All the Leaves are Brown…

Leaves

Autumn in northern Virginia is a wonderful thing.  The air is crisp; the temperatures still pleasant; and the warm palette of leaves create a truly magical view.  When we lived in Brooklyn, we would pack up all the kids in our van and drive upstate a ways just to see the leaves change colors.  Now, I just have to look out my back door.  

As I look out my back door though, I realized that the leaves I once considered so beautiful, now carpet the majority of my still-green lawn.   Our property covers about 1 acre and within our property line loom some 50 deciduous trees (along with a few hollies and evergreens that I consider my good friends right now).  The broadleaf trees include oaks, maples, black walnuts, dogwoods and a few others I cannot identify but I know they still drop leaves like Leonard Hankerson drops passes.  This is a mature forest and some of the trees tower some 70 feet about the ground.  Experts suggest that a large, mature tree may hold 200,000 leaves.  That would suggest each fall I need to deal with 10 million leaves!  

The good news is that I have a Billy Goat.  Not this kind:

Goat

But this kind:

mower

This machine is amazing.  It not only sucks up leaves like crazy, but it mulches them to 1/10 their original volume, making disposal much easier.  We have two large compost pits in the back of our yard where I dump the mulched leaves.  Eventually, they turn into nice, rich dark soil that we use in our gardens and other parts of the yard.  Over the last two weekends, I cleared the yard twice and dumped about 25 bags full into our compost piles.  I suspect that I will be doing this for at least three more weeks until all of the leaves are down.

The trees on our property are truly beautiful and handsomely improve our appreciation of where we live.  But, once a year, they require a good deal of work on my behalf. 

So what does that have to do with investing?  I see my leaf mulching experience much like rebalancing a portfolio. Like a tree, a portfolio can be a beautiful thing, growing and blooming as one would hope.  But like a tree, it will need occasional trimming, pruning and sometimes extra care when share prices fall.  Unlike the annual ritual of the falling leaves, portfolios may require tuning more than once a year.  In my current position, I perform about 360 portfolio reviews each year.  Every time I look at a client portfolio, I deploy my best effort to position the portfolio for optimum future growth.  I view each portfolio as unique as every one of my wonderful trees.  But as in nature, future growth is not assured, and sometimes returns lag the broader indices.  Such is the nature of the capital markets.

Yet, I know the best chance of long-term success in investing comes from finding a compatible investment style and philosophy and sticking with it over the long haul.  My approach has worked for me for over three decades and I suspect it also will serve me well into the future.  Despite this confidence, I acknowledge that any investment style will find itself out of favor from time to time; returns will not be as expected. When one has high conviction in the long-term investment strategy being employed, these periods of underperformance are usually opportunities to increase exposure to the out-of-favor investment approach, not run away from it.

Did I Just Get Stupid, or What?

dumb-and-dumber-1260x840I have been a professional investor for a long time.  In any other profession, I would be nearly perfect in doing what I’m paid to do.  If I were a dentist, I could fill a cavity with my eyes closed.  If I were a pastry chef, my wedding cakes would be works of art.  If I were a dock worker, I could load and unload those 3-ton cargo containers like they were Legos. 

Alas, I did not choose a different line of work.  The complex nature of the capital markets prevents most of us from feeling like we are ever “nearly perfect.”  The best way to be successful in this business is to develop and stick to a well-defined investment philosophy.  Trying to invest in line with whatever is popular or working at any given time is a well-documented recipe for failure. 

The downside of the “best way” to invest is that sometimes one’s chosen approach will underperform any number of benchmarks.  Occasionally, this underperformance will persist for a number of quarters or *gasp* even years.

I recall the legendary John Neff’s experience in the early 1980s.  A well-known value investor, he concluded that metal and mining stocks represented tremendous value, and loaded up on them.  For four years, this overweight position hurt his performance.  In the fifth year, however, the bulk of his metals holdings appreciated something like 5 fold.  Ultimately he was right, but he looked wrong for four years.

We all know that 2014 was a challenging year for active managers; something like only 15% of us was able to beat their benchmarks.  2015 has proven to be another hard year, especially for investors who have exposure to smaller-cap names, commodities and/or overseas markets.  The fact that the major markets indices are down year to date has made a challenging year even more painful. 

