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 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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Equity as the Way to Wealth

January 3, 2014

According to a recent Gallup Poll, most Americans don’t think much of the stock market as a way to build wealth.  I find that quite distressing, and not just because stocks are my business.  Stocks are equity—and equity is ownership.  If things are being done right, the owner should end up making more than the employee as the business grows.  I’ve reproduced a table from Gallup’s article below.

Source: Gallup  (click on image to enlarge)

You can see that only 37% felt that the stock market was a good way to build wealth—and only 50% among investors with more than $100,000 in assets.

Perhaps investors will reconsider after reading an article from the Wall Street Journal, here republished on Yahoo! Finance.  In the article, they asked 40 prominent people about the best financial advice they’d ever received.  (Obviously you should read the whole thing!)  Two of the comments that struck me most are below:

Charles Schwab, chairman of Charles Schwab Corp.

A friend said to me, Chuck, you’re better off being an owner. Go out and start your own business.

Richard Sylla, professor of the history of financial institutions and markets at New York University

The best financial advice I ever received was advice that I also provided, both to myself and to Edith, my wife. It was more than 40 years ago when I was a young professor of economics and she was a young professor of the history of science. I based the advice on what were then relatively new developments in modern finance theory and empirical findings that supported the theory.

The advice was to stash every penny of our university retirement contributions in the stock market.

As new professors we were offered a retirement plan with TIAA-CREF in which our own pretax contributions would be matched by the university. Contributions were made with before-tax dollars, and they would accumulate untaxed until retirement, when they could be withdrawn with ordinary income taxes due on the withdrawals.

We could put all of the contributions into fixed income or all of it into equities, or something in between. Conventional wisdom said to do 50-50, or if one could not stomach the ups and downs of the stock market, to put 100% into bonds, with their “guaranteed return.”

Only a fool would opt for 100% stocks and be at the mercies of fickle Wall Street. What made the decision to be a fool easy was that in those paternalistic days the university and TIAA-CREF told us that we couldn’t touch the money until we retired, presumably about four decades later when we hit 65.

Aware of modern finance theory’s findings that long-term returns on stocks should be higher than returns on fixed-income investments because stocks were riskier—people had to be compensated to bear greater risk—I concluded that the foolishly sensible thing to do was to put all the money that couldn’t be touched for 40 years into equities.

At the time (the early 1970s) the Dow was under 1000. Now it is around 16000. I’m now a well-compensated professor, but when I retire in a couple of years and have to take minimum required distributions from my retirement accounts, I’m pretty sure my income will be higher than it is now. Edith retired recently, and that is what she has discovered.

Not everyone has the means to start their own business, but they can participate in thousands of existing great businesses through the stock market!  Richard Sylla’s story is fascinating in that he put 100% of his retirement assets into stocks and has seen them grow 16-fold!  I’m sure he had to deal with plenty of volatility along the way, but it is remarkable how effective equity can be in creating wealth.  His wife discovered that her income in retirement—taking the required minimum distribution!—was greater than when she was working!  (The italics in the quote above are mine.)

Equity is ownership, and ownership of productive assets is the way to wealth.

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Warren Buffett and Charlie Munger’s Best Advice

November 26, 2013

…talk about the best advice they have even gotten in a short piece from Fortune.  I think it clarifies the difference between a blind value investor and an investor who is looking for good companies (not coincidentally, many of those good companies have good relative strength).  Warren Buffett and Charlie Munger have made a fortune implementing this advice.

Buffett: I had been oriented toward cheap securities. Charlie said that was the wrong way to look at it. I had learned it from Ben Graham, a hero of mine. [Charlie] said that the way to make really big money over time is to invest in a good business and stick to it and then maybe add more good businesses to it. That was a big, big, big change for me. I didn’t make it immediately and would lapse back. But it had a huge effect on my results. He was dead right.

Munger: I have a habit in life. I observe what works and what doesn’t and why.

I highlighted the fun parts.  Buffett started out as a Ben Graham value investor.  Then Charlie wised him up.

