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 1%

January 6, 2014

“The 1%” phrase has been used a lot to decry income inequality, but I’m using it here in an entirely different context.  I’m thinking about the 1% in relation to a recent article by Motley Fool’s Morgan Housel.  Here’s an excerpt from his article:

Building wealth over a lifetime doesn’t require a lifetime of superior skill. It requires pretty mediocre skills — basic arithmetic and a grasp of investing fundamentals — practiced consistently throughout your entire lifetime, especially during times of mania and panic.  Most of what matters as a long-term investor is how you behave during the 1% of the time everyone else is losing their cool.

That puts a little different spin on it.  Maybe your behavior during 1% of the time is how you get to be part of the 1%.  (The bold in Mr. Housel’s quotation above is mine.)

In his article, Housel demonstrates how consistency—in this case, dollar-cost averaging—beats a couple of risk avoiders who try to miss recessions.  We’ve harped on having some kind of systematic investment process here, so consistency is certainly a big part of success.

But also consider what might happen if you can capitalize on those periods of panic and add to your holdings.  Imagine that kind of program practiced consistently over a lifetime!  Warren Buffett’s article in the New York Times, “Buy American.  I Am.” from October 2008 comes to mind.  Here is a brief excerpt of Mr. Buffett’s thinking during the financial crisis:

THE financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary.

So … I’ve been buying American stocks.

If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.

A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.

Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.

Gee, I wonder how that worked out for him?  It’s no mystery why Warren Buffett has $60 billion—he is as skilled a psychological arbitrageur as there is and he has been at it for a very long time.

As Mr. Housel points out, even with mediocre investing skills, just consistency can go a long way toward building wealth—and the ability to be greedy when others are fearful has the potential to compound success.

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Stock Market at All-Time Highs

December 2, 2013

“I can’t buy now—the stock market is at all-time highs.”  I’ve heard that, or some version of it, from multiple clients in the last few weeks.  I understand where clients are coming from.  Their past experience involves waiting too long to buy and then getting walloped.  That’s because clients often wait for the bubble phase to invest.  Not only is the stock market at all-time highs, but valuations tend to be stretched as well.

Here’s the thing: buying at all-time highs really doesn’t contain much information about whether you are making an investing mistake or not.

For proof, I will turn to a nice piece in Advisor Perspectives penned by Alliance Bernstein.  Here’s what they have to say:

With the US stock market repeatedly reaching all-time highs in recent weeks, many investors are becoming leery of investing in stocks. Focusing on the market’s level is a mistake, in our view. It’s market valuation, not level, that matters.

Since 1900, the S&P 500  Index has been close to (within 5%) of its prior peak almost half the time. There’s a simple reason for this. The stock market goes up over time, along with the economy and corporate earnings.

Fear of investing at market peaks is understandable. In the short term, there’s always the risk that other investors will decide to take gains, or that geopolitical, economic or company-specific news will trigger a market pullback.

But for longer-term investors, market level has no predictive power. Market valuation—not market level—is what historically has mattered to future returns.

They have a nice graphic to show that investing near the high—or not near the high—is inconsequential.  They show that future returns are much more correlated to valuation.

Source: Advisor Perspective  (click on image to enlarge)

I’m no fundamental analyst, but commentators from Warren Buffett to Ed Yardeni to Howard Marks have suggested that valuations are reasonable, although slightly higher than average.  There’s obviously no guarantee that stocks will go up, but you are probably not tap dancing on a landmine.  Or let’s put it this way: if the stock market goes down from here, it won’t be because we are at all-time highs.  The trend is your friend until it ends.

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The Top Ten Ways to Sabotage Your Portfolio

November 4, 2013

Good portfolio management is difficult, while poor portfolio management is almost effortless!  In the spirit of David Letterman’s Top Ten list, here is my contribution to the genre of things to avoid, with a special nod to our brand of investing.  I made a version of this presentation originally at a 1996 Dorsey Wright Broker Institute.

 

THE TOP TEN WAYS TO SABOTAGE YOUR PORTFOLIO

1. BE ARROGANT.  Assume your competition is lazy and stupid.  Don’t do your homework  and don’t bother with a game plan.  Panic if things don’t go well.

2. WHEN A SECTOR OR THE MARKET REVERSES UP, WAIT UNTIL YOU FEEL COMFORTABLE TO BUY.  This is an ideal method for catching stocks 10 points higher.

3. BE AFRAID TO BUY STRONG STOCKS.  This way you can avoid the big long-term relative strength winners.

4. SELL A STOCK ONLY BECAUSE IT HAS GONE UP.  This is an excellent way to cut your profits short.  (If you can’t stand prosperity, trim if you must, but don’t sell it all.)

5. BUY STOCKS IN SECTORS THAT ARE SUPER EXTENDED BECAUSE IT’S DIFFERENT THIS TIME.  Not.

6. TRY TO BOTTOMFISH A STOCK IN A DOWNTREND.  Instead, jump off a building and try to stop 5 floors before you hit the ground.  Ouch.

7. BUY A STOCK ONLY BECAUSE IT’S A GOOD VALUE.  There are two problems with this.  1) It can stay a good value by not moving for the next decade, or worse 2) it can become an even better value by dropping another 10 points.

8. HOLD ON TO LOSING STOCKS AND HOPE THEY COME BACK.  An outstanding way to let your losses run.  Combined with cutting your profits short, over time you can construct a diversified portfolio of losers and register it with the Kennel Club.

9. PURSUE PERFECTION.  There are two diseases.  1) Hunting for the perfect method.  Trying a new “system” each week will not get you to your goal.  It requires remaining focused on one method,  maintaining consistency and discipline, and making incremental improvements.  2) Waiting for the perfect trade.  The sector is right, the market is supporting higher prices, the chart is good—try to buy it a point cheaper and miss it entirely.  Doh.  Better to be approximately right than precisely wrong.

10. MAKE INVESTMENT DECISIONS BASED ON A MAGAZINE COVER, MEDIA ARTICLES, OR PUNDITS.  Take investment advice from a journalist or a hedge fund manager talking his book!  Get fully engaged with your emotions of fear and greed!  This is the method of choice for those interested in the fastest route to the poorhouse.

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Rats, Humans, and Probability

October 9, 2013

Investors—or people generally—find it difficult to think in terms of probability.  A quote from a recent ThinkAdvisor article on probability is instructive:

In multiple studies (most prominently those by Edwards and Estes, as reported by Philip Tetlock in his book Expert Political Judgment), subjects were asked to predict which side of a “T-maze” held food for a rat. The maze was rigged such that the food was randomly placed (no pattern), but 60% of the time on one side and 40% on the other. The rat quickly “gets it” and waits at the “60% side” every time and is thus correct 60% of the time. Human observers keep looking for patterns and choose sides in rough proportion to recent results. As a consequence, the humans were right only 52% of the time—they (we!) are much dumber than rats. We routinely misinterpret probabilistic strategies that accept the inevitability of randomness and error.

Even rats get probability better than people!  It is for this reason that a systematic investing process can be so valuable.  Away from the pressure and hubbub of the markets, strategies can be researched and probabilities investigated and calculated.  Decisions can be made on the basis of probability because a systematic process incorporates the notion that there is a certain amount of randomness that cannot be overcome with clever decision-making.

