Wow.  I recently finished examining the first two years of returns for our Formula Investing U.S. separately managed accounts.  The results are stunning.  But probably not for the reasons you’re thinking.  Let me explain.

Formula Investing provides two choices for retail clients to invest in U.S. stocks, either through what we call a “self-managed” account or through a “professionally managed” account. A self-managed account allows clients to make a number of their own choices about which top ranked stocks to buy or sell and when to make these trades. Professionally managed accounts follow a systematic process that buys and sells top ranked stocks with trades scheduled at predetermined intervals. During the two year period under study[1], both account types chose from the same list of top ranked stocks based on the formulas described in The Little Book that Beats the Market.

Let’s put it another way: on average the people who “self-managed” their accounts took a winning system and used their judgment to unintentionally eliminate all the outperformance and then some!

Mr. Greenblatt analyzed the data and explains exactly how it happened.  Consider these the four deadly sins.

1. Self-managed investors avoided buying many of the biggest winners.

2. Many self-managed investors changed their game plan after the strategy underperformed for a period of time.

3. Many self-managed investors changed their game plan after the market and their self-managed portfolio declined (regardless of whether the self-managed strategy was outperforming or underperforming a declining market).

4. Many self-managed investors bought more AFTER good periods of performance.

I didn’t even have to add the bold type—Mr. Greenblatt did it for me.  He has useful discussions about why each of these things happen, but this is absolutely typical investor behavior, stuff we have written about over and over again.  Investors on their own, I suspect, could figure out a way to perform poorly even if they had tomorrow’s Wall Street Journal.  Implied in Greenblatt’s commentary is a strong argument in favor of hiring a disciplined and systematic investment advisor.

Think about this: all of the excess return that typical investors are giving away is available to investors who are 1) willing to implement a strategy even when it is uncomfortable, 2) willing to stick with a solid long-term investment strategy, and 3) add money during periods of weakness.  If your advisor is willing to do that, they are probably worth every penny.

Source: Calculated Risk  (click on chart to expand)

Maybe the world isn’t ending after all.  One never knows exactly how investors will respond to economic data, but movement from low levels to consumer sentiment to high levels of consumer sentiment is usually associated with decent equity markets.  The best entries tend to occur when sentiment is very poor—i.e., investors are perhaps overly pessimistic.

We recently developed a series of scenarios  for our clients and prospective clients to consider as a way to establish how  they really feel about investment risk.

Scenario 1:

You’re on a plane preparing land at LaGuardia Airport in New  York City during a thunderstorm.  With  minutes to go before landing, the plane is suddenly rocked by violent down  drafts.  Do you:

• Buckle your seatbelt tighter, clutch your armrests and toss a  prayer to your personal deity.
• Rush down the aisle, kick open the cockpit door and seize  controls of the plane yourself.

Scenario 2:

You’re at the dentist having root canal.  Suddenly, you feel acrid dust on your tongue  and smell smoke.  Do you:

• Ask for a moment to rinse your mouth and clear your throat (this  will be over soon.)
• Grab the drill and finish the operation yourself.

Scenario 3:

You’re a defendant in a major product liability case.  If you lose, you could be out $500,000.  After two weeks of trial, the case could go  either way.  During the final summation  do you:

• Rely on your attorney to finish the trial – win or lose, he’s  the one who went to law school.
• Address the judge and jury yourself.

Scenario 4:

Your three year old car develops a case of “mushy” brakes and  won’t stop as quickly as you expect.  Do  you:

• Take the car into the dealer for a thorough inspection.
• Tinker with the master cylinder, calipers and brake pads  yourself.

Scenario 5:

Stock prices have fallen 20% over the last 6 months, and  leveraged investors everywhere are vomiting up securities.  On the television, investment analysts  soberly explain how you must hedge your portfolio by “loading up on the  UltraProShares Triple-Short ETF.”  Your  brother-in-law is buying gold and dividing his cash up among 6 different banks,  in case one of them fails.  Do you:

• Hang tight, knowing that you won’t draw on your assets in stocks  for at least five years, and think about maxing out your 401K contributions a  bit early this year.
• Fire your investment advisor (“that idiot!”) and convert all  your stocks to cash.

