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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Relative Strength Everywhere

December 14, 2012

Eric Falkenstein has an interesting argument in his paper Risk and Return in General: Theory and Evidence.  He proposes what is essentially a relative strength argument about risk and return.  He contends that investors care only about relative wealth and that risk is really about deviating from the social norm.  Here is the summary of his draft from the excellent CXO Advisory:

Directly measured risk seldom relates positively to average returns.  In fact, there is no measure of risk that produces a consistently linear scatter plot with returns across a variety of investments (stocks, banks, stock options, yield spread, corporate bonds, mutual funds, commodities, small businesses, movies, lottery tickets and bets on horse  races).

  • Humans are social animals, and processing of social  information (status within group) is built into our brains. People care only about relative wealth.
  • Risk is a deviation from what everyone else is doing (the market portfolio) and is therefore avoidable and unpriced. There is no risk premium.

The whole paper is a 150-page deconstruction of the flaws in the standard model of risk and return as promulgated by academics.  The two startling conclusions are that 1) people care only about relative wealth and that 2) risk is simply a deviation from what everyone else is doing.

This is a much more behavioral interpretation of how markets operate than the standard risk-and-return tradeoff assumptions.  After many years in the investment management industry dealing with real clients, I’ve got to say that Mr. Falkenstein re-interpretation has a lot going for it.  It explains many of the anomalies that the standard model cannot, and it comports well with how real clients often act in relation to the market.

In terms of practical implications for client management, a few things occur to me.

  • Psychologists will tell you that clients respond more visually and emotionally than mathematically.  Therefore, it may be more useful to motivate clients emotionally by showing them how saving money and managing their portfolio intelligently is allowing them to climb in wealth and status relative to their peers, especially if this information is presented visually.
  • Eliminating market-related benchmarks from client reports (i.e., the reference to what everyone else is doing) might allow the client to focus just on the growth of their relative wealth, rather than worrying about risk in Falkenstein’s sense of deviation from the norm.  (In fact, the further one gets from the market benchmark, the better performance is likely to be, according to studies on active share.)  If any benchmark is used at all, maybe it should be related to the wealth levels of the peer group to motivate the client to strive for higher status and greater wealth.

I’m sure there is a lot more to be gleaned from this paper and I’m looking forward to having time to read it again.

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Relative Strength Still Off the Radar

May 16, 2012

The Big Picture has a thumbnail summary of the annual Merrill Lynch US Equity and US Quant Strategy pieces, where they interview 100 large institutional managers.  Of particular interest to me was the top ten return factors by popularity.

via The Big Picture  (click on image to enlarge)

You can see that relative strength did not crack the top ten.  On the bigger chart, which you can see in the article, relative strength came in at #11.  Of course, there are many formulations of relative strength, so even that ranking probably covers a lot of different methods.

A number of the popular factors are value-related and some are based on profitability.  All of these factors ultimately interact in complicated ways, but you don’t have to worry about a crowded trade in relative strength.

Value, quality, and risk-related factors are all much more popular than relative strength.

via The Big Picture     (click on image to enlarge)

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Combining Relative Strength and Low Volatility

October 12, 2011

The power of relative strength as a return factor has been well documented and that evidence is the reason that relative strength drives all of our investment strategies.  However, just because it is a winning return factor over time doesn’t mean that anyone should or will construct an asset allocation composed entirely of relative strength-based strategies.  Financial advisors who are in a position to decide which strategies to include in an asset allocation must then decide how to find complementary return factors.  We have previously written about the benefits of combining relative strength and value, for example.

However, it appears that value is not the only suitable complement for relative strength strategies.  Another option would be to consider combining the recently introducted PowerShares S&P Low Volatility Portfolio (SPLV) with our own PowerShares DWA Techical Leaders Portfolio (PDP).

A description of each is as follows:

The PowerShares DWA Technical Leaders Portfolio (PDP) is based on the Dorsey Wright Technical Leaders™ Index (Index). The Fund will normally invest at least 90% of its total assets in securities that comprise the Index and ADRs based on the securities in the Index. The Index includes approximately 100 U.S.-listed companies that demonstrate powerful relative strength characteristics. The Index is constructed pursuant to Dorsey Wright proprietary methodology, which takes into account, among other factors, the performance of each of the 3,000 largest U.S.-listed companies as compared to a benchmark index, and the relative performance of industry sectors and sub-sectors. The Index is reconstituted and rebalanced quarterly using the same methodology described above.

The PowerShares S&P 500® Low Volatility Portfolio (SPLV) is based on the S&P 500® Low Volatility Index (Index). The Fund will invest at least 90% of its total assets in common stocks that comprise the Index. The Index is compiled, maintained and calculated by Standard & Poor’s and consists of the 100 stocks from the S&P 500 Index with the lowest realized volatility over the past 12 months. Volatility is a statistical measurement of the magnitude of up and down asset price fluctuations over time.

The efficient frontier below points out that combining the two can be an effective way to reduce the volatility and/or increase the return over using PDP or SPLV independently. 

