Real Returns on Bonds

December 6, 2013

First Trust’s Bob Carey had a blog post of couple of months ago that examined the real return on bonds.  (I encourage you to read the whole post because he also had some interesting comments.)  Bonds, I think, are a pretty good diversifier because they can often reduce overall portfolio volatility.  But there’s not much real return—return after inflation—in bonds right now.

Source: First Trust  (click on image to enlarge)

In 2011, in fact, you have evidence of a bond bubble.  Even in the TIPs market, expected real returns were negative for a period of time.  When investors are willing to buy an asset expecting to lose purchasing power, well, that seems a little crazy.  Right now, expected real returns are still quite low.

If inflation drops from here, maybe things will work out.  If the stock market has a significant decline, holding bonds might turn out to be the better alternative.  But if real returns go back to their historic norms, there may be more turmoil ahead in the bond market.  There’s no way to know what will happen going forward, of course, but it’s probably a good idea to know where you stand relative to history.

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Correlation and Expected Returns

July 31, 2013

Modern portfolio theory imagines that you can construct an optimal portfolio, especially if you can find investments that are uncorrelated.  There’s a problem from the correlation standpoint, though.  As James Picerno of The Capital Spectator points out, correlations are rising:

A new study from the Bank of International Settlements (BIS) raises doubts about the value of commodities as a tool for enhancing portfolio diversification. The paper’s smoking gun, so to speak, is that “the correlation between commodity and equity returns has substantially increased after the onset of the recent financial crisis.”

Correlations are a key factor in the design and management of asset allocation, but they’re not the only factor. And even if we can find assets and strategies with reliably low/negative correlations with, say, equities, that alone isn’t enough, as I discussed last week. You also need to consider other factors, starting with expected return. It may be tempting to focus on one pair of assets and consider how the trailing correlation stacks up today. But that’s hardly the last word on making intelligent decisions on how to build a diversified portfolio.

As more investors pile into commodities, REITs, hedge funds, and other formerly obscure corners, the historical diversification benefits will likely fade. Granted, the outlook for expected diversification benefits fluctuates through time, and so what looks unattractive today may look considerably more compelling tomorrow (and vice versa). But as a general proposition, it’s reasonable to assume that correlations generally will inch closer to 1.0. That doesn’t mean that diversifying across asset classes is destined to become worthless, but the expected payoff is likely to dim with the passage of time.

Mathematically, any two items that are not 100% correlated will reduce volatility when combined.  But that doesn’t necessarily mean it’s a good addition to your portfolio—or that modern portfolio theory is a very good way to construct a portfolio.  (We will set aside for now the MPT idea that volatility is necessarily a bad thing.)  The article includes a nice graphic, reproduced below, that shows how highly correlated many asset classes are with the US market, especially if you keep in mind that these are 36-month rolling correlations.  Many asset classes may not reduce portfolio volatility much at all.

Source: The Capital Spectator  (click on image to enlarge)

As Mr. Picerno points out, optimal allocations are far more sensitive to returns than to correlations or volatility.  So even if you find a wonderfully uncorrelated investment, if it has a lousy return it may not help the overall portfolio much.  It would reduce volatility, but quite possibly at a big cost to overall returns.  The biggest determinant of your returns, of course, is what assets you actually hold and when.  The author puts this a slightly different way:

Your investment results also rely heavily on how and when you rebalance the mix.

Indeed they do.  If you hold equities when they are doing well and switch to other assets when equities tail off, your returns will be quite different than an investor holding a static mix.  And your returns will be way different than a scared investor that holds cash when stocks or other assets are doing well.

In other words, the return of your asset mix is what impacts your performance, not correlations or volatility.  This seems obvious, but in the fog of equations about optimal portfolio construction, this simple fact is often overlooked.  Since momentum (relative strength) is generally one of the best-performing and most reliable return factors, that’s what we use to drive our global tactical allocation process.  The idea is to own asset classes as long as they are strong—and to replace them with a stronger asset class when they begin to weaken.  In this context, diversification can be useful for reducing volatility, if you are comfortable with the potential reduction in return that it might entail.  (We  generally advocate diversifying by volatility, by asset class, and by strategy, although the specific portfolio mix might change with the preference of the individual investor.)  If volatility is well-tolerated, maybe the only issue is trying to generate the strongest returns.