Ironically, because humans have sophisticated pattern recognition skills built in, we see patterns in probability where there are none.  A systematic investment process can reduce or eliminate the “overinterpretation” inherent in our own cleverness.  When we can base our decisions only on the actual probabilities embedded in the data, those decisions will be much better over a large number of trials.

Good investing is never easy, but a systematic investing process can eliminate at least one barrier to good performance.

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Dumb Talk About Smart Beta?

October 7, 2013

John Rekenthaler at Morningstar, who usually has some pretty smart stuff to say, took on the topic of smart beta in a recent article.  Specifically, he examined a variety of smart beta factors with an eye to determining which ones were real and might persist.  He also thought some factors might be fool’s gold.

Here’s what he had to say about value:

The value premium has long been known and continues to persist.

And here’s what he had to say about relative strength (momentum):

I have trouble seeing how momentum can succeed now that its existence is well documented.

The italics are mine.  I didn’t take logic in college, but it seems disingenuous to argue that one factor will continue to work after it is well-known, while becoming well-known will cause the other factor to fail!  (If you are biased in favor of value, just say so, but don’t use the same argument to reach two opposite conclusions.)

There are a variety of explanations about why momentum works, but just because academics can’t agree on which one is correct doesn’t mean it won’t continue to work.  It is certainly possible that any anomaly could be arbitraged away, but Robert Levy’s relative strength work has been known since the 1960s and our 2005 paper in Technical Analysis of Stocks & Commodities showed it continued to work just fine just the way he published it.  Academics under the spell of efficient markets trashed his work at the time too, but 40 years of subsequent returns shows the professors got it wrong.

However, I do have a background in psychology and I can hazard a guess as to why both the value and momentum factors will continue to persistthey are both uncomfortable to implement.  It is very uncomfortable to buy deep value.  There is a terrific fear that you are buying a value trap and that the impairment that created the value will continue or get worse.  It also goes against human nature to buy momentum stocks after they have already outperformed significantly.  There is a great fear that the stock will top and collapse right after you add it to your portfolio.  Investors and clients are quite resistant to buying stocks after they have already doubled, for example, because there is a possibility of looking really dumb.

Here’s the reason I think both factors are psychological in origin: it is absurdly easy to screen for either value or momentum.  Any idiot can implement either strategy with any free screener on the web.  Pick your value metric or your momentum lookback period and away you go.  In fact, this is pretty much exactly what James O’Shaughnessy did in What Works on Wall Street.  Both factors worked well—and continue to work despite plenty of publicity.  So the barrier is not that there is some secret formula, it’s just that investors are unwilling to implement either strategy in a systematic way–because of the psychological discomfort.

If I were to make an argument—the behavioral finance version—about which smart beta factor could potentially be arbitraged away over time, I would have to guess low volatility.  If you ask clients whether they would prefer to buy stocks that a) had already dropped 50%, b) had already gone up 50%, or c) had low volatility, I think most of them would go with “c!”  (Although I think it’s also possible that aversion to leverage will keep this factor going.)

Value and momentum also happen to work very well together.  Value is a mean reversion factor, while momentum is a trend continuation factor.  As AQR has shown, the excess returns of these two factors (unsurprisingly, once you understand how they are philosophical opposites) are uncorrelated.  Combining them may have the potential to smooth out an equity return stream a little bit.  Regardless, two good return factors are better than one!

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Underperformance

September 26, 2013

Whether you are an investment manager or a client, underperformance is a fact of life, no matter what strategy or methodology you subscribe to.  If you don’t believe me, take a look at this chart from an article at ThinkAdvisor.

Source: Morningstar, ThinkAdvisor  (click on image to enlarge)

Now, this chart is a little biased because it is looking at long periods of underperformance—3-year rolling periods—from managers that had top 10-year track records.  In other words, these are exactly the kinds of managers you would hope to hire, and even they have long stretches of underperformance.  When things are going well, clients are euphoric.  Clients, though, often feel like even short periods of underperformance mean something is horribly wrong.

The entire article, written by Envestnet’s J. Gibson Watson, is worth reading because it makes the point that simply knowing about the underperformance is not very helpful until you know why the underperformance is occurring.  Some underperformance may simply be a style temporarily out of favor, while other causes of underperformance might suggest an intervention is in order.

It’s quite possible to have a poor experience with a good manager if you bail out when you should hang in.  Investing well can be simple, but that doesn’t mean it will be easy!

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Buy and Hold

September 9, 2013

John Rekenthaler at Morningstar launched into a spirited defense of buy and hold investing over the weekend.  His argument is essentially that since markets have bounced back since 2009, buy and hold is alive and well, and any arguments to the contrary are flawed.  Here’s an excerpt:

There never was any logic behind the “buy-and-hold is dead” argument. Might it have lucked into being useful? Not a chance. Coming off the 2008 downturn, the U.S. stock market has roared to perhaps its best four and a half years in history. It has shone in absolute terms, posting a cumulative gain of 125% since spring 2009. It has been fabulous in real terms, with inflation being almost nonexistent during that time period. It’s been terrific in relative terms, crushing bonds, cash, alternatives, and commodities, and by a more modest amount, beating most international-stock markets as well. This is The Golden Age. We have lived The Golden Age, all the while thinking it was lead.

Critics will respond that mine is a bull-market argument. That’s backward. “Buy-and-hold is dead” is the strategy that owes its existence to market results. It only appears after huge bear markets, and it only looks good after such markets. It is the oddity, while buy-and-hold is the norm.

Generally, I think Morningstar is right about a lot of things—and Rekenthaler is even right about some of the points he makes in this article.  But in broad brush, buy and hold has a lot of problems, and always has.

Here’s where Rekenthaler is indisputably correct:

  • “Buy and hold is dead” arguments always pop up in bear markets.  (By the way, that says nothing about the accuracy of the argument.)  It’s just the time that anti buy-and-holders can pitch their arguments when someone might listen.  In the same fashion, buy and hold arguments are typically made after a big recovery or in the midst of a bull market—also when people are most likely to listen.  Everyone has an axe to grind.
  • Buy and hold has looked good in the past, compared to forecasters.  As he points out in the article, it is entirely possible to get the economic forecast correct and get the stock market part completely wrong.
  • The 2008 market crash gave the S&P 500 its largest calendar year loss in 77 years.  No doubt.

The truth about buy and hold, I think, is considerably more nuanced.  Here are some things to consider.

  • The argument for buy and hold rests on hindsight bias.  Historical returns in the US markets have been among the strongest in history over very long time periods.  That’s why US investors think buy and hold works.  If buy and hold truly works, what about Germany, Argentina, or Japan at various time periods?  The Nikkei peaked in 1989.  Almost 25 years later, the market is still down significantly.  Is the argument, then, that only the US is special?  Is Mr. Rekenthaler willing to guarantee that US returns will always be positive over some time frame?  I didn’t think so.  If not, then buy and hold is not a slam dunk either.
  • Individual investors have time frames.  We only live so long.  A buy and hold retiree in 1929 or 1974 might be dead before they got their money back.  Same for a Japanese retiree in 1989.  Plenty of other equity markets around the world, due to wars or political crises, have gone to zero.  Zero.  That makes buy and hold a difficult proposition—it’s a little tough mathematically to bounce back from zero.  (In fact, the US and the UK are the only two markets that haven’t gone to zero at some point in the last 200 years.)  And plenty of individual stocks go to zero.  Does buy and hold really make sense with stocks?
  • Rejecting buy and hold does not have the logical consequence of missing returns in the market since 2009.  For example, a trend follower would be happily long the stock market as it rose to new highs.
  • Individual investors, maddeningly, have very individual tolerances for volatility in their portfolios.  Some investors panic too often, some too late, and a very few not at all.  How that works out is completely path dependent—in other words, the quality of our decision all depends on what happens subsequently in the market.  And no one knows what the market will do going forward.  You don’t know the consequences of your decision until some later date.
  • In our lifetimes, Japan.  It’s funny how buy and hold proponents either never mention Japan or try to explain it away.  “We are not Japan.”  Easy to say, but just exactly how is human nature different because there is an ocean in between?  Just how is it that we are superior?  (Because in 1989, if you go back that far, there was much hand-wringing and discussions of how the Japanese economy was superior!)