Some days I wonder if I suddenly became stupid or something.  I am investing in the same way I have for decades.  My ability to measure value feels the same.  Many of the stocks that I found and bought in the past have shown sparkling results.  A long, dry spell like now, however, can challenge one’s confidence, and I find myself constantly reviewing and challenging my approach.  So far, I find nothing troubling in my methodology.  I must conclude that my investment philosophy remains solid and will again lead to superior returns. 

I am not ready to hang up my HP 12-C and go drive semis like many of my cousins and uncles.  I come to work every day with the same level of enthusiasm as ever.  I relish in the thought that today I may find yet another dusty rock of value that will one day shine as a brilliant diamond. 

The recent volatility has no doubt dampened the spirits of many investors.  Remember that in the short-run, all kinds of fears (are we going to see a new global recession?) and technical trading schemes (see my previous blog) can and will affect the market.  In the long-run, fundamentals always win out, all stocks eventually move to their intrinsic value, and value investing beats most other approaches. 

Patience will be rewarded.

I, Robot

iRobotScience fiction has long been fascinated with the concept of robots.  The godfather of the genre, Isaac Asimov, even codified the rules of robot behavior as the “Three Laws of Robotics” (often shortened as the “The Three Laws”).  Many authors foresaw a time in the future where robots might become hostile to humans (the Terminator movies are based on this concept), and The Three Laws were Asimov’s way of assuaging this concern.

Here are the three laws:

  • A robot may not injure a human being or, through inaction, allow a human being to come to harm.
  • A robot must obey the orders given by human beings except where such orders would conflict with the First Law.
  • A robot must protect its own existence as long as such protection does not conflict with the First or Second Law.

Many science fiction fans are likely disappointed that our world does not feature robots as depicted in the popular stories.  Apart from the limited-use robot made by companies like Honda (see picture), most of our robots are on the factory floor making welds and fabricating metal components.  Concern over robots harming humans is not a top ten worry on anyone’s list.

Yet, I wonder….

When the market began its rapid decline in August, commentators were quick to assume that worries about China were driving share prices.  As volatility increased, further analysis uncovered additional fears about the timing of a Fed “lift off,” weakening corporate profits and so forth.  The prime assumption to all of this “analysis” was that human behavior was driving the action in the markets.

I was part of this chorus as well.  I opined that some investors in an abundance of caution may have sold just a little bit, just in case China becomes a bigger problem.  If many people sell just a little bit, it could lead to the downward pressure we saw.  We all crave a simple answer to something we see happen in the market.

We now find that the story is a bit more complicated than we thought.  At the heart of this recent spate of volatility may be robots, and they obviously were not heeding The Three Laws.

Investors and traders have been using quantitative analysis for many years.  Every investment bank, hedge fund and large mutual fund no doubt has many math PhDs working for them, trying to find some kind of edge.  Many of these schemes can be employed by a large number of investors, leading to massive pools of money being invested this way.  Because these decisions are largely driven by the software programs (robots?) embedded in them, they will buy/sell assets without much human input (other than the original programming).  These schemes come in many varieties, such as “volatility targeting strategies” or “risk parity,” but they all have the common goal of making money no matter what the market does.

It seems that as stock prices began to fall, many of these programs (robots?) responded by selling more stock.  This additional selling pressure no doubt encouraged human traders to join in the selling chorus.  Bam!  The Dow Jones goes down 1,000 point in one day.  Why then did the market turn so quickly and move higher so soon?  The robots concluded stocks had declined enough to buy again.  Here too the collective force of this buying propelled stock prices higher.  In calmer markets, these strategies are likely to provide some small amount of incremental gains to those who use them, but they can be the cause of increased volatility in unsettled times like these.

I am not suggesting that the market is somehow messed up by these trading schemes.  However, I do think that much of the recent volatility may be technical and not fundamental. This kind of market action is upsetting, but remembering one’s long-term goals can help us weather any kind of short-term storm.

