Relative Strength And Portfolio Management

February 3, 2012

Years ago we developed a testing protocol to help us determine how robust a strategy really is.  We wanted to determine how much of the strategy’s tested returns were a result of luck and how much of the return was due to the underlying factor performance.  We have run all of our strategies through that process over the years, and we published some of those results back in 2010.  The data was just updated through the end of last year and the updated can be found here.

When testing a model it is always difficult to determine if the results you are achieving are repeatable or not.  If you are testing a high relative strength model, for example, are the results coming from one or two stocks that make the whole test look fantastic?  If that is the case I would have my doubts about how that strategy would perform in real-time.  But if the results are truly from an underlying factor performance (regardless of the individual securities in the portfolio) then you have something you can work with.

The way we determine if a model is lucky or not is to run multiple simulations based on a random draw of securities.  In a relative strength model we might break our universe into ten different buckets.  Out of the highest bucket we might draw 50 stocks at random.  We hold those stocks until they are no longer classified as high relative strength securities.  Once they fall below a specific rank we sell the security and buy another one at random.  If we run 100 trials we get 100 different portfolios over time.  What we are trying to determine is if the individual securities in the test really matter, or is just the concept of buying high relative strength securities over time what causes the outperformance.

As it turns out, what stocks go in to the portfolio aren’t as important as exploiting the factor.  A disciplined approach is that consistently drives the portfolio to strength is what drives the returns over time.

(Click To Enlarge)

The table shows the results from one of the factors tested in the paper.  You can see the range of outcomes each year as well as how each model did over the 16 year test period.  Sometimes the models outperform, sometimes the underperform, and some years you have mixed results.  But over 16 years, all of the models outperformed!  All we did was pick stocks at random out of a high relative strength basket.  There is nothing complicated about it.  The main thing is that the process is systematic and extremely disciplined.

More details about the testing process and results can be found in the paper (click here).

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Posted by John Lewis

From the Archives: Thinking of Relying on an Expert?

February 3, 2012

From The Frontal Cortex:

In the early 1980s, Philip Tetlock at UC Berkeley picked two hundred and eighty-four people who made their living “commenting or offering advice on political and economic trends” and began asking them to make predictions about future events. He had a long list of pertinent questions. Would George Bush be re-elected? Would there be a peaceful end to apartheid in South Africa? Would Quebec secede from Canada? Would the dot-com bubble burst? In each case, the pundits were asked to rate the probability of several possible outcomes. Tetlock then interrogated the pundits about their thought process, so that he could better understand how they made up their minds. By the end of the study, Tetlock had quantified 82,361 different predictions.

After Tetlock tallied up the data, the predictive failures of the pundits became obvious. Although they were paid for their keen insights into world affairs, they tended to perform worse than random chance. Most of Tetlock’s questions had three possible answers; the pundits, on average, selected the right answer less than 33 percent of the time. In other words, a dart-throwing chimp would have beaten the vast majority of professionals. Tetlock also found that the most famous pundits in Tetlock’s study tended to be the least accurate, consistently churning out overblown and overconfident forecasts. Eminence was a handicap.

This is the very reason that we rely on systematic trend following. Experts may sound convincing, but don’t count on their predictions.

—-this article was originally published 11/17/2009.  Expert opinion is still worse than random chance.  Improve your odds with a systematic investment process.

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Posted by Mike Moody

Nobody Knows How To Value Anything

February 2, 2012

Jerry Bowyer makes an interesting point about interest rates (which are a key input into valuation models):

The fact that interest rates tell us the truth about ourselves is intolerable to the political class. They don’t want us to be told the truth. They want low interest rates to foster the illusion that inflation is low in order to create the perception that capital is abundant, and to enable their governments to borrow more than they should by subsidizing the interest rates through money creation; the latter necessary to muffle the alarm bells of rising default risk.

But if the interest rate is the basis on which all investments, or for that matter, all spending decisions are made, and the interest rates are being distorted by central banks, then that means that all valuation is plunged into chaos. That is exactly what is happening right now. Nobody knows how to value anything. (emphasis added)

Valuation models are vulnerable to paradigm shifts.  Interest rates are arguably being manipulated to a much greater degree than has been seen in the past.  Price, on the other hand, will always be the intersection of supply and demand.  Trend following models should do just fine in an era of highly manipulated interest rates and are likely to effectively capitalize on the resultant bubbles.