Every strategy, including buy and hold, has risks and opportunity costs.  Every transaction is a risk, as well as an implicit bet on what will happen in the future.  The outcome of that bet is not known until later.  Every transaction, you make your bet and you take your chances.  You can’t just assume buy and hold is going to work forever, nor can you assume it will stop working.  Arguments about any strategy being correct because it worked over x timeframe is just a good example of hindsight bias.  Buy and hold doesn’t promise good returns, just market returns.  Going forward, you just don’t know—nobody knows.  Yes, ambiguity is uncomfortable, but that’s the way it is.

That’s the true state of knowledge in financial markets: no one knows what will happen going forward, whether they pretend to know or not. 

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Bucket Portfolio Stress Test

September 4, 2013

I’ve long been a fan of portfolio buckets or sleeves, for two reasons.  The first reason is that it facilitates good diversification, which I define as diversification by volatility, by asset class, and by strategy.  (We happen to like relative strength as one of these primary strategies, but there are several offsetting strategies that might make sense.)  A bucket portfolio makes this kind of diversification easy to implement.

The second benefit is largely psychological—but not to be underestimated.  Investors with bucket portfolios had better performance in real life during the financial crisis because they didn’t panic.  While the lack of panic is a psychological benefit, the performance benefit was very real.

Another champion of bucketed portfolios is Christine Benz at Morningstar.  She recently wrote a series of article in which she stress-tested bucketed portfolios, first through the 2007-2012 period (one big bear market) and then through the 2000-2012 period (two bear markets).  She describes her methodology for rebalancing and the results.

If you have any interest in portfolio construction for actual living, breathing human beings who are prone to all kinds of cognitive biases and emotional volatility, these articles are mandatory reading.  Better yet for fans of portfolio sleeves, the results kept clients afloat.  I’ve included the links below.  (Some may require a free Morningstar registration to read.)

Article:  A Bucket Portfolio Stress Test  http://news.morningstar.com/articlenet/article.aspx?id=605387&part=1

Article:  We Put the Bucket System Through Additional Stress Tests  http://news.morningstar.com/articlenet/article.aspx?id=607086

Article:  We Put the Bucket System Through a Longer Stress Test  http://news.morningstar.com/articlenet/article.aspx?id=608619

 

 

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Adventures in Fictive Learning

September 3, 2013

What the heck is fictive learning?  Well, I’m glad you asked.  Fictive learning refers to our ability to imagine “what if” situations.  We learn not only from our actual actions, but from our perceptions of what would have happened if we had done something differently.  It turns out that fictive learning has a lot to do with investor behavior too.  Here are a few excerpts about relevant experiments discussed in an article in Wired magazine.

To better understand the source of our compulsive speculation, Read Montague, a neuroscientist now at Virginia Tech, has begun investigating the formation of bubbles from the perspective of the brain. He argues that the urge to speculate is rooted in our mental software. In particular, bubbles seem to depend on a unique human talent called “fictive learning,” which is the ability to  learn from hypothetical scenarios and counterfactual questions. In other words, people don’t just learn from mistakes they’ve actually made, they’re able to learn from mistakes they might have made, if only they’d done something different.

Investors, after all, are constantly engaging in fictive learning, as they compare their actual returns against the returns that might have been, if only they’d sold their shares before the crash or bought Google stock when the company first went public. And so, in 2007, Montague began simulating stock bubbles in a brain scanner, as he attempted to decipher the neuroscience of irrational speculation. His experiment went like this: Each subject was given $100 and some basic information about the “current” state of the stock market. After choosing how much money to invest, the players watched nervously as their investments either rose or fell in value. The game continued for 20 rounds, and the subjects got to keep their earnings. One interesting twist was that instead of using random simulations of the stock market, Montague relied on distillations of data from famous historical markets. Montague had people “play” the Dow of 1929, the Nasdaq of 1998 and the S&P 500 of 1987, so the neural responses of investors reflected real-life bubbles and crashes.

Montague, et. al. immediately discovered a strong neural signal that drove many of the investment decisions. The signal was fictive learning. Take, for example, this situation. A player has decided to wager 10 percent of her total portfolio in the market, which is a rather small bet. Then, she watches as the market rises dramatically in value. At this point, the investor experiences a surge of regret, which is a side-effect of fictive learning. (We are thinking about how much richer we would be if only we’d invested more in the market.) This negative feeling is preceded by a swell of activity in the ventral caudate, a small area in the center of the cortex.  Instead of enjoying our earnings, we are fixated on the profits we missed, which leads us to do something different the next time around.

When markets were booming, as in the Nasdaq bubble of the late 1990s, people perpetually increased their investments. In fact, many of Montague’s subjects eventually put all of their money into the rising market. They had become convinced that the bubble wasn’t a bubble. This boom would be different.

And then, just like that, the bubble burst. The Dow sinks, the Nasdaq collapses, the Nikkei implodes. At this point investors race to dump any assets that are declining in value, as their brain realizes that it made some very expensive mistakes. Our investing decisions are still being driven by regret, but now that feeling is telling us to sell. That’s when we get a financial panic.

Montague has also begun exploring the power of social comparison, or what he calls the “country club  effect,” on the formation of financial bubbles. “This is what happens when you’re sitting around with your friends at the country club, and they’re all talking about how much money they’re making in the market,” Montague told me. “That casual conversation is going to change the way you think about investing.” In a series of ongoing experiments, Montague has studied what happens when people compete against each other in an investment game. While the subjects are making decisions about the stock market, Montague monitors their brain activity in two different fMRI machines. The first thing Montague discovered is that making more money than someone else is extremely pleasurable.  When subjects “win” the investment game, Montague observes a large increase in activity in the striatum, a brain area typically associated with the processing of pleasurable rewards. (Montague refers to this as “cocaine brain,” as the striatum is also associated with the euphoric high of illicit drugs.) Unfortunately, this same urge to outperform others can also lead people to take reckless risks.

More recently, a team of Italian neuroscientists led by Nicola Canessa and Matteo Motterlini have shown that regret is also contagious, so that “observing the regretful outcomes of another’s choices reactivates the regret network.” (In other words, we internalize the errors of others. Or, as Motterlini wrote in an e-mail, “We simply live their emotions like these were our own.”) Furthermore, this empathy impacts our own decisions: The “risk-aptitude” of investors is significantly shaped by how well the risky decisions of a stranger turned out. If you bet the farm on some tech IPO and did well, then I might, too.

If you are an investment advisor, all of this is sounding pretty familiar.  We’ve all seen clients make decisions based on social comparison, regret, or trying to avoid regret.  Sometimes they are simply paralyzed, trapped between wanting to do as well as their brother-in-law and wanting to avoid the regret of losing money if their investment doesn’t work out.