If you would select option “B” in any of these scenarios, please  write a few sentences as to why.

A good tongue-in-cheek reminder of why it sometimes makes sense to take professional advice and stick with a well thought out strategy!

However, simply pointing this reality out to a client with inadequate savings who is approaching retirement doesn’t do them a lot of good.  That information may be motivational to younger people who still have the time to increase their savings, but those approaching retirement need two things.  First, they need financial planning help to determine a prudent withdrawal rate on their portfolio to minimize the risk that they actually do run out of money.  Second, they need help determining a prudent approach to asset allocation to take them through the next 30 plus years.

One of the most influential studies on withdrawal rates and asset allocations in retirement was a 1998 paper by three professors of finance at Trinity University.

Its conclusions are often encapsulated in a “4% safe withdrawal rate rule-of-thumb.” It refers to one of the scenarios examined by the authors. The context is one of annual withdrawals from a retirement portfolio containing a mix of stocks and bonds. The 4% refers to the portion of the portfolio withdrawn during the first year; it’s assumed that the portion withdrawn in subsequent years will increase with the CPI index to keep pace with the cost of living. The withdrawals may exceed the income earned by the portfolio, and the total value of the portfolio may well shrink during periods when the stock market performs poorly. It’s assumed that the portfolio needs to last thirty years. The withdrawal regime is deemed to have failed if the portfolio is exhausted in less than thirty years and to have succeeded if there are unspent assets at the end of the period.

The authors backtested a number of stock/bond mixes and withdrawal rates against market data compiled by Ibbotson Associates covering the period from 1925 to 1995. They examined payout periods from 15 to 30 years, and withdrawals that stayed level or increased with inflation.   The table below shows the percentage of trials in which the portfolios survived for the entire testing period.

Table: Portfolio Success Rate: Percentage of all Past Payout Periods From 1926 to 1995 that are Supported by the Portfolio After Adjusting Withdrawals for Inflation and Deflation

Note: Numbers in the table are rounded to the nearest whole percentage. The number of overlapping 15-year payout periods from 1926 to 1995, inclusively, is 56; 20-year periods, 51; 25-year periods, 46; 30-year periods, 41. Stocks are represented by Standard and Poor’s 500 Index, bonds are represented by long-term, high-grade corporates, and inflation (deflation) rates are based on the Consumer Price Index (CPI). Data source: Calculations based on data from Ibbotson Associates.

Source: Retirement-Income.net

It becomes clear from reviewing this table that being “conservative” and allocating heavily to bonds may be safe in the short run, but it may very well lead to eating dog food over the long term.  Furthermore, any withdrawal rate over 3-4% is likely to be disastrous over a 30 year period of time.

The biggest opportunity for a financial advisor to be able to add value to their client’s dilemma is to be able to help them commit to an appropriate withdrawal rate and then to focus on the asset allocation.  The financial advisor who is able to clearly explain how a global tactical asset allocation strategy may be able to address the weakness of static asset allocation or strategic asset allocation and potentially decrease the probability of running out of money is the financial advisor who can make a real difference for their clients.

—-this article was originally published 11/24/2009.  The payout tables are based on 1926-1995 returns and suggest real conservatism in withdrawal rate assumptions.  Returns since 1995, and especially since 2000, have been lower than the long-term averages.  If you had opted for a high withdrawal rate, things would be tough right now.  Investors need to save more and invest intelligently and patiently to have retirement success.  Consider incorporating portfolio fecundity into your withdrawal assumptions because it will better reflect the current investing environment.

Being wrong isn’t fun. When there’s a problem, it’s often because we’ve made a mistake. We’ve been conditioned to believe that making a mistake is something shameful. Embarrassed, we tell ourselves stories to avoid recognizing that we’re in trouble. We tell ourselves that things aren’t actually that bad. We tell ourselves that things will get better. We even look for others to blame.