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Posted by Andy Hyer

Revisionist History

February 1, 2012

In certain regimes, political figures who fell into disfavor were expunged from the history books.  The Conference Board is somehat better, in that the old and the new indicators can be compared.  Specifically, the Conference Board has changed the composition of the US Leading Economic Indicator.  Ed Yardeni comments:

The Conference Board has made the first major overhaul of the components of the LEI since it assumed responsibility of the index in 1996. It replaced real money supply with its proprietary leading credit index, and the ISM supplier delivery index with the new orders index. In place of the Thomson Reuters/University of Michigan consumer expectations measure, it will now use an equally weighted average of its own consumer expectations index and the current measure. Also, the nondefense capital goods gauge was tweaked to exclude commercial aircraft.

The impact of these changes has been shocking, and really questions the credibility of constructing LEIs. The old LEI rose to a new record high in November, exceeding the previous cyclical peak (where it hovered during 2006 and 2007) by 12.7%. The new LEI edged back up in December to its previous high for the year during July, but that’s 13.1% below the previous cyclical peak!

I added the bold, but you can see why economists are shocked when you see the visual difference in the chart reproduced below (I think Dr. Yardeni included the ECRI leading indicator for good measure):


Source: Ed Yardeni/Conference Board/Haver Analytics (click on chart to enlarge)

The old LEI is blasting off into the stratosphere, but the new LEI is still way, way below the old highs.  In addition, the old LEI showed a very modest decline from the 2006 peak, while the new version shows a bloodbath that took out the 2000-2002 recession lows!

Mr. Yardeni has a very apt comment on the problems with indicators that are revised:

These man-made indexes combine a bunch of indicators that purportedly lead the business cycle. When they fail to do so, the men and women who made these indexes recall them, retool them, and send them back out for all of us to marvel at how well these new improved versions would have worked in the past. I can accurately predict that when they fail in the future, they will be recalled and redesigned yet again.

Of course, it’s not just the US LEI that economists revise.  They revise GDP, CPI, employment data, and virtually everything else.  Analysts revise earnings estimates with regularity, which I suppose is a good way to avoid saying “Our old estimate turned out to be wrong.”

Here we see one of the benefits of using relative strength: since it uses only market prices, it is not subject to revision.  Prices reflect true supply and demand.  No one can come back to you and say, “You know those IBM shares you sold in 2010 for $141?  We’ve revised the data and it was really only $123, so you need to send us a check.  Of course, we might revise it again later, so keep your address current.”  It is difficult to make good investment decisions even when using good data!  It’s got to be near impossible using data that turns out to have been completely wrong.

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Posted by Mike Moody

Quantitative Wheezing

January 31, 2012

Central bank balance sheets are being rapidly expanded all over the world.  Jim Bianco has a nice piece at The Big Picture, replete with amazing graphics.  For the record, I’ve known Jim for 20 years and he does some of the most intriguing fixed income research you will ever see.  He writes:

The degree to which central banks around the world are printing money is unprecedented.

He proceeds to show the balance sheets for each of the large central banks, converted back into dollars.  Your eyes will bug out when you see the original article.  For the sake of brevity, all I show here is his graphic of the composite of eight large central banks.

Source: Bianco Research/The Big Picture  (click on image for a sharper version)

Jim points out that:

The combined size of  these eight central banks’ balance sheets has almost tripled in the last  six years from $5.42 trillion to more than $15 trillion and is still on  the rise!

I have no idea if this is a good or bad thing.  How you interpret it probably depends on which group of economists you put your faith in.  My guess—and this is only a guess—is that huge increases in the money supply will eventually result in some inflation.  Commodities generally respond fairly well to inflation, while fixed income may be gasping for air.  (This sort of fits the ”retail investor is always wrong” template, given the huge amounts poured into bonds over the last couple of years.)  Inflation might be a good thing from the Federal government’s point of view, as it will make paying off debt a lot less expensive in real terms.  It might not be so good for investors, depending on how their portfolio is constructed.

