%, a full three points better than the average ETF portfolio put together by the same advisers and newsletter editors. The discrepancy narrows to two full percentage points over the last decade, and Hulbert noted he was only looking at advisers who run portfolios on both sides of the aisle.

Hulbert posited that if you give one manager both vehicles, the advantages of the better structure should show up in performance.

It didn’t.

Hulbert—who noted that the performance differences are “persistent” — speculated “that ETFs’ advantages are encouraging counterproductive behavior.” Effectively, he bought into Bogle’s argument and suggested that if you give an investor a trading vehicle, they will trade it more often.

Does it make any sense to blame the vehicle for the poor driving?  (Not to mention that DALBAR data make it abundantly clear that mutual fund drivers frequently put themselves in the ditch.)  Would it make sense to run a headline like “The Growing Case Against Stocks” because stocks can be traded?

Mutual funds, ETFs, and other investment products exist to fulfill specific needs.  Obviously not every product is right for every investor, but there are thousands of good products that will help investors meet their goals.  When that doesn’t happen, it’s usually investor behavior that’s to blame.  (And you’re not under any obligation to invest in a particular product.  If you don’t understand it, or you get the sinking feeling that your advisor doesn’t either, you should probably run the other way.)

Investors engage in counterproductive behavior all the time, period.  It’s not a matter of encouraging it or not.  It happens in every investment vehicle and the problem is almost always the driver.  In fact, advisors that can help manage counterproductive investor behavior are worth their weight in gold.   We’re not going to solve problems involving investor behavior by blaming the product.

A certain amount of common sense has to be applied to investing, just like it does in any other sphere of life.  I know that people try to sue McDonald’s for “making” them fat or put a cup of coffee between their legs and then sue the drive-thru that served it when they get burned, but whose responsibility is that really?  We all know the answer to that.

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The Power of Buying Pullbacks

February 5, 2014

Buying pullbacks is a time-tested way to boost returns.  From time to time, we’ve discussed the utility in buying pullbacks in the market.  Buying the dips—instead of panicking and selling—is essentially doing the opposite of how most investors conduct their affairs.  In the past, much of that discussion has involved identification of market pullbacks using various oversold indicators.  (See, for example, Lowest Average Cost Wins.)  In a recent article in Financial Planning, Craig Israelsen proposes another good method for buying pullbacks.

The gist of his method is as follows:

The basic rule for investment success is as old as the hills: Buy low, sell high. But actually doing it can be surprisingly difficult.

Selling a stock or fund that has been performing well is tough. The temptation to ride the rocket just a little longer is very strong. So let’s focus on the other element: Buy low.

I propose a disciplined investment approach that measures performance against an annual account value target. If the goal is not met, the account is supplemented with additional investment dollars to bring it up to the goal. (For this exercise, I capped supplemental investment at $5,000, in acknowledgement that investors don’t have endlessly deep pockets.)

Very simply, the clients will “buy low” in years when the account value is below the target. If, however, the target goal is met at year’s end, the clients get to do a fist pump and treat themselves to a fancy dinner or other reward.

One benefit of this suggested strategy is that it is based on a specific performance benchmark rather than on an arbitrary market index (such as the S&P 500) that may not reflect the attributes of the portfolio being used by the investor.

In the article, he benchmarks a diversified portfolio against an 8% target and shows how it would have performed over a 15-year contribution period.  In years when the portfolio return exceeds 8%, no additional contributions are made.  In years when the portfolio return falls short of 8%, new money is added.  As he points out:

It’s worth noting that the added value produced by this buy-low strategy did not rely on clever market timing in advance of a big run-up in the performance of the portfolio. It simply engages a dollar cost averaging protocol – but only on the downside, which is where the real value of dollar cost averaging resides.

Very smart!  (I added the bold.)  It’s a form of dollar-cost averaging, but only kicks in when you can buy “shares” of your portfolio below trend.  He used an 8% target for purposes of the article, but an investor could use any reasonable number.  In fact, there might be substantial value in using a higher number like 15%.  (You could also use a different time frame, like monthly, if that fit the client’s contribution schedule better.)  Obviously you wouldn’t expect a 15% portfolio return every year, but it would get clients in the habit of making contributions to their account in most years.  Great years like 2013 would result in the fancy dinner reward, while lousy market years would result in maximum contributions—hopefully near relative lows where they would do the most good.

This is an immensely practical method for getting clients to contribute toward some kind of goal return—and his 15-year test shows good results.  In six of the 15 years, portfolio results were below the yardstick and additional contributions were made totalling $13,802.  Making those additional investments added an extra $12,501 to what the balance would have been otherwise, resulting in a 7.7% boost in the portfolio total.  Looked at another way, over time you ended up with nearly a 100% return on the extra money added in poor years.

Of course, Israelsen points out that although his proposed method is extremely simple, client psychology may still make it challenging to implement.  Clients are naturally resistant to committing money to an underperforming market or during a period of time when there is significant uncertainty.  Still, this is one of the better proposals I have seen on how to motivate clients to save, to invest at reasonable times, and to focus on a return goal rather than on how they might be doing relative to “the market.”  You might consider adding this method to your repertoire.

Rollercoaster3 zps2aa050fa The Power of Buying Pullbacks

Buy pullbacks and use the rollercoaster ride of the market to your advantage.

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