Valuation has its place, obviously.  All things being equal, it’s better to buy cheaply than to pay up.  But Charlie Munger had observed that good businesses tended to keep on going.  The same thing is typically true of strong stocks—and most often those are the stocks of strong businesses.

Buy strong businesses and stick with them as long as they remain strong.

Source: CNN/Money (click on image to enlarge)

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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.



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.)


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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More on Systematic Process

October 18, 2013

We use a systematic process for investment because we think that’s the best way to go.  Our systematic process also happens to be adaptive because we think adaptation to the current market environment is also an important consideration.  (If you don’t adapt you die.)  Our decision to use a systematic process is grounded in evidence that, over time, systematic processes tend to win out over inconsistent human decision making.  (See here, for example.)

The latest instance of this was an interesting article on Quartz about the coming wave of full-service coffee machines that may have the potential to replace baristas.  Consider, for example, what this particular quotation says about the power of a systematic process:

In 2012, Julian Baggini, a British philosophy writer and coffee aficionado, wondered why dozens of Europe’s Michelin-starred restaurants were serving guests coffee that came out of vacuum-sealed plastic capsules manufactured by Nespresso. So he conducted a taste test on a small group of experts. A barista using the best, freshly-roasted beans went head to head with a Nespresso capsule coffee brewing machine. It’s the tale of John Henry all over again, only now it was a question of skill and grace rather than brute strength.

As the chefs at countless restaurants could have predicted, the Nespresso beat the barista.

Suffice it to say that most manufacturing nowadays is done by machine because it is usually faster, less expensive, and more accurate than a human.  Perhaps you will miss terribly your nose-ringed, pink-haired, tatooed barista, but then again, maybe not so much.

Systematic investing has its problems—sometimes the adaptation seems too slow or too fast.  Sometimes your process is just out of favor.  But like a manufacturing process, a systematic investment process holds the promise of consistency and potential improvement as technology and new techniques are incorporated over time.  While it may seem less romantic than the lone stock picker, systematic investment could well be the wave of the future.

HT to Abnormal Returns

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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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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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Ritholtz on Prediction

July 12, 2013

In Financial Advisor, Barry Ritholtz of The Big Picture blog gets asked about his market outlook.  He answers with his view on prediction, which I would very much endorse.

Let’s start out with a basic question: What’s your outlook on the markets and the economy?

Let me begin with an answer you will hate: My opinion as to the future state of the economy or where the market might be going will be of no value to your readers. Indeed, as my blog readers will tell you, I doubt anyone’s perspectives on these issues are of any value whatsoever.

Here’s why: First, we have learned that you Humans are not very good at making these sorts of predictions about the future. The data overwhelmingly shows that you are, as a species, quite awful at it.

Second, given the plethora of conflicting conjectures in the financial firmament, how can any reader determine which author to believe and which to ignore? You can find an opinion to confirm any prior view, which is a typical way many investors make erroneous decisions. (Hey, that agrees with my perspective, I’ll read THAT!)

And third, relevant to the above, studies have shown that the most confident, specific and detailed forecasts about the future are: a) most likely to be believed by readers and TV viewers; and b) least likely to be correct. (So you have that going for you, which is nice.)

Last, across the spectrum of possible opinions, forecasts and outlooks, someone is going to be correct—how can you ever tell if it was the result of repeatable skill or merely random chance?

Kudos to Mr. Ritholtz for telling it like it is.

There is no way to know what is going to happen in the future.  Prediction is neither useful or necessary.

Later in the article, Mr. Ritholtz makes the point that most investors do not know even what is going on right now.  That is where relative strength can be a useful technique.  Relative strength can identify what is strong, and trend following is a practical way to implement it, by owning what is strong as long as it remains strong.  Long-term mean reversion methodologies will work too, of course.  In other words, you don’t need to predict the future as long as you can assume that trends and reversion to the mean will continue to occur as they always have.