Portfolio construction can’t really be reduced to some “optimal” set of tradeoffs.  It’s complicated because correlations change over time, and because investor preferences between return and volatility are in constant flux.  There is nothing stable about the portfolio construction process because none of the variables can be definitively known; it’s always an educated approximation.  Every investor gets to decide—on an ongoing basis—what is truly important: returns (real money you can spend) or volatility (potential emotional turmoil).  I always figure I can afford Maalox with the extra returns, but you can easily see why portfolio management is overwhelming to so many individual investors.  It can be torture.

Portfolio reality, with all of its messy approximations, bears little resemblance to the seeming exactitude of Modern Portfolio Theory.

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From the Archives: If You Miss the 10 Best Days

June 7, 2013

We’ve all seen numerous studies that purport to show how passive investing is the way to go because you don’t want to be out of the market for the 10 best days.  No one ever mentions that the “best days” most often occur during the declines!

It turns out that the majority of the best days and the worst days occur near one another, during the declines.  Why?  Because the market is more volatile during declines.  It is true that the market goes down 2-3x as fast as it goes up.  (World Beta has a nice post on this topic of volatility clustering, which is where this handy-dandy table comes from.)

 If You Miss the 10 Best Days

from World Beta

You can see how volatility increases and the number of days with daily moves greater than 2.5% really spikes when the market is in a downward trend.  It would seem to be a very straightforward proposition to improve your returns simply by avoiding the market when it is in a downtrend.

However, not every strategy can be improved by going to cash.  Think about the math: if your investing methodology makes enough extra money on the good days to offset the bad days, or if it can make money during a significant number of the declines, you might be better off just gritting your teeth during the declines and banking the higher returns.  Although the table above suggests it should help, a simple strategy of exiting the market (i.e., going to cash) when it is below its 200-day moving average may not always live up to its theoretical billing.

 If You Miss the 10 Best Days

 If You Miss the 10 Best Days

click to enlarge

Consider the graphs above.  (The first graph uses linear scaling; the second uses logarithmic scaling for the exact same data.)  This test uses Ken French’s database to get a long time horizon and shows the returns of two portfolios constructed with market cap above the NYSE median and in the top 1/3 for relative strength.  In other words, the two portfolios are composed of mid- and large-cap stocks with good relative strength.  The only difference between the two portfolios is that one (red line) goes to cash when it is below its 200-day moving average.  One portfolio (blue line) stays fully invested.  The fully invested portfolio turns $100 into $49,577, while the cash-raising portfolio yields only $26,550.

If you would rather forego the extra money in return for less volatility, go right ahead and make that choice.  But first stack up 93 boxes of  Diamond matches so that you can burn 23,027 $1 bills, one at a time, to represent the difference–and then make your decision.

 If You Miss the 10 Best Days

The drawdowns are less with the 200-day moving average, but it’s not like they are tame–equities will be an inherently volatile asset class as long as human emotions are involved.  There are still a couple of drawdowns that are greater than 20%.  If an investor is willing to sit through that, they might as well go for the gusto.

As surprising as it may seem, the annualized return over a long period of time is significantly higher if you just stay in the market and bite the bullet during train wrecks–and even two severe bear markets in the last decade have not allowed the 200-day moving average timer to catch up.

At the bottom of every bear market, of course, it certainly feels like it would have been a good idea (in hindsight) to have used the 200-day moving average to get out.  In the long run, though, going to cash with a high-performing, high relative strength strategy might be counterproductive.  When we looked at 10-year rolling returns, the fully invested high relative strength model has maintained an edge in returns for the last 30 years running.

 If You Miss the 10 Best Days

click to enlarge

Surprising, isn’t it?  Counterintuitive results like this are one of the reasons that we find testing so critical.  It’s  easy to fall in line with the accepted wisdom, but when it is actually put to the test, the accepted wisdom is often wrong.  (We often find that even when shown the test data, many people refuse, on principle, to believe it!  It is not in their worldview to accept that one of their cherished beliefs could be false.)  Every managed portfolio in our Systematic RS lineup has been subjected to heavy testing, both for returns and–and more importantly–for robustness.  We have a high degree of confidence that these portfolios will do well in the long run.