The one thing I don’t have to guess at is that quantitative easing, whether it continues to accelerate to ever-giddier heights or starts to wind down, will lead to trends of some kind.  When that happens, relative strength will be a useful guide to sort out where the investment opportunities lie.

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Posted by Mike Moody

The Cleansing Effect of Recessions

January 30, 2012

Now that we seem to be through the recession and investor sentiment is beginning to improve to the point that maybe Recession 2.0 is not on the immediate horizon, investors are faced with trying to figure out what to do next.  The Freakonomics blog has a useful thought about what they call the “cleansing effect” of recessions:

In the past, when I’ve tried to schedule our window cleaners they have always been able to come within two days. Despite the still-slow economy, the first available appointment this time is not for three weeks.

“Why?” I ask. The owner says that during the worst of the recession his firm had enough clients to survive, but barely; smaller, less efficient companies died off. Now that demand for cleaning has increased, his own customers are coming back; and the customers of the now-defunct companies are hiring him too, so he’s swamped with business. Recessions kill off inefficient firms; but at least in this case, those that survive come out stronger than before.

Relative strength is a good tool for sorting out the winners from the losers.  Companies that have been hit hard from the lingering recession often show weak relative strength, while companies that have managed to power through tough times and grow despite it are often leaders.

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Posted by Mike Moody

Consumer Sentiment Improves

January 27, 2012

The final University of Michigan Consumer Sentiment Index came in at 75.0 for January.  That’s a sharp improvement from where it was last summer and fall, but it’s still in the lower part of the range over the past 30 years.  Check out the fantastic graphic from Calculated Risk:

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.

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Posted by Mike Moody

Harnessing the Power of Momentum

January 27, 2012

That’s the title of a recent article in Advisor Perspectives about relative strength investing.  (Academics call it momentum.)  The article was written by a principal at a Canadian money management firm, Michael Nairne, so it’s nice to see a little cross-border validation.  From the article:

Numerous academic studies have confirmed that, when measured in periods of approximately three to 12 months, past investment winners tend to keep on outperforming while past losers tend to keep underperforming.

Momentum is not simply a US phenomenon. A recent study2 covering equities in 23 countries from November 1989 to September 2010 found evidence of strong momentum returns in North America, Europe and Asia Pacific; only Japan was an exception. Another study tracking the largest 100 stocks in the British market from 1900 to 2009 found that a portfolio comprised of the 20 best performers over the prior 12 months outperformed the worst performers by 10.3% annually3.  The same authors found momentum in 18 out of 19 markets, dating back to 1975 in larger European markets and 1926 in the US.

Momentum is not confined to portfolios of individual stocks – it exists in a variety of asset classes. A recent study4 has found that momentum exists in government bonds, commodities and currencies as well as country equity indexes. Momentum has also been found in corporate bonds5 as well as the financial futures market6.

The article is well-footnoted.  I recommend you read the original, which I linked to above.  The article does a good job discussing both the pros and cons of relative strength.  For example, the author points out that:

…there are prolonged periods where stocks with positive momentum underperform the market.  Despite an overall annualized premium of 3.9%, there have 22 periods where stocks with positive momentum have underperformed the market by greater than 5%, with durations as long as several years.

Although investors have a marked tendency to abandon strategies when they underperform for a period of time, that might not be a good idea with relative strength.  Despite periods of underperformance, long-term results have been remarkable:

The $1.00 investment in momentum stocks grew to $67,309, nearly 30-times larger than the $2,321 earned in the S&P 500. [August 1927 to July 2011]  For long-term investors, this outperformance has been remarkably enduring. In 99.6% of the 10-year rolling periods since July 1937, momentum stocks have outperformed the S&P 500. [my emphasis]

Investors have a lot of choices when it comes to selecting an investment strategy, but not many have been as well validated over as long a period of time in multiple markets as relative strength.

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Posted by Mike Moody

Whole Wide World

January 26, 2012

Sometimes we focus so much on our own situation that we forget there is a whole wide world out there–and lots of investment opportunities.  A chart that was eye-opening for me appeared recently on Dr. Ed’s Blog, written by the estimable Wall Street economist Ed Yardeni.  Check it out:

Source: Ed Yardeni   (click on image to expand)

Ok, so the developed world isn’t really boosting oil demand.  There could be a lot of reasons for that besides a lack of economic growth: conservation, increased efficiency, substitution of other energy sources, etc.  But emerging markets—wow!  The financial crisis was barely a blip in oil demand.