No one likes losing. For most of us, the pleasure we get from gain, like our investments doing well, is dwarfed by the pain we feel from loss. While this pain can be chronic from a continuing issue, it becomes acute when we decide to face the facts and do something about it.

…big mistakes almost always start as small mistakes. Then we delay doing something about them, and they grow until we find ourselves in a hole that we thought unimaginable just a short time before.

By the way, psychological studies verify that we feel the pain of loss 2x-3x more than we feel the pleasure of a gain.  It’s not your imagination.  Losses are definitely hard to take.

The most important reason that we use a systematic investment process that ranks everything using relative strength is so we have an objective guideline to make portfolio changes.  Did a stock fall in the ranks?  Then we cut our losses and out it goes, no questions asked.  Is a stock or asset class still ranked highly, however toppy it might feel to us at the moment?  Then it stays in the portfolio and we (perhaps reluctantly) let our profits run.  On any one transaction we never know if we made the correct decision–that’s something you can only find out in hindsight.  But the discipline of a systematic way to cut losses and let profits run gives you a much better chance of coming out ahead than caving in to your emotions at every turn.

Successful investing, whether you use relative strength or value or any other method, is more about temperament and discipline than analysis.

HT to Abnormal Returns.

Legg Mason Capital Management Value Trust (LMVTX), run by Miller since 1982, disclosed in a semi-annual report last week that the fund sold 18.2 million Kodak shares late last year and during this year’s first quarter for about $3.89 each on average. The fund realized a $551 million loss through the divestiture, according to the report.

Miller, 61, began loading up on Kodak shares in 2000 and, by the end of 2005, his firm owned as much as 25 percent of the Rochester, New York, company. Value Trust, one of several Legg Mason funds and accounts to hold Kodak stock, kept the bulk of its stake for more than a decade, only to sell after the film company had lost more than 90 percent of its market value.

Someone took the Kodachrome away

Source: www.photographymonthly.com

One of the challenges that value investors must take on is the value trap.  A value trap is a stock that looks cheap, but turns out to be cheap for a reason.  EK didn’t necessarily hold Bill Miller back; he had quite a number of years of market outperformance with Kodak included in the portfolio.  Other selections did pan out and more than offset the problem stocks.  The problem with value traps is psychological.  The Bloomberg article goes on:

“Part of it was just this mentality that this was just a temporary setback and Kodak would be able to get quickly back on track,” said Bridget Hughes, an analyst at Morningstar Inc., a Chicago-based stock and fund research firm. “It was not only a mistake, it was also causing a lot of client angst.”

I put the psychological problem in bold.  It drives clients crazy to see a big loser in the portfolio quarter after quarter, year after year. Even when buying cheap stocks is obviously part of the investment philosophy and when patience is required to get good returns, clients sometimes struggle with it.

Portfolio management using a systematic relative strength process has different strengths and weaknesses.  Clients are less likely to see a big loser sitting in the portfolio quarter after quarter, but are more likely to see more numerous transactions that result in small or moderate losses.   I suspect clients are no happier about a string of small losses, but they often seem to be able to let it go.  On the plus side, when using relative strength, most of the big winners will be retained in the portfolio for an extended time.

No investment approach is perfect, and every investment methodology will have its fair share of mistakes.  Still, clients choose to stick with some investment managers and bail on others, even when their long-run performance is comparable.  The client’s choice is often made primarily on the basis of emotion—sometimes just how they feel about how things are going.  All other things being equal, why would you elect to have your big losers show up on client statements for an extended period of time?

—-this article was originally published 6/30/2011.  Today EK filed for bankruptcy.  Someone finally took their Kodachrome away.  Kodak has had persistently poor relative strength for years.  Relative strength has its issues, but getting stuck in value traps is not one of them!