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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

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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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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Serenity for Investors

October 9, 2012

Grant me the serenity to accept the things I cannot change, the courage to change the things I can, and the wisdom to know the difference—-Reinhold Niebuhr

Serenity is in short supply in the investment community!  Capital Group/American Funds recently posted a fantastic commentary on uncertainty, pointing out that investors are much better off if they focus on what they can control and don’t sweat the other stuff.  Here are some excerpts that struck me—but you should really read the whole thing.

Powerless. That’s how a lot of investors feel. In a recent Gallup poll, 57% of investors said they feel they have little or no control over their efforts to build and maintain their retirement savings. What’s causing them to feel so lost? According to 70% of those polled, the most important factor affecting the investment climate is something they can’t control, the federal budget deficit.

On the flip side, among investors with a written financial plan having specific goals or targets, the poll showed 80% of nonretirees and 88% of retirees said their plan gives them the confidence to achieve their financial goals. It seems like some investors have figured out what they can control and what they can’t.

Life for investors would be simpler if there were a handy timetable by which these issues would be resolved in a quick and orderly fashion. But successful investors know they can’t control the outcome of the euro-zone summits or American fiscal debates, much less plug politics into a spreadsheet.

They can, however, review their goals, manage risk, be mindful of valuation and yield and remember that diversification may matter now more than ever. It’s easy to overlook in such a challenging environment, but unsettled times can also offer opportunities for long-term investors. In the midst of uncertainty, there are companies with strong balance sheets, smart management and innovative products that continue to thrive, and whose shares may be attractively valued.

All true!  We’ve written before about what an important investment attribute patience is.  Maybe in some important way, serenity contributes to patience.  It’s hard to be patient when you’re worried about everything, especially things you have no control over!  They even include a handy-dandy graphic with suggested responses to all of those things disturbing your serenity.

Source: American Funds Distributors  (click on image to enlarge)

At some level, perhaps we are all control freaks.  Unfortunately for us, in a relationship with the market, it’s the market that is in control!  We can’t control market events, but we can control our responses to those events.  Finding healthy ways to manage market anxiety is a primary focus for every successful investor.

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The Pragmatist’s Approach to Investing

September 27, 2012

Adam Davidson’s article “Hey, Big Saver!” in the New York Times is an excellent summary of the competing arguments on the merits of QE3. There truly are compelling arguments for why this will work and there are compelling arguments why it won’t. Effectiveness aside,  Bernanke has made his intentions perfectly clear:

When Bernanke announced that the Fed would be investing in the mortgage market indefinitely, he signaled that he’s had it with short-term fixes. His Fed is committed, he said, to taking extraordinary measures until unemployment goes down. In Fed-speak, Q.E. 3 is a clear message to banks, investors and private companies that the economy is going to grow, and the riskiest thing they can do is to hold on to their cash and riskless securities and watch their competitors profit.

Are his policies working or not? This is why I love technical analysis. Rather than get caught up in theoretic debates, technical analysis cuts to the chase and asks a different question: What stocks, sectors, and asset classes have the best relative strength? Based on that information, relative strength investors can orient their portfolio to capitalize on those trends.

Investors are not interested in winning theoretical debates. Investors are interested in making money! Rather than focusing on what the Fed, Congress, the President, the ECB, banks, consumers, economists, investment strategists, your brother-in-law… have to say about what is going to happen in the market, take the pragmatist’s approach and let relative strength dictate your investment decisions.

Source: CBS News

HT: Real Clear Markets

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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:

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From the Archives: Two Approaches to Motivating Clients

June 28, 2012

Ken Haman, a managing director at the Advisor Institute at AllianceBernstein responds to the following question posed by an advisor and published in Investment News:

Q: I’ve had some frustrating conversations with clients recently—trying to get them back in the market. Very few are taking my advice, even though they seem to know that staying on the sidelines is a mistake. What’s going on, and how can I get them “unstuck”?

A: Problems like this have to do with how people make decisions. Behavioral finance uses the term “inappropriate extrapolation”–and insights about it can help you understand your clients and respond to them more effectively.