And be sure to keep a careful eye on your iPad for any signs of sentient behavior…

 

Wise Words from Smart People

wise

Over the weekend I did a lot of reading and quiet thinking about the market’s action last week.  Whenever the market goes down, the natural reaction is to want to do something.  Often the smartest thing to do is to do nothing.

Here are my conclusions from the weekend’s study and contemplation:

  1. We are still in a bull market.  Bull markets usually don’t end this way in an environment of low interest rates and rising corporate profits.  Also, the U.S. economy is strong enough to weather economic disruptions in other nations, even China.
  2. Corrections are normal in a bull market. By my calculation, we have had at least 5 sizable corrections since the bull market begin in early 2009.  The latest one was September of last year (-6%) and the biggest one was in 2011 (where the market fell 16%).  Ten percent is the average correction size.
  3. Investors should not pretend they know what will happen in the short run.  There are three possibilities – the market goes down, stays flat or goes up.  Some people may want to sell because the market has gone down.   That’s like closing the barn door after the horse ran out.  If you think you know what will happen in the near term, you’re wrong.  No one knows.
  4. In the long run, stocks provide better returns than any other asset class.  This is an empirical fact.  The volatility of stocks (as we are seeing now) is the reason why they outperform other assets.  Stay with stocks.

Here are a few other ideas from smart people I respect:

Sir John Templeton (legendary fund manager) – “Even if everyone around you is selling, sometimes the best idea is to take a breath and hold on to your portfolio.  In the event of a sell-off, only divest if you have identified more attractive stocks to pick up.”

Liz Ann Saunders – (Equity Strategist for Charles Schwab) – “I think that corrections are healthy.  They bring sentiment.  It keeps complacency from becoming pervasive… They are a cleansing process… Panic is not an investment strategy.”

Jason Zweig (Wall Street Journal writer) – “Don’t fixate on the news.  [This] will make it harder for you to remain focused on your long-term investing goals.  Don’t Panic.  Don’t be complacent.  You should use the latest turbulence as a pretext to ask yourself honestly whether you are prepared to withstand a much worse decline.  Don’t get hung up on the talk of a ‘correction.’  What matters is the outlook for the future; that doesn’t depend on whether the market is down 10.2% or 9.8%.  Don’t think you – or anyone else – knows what will happen next.  The one thing you can be fairly sure of is that the louder and more forcefully a market pundit voices his certainty about what is going to happen next, the more likely that he will turn out to be wrong.”  (See his full article here:  http://blogs.wsj.com/briefly/2015/08/21/5-things-investors-shouldnt-do-now/)

Hey, There’s Greece on my China!

As Roseanne Roseannadanna was wont to say, “Well, Jane, it just goes to show you, it’s always something — if it ain’t one thing, it’s another.”

Grease

Hey, there’s Greece on my China!

For a while now the capital markets have been trying to grapple with Greek issues – the referendum vote last weekend, tense negotiations among its creditors and trying to figure out how contagion might occur were Greece to default and/or leave the European Union.  Now we can add to this toxic mix a stock market “meltdown” (to use the breathless phraseology of the capital markets media folks) in China.

China had been the hottest market on the planet until recently and some sort of correction would have not been all that surprising, but what troubles investors most (I surmise) is the Chinese government’s reaction to this volatility – they are trying to prop up the stock market by 1) suspending trading and 2) using the government’s capital to buy stocks.  One wag described the situation well – “the invisible hand meets the iron fist.”  Capitalism and free markets are messy things, and those wishing to control nearly everything may from time to time find this unsettling.

It’s not like government intervention in stock markets is unprecedented.  Hong Kong in 1997 used its money to prop up the stock market during the great Asian crisis of the time.  It was widely criticized for this policy (mostly by Western observers), but in the end, it turned out reasonably well.  Not so well was Japan’s infamous “Price Keeping Operation (PKO)” in the early 1990s.  Although never officially announced, everyone I knew (I was a Japan equity market strategist at the time) knew that the government was buying stocks directly or indirectly through moral suasion of insurance companies, banks, and pension funds.  PKO might have put a floor on the market, but it took decades for Japanese investors to recoup their losses following the great bubble burst of the 1980s.