The broader point is that a lot of what drives trends in the market is rooted in human behavior, not valuations and fundamentals.  Human nature is unlikely to change, especially a feature like fictive learning which is actually incredibly helpful in many other contexts.  As a result, markets will continue to trend and reverse, to form bubbles and to have those bubbles implode periodically.

While social science may be helpful in understanding why the market behaves as it does, we still have to figure out a way to navigate it.  As long as markets trend, relative strength trend following should work.  (That’s the method we follow.)  As long as bubbles form and implode, other methods like buying deep value should help mitigate the risk of permanent loss.  Most important, the discipline to execute a systematic investment plan and not get sucked into all of the cognitive biases will be necessary to prosper with whatever investment method you choose.

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Saving Investors From Themselves

June 28, 2013

Jason Zweig has written one of the best personal finance columns for years, The Intelligent Investor for the Wall Street Journal.  Today he topped it with a piece that describes his vision of personal finance writing.  He describes his job as saving investors from themselves.  It is a must read, but I’ll give you a couple of excerpts here.

I was once asked, at a journalism conference, how I defined my job. I said: My job is to write the exact same thing between 50 and 100 times a year in such a way that neither my editors nor my readers will ever think I am repeating myself.

That’s because good advice rarely changes, while markets change constantly. The temptation to pander is almost irresistible. And while people need good advice, what they want is advice that sounds good.

The advice that sounds the best in the short run is always the most dangerous in the long run. Everyone wants the secret, the key, the roadmap to the primrose path that leads to El Dorado: the magical low-risk, high-return investment that can double your money in no time. Everyone wants to chase the returns of whatever has been hottest and to shun whatever has gone cold. Most financial journalism, like most of Wall Street itself, is dedicated to a basic principle of marketing: When the ducks quack, feed ‘em.

In practice, for most of the media, that requires telling people to buy Internet stocks in 1999 and early 2000; explaining, in 2005 and 2006, how to “flip” houses; in 2008 and 2009, it meant telling people to dump their stocks and even to buy “leveraged inverse” exchange-traded funds that made explosively risky bets against stocks; and ever since 2008, it has meant touting bonds and the “safety trade” like high-dividend-paying stocks and so-called minimum-volatility stocks.

It’s no wonder that, as brilliant research by the psychologist Paul Andreassen showed many years ago, people who receive frequent news updates on their investments earn lower returns than those who get no news. It’s also no wonder that the media has ignored those findings. Not many people care to admit that they spend their careers being part of the problem instead of trying to be part of the solution.

My job, as I see it, is to learn from other people’s mistakes and from my own. Above all, it means trying to save people from themselves. As the founder of security analysis, Benjamin Graham, wrote in The Intelligent Investor in 1949: “The investor’s chief problem – and even his worst enemy – is likely to be himself.”

……..

From financial history and from my own experience, I long ago concluded that regression to the mean is the most powerful law in financial physics: Periods of above-average performance are inevitably followed by below-average returns, and bad times inevitably set the stage for surprisingly good performance.

But humans perceive reality in short bursts and streaks, making a long-term perspective almost impossible to sustain – and making most people prone to believing that every blip is the beginning of a durable opportunity.

……..

But this time is never different. History always rhymes. Human nature never changes. You should always become more skeptical of any investment that has recently soared in price, and you should always become more enthusiastic about any asset that has recently fallen in price. That’s what it means to be an investor.

Simply brilliant.  Unless you write a lot, it seems deceptively easy to write this well and clearly.  It is not.  More important, his message that many investment problems are actually investor behavior problems is very true—and has been true forever.

To me, one of the chief advantages of technical analysis is that it recognizes that human nature never changes and that, as a result, behavior patterns recur again and again.  Investors predictably panic when market indicators get deeply oversold, just when they should consider buying.  Investors predictably want to pile into a stock that has been a huge long-term winner when it breaks a long-term uptrend line—because “it’s a bargain”—just when they might want to think about selling.  Responding deliberately at these junctures doesn’t usually require the harrowing activity level that CNBC commentators seem to believe is necessary, but can be quite effective nonetheless.  Technical indicators and sentiment surveys often show these turning points very clearly, but as Mr. Zweig describes elsewhere in the article, the financial universe is arranged to deceive us—or at least to tempt us to deceive ourselves.

Investing is one of the many fields where less really is more.

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Cognitive Biases

June 5, 2013

Motley Fool had an excellent article by Morgan Housel on a couple of the most common cognitive biases that cause problems for investors, cognitive dissonance and confirmation bias.  The information is not new, but what makes this article so fun is Housel’s writing style and good analogies.  A couple of excerpts should suffice to illuminate the problem with cognitive biases.

Study successful investors, and you’ll notice a common denominator: They are masters of psychology. They can’t control the market, but they have complete control over the gray matter between their ears.

And lucky them. Most of us, on the other hand, are mental catastrophes. As investor Barry Ritholtz once put it:

You’re a monkey. It all comes down to that. You are a slightly clever, pants-wearing primate. If you forget that you’re nothing more than a monkey who has been fashioned by eons on the plains, being chased by tigers, you shouldn’t invest. You have to be aware of how your own psychology affects what you do.

Take one of the most powerful theories in behavior psychology: cognitive dissonance. It’s the term psychologists use for the uncomfortable feeling you get when having two conflicting thoughts at the same time. “Smoking is bad for me. I’m going to go smoke.” That’s cognitive dissonance.

We hate cognitive dissonance, and jump through hoops to reduce it. The easiest way to reduce it is to engage in mental gymnastics that justifies behavior we know is wrong. “I had a stressful day and I deserve a cigarette.” Now you can smoke guilt-free. Problem solved.

Classic.  And this:

Cognitive dissonance is especially toxic in the emotional cesspool that is managing money. Raise your hand if this is you:

  • You criticize Wall Street for being a casino while checking your portfolio twice a day.
  • You sold your stocks in 2009 because the Fed was printing money. When stocks doubled in value soon after, you blamed it on the Fed printing money.
  • You put $1,000 on a hyped penny stock your brother convinced you is the next Facebook. After losing everything, you tell yourself you were just investing for the entertainment.
  • You call the government irresponsible for running a deficit while simultaneously saddling yourself with an unaffordable mortgage.
  • You buy a stock only because you think it’s cheap. When you realize you were wrong, you decide to hold it because you like the company’s customer service.

Almost all of us do something similar with our money. We have to believe our decisions make sense. So when faced with a situation that doesn’t make sense, we fool ourselves into believing something else.

And this about confirmation bias:

Worse, another bias — confirmation bias — causes us to bond with people whose self-delusions look like our own. Those who missed the rally of the last four years are more likely to listen to analysts who forecast another crash. Investors who feel burned by the Fed visit websites that share the same view. Bears listen to fellow bears; bulls listen to fellow bulls.

Before long, you’ve got a trifecta of failure: You make a bad decision, rationalize it by fighting cognitive dissonance, and reinforce it with confirmation bias. No wonder the average investor does so poorly.

It’s worth reading the whole article, but the gist of it is that we are all susceptible to these cognitive biases.  It’s possible to mitigate the problem with some kind of systematic investment process, but you still have to be careful that you’re not fooling yourself.  Investing well is not easy and mastering one’s own psyche may be the most difficult part of all.