(Click to enlarge)

The table below is also for the period April 1997-September 2011.  (The hypothetical returns for PDP only go back to April 1997.)

Perhaps most interesting to asset allocators is the fact that the correlation of excess returns of PDP and SPLV over this time period was -0.29.  The goal of asset allocation is to not only add value, but to also construct an allocation that clients will stay with for the long-run.  Rather than whip in and out of PDP, perhaps a more enlightened approach is to buy and hold positions in both PDP and SPLV for a portion of the allocation.

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

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Dare to be Different

July 28, 2011

Advisor Perspectives ran a recent article by Sitka Pacific’s J.J. Abodeely.  There was a fantastic quotation he pulled out from Ben Inker at GMO:

“The good news is that in the investment business there are very few people who do real asset allocation and actually move money around in an aggressive way,” Inker said. “It’s a tough thing to do and survive. The nice thing about it, and the reason why we do it, is because this means it’s an inefficiency that is not going to get arbitraged away anytime soon.”

We’ve written in the past about this exact feature of many winning investment strategies: the arbitrage involved is behavioral, not financial.  Good returns derived from uncomfortable strategies do not get arbitraged away, because very few people will actually do it.  In other words, if you look at your portfolio and get a warm, fuzzy feeling, you’re probably doing it wrong.

Simple examples of this phenomenon abound.  Here’s one: to lose weight 1) eat less and 2) exercise more.  Have I now arbitraged away the entire diet book industry because I just gave you the basic advice for free?  Of course not!  When I searched Amazon for “The * Diet,” I got 65,338 results (!!), ranging from The Warrior Diet to Crazy Sexy Diet to The Juice Lady’s Turbo Diet.  Although I am in awe of publishers’ ingenuity in coming up with great book titles, none of these diets will necessarily work any better than my basic advice.  The reason people struggle to lose weight is not because reasonable advice is not readily available; it’s because the advice is hard to implement.  Eating less and exercising more is simply less comfortable than our default position of eating more and exercising less!

Relative strength is often an uncomfortable strategy whether it is implemented in equities or global asset classes simply because the portfolios can deviate significantly from the market or from traditional notions of asset allocation.  On the plus side, it may give you some comfort to realize that relative strength methods have shown excellent returns for many decades—returns that are not likely to be arbitraged away unless human nature undergoes a substantial change.

Dare to be different


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Ibbotson Kills Strategic Asset Allocation

March 11, 2010

Today we celebrate the death of another myth–that asset allocation is responsible for 90% of your return–surprisingly done in by none other than Roger Ibbotson of Ibbotson Associaties, purveyors of the ubiquitous asset class return charts.  This myth is particularly pernicious because it is used by strategic asset allocators of all stripes to imply that active management or stock picking doesn’t really matter–if you just allocate properly you will be fine.

There are two problems with the myth that asset allocation is responsible for 90% of your returns:  1) the original Brinson et al. (BHB) study actually said that asset allocation explained 90% of the variation in returns between two sets of institutional portfolios, and 2) even that was wrong.  In his recent article in the Financial Analysts Journal, “The Importance of Asset Allocation.” Roger Ibbotson writes:

Surprisingly, many investors mistakenly believe that the BHB (1986) result (that asset allocation policy explains more than 90 percent of performance) applies to the return (the 100 percent answer).  BHB, however, wrote only about the returns, so they likely never encouraged this misrepresentation.

Whether BHB ever encouraged it or not, the misreading of the results was seized upon by hungry marketing departments everywhere to serve their own purposes.   

Calculating the actual impact of active management versus the impact of asset allocation is actually pretty tricky.  There have been several different studies that address it and their numbers vary, depending on the time horizon and the type of portfolio.  Ibbotson’s own research into this area concludes:

Ibbotson and Kaplan (2000) presented a cross-sectional regression on annualized cumulative returns across a large universe of balanced funds over a 10-year period and found that about 40 percent of the variation of returns across funds was explained by policy.

Clearly, 40% is a whole lot different than 90%.  It turns out that active management and stock selection is way, way more important than the strategic asset allocation crowd would like to admit. 

Tactical asset allocation and active management may have a major role if investor returns are significantly dependent not just on how you are allocated, but on exactly what you own and when.  Ibbotson’s article points out that:

The time has come for folklore to be replaced with reality. Asset allocation is very important, but nowhere near 90 percent of the variation in returns is caused by the specific asset allocation mix. Instead, most time-series variation comes from general market movement, and Xiong, Ibbotson, Idzorek, and Chen (forthcoming 2010) showed that active management has about the same impact on performance as a fund’s specific asset allocation policy.

The emphasis is mine, but the “replacing folklore with reality” phrasing is pretty strong for an academic journal.  Modern portfolio theory and its near cousin, strategic asset allocation, however, seem to be dying a lingering death.  It is still the dominant method of structuring portfolios, but clearly it is just as important to consider tactical asset allocation and to make sure that active management processes are robust.  The next time you read the 90% number somewhere, I hope you will give it the consideration it deserves—none.

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