Money will go wherever it is treated best–and it tends to seek out growth.  Markets are global and your portfolio should be too.

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Posted by Mike Moody

Tactical Management and Flawed Forecasting

January 26, 2012

Bob Veres is a highly respected columnist for Financial Planning magazine.  He’s been in the forefront of advocating good practices in financial planning.  He had an interesting article about the dangers of tactical management last month–and the longer I chew over that article, the more problems I see with forecasting, explicit and implicit.

First, let me set the scene for you.  Mr. Veres indicated that he had spent a month doing data analysis of a survey of over 1000 financial planners.  One of the most interesting takeaways:

Perhaps the most striking thing I learned is that, post-2008, activities once labeled “market timing” are now solidly in the mainstream.  No, planners are not moving into or out of the market based on reading the entrails of animal sacrifices. But they seem to be taking a much more active approach to protecting clients from downside risk. The survey asked whether advisors planned to raise or lower their allocations to each of 35 different investment classes or vehicles in the next three months. A remarkable 83% are anticipating at least one tactical adjustment – and the great majority expects to make several.

Mr. Veres raises a legitimate question about how accurate planner’s forecasts are, and what the possible consequences of poor forecasts could be.  As an example, he cites inflation forecasts:

One of the most provocative set of responses came when advisors were asked to forecast the inflation rate and the real (after-inflation) return of both equities and 10-year Treasuries over the next 10 years. On inflation, the majority of responses clustered between 3% and 5%, and the remaining responses had a center of gravity on the 6% to 7% part of the chart. If there is wisdom in the crowd, the crowd of advisors seems to believe we will experience above-average inflation for at least the remainder of this decade.

But we also had responses as low as -4% a year (projecting severe Japanese-style deflation), several as high as 10% and one advisor who anticipates annual inflation of 13% over the coming decade. One or the other group on the fringes is going to be spectacularly wrong (or both will), and I suspect that damaging consequences will show up in the portfolios they recommend.

He is absolutely correct in his belief that a strategic allocation based on a wildly incorrect forecast will be damaging to a client.  And, he indicated that expectations for real returns were even more widely dispersed.  It’s where he goes next that made me think.  He writes:

Say what you will about the buy-and-hold ethos that lasted until September 2008. It may not have been an ideal strategy during the worst of the bear markets, but it did keep the members of the herd from straying too far from the center – and, more important, it kept the profession from getting the kinds of black eyes I think advisors are going to encounter in the future.

I think there is a critical error in this line of thinking.  Buy-and-hold strategic allocations are typically based on historic returns.  Those historic returns, of course, are the same for everybody and they do have the effect of keeping everyone in the middle of the herd.

This is the critical error: basing your allocation on historic returns is also a forecast–it’s simply an implicit forecast that historic returns will continue along the same path!  If that doesn’t happen, you will end up just as horribly wrong as the advisors on the forecasting fringes!  Yes, you will fail conventionally along with everyone else in the middle of the herd, but you will fail nonetheless.  (How do you think most clients feel right now, with their equity allocations based for the last decade on an 8-10% historic return, a return that has not materialized?  And there’s always Japan.)

Frankly, if you’re going to do strategic asset allocation at all, research shows that naive equal-weighting performs as well as anything else.  The reason advisors are gravitating toward tactical management in the first place is because traditional strategic asset allocation has so much trouble with tail events, and 2008-2009 was a big tail event.  Clients have memories, and advisors are simply responding to client demand for a more active form of risk management.  Now, like Mr. Veres, I’m not very confident in the forecasting abilities of financial planners.  I’m not very confident in the forecasting abilities of anyone, for that matter, including me.

All forecasting is flawed, whether it is explicit or implicit.  To me, there are only two realistic choices for asset allocation.  Either 1) equal-weight a large number of asset classes and rebalance periodically or 2) commit to a systematic method of tactical asset allocation.  There are funds that use valuation triggers and funds that use relative strength to rotate among asset classes–and I suspect either will perform acceptably over time if it is systematic and disciplined.