—-this article originally appeared 3/5/2010.  We find that many investors continue to refuse, on principle, to believe the data!  If you have a robust investment method, the idea that you can improve your returns by getting out of the market during downturns appears to be false.  (Although it could certainly look true for small specific samples.  And, to be clear, 100% invested in a volatile strategy is not the appropriate allocation for most investors.)  Volatility can generally be reduced somewhat, but returns suffer.  One of our most controversial posts ever—but the data is tough to dispute.

In more recent data, the effect can be seen in this comparison of an S&P 500 ETF and an ETN that switches between the S&P 500 and Treasury bills based on a 200-day moving average system.  The volatility has been muted a little bit, but so have the returns.

(click on image to enlarge)

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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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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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Target Date Fund Follies

March 7, 2013

Target date and lifecycle funds have taken off since 2006, when they were deemed qualified default investment alternatives in the Pension Protection Act.  I’m sure it seemed like a good idea at the time.  Unfortunately, it planted the idea that a glidepath that moved toward bonds as the investor moved toward retirement was a good idea.  Assets in target date funds were nearly $400 billion at the end of 2011—and they have continued to grow rapidly.

In fact, bonds will prove to be a good idea if they perform well and a lousy idea if they perform poorly.  Since 10-year future returns correlate closely with the current coupon yield, prospects for bonds going forward aren’t particularly promising at the moment.  I’ve argued before that tactical asset allocation may provide an alternative method of accumulating capital, as opposed to a restrictive target-date glidepath.

A new research paper by Javier Estrada, The Glidepath Illusion: An International Perspective, makes a much broader claim.  He looks at typical glidepaths that move toward bonds over time, and then at a wide variety of alternatives, ranging from inverse glidepaths that move toward stocks over time to balanced funds.  His findings are stunning.

This lifecycle strategy implies that investors are aggressive with little capital and conservative with much more capital, which may not be optimal in terms of wealth accumulation. This article evaluates three alternative types of strategies, including contrarian strategies that follow a glidepath opposite to that of target-date funds; that is, they become more aggressive as retirement approaches. The results from a comprehensive sample that spans over 19 countries, two regions, and 110 years suggest that, relative to lifecycle strategies, the alternative strategies considered here provide investors with higher expected terminal wealth, higher upside potential, more limited downside potential, and higher uncertainty but limited to how much better, not how much worse, investors are expected to do with these strategies.

In other words, the only real question was how much better the alternative strategies performed.  (I added the bold.)

Every strategy option they considered performed better than the traditional glidepath!  True, if they were more focused on equities, they were more volatile.  But, for the cost of the volatility, you ended up with more money—sometimes appreciably more money.  This data sample was worldwide and extended over 110 years, so it wasn’t a fluke.  Staying equity-focused didn’t work occasionally in some markets—it worked consistently in every time frame in every region.  Certainly the future won’t be exactly like the past, so there is no way to know if these results will hold going forward.  However, bonds have had terrific performance over the last 30 years and the glidepath favoring them still didn’t beat alternative strategies over an investing lifetime.

Bonds, to me, make sense to reduce volatility.  Some clients simply must have a reduced-volatility portfolio to sleep at night, and I get that.  But Mr. Estrada’s study shows that the typical glidepath is outperformed even by a 60/40-type balanced fund.  (Balanced funds, by the way, are also designated QDIAs in the Pension Protection Act.)   Tactical asset allocation, where bonds are held temporarily for defensive purposes, might also allow clients to sleep at night while retaining a growth orientation.  The bottom line is that it makes sense to reduce volatility just enough to keep the client comfortable, but no more.

I’d urge you to read this paper carefully.  Maybe your conclusions will be different than mine.  But my take-away is this: Over the course of an investing lifetime, it is very important to stay focused on growth.