The Beardstown Ladies are members of a famous investment club formed in the early 1980s. The ladies rose to prominence in the mid-1990s after the club proclaimed fantastic investment results. For 10-years ending 1993, the club reported a compounded return of 23.4% in their stock portfolio versus 14.9% for the S&P 500. The ladies bought stocks of companies they knew, like McDonald’s and Coke. The investment success propelled the ladies into stardom. They appeared on TV shows and in commercials, spoke on radio programs, and not to miss a moneymaking opportunity, published best selling books on the subject of personal finance and investing. The world changed for the Beardstown ladies in late 1997. A reporter from the Chicago magazine noticed something peculiar about their published investment results. After calculating the numbers several times, he concluded that a gross error had been made. The error was so large, that the accounting firm of Price Waterhouse was called in to clear the air. In the final tally, the clubs worst fears were realized. The ladies’ actual return was only 9.1%, far below the 23.4% they reported, and well below the S&P 500. For years the ladies deposited monthly dues into their account and classified it as an investment gain, rather than additional capital. An embarrassed treasurer blamed the error on her misunderstanding of the computer software the club was using.

Unfortunately it’s not just the Beardstown Ladies who can’t do math.  No one questioned the returns initially because they wanted to believe it was true.  The exact same error is repeated by most 401k investors who often count their contributions as part of their performance.  Even in the absence of contributions, the rest of us favorably mis-remember our results anyway.  Psychology Today explains:

What was your portfolio return last calendar year? How did you perform relative to market indexes and other investors? Most investors don’t know the answers to these questions. But their belief in their performance is quite flattering to themselves!

Two interesting studies illustrate this point. In the first study, William Goetzmann and Nadav Peles surveyed a group of investors belonging to the American Association of Individual Investors (AAII) and a group of architects about their retirement plan investment returns. The AAII investors are presumably very knowledgeable about investing from their participation in the association. When asked about their return the previous year, they overestimated their performance by 3.4% (= estimate – actual). Architects are very intelligent with a high degree of education, though they may not be knowledgeable investors. They overestimated their return by 8.6%. Both groups were also asked about their performance relative to a benchmark made up of the same asset allocation. The groups overestimated their relative performance by 5.1% and 4.2%, respectively.

Markus Glaser and Marin Weber also conclude that investors have biased views of their portfolio performance in the past. They surveyed individual investors from a German online brokerage firm and compared their self-assessments to their actual returns over four years. They reported a belief of an annual return mean of 14.9% over the period. Their actual return was more like 3.3%. Now that is overconfidence! In fact, there was no correlation between the actual return and the beliefs about the returns in the sample.

Cognitive dissonance strikes again.  According to Goetzmann and Peles in the Psychology Today article:

The authors attribute this to a psychological phenomenon called cognitive dissonance. The investors are mentally distressed by the conflict between a good self-image and empirical evidence of poor choices. To reduce the discomfort, investors adjust their memory about that evidence and those choices. This is then selectively re-enforced by noticing the returns of just their good performing stocks and mutual funds in the portfolio and not the poor ones.

Self-image wins every time.  A keen observer will note that investors never vastly underestimate their aggregate returns!

What can we learn from this, other than Germans are the most confident investors on the planet?  I’ve bolded the return estimates, just so you can see clearly how large the gap in perception created by cognitive dissonance really is.  The bottom line is that we all want to imagine we are getting or can get fantastic returns.

Right now we are smack in the middle of crazy season, where investors are examining their prior year returns and determining whether to stay with their current mutual fund or investment manager.  As an investment professional, one of the things you quickly realize is that you are being compared with imaginary numbers–what the client believes you should have done, or what they imagine they would have done!  Of course, as discussed above, the imaginary numbers are always terrific.