3 Comments | Tactical Asset Alloc, Thought Process | Permalink
Posted by Mike Moody

Divergent Investment Market Scenarios

January 25, 2012

TFC Financial Management makes an argument for divergent market performance:

The global financial markets today appear to be divided into three distinct economic modes: 1) Europe with its sovereign debt crisis seemingly headed into recession; 2) the emerging countries and Asia, most apparently back on a moderate growth track; and 3) the U.S. entering a surprisingly improved economic recovery which seems to have caught the “experts” unaware.  What may be unfolding is a global picture of divergent investment market scenarios, not the free market convergence which investors have come to accept as gospel these past 15-20 years.

As a general rule, the larger the dispersion in returns in a given investment universe, the better the environment for relative strength strategies.

HT: Real Clear Markets

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Posted by Andy Hyer

Tasty Flavor of the Month: Low Volatility

January 24, 2012

Low volatility funds have been hot lately.  They are easy to market right now.  Low volatility sounds appealing and they have performed well.  According to the Wall Street Journal:

…it’s not difficult to see why investors might prefer a low-volatility strategy. It certainly paid off last year: The S&P 500 Low Volatility Index returned 10.9% in 2011, more than eight percentage points higher than the Standard & Poor’s 500-stock index.

But there is a caveat:

If the market continues to rally this year, low-volatility strategies could underperform.

Since 2008, the S&P 500 Low Volatility Index has underperformed during years when the Chicago Board Options Exchange Market Volatility Index, or VIX—which  tracks investor expectations for market volatility—dropped, while outperforming when the VIX rose. (One exception: In 2007, the VIX rose, but the Low Volatility Index underperformed.)

Low volatility funds tend to lag when markets get hot.  Investors, wrapped in their current bearish gloom, aren’t worrying about that right now.  But flat market years like 2011 are often followed by above-average years.

One way to use low volatility funds in your portfolio without perhaps taking the full brunt of underperformance is to pair the low volatility return factor with relative strength.  Examine, if you will, an efficient frontier constructed from SPLV and PDP.  Relative strength often outperforms when markets trend.  It’s a nice efficient frontier and might smooth out your core equity exposure over time.

Source: Dorsey Wright Money Management (click on chart to expand)

For the time periods when hypothetical returns were used, the returns are that of the PowerShares Dorsey Wright Technical Leaders Index and of the S&P 500 Low Volatility Index.  The hypothetical returns have been developed and tested by the Manager (Dorsey Wright in the case of PDP and Standard & Poors in the case of SPLV), but have not been verified by any third party and are unaudited. The performance information is based on data supplied by the Dorsey Wright or from statistical services, reports, or other sources which Dorsey Wright believes are reliable.  The performance of the Indexes, prior to the inception of actual management, was achieved by means of retroactive application of a model designed with hindsight.  For the hypothetical portfolios, returns do not represent actual trading or reflect the impact that material economic and market factors might have had on the Manager’s decision-making under actual circumstances.  Actual performance of PDP began March 1, 2007 and actual performance of  SPLV began May 5, 2011.  See PowerShares.com for more information.

2 Comments | Markets, Thought Process | Permalink
Posted by Mike Moody

Debt and Deleveraging

January 23, 2012

This is the title of a new report from McKinsey & Company on global debt.  So far, things are playing out pretty much like Ken Rogoff and Carmen Reinhart suggested they would.  To wit:

…major economies have only just begun deleveraging. In only three of the largest mature economies—the United States, Australia, and South Korea—has the ratio of total debt relative to GDP fallen. The private sector leads in debt reduction, and government debt has continued to rise, due to recession. However, history shows that, under the right conditions, private-sector deleveraging leads to renewed economic growth and then public-sector debt reduction.

In many countries, debt is still growing.  In a few, debt has gone down in the private sector (corporations and individuals), mostly offset by rising debt in the government sector.  The good news is that the public sector debt may start to drop when the economy begins to grow.

The Economist has some nice graphics from the McKinsey study.  It’s very interactive and allows you to see what happened around the world over time.  And they make a good point about debt and wealth:

Wealth ebbs away a lot faster than debt. Our interactive guide shows levels of debt as a % of GDP for a selection of rich countries and emerging markets. With a few exceptions, such as Germany and Japan, most rich countries saw a huge rise in debt levels in the years running up to the crisis. Unwinding these dues will take a lot longer. In many rich countries the process of debt reduction hasn’t even started.