To make any decision, human beings create a mental picture of the future. That’s what “expectations” are–the ability to take information from the past and present, and project it into the future. Unlike most animals, human beings can project far into the future; as a result, we are able to “plan ahead.” Unfortunately, we usually don’t create these future images terribly well. Instead of making a thoughtful assessment of what’s likely to happen in the future, we typically picture the future as just a continuation of the recent past.

Essentially, you want to learn how to install a positive picture of the future that the client feels is likely to happen in reality. Start by explaining the mechanisms of the market and illustrating visually how those mechanisms work. Many investors have only the vaguest understanding of the cause-effect dynamics in the markets. Instead of making thoughtful, well-informed decisions, they react to their perception of patterns and trends. Market “mechanisms” are those cause-effect relationships that equip financial professionals to invest rationally instead of speculating randomly.

By looking at how market mechanisms operated in both the recent and more distant past, you teach your clients how to think more strategically about the markets. This allows them to build a more vivid mental picture of market behaviors in the future. Make sure you explain market mechanisms visually as well as verbally: use charts and graphs that show market behaviors over time. Whenever possible, connect your investment recommendations to a clear explanation of the mechanism that is involved.

Second, provide an adequate level of detail about the mechanisms you explain. There’s a commonly held myth that clients aren’t interested in hearing about the markets. So, many financial advisors gloss over important information and rush to their proposal without creating a case the client understands. But clients are interested in understanding the mechanisms that drive their investment results–as long as your explanation is clearly illustrated and easy to understand.

Finally, you have to deliver your message with personal conviction–that you fully believe the future will look the way you anticipate. Your clients need to borrow your conviction and clarity about the future. That’s how they’ll build their sense of confidence in the decisions you’re asking them to make. Take a stand on what you believe about the future, and add the courage of your own convictions to the clarity of your explanation.

There is also an alternative approach of just being frank with the client and telling them that you don’t know exactly what the future holds, nor does anyone else.  However, you adhere to a systematic relative strength process that gives you great flexibility to allocate to a wide range of asset classes depending on how the future unfolds.  At times, the approach can be allocated very conservatively and at times it can be allocated quite aggressively.  My experience has been that clients appreciate the honesty and are willing to embrace a trend-following approach that deals very effectively with not being able to see into the future.

—-this article originally appeared 1/12/2010.  More than two years later, many clients are still on the sidelines.    Many of them definitely do engage in inappropriate extrapolation!  An advisor’s first duty is to be honest, but you’ve got to do it in a way that is motivating and not paralyzing.

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From the Archives: The Future of Decision-Making

June 13, 2012

Man versus machine, art versus science, intuition versus logic—all of these are ways of expressing what we often think of as contradictory approaches to problem solving.  Should we be guided more by data and precedent, or is it more important to allow for the human element?  Is it critical to be able to step aside and say, with the benefit of our judgment, “maybe this time really is different?”

The Harvard Business Review recently took on this topic and a few of their points were quite provocative.

A huge body of research has clarified much about how intuition works, and how it doesn’t. Here’s some of what we’ve learned:

  • It takes a long time to build good intuition. Chess players, for example, need 10 years of dedicated study and competition to assemble a sufficient mental repertoire of board patterns.
  • Intuition only works well in specific environments, ones that provide a person with good cues and rapid feedback . Cues are accurate indications about what’s going to happen next. They exist in poker and firefighting, but not in, say, stock markets. Despite what chartists think, it’s impossible to build good intuition about future market moves because no publicly available information provides good cues about later stock movements. [Needless to say, I don’t agree with his assessment of stock charts!] Feedback from the environment is information about what worked and what didn’t. It exists in neonatal ICUs because babies stay there for a while. It’s hard, though, to build medical intuition about conditions that change after the patient has left the care environment, since there’s no feedback loop.
  • We apply intuition inconsistently. Even experts are inconsistent. One study determined what criteria clinical psychologists used to diagnose their patients, and then created simple models based on these criteria. Then, the researchers presented the doctors with new patients to diagnose and also diagnosed those new patients with their models. The models did a better job diagnosing the new cases than did the humans whose knowledge was used to build them. The best explanation for this is that people applied what they knew inconsistently — their intuition varied. Models, though, don’t have intuition.
  • We can’t know or tell where our ideas come from. There’s no way for even an experienced person to know if a spontaneous idea is the result of legitimate expert intuition or of a pernicious bias. In other words, we have lousy intuition about our intuition.
  • It’s easy to make bad judgments quickly. We have many biases that lead us astray when making assessments. Here’s just one example. If I ask a group of people “Is the average price of German cars more or less than $100,000?” and then ask them to estimate the average price of German cars, they’ll “anchor” around BMWs and other high-end makes when estimating. If I ask a parallel group the same two questions but say “more or less than $30,000″ instead, they’ll anchor around VWs and give a much lower estimate. How much lower? About $35,000 on average, or half the difference in the two anchor prices. How information is presented affects what we think.