So what?  As always, my crystal ball is a bit hazy about the near-term outlook.  I suspect Greece will not have a big lasting impact on European or U.S. economies, but until the details of the current negotiations are finalized, we could continue to see some Greece-induced volatility.  Greece’s biggest creditors now are the European Central Bank and the International Monetary Fund – representing the nation’s lenders of last resort.  U.S. banks appear to have close to zero exposure; European banks’ exposure is also very low.

China’s situation is probably much more positive than Greece’s.  The Chinese stock market’s recent strength can be linked to 1) a new program that opened the market to a huge wave of new money and 2) an explosion in margin lending.  Given that this market is mostly driven by individual investors, it is more susceptible to the ebb and flow of fear and greed.  We must not conclude that the Chinese economy is doing poorly because the nation’s volatile stock market.  I sense that this is a “stock market” problem, not a “Chinese economy” problem.  Over time, capital market always care more about fundamentals than sentiment.

Any weakness we might see in the U.S. stock market will probably be driven by the usual suspects selling some portion of their portfolios in an abundance of caution.  I find it somewhat ironic that what is deemed an act of caution by a few and lead to increased volatility and concern for all.

I remain firm in my view that we are still in a secular bull market, and I would be a buyer of U.S. stocks on weakness

Verruggio’s Essential Rules of Investing

Charless

Today I am featuring a guest blogger on “Persuasion Time.”  He is Charles Verruggio, one the senior advisors working at my firm.  He is also a voting member of our company’s Investment Policy Committee.  Investors and would-be investors would do well to lend an ear to his good advice.

1. Start Early (and remember to rebalance)

Taking advantage of the power of compounding is probably the most important rule when it comes to being a successful investor.  In theory, it should be the easiest as well.  Consider the following:

If you had invested $100,000 on 1/01/81 (in a pre-tax account) and split the money 70/30 between stocks (S&P 500) and bonds (Barclays Aggregate Bond Index) and never rebalanced, your total would have been $3.098 million (before tax) after 34 years (1/01/15). If you rebalanced back to a 70/30 split at the end of each year, your total would be $3.173 million (before tax) as of 1/01/15, i.e., $75,000 more. The Barclays Aggregate bond index, calculated using 6,000 publicly traded government and corporate bonds with an average maturity of 10 years, was used as the bond measurement (source: BTN Research).

This example also illustrates the importance of rebalancing

2. Stay Diversified

Although some individuals do indeed get rich off of a very concentrated position of one particular company (think employees with company stock options), the vast majority of individuals are more likely to do better with a balanced, well-diversified portfolio of stocks and bonds.  Diversification will help in the quest to preserve capital and reduce risk.  One simply needs to look at the Callan Periodic Table of Investment Returns to determine that it is nearly impossible to know in advance which asset class will lead the way in any given year.

Armed with this knowledge, one can easily see that diversifying across asset classes and market capitalizations can help protect one’s portfolio from experiencing the violent swings associated with a more concentrated portfolio, with only a few stocks in it.

Callan

3. Keep a long-term time horizon

A long-term time horizon allows one to withstand the inevitable volatility that the stock market displays from time to time.  Consider the following:

In the past 60+ years there has not been a 20-year period where the rolling stock market return has been less than 6%.  This is to say, had someone invested in 1931 or later and left the funds invested in the market for 20 years or more, they would have achieved an annualized total return of 6% or more in every single one of these 60+ twenty year periods.  To put this statistic in perspective, if an investor had put $100,000 in the stock market at any time from 1931 onward, and left this sum of money invested for 20 years or longer, the absolute minimum an investor would have is $320,713 at the end of the 20 years.

As legendary investor Warren Buffett says, “My favorite holding period is forever.”

4. Keep it simple

Speaking of Warren Buffett, keeping it simple is one of his favorite investment rules.  As he says “there seems to be some perverse human characteristic that likes to make easy things difficult.”