I added the bold.  It will take some spending restraint and renewed economic growth to start to pare the debt burdens.  By the way, this is true on an individual level as well as a national level!  When asset values implode, the debt remains.

It’s too early to tell if the US market has turned the corner and will pay more attention to growth than debt going forward.  There are still a lot of things up in the air in Europe and in domestic politics.  Once again, relative strength may be the best option for sorting out what assets are going to perform over time.

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Posted by Mike Moody

From the Archives: Value Trap: Eastman Kodak

January 19, 2012

Bill Miller at Legg Mason Value Trust had one of the longest mutual fund outperformance streaks in history, 15 years through 2005.  His record may end up like Joe DiMaggio’s longstanding consecutive game hits record—never equalled and rarely even approached.  Yet even superstar fund managers may occasionally have feet of clay.  According to a Bloomberg article, his fund has had a rough time with Eastman Kodak:

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!

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Posted by Mike Moody

Your Inner Beardstown Lady

January 19, 2012

Most of the whippersnappers in the business don’t even remember the Beardstown Ladies.  They were grandmotherly-looking members of an investment club in Beardstown, Illinois who had generated 23% returns on the investment pool for many years.  According to an 1998 story in the Wall Street Journal:

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!

 

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

From the Archives: Punting When the Chips Are Down

January 19, 2012

Sunday night’s football game between the Patriots and the Colts was one for the ages.  Two future Hall of Fame quarterbacks on the two winningest teams in recent years faced off.  Ultimately the game turned on a decision that had to be made by the Patriots’ coach, Bill Belichick.  The Patriots had a fourth down with two yards to go deep in their own territory.  If they succeeded in getting it, they could run out the clock and win the game.  If they failed, the Colts would have the ball and enough time to score.

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.

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

Anything Can Happen–and Probably Will

January 17, 2012

Investors have their hands full right now.  There are a lot of global political and economic uncertainties, as well as a few complicating factors that we haven’t seen before (i.e., interest rates at zero).  Trying to figure out what might happen next is next to impossible.  In a recent commentary in Advisor Perspectives, Neel Kashkari of PIMCO laid out a number of possible outcomes.

  1. Austerity and deflation
  2. Explicit default
  3. Mild inflation
  4. Runaway inflation
  5. Miraculous growth

He points out further that this state of affairs is pretty chaotic–and that every opinion can be supported with precedents and sound reasoning.  There’s no easy way to figure out what is more or less likely.  Not to mention that the range of outcomes pretty much covers the waterfront.

In a “normal” economic environment investors debate a narrow range of outcomes: will the U.S. grow by 2.8% or 3.2%? Will inflation remain at 2.0% or climb to 2.3%? Debating a future of inflation vs. deflation is radically new territory for investors. The chaotic nature of the choice facing societies is whipsawing equity markets and dominating bottom-up factors.

There is a wide range of opinions, each supported by relevant precedents and sound economic reasoning. Yet despite our intense focus, we don’t know the answer with certainty.

This is brutal for investors, at least if you are trying to construct a strategic asset allocation.  Your ideal allocations would be almost diametrically opposed if they were optimized for austerity/deflation or runaway inflation!

The situation is further complicated by the fact that different players may make different choices.  For example, what if Greece decides on explicit default, but the UK opts for austerity and deflation?  Trying to figure out the net result of that interaction for a multitude of financial assets is a daunting prospect.

No investment method is going to get everything right ever, and especially not in this environment.  Yet, it seems to me that an adaptive process powered by relative strength has a good chance of rolling with the punches enough to capture returns from some of the themes.  Different assets will respond to evidence of different outcomes, and while there will doubtless be any number of cross-currents, the strongest assets will probably point us toward the weight of the evidence.  A disciplined tactical asset allocation process might be the best we can do when the range of possible outcomes is so wide.