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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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Yet Another Blow to Modern Portfolio Theory

November 19, 2012

Modern Portfolio Theory is predicated on the ability to construct an efficient frontier based on returns, correlations, and volatility.  Each of these parameters needs to be accurate for the efficient frontier to be accurate.  Since forecasting is tough, often historical averages are used.  Since the next five or ten years is never exactly like the last 50 years, that method has significant problems.  Apologists for modern portfolio theory claim that better efficient frontiers can be generated by estimating the inputs.  Let’s imagine, for a moment, that this can actually be done with some accuracy.

There’s still a big problem.  Volatility bumps up during adverse market conditions, as reported by Research Affiliates.  And correlations change during declines—and not in a good way.

From the abstract of a recent paper, Quantifying the Behavior of Stock Correlations Under Market Stress:

Understanding correlations in complex systems is crucial in the face of turbulence, such as the ongoing financial crisis. However, in complex systems, such as financial systems, correlations are not constant but instead vary in time. Here we address the question of quantifying state-dependent correlations in stock markets. Reliable estimates of correlations are absolutely necessary to protect a portfolio. We analyze 72 years of daily closing prices of the 30 stocks forming the Dow Jones Industrial Average (DJIA). We find the striking result that the average correlation among these stocks scales linearly with market stress reflected by normalized DJIA index returns on various time scales. Consequently, the diversification effect which should protect a portfolio melts away in times of market losses, just when it would most urgently be needed.

I bolded the part that is most inconvenient for modern portfolio theory.  By the way, this isn’t really cutting edge.  The rising correlation problem isn’t new, but I find it interesting that academic papers are still being written on it in 2012.

The quest for the magical efficient portfolio should probably be ended, especially since there are a number of useful ways to build durable portfolios.  We’re just never going to get to some kind of optimal portfolio.  Mean variance optimization, in fact, turns out to be one of the worst methods in real life.  We’ll have to make do with durable portfolio construction.  It may be messy, but a broadly diversified portfolio should be serviceable under a broad range of market conditions.

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The New Death of Equities

May 21, 2012

From AdvisorOne, yet another article about how much investors hate the market these days:

Despite strong U.S. equity market returns in early 2012 that sent the Dow back above 13,000 by the end of February, indications are that many Americans remain investment spectators, reluctant to participate in the equity market rally, a Franklin Templeton global poll has found.

Investor skepticism appears to be tied to the extreme volatility witnessed in 2011, in which the Dow Jones Industrial Average had 104 days of triple-digit swings-representing a significant portion of the 252 total trading days last year. Indeed, when asked about the importance of various market scenarios when deciding to purchase an equity investment, market stability was most frequently identified by U.S. respondents as an important factor.

“The market volatility that has persisted since 2008 is keeping many investors on the sidelines, and their ability to view positive equity market performance constructively has been thwarted by the market ups and downs that are at odds with the stability they are seeking,” John Greer, executive vice president of corporate marketing and advertising at Franklin Templeton Investments, said in a statement. “But the reality is that investors who have been waiting for ‘the right time’ to get back into the equity market have been missing out on the market rally we’ve witnessed over the past few years.”

This is sadly typical of retail investors.  Volatility tends to be greatest at market bottoms, and volatility tends to be what investors most avoid.  As a result, investors often avoid returns as well!

This period strikes me as psychologically reminiscent of the late 1970s, when Business Week famously published a cover announcing the death of equities.  Consider what investors had been through: in the late 1960s, the speculative names had gotten torched.  By 1973-74 even the bluest of the blue chips had gotten ripped.  By the late 1970s, 20% annual corrections were the norm.  The economy was a mess and investors simply opted out.  The Business Week cover just reflected the spirit of the time.

The late 1970s are not so different from now.  The speculative names collapsed in 2000-2002, followed by a bear market in 2008-2009 that got everything.  The last couple of summers have been punctuated by scary 15-20% corrections.  The economy is still a mess.  Psychologically, investors are in the same spot they were when the original cover came out.  Based on fund flows, “anything but stocks” seems to be the battle cry.