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From the Archives: Investing Lies We Grew Up With

May 15, 2013

This is the title of a nice article by Brett Arends at Marketwatch.  He points out that a lot of our assumptions, especially regarding risk, are open to question.

Risk is an interesting topic for a lot of reasons, but principally (I think) because people seem to be obsessed with safety.  People gravitate like crazy to anything they perceive to be “safe.”  (Arnold Kling has an interesting meditation on safe assets here.)

Risk, though, is like matter–it can neither be created nor destroyed.  It just exists.  When you buy a safe investment, like a U.S. Treasury bill, you are not eliminating your risk; you are just switching out of the risk of losing your money into the risk of losing purchasing power.  The risk hasn’t gone away; you have just substituted one risk for another.  Good investing is just making sure you’re getting a reasonable return for the risk you are taking.

In general, investors–and people generally–are way too risk averse.  They often get snookered in deals that are supposed to be “low risk” mainly because their risk aversion leads them to lunge at anything pretending to be safe.  Psychologists, however, have documented that individuals make more errors from being too conservative than too aggressive.  Investors tend to make that same mistake.  For example, nothing is more revered than a steady-Eddie mutual fund.  Investors scour magazines and databases to find a fund that (paradoxically) is safe and has a big return.  (News flash: if such a fund existed, you wouldn’t have to look very hard.)

No one goes looking for high-volatility funds on purpose.  Yet, according to an article, Risk Rewards: Roller-Coaster Funds Are Worth the Ride at TheStreet.com:

Funds that post big returns in good years but also lose scads of money in down years still tend to do better over time than funds that post slow, steady returns without ever losing much.

The tendency for volatile investments to best those with steadier returns is even more pronounced over time. When we compared volatile funds with less volatile funds over a decade, those that tended to see big performance swings emerged the clear winners. They made roughly twice as much money over a decade.

That’s a game changer.  Now, clearly, risk aversion at the cost of long-term returns may be appropriate for some investors.  But if blind risk aversion is killing your long-term returns, you might want to re-think.  After all, eating Alpo is not very pleasant and Maalox is pretty cheap.  Maybe instead of worrying exclusively about volatility, we should give some consideration to returns as well.

—-this article originally appeared 3/3/2010.  A more recent take on this theme are the papers of C. Thomas Howard.  He points out that volatility is a short-term factors, while compounded returns are a long-term issue.  By focusing exclusively on volatility, we can often damage long term results.  He re-defines risk as underperformance, not volatility.  However one chooses to conceptualize it, blind risk aversion can be dangerous.

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Investment Risk Re-imagined

May 8, 2013

Risk is fundamental to investing, but no one can agree what it is.  Modern Portfolio Theory defines it as standard deviation.  Tom Howard of AthenaInvest thinks investment risk is something completely different.  In an article at Advisor Perspectives, he explains how he believes investment risk should be defined, and why the MPT definition is completely wrong.  I think his point is a strong one.  I don’t know how investment risk should be defined—there’s a lot of disagreement within the industry—but I think he makes, at the very least, a very clear case for why volatility is not the correct definition.

Here’s how he lays out his argument:

The measures currently used within the investment industry to capture investment risk are really mostly measures of emotion. In order to deal with what is really important, let’s redefine investment risk as the chance of underperformance. As Buffett  suggests, focus on the final outcome and not on the path travelled to get there.

The suggestion that investment risk be measured as the chance of underperformance is intuitively  appealing to many investors. In fact, this measure of risk is widely used in a number of industries. For example, in industrial applications, the risk of  underperformance is measured by the probability that a component, unit or service will fail. Natural and manmade disasters use such a measure of risk. In each situation, the focus is on the chances that various final outcomes might occur. In general, the path to the outcome is less important and has little influence on the measure of risk.

I added the bold to highlight his preferred definition.  Next he takes on the common MPT measurement of risk as volatility and spells out why he thinks it is incorrect:

In an earlier article I reviewed the evidence regarding stock market volatility and showed that most volatility stems from crowds overreacting to information. Indeed, almost no volatility can be explained by changes in underlying economic fundamentals at the market and individual stock levels.  Volatility measures emotions, not necessarily investment risk. This is also true of other measures of risk, such as downside standard deviation, maximum drawdown and downside capture.

But unfortunately, the investment industry has adopted this same volatility as a risk measure that, rather than focusing on the final outcome, focuses on the bumpiness of the ride. A less bumpy ride is thought to be less risky, regardless of the final outcome. This leads to the unintended consequence of building portfolios that result in lower terminal wealth and, surprisingly, higher risk.

This happens because the industry mistakenly builds portfolios that minimize short-term volatility relative to long-term returns, placing emotion at the very heart of the long-horizon portfolio  construction process. This approach is popular because it legitimizes the  emotional reaction of investors to short-term volatility.

Thus risk and volatility are frequently thought of as being interchangeable. However, focusing on short-term volatility when building long horizon portfolios can have the unintended consequence of actually increasing investment risk. Since risk is the chance of underperformance, focusing on short-term volatility will often lead to investing in lower expected return markets with little impact on long-term volatility.1 Lowering expected portfolio return in an effort to reduce short-term volatility actually increases the chance of underperformance, which means increasing risk.

A clear example of this is the comparison of long-term stock and bond returns. Stocks dramatically outperform bonds over the long run. By investing in bonds rather than stocks, short-term volatility is reduced at the expense of decreasing long-term wealth. Equating short-term volatility with risk leads to inferior long-horizon portfolios.

The cost of equating risk and emotional volatility can be seen in other areas as well. Many investors pull out of the stock market when faced with heightened volatility. But research shows this is exactly when they should remain in the market and even increase their stock holdings, as subsequent returns are higher on average.2  It is also the case that many investors exit after market declines only to miss the subsequent rebounds. Following the 2008 market crash, investors withdrew billions of dollars from equity mutual funds during a period in which the stock market more than doubled.

The end result is that investors frequently suffer the pain of losses without capturing the subsequent gains. Several studies confirm that the typical equity mutual fund investor earns a return substantially less than the fund return because of poorly timed movements in and out of the fund. Again, these are the dangers of not carefully distinguishing emotions from risk and thus allowing emotions to drive investment decisions.

I added the bold here as well.  I apologize for such a big excerpt, but I think it’s important to get the full flavor here.  The implication, which he makes explicit later in the article, is that current risk measures are largely an agency issue.  The advisor is the “agent” for the client, and thus the advisor is likely to pander to the client’s emotions—because it results in less business risk (i.e., the client leaving) for the advisor.  Of course, as he points out in the excerpt above, letting emotions drive the bus results in poor investment results.

Tom Howard has hit the nail on the head.  Advisors often have the choice of a) pandering to the client’s emotions at the cost of substantial long-term return or b) losing the client.  Since investment firms are businesses, the normal decision is to retain the client—which, paradoxically, leads to more risk for the client.  While “the customer is always right” may be a fine motto for a retail business, it’s usually the other way around in the investment business!

There’s another wrinkle to investment risk too.  Regardless of how investment risk is defined, it’s unlikely that human nature is going to change.  No matter how much data and logic are thrown at clients, their emotions are still going to be prone to overwhelm them at inopportune times.   It’s here, I think, that advisors can really earn their keep, in two important ways, through both behavior and portfolio construction.