If an investment product or approach seems extremely complex, it is likely that the results may cause serious damage to the value of your portfolio.  Think of the Long-Term Capital Management (LTCM) debacle.  A famous bond trader brings together a team of other all-star traders and academics in an attempt to profit from the vast intelligence of this so-called “dream team.”  Less than 4 years later, the fund had lost more than 90% of its original investment and the Federal Reserve felt compelled to organize a bailout of LTCM, encouraging 14 banks to invest $3.65 billion in return for a 90% stake in the firm.  During this entire crisis, LTCM posed a serious threat of a systemic crisis to the world financial system!  This example brings to mind the “smartest guy in the room” types who outsmarted themselves into catastrophic losses.

The Problem with the Calendar

Anyone who has done any deep thinking or research about it would agree that the best way to invest is with a long-term perspective.  Investors who use and stick with a well-diversified portfolio with an asset allocation well suited for their risk tolerance tend to achieve better performance than those employing any other approach.  Investors who let their emotions or near-term market actions dictate investment decisions generally underperform those who maintain a long-term, disciplined approach.  Studies show that the longer the investment time horizon, the less variable the annual rates of returns become.

Range of S&P 500 Returns, 1926-2005

Source: Schwab.com

Despite the overwhelming benefits of investing for the long term, most professional investors provide their clients with quarterly reports.  I understand that most people would like to know what’s happening with their portfolios, but I would argue that quarterly updates provide little information that is useful to the average investor.  On the contrary, these reports may provide them sufficient reason to do something that might damage the potential for long-term investment success.

Taking this focus on the short-term to its ridiculous extreme, investors can now track portfolio values (I do it too!) in real time.  They can see not only daily price movements, but can see them by the minute.  The news media dedicated to reporting on capital market matters also encourage a short-term perspective.  “Breaking news” needs to be dramatic, and if a stock is up or down a bunch, it becomes “news” and viewers may feel compelled to “do something” in response to this development.  Short-term traders obviously like this stuff and use daily volatility to their benefit, but most investors should avoid the temptation to consider short-term price moves and/or news as a reason to adjust one’s portfolio.

[Old joke:  How does one make a small fortune day trading?  Start with a large fortune!]

But surely looking at one’s portfolio on an annual basis must be a good idea, right? I have seen studies and even written about the fact that investors who look at/rebalance their portfolios only once a year tend to outperform those who look at and take actions more frequently.  If we can step aside for a minute and realize that an annual accounting for anything is a human construct born out of tradition more than anything else, we might be able to see why even an annual review (12-months, January to December) may be less informative and useful than we think.

Last year is a great example of the perils of making portfolio shifts based on even yearly performance.  We all know that the S&P 500 was the best performing major index in 2014.  This table shows this:

Index

4th Qtr 2014

Year to Date

Trailing 12 Months

Dow Jones Industrial Average

5.2%

10.0%

10.0%

S&P 500

9.7%

13.7%

13.7%

NASDAQ

5.4%

13.4%

13.4%

Russell 2000

9.7%

4.9%

4.9%

MSCI EAFE

-3.5%

-4.5%

-4.5%

MSCI EAFE Small Cap

-2.2%

-4.6%

-4.6%

MSCI Emerging Markets

-4.4%

-1.8%

-1.8%

Barclays Aggregate Bond

1.8%

6.0%

6.0%

Barclays Municipal Bond

1.4%

9.1%

9.1%

Dow Jones Commodities

-11.9%

-18.8%

-18.8%

There are many people out there who concluded that the S&P 500 was the best investment to own simply because of its showing last year.  Most people who concluded this were probably unaware that the last time the S&P 500 stood at the top of this list was 1998 – that is to say, most other indices beat the S&P 500 on an annual basis each of the last 16 years.  Despite this fact, some people who looked at the S&P 500’s performance last year concluded that they should sell their small cap names, international mutual funds and other “underperforming” assets and buy the S&P 500.  This is exactly the kind of behavior that leads to the average investor lagging the market and even average mutual fund returns.