Yet, consider how things unfolded subsequently.  Only a few years later both the market and the economy were booming.  (High relative strength stocks began to perform very well several years ahead of the 1982 bottom, by the way.)  The Business Week cover is now famous as a contrary indicator.  It wouldn’t shock me if the current investor disdain for stocks has a similar outcome down the road.


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Relative Strength and Market Volatility

September 30, 2011

Markets have been extremely volatile over the last couple of months.  Volatile markets are very difficult to navigate.  It is very easy to make mistakes, and when a mistake is made it is magnified by the volatility.  From a relative strength standpoint, there are things you can do to help ease the pain of all of these large, unpredictable market moves.  But judging by all the client calls we have taken over the years–almost always when volatility was high–the steps needed to make a relative strength model perform well are most definitely not what most investors would think!

Before we look at relative strength specifically, let’s take a step back and look at different investment strategies on a very broad basis.  There are really two types of strategies: trend continuation and mean reversion.  A trend continuation strategy buys a security and assumes it will keep moving in the same direction.  A mean reversion (or value) strategy buys a security and assumes it will reverse course and come closer to a more “normal” state.  Both strategies work over time if implemented correctly, but volatility affects them in different ways.  Mean reversion strategies tend to thrive in high volatility markets, as those types of markets create larger mispricings for value investors to exploit.

When we construct systematic relative strength models, we have always preferred to use longer-term rather than shorter-term signals.   This decision was made entirely on the basis of data—by testing many models over a lot of different types of markets.  Judging by all the questions we get during periods of high volatility, I would guess that using a longer-term signal when the market is volatile strikes most investors as counter-intuitive.  In my years at Dorsey Wright, I can’t remember talking to a single client or advisor that told me when markets get really volatile they look to slow things down!

During volatile markets, generally we hear the opposite view–everyone wants to speed up their process.  Speeding up the process can take many forms.  It might mean using a smaller box size on a point and figure chart, or using a 3-month look back instead of a 12-month look back when formulating your rankings.  It might be as simple as rebalancing the portfolio more often, or tightening your stops.  Whatever the case, most investors are of the opinion that being more proactive in these types of markets makes performance better.

Their gut response, however, is contradicted by the data.  As I mentioned before, our testing has shown that slowing down the process actually works better in volatile markets.  And we aren’t the only ones who have found that to be the case!  GMO published a whitepaper in March 2010 that discussed momentum investing (the paper can be found here).  Figure 17 on page 11 specifically addresses what happens to relative strength models during different states of market volatility.

(Click Image To Enlarge.  Source: GMO Whitepaper, Sept. 2010)

The chart clearly shows how shortening your look back period decreases performance in volatile markets.  The 6-12 month time horizon has historically been the optimal time frame for formulating a momentum model.  But when the market gets very volatile, the best returns come from moving all the way out to 12 months, not shortening your window to make your model more sensitive.

Psychologically, it is extremely difficult to lengthen your time horizon in volatile markets.  Every instinct you have will tell you to respond more quickly in order to get out of what isn’t working and into something better.  But the data says you shouldn’t shorten your window, and conceptually this makes sense.  Volatile markets tend to be better for mean reversion strategies.  But for a relative strength strategy, volatile markets also create many whipsaws.  When thinking about how volatility interacts with relative strength, it makes sense to lengthen your time horizon.  Hopping on every short term trend is problematic if the trends are constantly reversing!  All the volatility creates noise, and the only way to cancel out the noise is to use more (not less) data.  You can’t react to all the short-term swings because the mean reversion is so violent in volatile markets.  It doesn’t make any sense to get on trends more rapidly when you are going through a period that is not optimal for a trend following strategy.

We use a data-driven process to construct models.  We have found that using a relatively longer time horizon, while uncomfortable, ultimately leads to better performance over time.  Outside studies show the same thing.  If the data showed that reacting more quickly to short-term swings in volatile markets was superior we would advocate doing exactly that!

As is often the case in the investing world, this seems to be another situation where doing the most uncomfortable thing actually leads to better performance over time.  Good investing is an uphill run against human nature.  Of course, it stands to reason that that’s the way things usually are.  If it were comfortable, everyone would do it and investors would find their excess return quickly arbitraged away.

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