  1. Advisor Behavior: The advisor can stay calm under pressure.  Hand-holding, as it is called in the industry, is really, really important.  Almost no one gets good training on this subject.  They learn on the job, for better or worse.  If the advisor is calm, the client will usually calm down too.  A panicked advisor is unlikely to promote the mental stability of clients.
  2. Portfolio Construction: The portfolio can explicitly be built with volatility buckets.  The size of the low-volatility bucket may turn out to be more a function of the client’s level of emotional volatility than anything else.  A client with a long-horizon and a thick skin may not need that portfolio piece, but high-beta Nervous Nellies might require a bigger percentage than their actual portfolio objectives or balance sheet necessitate—because it’s their emotional balance sheet we’re dealing with, not their financial one.  Yes, this is sub-optimal from a return perspective, but not as sub-optimal as exceeding their emotional tolerance and having the client pull out at the bottom.  Emotional blowouts are financially expensive at the time they occur, but usually have big financial costs in the future as well in terms of client reluctance to re-engage.  Psychic damage can impact financial returns for multiple market cycles.

Tom Howard has laid out a very useful framework for thinking about investment risk.  He’s clearly right that volatility isn’t risk, but advisors still have to figure out a way to deal with the volatility that drives client emotions.  The better we deal with client emotions, the more we reduce their long-term risk.

Note: This argument and others are found in full form in Tom Howard’s paper on Behavioral Portfolio Management.  Of course I’m coming at things from a background in psychology, but I  think his framework is excellent.  Behavioral finance has been crying out for an underlying theory for years.  Maybe this is it.  It’s required reading for all advisors, in my opinion.

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The Wonders of Momentum

April 18, 2013

Relative strength investors will be glad to know that James Picerno’s Capital Spectator blog has an article on the wonders of momentum.  He discusses the momentum “anomaly” and its history briefly:

Momentum is one of the oldest and most persistent anomalies in the financial literature. The tendency of positive or negative returns to persist for a time seems like a ridiculously simple predictor, but it works. There’s an ongoing debate about why it works, but the results in numerous tests speak loud and clear. Unlike many (most?) reported sources of alpha, the market-beating and risk-lowering results linked to momentum strategies appear to be immune to arbitrage.

Informally, it’s fair to say that investors have been exploiting momentum in various forms for as long as humans have been trading assets. Formally, the concept dates to at least 1937, when Alfred Cowles and Herbert Jones reviewed momentum in their paper “Some A Priori Probabilities in Stock Market Action.” In the 21st century, an inquiring reader can easily find hundreds of papers on the subject, most of it published in the wake of Jegadeesh and Titman’s seminal 1993 work: “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency,” which marks the launch of the modern age of momentum research.

I think his observation that momentum (relative strength to us) has been around since humans have been trading assets is spot on.  It’s important to keep that in mind when thinking about why relative strength works—and why it has been immune to arbitrage.  He writes:

Momentum, it seems, is one of the rare risk factors with features that elude so many other strategies: It’s persistent, conceptually straightforward, robust across asset classes, and relatively easy to implement. It’s hardly a silver bullet, but nothing else is either.

The only mystery: Why are we still talking about this factor in glowing terms? We still don’t have a good answer to explain why this anomaly hasn’t been arbitraged away, or why it’s unlikely to meet an untimely demise anytime soon.

Mr. Picerno raises a couple of important points here.  Relative strength does have a lot of attractive features.  The reason it is not a silver bullet is that it underperforms severely from time to time.  Although that is also true of other strategies, I think the periodic underperformance is one of the reasons why the excess returns have not been arbitraged away.

Although he suggests we don’t have a good answer about why momentum works, I’d like to offer my explanation.  I don’t know if it’s a good answer or not, but it’s what I’ve arrived at after years of research and working with relative strength portfolios—not to mention a degree in psychology and a couple of decades of seeing real investors operate in the market laboratory.

  • Relative strength straddles both fundamental analysis and behavioral finance.
  • High relative strength securities or assets are generally strong because they are undergoing fundamental improvement or are in a sweet spot for fundamentals.  In other words, if oil prices are trending strongly higher, it’s not surprising that certain energy stocks are strong.  That’s to be expected from the fundamentals.  Often there is improvement at the margin, perhaps in revenue growth or operating margin—and that improvement is often underestimated by analysts.  (Research shows that investors are more responsive to changes at the margin than to the absolute level of fundamental factors.  For example, while Apple’s operating margin grew from 2.2% in 2003 to 37.4% in 2012, the stock performed beautifully.  Even though the operating margin is expected to be in the 35% range this year—which is an extremely high level—the stock is getting punished.  Valero’s stock price plummeted when margins went from 10.0% in 2006 to 2.4% in 2009, but has doubled off the low as margins rebounded to 4.8% in 2012.  Apple’s operating margin on an absolute basis is drastically higher than Valero’s, but the delta is going the wrong way.)  High P/E multiples can often be maintained as long as margin improvement continues, and relative strength tends to take advantage of that trend.  Often these trends persist much longer than investors expect.
  • From the behavioral finance side, social proof helps reinforce relative strength.  Investors herd and they gravitate toward what is already in motion, and that reinforces the price movement.  They are attracted to the popular and repelled by the unpopular.
  • Periodic bouts of underperformance help keep the excess returns of relative strength high.  When momentum goes the wrong way it can be ugly.  Perhaps margins begin to contract and financial results are worse than analysts expect.  The security has been rewarded with a high P/E multiple, which now begins to unwind.  The herd of investors begins to stampede away, just as they piled in when things were going well.  Momentum can be volatile and investors hate volatility.  Stretches of underperformance are psychologically painful and the unwillingness to bear pain (or appropriately manage risk) discourages investors from arbitraging the excess returns away.

In short, I think there are multiple reasons why relative strength works and why it is difficult to arbitrage away the excess returns.  Those reasons are both fundamental and behavioral and I suspect will defy easy categorization.  Judging from my morning newspaper, human nature doesn’t change much.  Until it does, markets are likely to work the same way they always have—and relative strength is likely to continue to be a powerful return factor.

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Buy the Unloved

March 25, 2013

Morningstar has a market-beating strategy call “Buy the Unloved” that they update from time to time.  Essentially, it consists of buying the fund categories with the most outflows and holding on to them for three years, on the theory that retail investors generally get things wrong.  Sadly, “Buy the Unloved” has a good track record, indicating that their thesis is largely correct!

Here are a couple of key excerpts from their 2013 update on the Buy the Unloved strategy:

Morningstar has followed this strategy since the early 1990s, using annual net cash flows to identify each year’s three most unloved and loved equity categories, which feed into two separate portfolios (unloved and loved). We track the average returns for those categories for the subsequent three years, adding in new categories each year and swapping out categories after three years are up. We’ve found that holding a portfolio of the three most unpopular equity categories for at least three years is an effective approach: From 1993 through 2012, the “unloved” strategy gained 8.4% annualized to the “loved” strategy’s 5.1% annualized. The unloved strategy has also beaten the MSCI World Index’s 6.9% annualized gain and has slightly beat the Morningstar US Market Index’s 8.3% return.

According to Morningstar fund flow data, the most popular equity categories in 2012 were diversified emerging markets (inflows of $23.2 billion), foreign large value (inflows of $4.6 billion), and real estate (inflows of $3.8 billion). Those looking across asset classes might want to be cautious on sending new money to intermediate-term bond (inflows of $112.3 billion), short-term bond (inflows of $37.6 billion), and high-yield bond (inflows of $23.6 billion), particularly as interest rates have nowhere to go but up.