We’ve written before about how long it takes to become world-class.  Most studies show that it takes about ten years to become an expert if you apply yourself diligently.  Obviously, the “intuition” of an expert is much better than the intuition of a neophyte.  If you think about that for a minute, it’s pretty clear that intuition is really just judgment in disguise.  The expert is better than the novice simply because they have a bigger knowledge base and more experience.

Really, the art versus science debate is over and the machines have won it going away.  Nowhere is this more apparent than in chess.  Chess is an incredibly complex mental activity.  Humans study with top trainers for a decade to achieve excellence.  There is no question that training and practice can cause a player to improve hugely, but it is still no contest.  As processing power and programming experience has become more widespread, a $50 CD-ROM off-the-shelf piece of software can defeat the best players in the world in a match without much problem.  Most of the world’s top grandmasters now use chess software to train with and to check their ideas.  (In fact, so do average players since the software is so cheap and ubiquitous.)

How did we get to this state of affairs?  Well, the software now incorporates the experience and judgment of many top players.  Their combined knowledge is much more than any one person can absorb in a lifetime.  In addition, the processing speed of a standard desktop computer is now so fast that no human can keep it with it.  It doesn’t get tired, upset, nervous, or bored.  Basically, you have the best of both worlds—lifetimes of human talent and experience applied with relentless discipline.

A 2000 paper on clinical versus mechanical prediction by  Grove, Zald, Lebow, Snitz, & Nelson  had the following abstract:

>The process of making judgments and decisions requires a method for combining data. To compare the accuracy of clinical and mechanical (formal, statistical) data-combination techniques, we performed a meta-analysis on studies of human health and behavior. On average, mechanical-prediction techniques were about 10% more accurate than clinical predictions. Depending on the specific analysis, mechanical prediction substantially outperformed clinical prediction in 33%–47% of studies examined. Although clinical predictions were often as accurate as mechanical predictions, in only a few studies (6%–16%) were they substantially more accurate. Superiority for mechanical-prediction techniques was consistent, regardless of the judgment task, type of judges, judges’ amounts of experience, or the types of data being combined. Clinical predictions performed relatively less well when predictors included clinical interview data. These data indicate that mechanical predictions of human behaviors are equal or superior to clinical prediction methods for a wide range of circumstances.

That’s a 33-47% win rate for the scientists and a 6-16% win rate for the artists, and that was ten years ago.  That’s not really very surprising.  Science is what has allowed us to develop large-scale agriculture, industrialize, and build a modern society.  Science and technology are not without their problems, but if the artists have stayed in charge we might still be living in caves, although no doubt we would have some pretty awesome cave paintings.

This is the thought process behind our Systematic Relative Strength accounts.  We were able to codify our own best judgment, include lifetimes of other experience from investors we interviewed or relative strength studies that we examined, and have it all run in a disciplined fashion.  We chose relative strength because it was the best-performing factor and also because, since it is relative, it is adaptive.  There is always cooperation between man and machine in our process, but moving more toward data-driven decisions is indeed the future of decision making.

—-this article originally appeared 1/15/2010.  Our thought process hasn’t changed—we still believe that a systematic, adaptive investment process is the way to go.

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