1 Comment | Markets, Tactical Asset Alloc, Thought Process | Permalink
Posted by Mike Moody

Expert Opinion: Tom Brady Edition

January 17, 2012

In light of the Patriots’ blowout victory over the Broncos during Saturday’s AFC Divisional Playoff game, in which Tom Brady threw for 6 touchdowns, I thought it would be worthwhile to look back at the conventional wisdom on Tom Brady when he came into the league:

Tom Brady wasn’t supposed to be here.  He was the 199th pick in the 2000 draft.  Although Brady had broken passing records at the University of Michigan, most team scouts thought he was too fragile to play with the big boys.  The predraft report on Brady by Pro Football Weekly summarized the conventional wisdom: “Poor build.  Very skinny and narrow.  Ended the ’99 season weighing 195 pounds, and still looks like a rail at 211.  Lacks great physical stature and strength.  Can get pushed down more easily than you’d like.”  The report devoted only a few words to Brady’s positive attribute: “decision-making.” –How We Decide, Jonah Lehrer

So far, Brady has won three Super Bowls, two Super Bowl MVP awards, and has been selected to seven Pro Bowls.

Just another tidbit to tuck away for when you are tempted to yield to expert forecasts.

Prediction is very difficult, especially if it’s about the future. –Nils Bohr

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Posted by Andy Hyer

Fedspeak

January 13, 2012

The Federal Reserve Open Market Committee (FOMC) transcripts from 2006 were just released.  This is the committee of Federal Reserve personnel and rotating regional Fed bank presidents that make monetary policy.  The Fed has awesome resources and access to the best data on the planet to aid their decisions.  Calculated Risk reproduced some of their comments on housing in 2006.

You’ve got to check it out.  Simply amazing.  It will be really interesting to see if this line of thinking continued through 2007 when those transcripts are released next year.  (There’s a five-year lag.)  Most real estate securities peaked in 2007 and then plummeted, but you can see from some of the comments that there was very little concern about that outcome in 2006.

If the Fed has no idea that Armageddon is a few months away, why would you think that any private forecaster with access to less information would be any more accurate?  Relative strength is based on price–good old supply and demand–and not on anyone’s guess, however well-informed it might appear.

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Posted by Mike Moody

Cat on a Hot Stove

January 12, 2012

The cat, having sat upon a hot stove lid, will not sit upon a hot stove lid again. But he won’t sit upon a cold stove lid, either.—-Mark Twain

When you get burned, it’s important to learn your lesson.  As Mark Twain’s witticism suggests, it’s also important not to learn the wrong thing!  I was thinking about this in reference to James Surowiecki’s recent column in The New Yorker.  He notes:

It isn’t just that volatility costs ordinary investors money. It also makes them  more likely to give up on the stock market entirely: over the past three years,  investors have pulled almost two hundred and fifty billion dollars out of equity  funds, even though stock prices have almost doubled since the lowest point of  the crash. And, while some of that money has gone into exchange-traded funds,  most of it has just left the market. This flight from stocks is probably not a good thing for people’s retirement  accounts—after all, in a capitalist country owning some capital is usually a  smart way to make money. But it may well be a good thing for investors’ psychological well-being. In effect, they’ve decided that, in a market as  volatile as this one, the only way to win the game is simply not to play.

Even though stock prices have almost doubled.  Wow.

The problem here is pretty obvious.  Most investors don’t really want to earn good returns over time–they want to earn good returns all the time.  That’s not going to happen.  Investors are not winning by not playing.  They are just admitting defeat.  Winning the game takes a completely different mindset.

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

401k Millionaires

January 12, 2012

Smart Money ran a short piece about the 0.2%.

The 0.2% are the fraction of investors that have more than $1 million in their 401k plan.  Are they doing anything differently than other employees?

“The one characteristic that differentiates the winners from the non-winners here is contribution rate — a high percentage of those million-dollar savers had constant participation and high contribution rates,” he [Jack VanDerhei, Employee Benefit Research Institute's research director] says.

This is probably worth a New Year’s resolution.  Call your HR department or whoever handles the 401k in your office and bump up your contribution rate.  Combined with intelligent financial management, something that a qualified advisor should be able to help you with, it shouldn’t be that difficult to get to $1 million over the course of a working career.

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

Managing Client Impulses

January 10, 2012

Shlomo Benartzi, writing in Financial Planning, has some interesting ideas about managing client impulses.  He’s also the chief behavioral economist for Allianz and a professor at UCLA.  Here’s the gist of his argument:

The first step in the process is to help your clients understand the psychology of trading that can lead to poor decisions. Help them understand that these misguided impulses of the intuitive mind are quite natural, but that there is another, better path to follow, one that is guided by the reflective mind.