The most unloved equity categories are also the most unpopular overall: large growth (outflows of $39.5 billion), large value (outflows of $16 billion), and large blend (outflows of $14.4 billion). These categories have seen outflows despite posting double-digit gains in 2012. The money leaving from these categories reflects a broader trend of investors fleeing equity funds while piling into fixed-income offerings and passive ETFs.

Now that we are almost a full quarter into 2013, it might be worthwhile to think about what we have seen so far this year: good performance from large-cap equities and sluggish performance from bonds.

Morningstar should get a public service award for publishing this data—and it’s worth thinking about what you can learn from it.  The most popular investment trends are not always the profitable ones.  In fact, their work indicates that it could be valuable to spend time thinking about going into areas that are currently unpopular.  Obviously, this does not need to be used (and probably shouldn’t be) as a stand-alone strategy, but it might be useful as a guide to portfolio adjustments.

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Timeless Portfolio Lessons

February 1, 2013

The only thing new under the sun is the history you haven’t read yet.—-Mark Twain

Investors often have the conceit that they are living in a new era.  They often resort to new-fangled theories, without realizing that all of the old-fangled things are still around mainly because they’ve worked for a long time.  While circumstances often change, human nature doesn’t change much, or very quickly.  You can generally count on people to behave in similar ways every market cycle.  Most portfolio lessons are timeless.

As proof, I offer a compendium of quotations from an old New York Times article:

WHEN you check the performance of your fund portfolio after reading about the rally in stocks, you may feel as if there is  a great party going on and you weren’t invited. Perhaps a better way to look at it is that you were invited, but showed up at the wrong time or the wrong address.

It isn’t just you. Research, especially lately, shows that many investors don’t match market performance, often by a wide margin, because they are out of sync with downturns and rallies.

Christine Benz, director of personal finance at Morningstar, agrees. “It’s always hard to speak generally about what’s motivating investors,” she said, “but it’s emotions, basically,” resulting in “a pattern we see repeated over and over in market cycles.”

Those emotions are responsible not only for drawing investors in and out of the broad market at inopportune times, but also for poor allocations to its niches.

Where investors should be allocated, many professionals say, is in a broad range of assets. That will smooth overall returns and limit the likelihood of big  losses resulting from  an excessive concentration in a plunging market. It also limits the chances of panicking and selling at the bottom.

In investing, as in party-going, it’s often safer to  let someone else drive.

This is not ground-breaking stuff.  In fact, investors are probably bored to hear this sort of advice over and over—but it gets repeated because investors ignore the advice repeatedly!  This same article could be written today, or written 20 years from now.

You can increase your odds of becoming a successful investor by constructing a reasonable portfolio that is diversified by volatility, by asset class, and by complementary strategy.  Relative strength strategies, for example, complement value and low-volatility equity strategies very nicely because the excess returns tend to be uncorrelated.  Adding alternative asset classes like commodities or stodgy asset classes like bonds can often benefit a portfolio because they respond to different return drivers than stocks.

As always, the bottom line is not to get carried away with your emotions.  Although this is certainly easier said than done, a diversified portfolio and a competent advisor can help a lot.

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Keeping It Simple in the New Year

January 3, 2013

Barry Ritholtz at The Big Picture has some musings about portfolios for the New Year.  I think he’s right about keeping it simple—but I also think his thought is incomplete.  He writes:

May I suggest taking control of your portfolio as a worthwhile goal this year?

I have been thinking about this for awhile now. Last year (heh), I read a quote I really liked from Tadas Viskanta of Abnormal Returns. He was discussing the disadvantages of complexity when creating an investment plan:

“A simple, albeit less than optimal, investment strategy that is easily followed trumps one that will abandoned at the first sign of under-performance.”

I am always mindful that brilliant, complex strategies more often than not fail. Why? A simple inability of the Humans running them to stay with them whenever there are rising fear levels (typically manifested as higher volatility and occasional drawdowns).

Let me state this more simply: Any strategy that fails to recognize the psychological foibles and quirks of its users has a much higher probability of failure than one that anticipates and adjusts for that psychology.

Let me just say that there is a lot of merit to keeping things simple.  It’s absolutely true that complex things break more easily than simple things, whether you’re talking about kid’s Christmas toys or investor portfolios.  I believe in simplicity over complexity.

However, complexity is only the tip of the iceberg that is human nature.  Mr. Ritholtz hints at it when he mentions human inability to stay with a strategy when fear comes into the picture.  That is really the core issue, not complexity.  Adjust for foibles all you want; many investors will still find a way to express their quirks.  You can have an obscenely simple strategy, but most investors will still be unable to stay with it when they are fearful.

Trust me, human nature can foil any strategy.

Perhaps a simple strategy will be more resilient than a complex one, but I think it’s most important to work on our resilience as investors.

Tuning out news and pundits is a good start.  Delving deeply into the philosophy and inner workings of your chosen strategy is critical too.  Understand when it will do well and when it will do poorly.  The better you understand your return factor, whether it is relative strength, value, or something else, the less likely you are to abandon it at the wrong time.  Consider tying yourself to the mast like Ulysses—make it difficult or inconvenient to make portfolio strategy changes.  Maybe use an outside manager in Borneo that you can only contact once per year by mail.  I tell clients just to read the sports pages and skip the financial section.  (What could be more compelling soap opera than the Jet’s season?)  Whether you choose distraction, inconvenience, or steely resolve as your method, the  goal is to prevent volatility and the attendant fear it causes from getting you to change course.

The best gift an investor has is self-discipline.  As one of our senior portfolio managers likes to point out, “To the disciplined go the spoils.”

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Behavioral Finance: Volatility Edition

December 9, 2012

Volatility can cause investors to make terrible decisions.  Blackrock recently featured an ugly chart comparing the returns of every major asset class since 1992 to the returns of the average investor.  Amazingly enough, over that 20-year period investors underperformed every single major asset class including inflation!

Source: Blackrock  (click to enlarge)

Here is Blackrock’s take on the chart:

Volatility is often the catalyst for poor decisions at inopportune times. Amidst difficult financial times, emotional instincts often drive investors to take actions that make no rational sense but make perfect emotional sense. Psychological factors such as fear often translate into poor timing of buys and sells. Though portfolio managers expend enormous efforts making investment decisions, investors often give up these extra percentage points in poorly timed decisions.

As Blackrock points out, good investing decisions are often ruined by one poorly timed emotional decision, typically brought about by a response to volatility.  Volatility often engenders fear, and fear can overwhelm the client’s rational thought process.

One of the chief benefits of a good financial advisor is preventing clients from undermining themselves when the markets are rocky.  From an objective point of view, if you are fearful, it’s going to be difficult to calm the client down.  I don’t have any magic ideas about how to keep calm, but you could do worse than the British WWII propaganda poster:  Keep calm and carry on.

Source: SkinIt  (click to enlarge)

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Behavioral Finance: Inside the Client’s Brain

November 27, 2012

I admit to a prurient interest in behavioral finance.  Perhaps this is due to my background in psychology—or just from having dealt with a broad range of clients for many years.  Investor behavior is sometimes amazing, and behavioral finance, the academic specialty that has grown up to examine it, is equally interesting.  One of the most practical discussions of behavioral finance I have seen appeared recently on AdvisorOne.  It was written by Michael Finke, the coordinator for the financial planning program at Texas Tech.