Cognitive dissonance, I believe, accounts for a lot of the manager turnover in the industry, not just volatility and style rotation.  As evidence, consider that according to DALBAR, the average holding period for mutual fund investors is about three years–whether they own a stock fund or a bond fund.  The volatility of the average bond fund is probably not enough to shake investors out, but when comparing the bond manager’s actual returns with imaginary returns, investors can only handle three consecutive years of disappointment!  Ok, I’m being a little sarcastic here, but this corresponds perfectly with studies of black-box trading systems, which indicate that investors who purchase even a profitable system abandon it after three consecutive losses.  (For fans of Markov probability chains, an average of only fourteen coin flips is required to get three heads in a row.)

When it comes to returns, we are all Beardstown Ladies at heart.  Our imagined returns are always going to be significantly higher than what we actually get.  Keep in mind that, according to the Psychology Today article, there was no correlation between the actual return and the beliefs about the returns.  Instead of being bamboozled by your inner Beardstown Lady, step back and really think about your investments.  Do they meet your needs?  Is the underlying return factor still sound?  Keep in mind that the only investment acumen required to actually earn the mutual fund NAV returns is to hold the fund!  You don’t have to condemn yourself to DALBAR-type returns.  Sure, if something has gone really wrong, you might need to make a gradual change in course–but more often than not, if the return over a multi-year period is in the ballpark, you’re quite possibly better off leaving it alone.  If you want to be a successful investor, you need to learn to deal with the real world and not imaginary returns.

Reject your inner Beardstown Lady!

A statistician cited in the Wall Street Journal article about the play points out that the numbers are clear.  The Patriots had a 79% of winning the game by going for it on fourth down, either by converting or by stopping the Colts from scoring afterwards, but only a 70% chance of winning if they had to stop the Colts from driving down the field after a punt.  The Patriots, going with the numbers, elected to go for it, failed, and ended up losing the game.

The most interesting thing about the decision was not that the Patriots went with the odds and ended up with the short end of the stick.  The interesting thing is how vocal fans and the sports press have been about Mr. Belichick’s “bad” decision.

The kind of thing comes about because people have a tendency, in matters of probability, to confuse decisions and outcomes.  The Patriots indeed had a bad outcome, but the decision seems to have been statistically correct.  The reason that people are responding to the decision so harshly has to do with the cognitive bias of regret avoidance.  The Wall Street Journal article points this out very nicely:

In a recent study, researchers from Duke and UCLA found that when faced with a decision involving risk, people have an overwhelming tendency to make the supposedly safe choice—to err on the side of caution—even though doing so may lead to worse results.By studying thousands of hands of blackjack played by random people, the researchers found that when they strayed from the “book” or the optimal strategy, those players who did something aggressive were more successful than those who did something passive.

In fact, the subjects made four times as many passive mistakes as they did aggressive ones. And these passive mistakes—holding on a 16 when the dealer has a king showing, for example—were more costly: They cost $2 for every $1 won, versus $1.50 for every $1 won on aggressive mistakes.

Why do people embrace caution? “It’s because of the regret that people face when they take an action and it doesn’t turn out well for them,” says Bruce Carlin of UCLA’s Anderson School of Management, who worked on the study.

Think about that for a few minutes: people made four times as many passive mistakes as they did aggressive ones.  And the passive mistakes were more expensive.  Maybe risk aversion is not such a good idea in certain circumstances.  True, it feels better because we don’t have to feel dumb if we take a risk and it doesn’t work out.  Maybe feeling comfortable is overrated.  If we are truly concerned about outcomes over the long run, often it makes sense to err on the side of aggressiveness rather than passivity.

One of the biggest benefits of a systematic investment process is that it is unemotional.  Our process is designed to expose the portfolios to high relative strength picks–whether it feels comfortable to us or not–simply because research suggests that high relative strength outperforms over time.  If you punt when the chips are down, you won’t have the benefit of the odds working in your favor over time.

—-this article was originally published 11/17/2009.  No doubt we will see some NFL team this weekend make a conservative mistake as well.  Investors, like football coaches, have a conservatism bias due to fear of regret.  Interestingly, the bias toward conservatism often tilts the odds so that being aggressive is the more correct strategy.  Investors often cost themselves money by being too conservative.  The safe choice isn’t always the smart choice.