The second step is to agree on an investment strategy, which would include an acceptable balance between risky and conservative instruments. As financial advisors, you are already very familiar with this process.

What would be novel for most advisors, however, is to commit to a specific contingency plan. This is an agreement made in advance about what action will be taken should a certain event or condition occur -for example, if the market goes up 25% or down 25%.

The third component of the Ulysses Strategy is to formalize these agreements in a commitment memorandum, to which both the client and the financial advisor are parties. Although research shows that financial professionals are typically less affected by the impulses of the intuitive mind, they are not immune to them completely. And by being co-signatories to the memorandum, financial advisors put themselves on the same footing as their clients.

He calls it the Ulysses Strategy in honor of Ulysses being tied to the mast of his ship, in order to hear the Sirens’ song without steering the ship onto the rocks.  The basic idea is just to agree to a plan of action in advance.  Plans that are rational and thought out under calm conditions are probably more likely to work than impulse decisions made under market duress.

No doubt many advisors are already using indicators or market conditions to help make account management decisions–it’s the client involvement that is more novel and that Benartzi sees as beneficial.  I think it would be difficult to figure out the right mix of contingencies to put into a commitment memorandum, but the process may have merit.

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Posted by Mike Moody

Do Something, Anything

January 10, 2012

From I heart Wall Street comes a good point about taking Wall Street research reports with a grain of salt:

For all of the recommendations & observations that are made in Wall Street publications it’s what you need to read between the lines that’s the most crucial.

See, the way most of the big banks are set up they have an equally impressive bench of bears & bulls. This is not an accident. Depending on what foot the bank wants to insert into their mouth, they selective pull from their analyst/economist/strategist quiver whenever the markets are towing the line of whomever is right or will resonate for the day.

What is their objective?

The point in either case, with retail investors or institutional clients, is to get you to do something, anything, or at the very least fill your head with mantra-like talking points (Insert: “buy when there is blood in the streets”, “overdone”, “compelling valuation”) for why the market is doing what it’s doing.

This highlights one of the important reasons for using systematic relative strength models: subjectivity is removed from the process and buy and sell decisions are driven by models where price is the sole input.

HT: Abnormal Returns

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Posted by Andy Hyer

You Scream, I Scream, We All Scream for Tactical Allocation

January 9, 2012

Client mindset has changed.  During the long bull run of the 1980s and 1990s, clients felt very comfortable with a buy-and-hold strategy.  Regardless of whether it was ever a good idea, it was hard to knock–it was working.  Now clients have been shaken up by two bear markets in the last ten years.  They are more aware of global politics and of alternative asset classes.  The world is a scarier place, and client have decided they need to be more active.  According to a recent article in Smart Money:

In Jefferson National’s 2010 survey, 66% of advisors said clients were more confident with a tactical asset management strategy, while only 34% said clients were more confident with a traditional buy-and-hold strategy.

That’s a big change.  The majority of clients are now more comfortable with a tactical strategy—the problem is that very few management firms embrace tactical allocation.  (In fact, many of them have gone out of their way to ridicule it in the past.)  There’s not a lot of proven product in the tactical allocation space because buy-and-hold was the mantra for the last 20 years.

It’s important to do your due diligence and find experienced managers with a robust strategy, whether it is relative strength or valuation-based.  Both styles should work over time, but are likely to perform well at different points in the market cycle.  (Of course, we are partial to the Arrow DWA Balanced Fund, a top-quartile fund with a five-year track record!)

Click here to visit ArrowFunds.com for a prospectus & disclosures.  Click here for disclosures from Dorsey Wright Money Management.

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

From the Archives: Prices are “Objective Reality”

January 9, 2012

Barry Ritholtz succinctly makes the case for relative strength (without actually using the term relative strength.)

—-this article originally appeared 10/7/2009.  My favorite quote from Barry’s piece:  “Indeed, prices matter a great deal more to traders than theories or annoying things like ‘Objective Reality.’ To a trader, prices ARE the objective reality; to them economic theorists are peripheral players trying to rationalize reality.”  Price is what matters, and relative strength uses only price.

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

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