It is my strong recommendation that you read the entire article, but here are a few of the behavioral finance highlights that jumped out at me:

  • Breaking habits requires deliberate intention to change routines by using our rider to change the direction of the elephant. How do we motivate people to change behavior to meet long-term goals?  Neuroscience suggests that the worst way to motivate people is to focus on numbers. Telling someone they need to save a certain amount to achieve an adequate retirement accumulation goal may be convincing to the rational brain, but not so convincing to the elephant.
  • Explaining a concept in a visual or emotional sense uses much more of our brain functions than is used by numbers. If you think of people as being emotional and visual, you’ve essentially tapped into 70% of the brain real estate. There is that rational side, but that rational side might be more like 20% of the real estate. The rational side used to solve math problems might be 8% of the real estate.
  • It can be useful to frame desired actions as the status quo in order to take advantage of this preference. For example, setting defaults that are beneficial can have an unexpectedly large impact on improving behavior.
  • The most powerful emotional response related to financial choice is fear. Fear leads to a number of observed decision anomalies identified in behavioral finance such as the excessive attention paid to a loss.  Framing decisions so that they do not necessarily involve a loss is an important tool advisors can use to avoid bringing the amygdala to the table.
  • “Dollar cost averaging is an illusion,” notes James. “Unless we have mean reversion in the market (and if we do we can make lots of market timing bets and make ourselves rich), dollar cost averaging does not work. But if people believe that they are buying shares cheaper in a recession, the story makes people stay in the market at the times when their fear-driven emotional side wants them to get out of the market. We have a story that, even if it’s completely false, is generating the behavior that is going to be portfolio maximizing in the end. So maybe the answer to the usefulness of dollar cost averaging isn’t ‘well we’ve figured it out and it doesn’t work, so don’t use it,’ the answer is ‘actually it’s not true but it gets your clients to behave the right way so keep telling them that.’”

The biggest impediment to good returns is typically investor psychology.  If behavioral finance ideas can help clients control their behavior better—and thus lead to better investment outcomes—some of these ideas may prove useful.

Source: Lean Frog  (click on image to enlarge)

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Raging Bull Market

October 18, 2012

I saw an article on CNBC that discussed the opinion of Citigroup strategist Tobias Levkovich.  Here’s an excerpt of his thinking on a bull market:

Tobias Levkovich, Citigroup’s U.S. strategist, is expecting the market to enter a ‘raging bull’ market next year.

While he continues to stick with his 2013 year-end target on the S&P 500 of 1,615, that would take the index above the prior peak of 1,558 reached in 2007.

Is this valid?  I have no idea.  However, I am getting pretty sick of reading bearish forecasts, so I like the way Mr. Levkovich thinks!

In truth, things are never usually as bad or as good as people forecast.  Given the pervasive gloom surrounding equity markets for the last several years, a bull market is not out of the question.  The stock market often does whatever is required to make the most people wrong, and a bull market would certainly catch a lot of investors flat-footed.

 

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Why Is Trading So Hard?

September 20, 2012

Indeed, why is trading so hard?  Adam Grimes of Waverly Advisors addresses exactly this issue in blog post.  This is one of the most articulate expositions of the problems investors face with their own behavior that I have ever read.

What is it about markets that encourages people to do exactly the wrong thing at the wrong time, and why do many of the behaviors that serve us so well in other situations actually work against us in the market?

Part of the answer lies in the nature of the market itself. What we call “the market” is actually the end result of the interactions of thousands of traders across the gamut of size, holding period, and intent. Each trader is constantly trying to gain an advantage over the others; market behavior is the sum of all of this activity, reflecting both the rational analysis and the psychological reactions of all participants. This creates an environment that has basically evolved to encourage individual traders to make mistakes. That is an important point—the market is essentially designed to cause traders to do the wrong thing at the wrong time. The market turns our cognitive tools and psychological quirks against us, making us our own enemy in the marketplace. It is not so much that the market is against us; it is that the market sets us against ourselves.

I added the bold.  This is just great writing, and powerful because it is true.  Really competent people who are fantastic about making life decisions often have a rough time trading in the market, for just the reason Mr. Grimes’ points out.

He comes to the same solution that we have come to: a systematic investment process that can be implemented rigorously.  There’s no shortage of robust return factors that offer potential outperformance—the trick is always implementing them in a disciplined way.

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Stupid Investing Tricks

July 26, 2012

That’s the title of a Jason Zweig article for the Wall Street Journal.  In the article, he points out how investors over-react to short-term information.

According to new research, this area of the “rational” brain [frontopolar cortex] forms expectations of future rewards based largely on how the most recent couple of bets paid off. We don’t ignore the long term completely, but it turns out that we weight the short term more heavily than we should – especially in environments (like the financial markets) where the immediate feedback is likely to be random.

In short, the same abilities that make us smart at many things may make us stupid when it comes to investing.

For the ultimate in over-reaction, he writes:

For quick confirmation, look no further than this recent study, which analyzed the accounts of nearly 1.5 million 401(k) investors and found that many of them switch back and forth from stocks to bonds and other “safe” accounts based on data covering very short periods.

You might argue that the long run is nothing but a string of short runs put together,  or that you can get peace of mind by limiting your risk to fluctuating markets when prices fall, or that major new information should immediately be factored into even your longest-term decision-making. But many of these 401(k) investors were overhauling their portfolios based entirely on how markets performed on the very same day.

Yep—by “very short period,” he means the same day.  That’s what the authors in the academic article, Julie Agnew and Pierluigi Balduzzi, found.  They write:

We find that transfers into “safe” assets (money market funds and GICs) correlate strongly and negatively with equity returns. These results hold even after controlling for lead-lag relationships between returns and transfers, day-of-the-week effects, and macro-economic announcements. Furthermore, we find evidence of contemporaneous positive-feedback trading. That is, we find a positive effect of an asset class’ performance on the transfers into that asset class on the same day. Overall, these results are surprising, in light of the limited amount of rebalancing activity documented in 401(k) plans. It appears that while 401(k) investors rarely change allocations, when they do so their decisions are strongly correlated with market returns.

This is a very polite way for academics to say “when the stock market went down, investors panicked and piled into ‘safe’ assets.”  Jason Zweig’s article points out that people react to how their last two trials worked out.  That’s pretty much in line with anecdotal stories that buyers of profitable trading systems will stop using them after two or three losses in a row.  The long-term is ignored in favor of the very short term.

With typical understatement, Agnew and Balduzzi write:

This is potentially worrisome, as it suggests that some investors may deviate from their long-run investment objectives in response to one-day market returns. We provide evidence that these deviations can lead to substantial utility costs.

“Substantial utility costs” in plain English means investors are screwing themselves.

Now, none of this is a surprise for advisors.  We all have the same discussion with clients during every decline.  The party line is that more investor education is needed, but these neurological studies suggest that people, in general, are just wired to be bad investors.  They might overemphasize the last two trials no matter how we educate them.

So what is the takeaway from all of this?  I certainly don’t have a simple solution.  Perhaps it will be helpful to reframe what a “trial” is for clients as something much bigger than the last couple of quarters or the last two trades.  It might help, at the margin, to continue to emphasize process.    Maybe our best bet is just to distract them.  Like I said, I don’t have a simple solution—but I think that a lot of any advisor’s value proposition is how successful they are at getting the client to invert their normal thought process and get them to focus on the long term rather than the short term.

Source of Stupid Trick: StupidHumans.org

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