By the end of March, the tables had turned and the S&P 500 swap looked a lot less wonderful than it did in January.  This table shows what happened in Q1:

Index

1st Qtr 2015

Year to Date

Trailing 12 Months

Dow Jones Industrial Average

0.3%

0.3%

10.6%

S&P 500

1.0%

1.0%

12.7%

NASDAQ

3.5%

3.5%

16.7%

Russell 2000

4.3%

4.3%

8.2%

MSCI EAFE

4.9%

4.9%

-0.9%

MSCI EAFE Small Cap

5.6%

5.6%

-2.6%

MSCI Emerging Markets

1.9%

1.9%

-2.0%

Barclays Aggregate Bond

1.6%

1.6%

5.7%

Barclays Municipal Bond

1.0%

1.0%

6.6%

Dow Jones Commodities

-6.0%

-6.0%

-27.0%

The S&P 500 registered lower returns than nearly everything in Q1.  So what does the investor who made the switch in January do now?  This is the heart of the problem.  Looking at performance even annually can lead to common investment mistakes.

So what’s an investor to do?  What time frame measure is truly meaningful?  A recent white paper by the investment management company Invesco attempts to answer this question (click here for the full report – https://www.invesco.com/portal/site/us/financial-professional/active-passive-investing/).  This report suggests that the best time frame in which to assess the quality of a mutual fund, investment manager or one’s own investment approach is a complete cycle – that is from peak to peak and trough to trough.  Market tops and bottoms do not fall into neat, discrete annual packages.  They happen when they will.  How a portfolio manager does in a complete cycle can show the real value added of his/her approach to investing.

The paper goes on to suggest that actively managed portfolios tend to outperform passive investments when measured over complete cycles.  This is in stark contrast to the suggestion that 1) half of all mutual funds underperform their benchmarks and 2) you can’t beat the market.

Therefore what?

The complexity of the capital markets makes simple answers hard to find.  My purpose in penning this note was to highlight a tendency I have observed in people with investment portfolios.  “Don’t look at your quarterly statement” is probably not a great suggestion.  I guess if I had to offer some advice to those who find themselves chasing performance and always making changes in their portfolios at the wrong time I would circle back to where I started – invest with a long-term horizon, find an investment style/approach/manager and asset allocation that fits well with your risk tolerance and personality and then stick with it.  I believe that this patient approach to investing will pay big dividends in the long run.

Slow Going on 495 – an Investment Parable

Like many large U.S. cities, Washington D.C. is encircled by a busy road that (supposedly) allows drivers to bypass city traffic and arrive at their destination faster than they otherwise would.  In practice, D.C.’s highway I-495 is often a mess with commuters clogging the roadway from all directions.  Occasionally, however, driving on the Capital Beltway (as it is sometimes called) can be a real treat.

Such was the case last Saturday morning when my wife and I drove to our favorite place in Silver Spring, Maryland in less than 30 minutes.  We had listened to the weather report which told us snow was coming sometime around noon.  How bad could it be?  We expected to be heading back home sometime around noon, so we were not worried a bit.  After all, how bad could it be?

At 12:40 pm we began our return trip, only to find that about 2 inches of snow covered our vehicle.  The snow had arrived a bit earlier than we expected, but it was light and fluffy and we did not think it would disrupt our homeward trip dramatically.  Saturday traffic is always lighter, we reasoned, so it probably wouldn’t be too bad.

As we entered the highway, we were shocked at the number of vehicles on the road, but more shocked at the condition of the road – we saw little evidence of salt/sand or the mark of a snow plow.  We learned later that the cold weather before the snow made the snow removal chemicals less effective, and the large number of cars on the road made it hard for the snow plows to do their job.

The road surface was an unstable mix of mushy snow and ice.  But everyone was driving slowly and carefully, so we were quickly resigned to the idea that it would be a slow, but probably safe, ride home.  The snow was relentless – falling at a rate of one inch per hour.  The snow, once light and fluffy, was now quickly adding to the mush on the road.

We turned on the radio looking for traffic and weather updates.  We learned that snow was still falling and that 495 was crammed with vehicles stuck in the slop. Duh!  The reporters were earnestly telling us to stay off the roads if at all possible.  It was impossible for us.  We were committed to getting home.

Somewhere along the way, we began to see cars struggling to maneuver in the snow.  Some found it hard to stay in their lane.  Others ended up nearly sideways in their lanes as they fought against the slushy road conditions.  Yet others ended up on the side of the road totally immobilized by the slick and deepening snow.  We were somewhat shocked to see so many expensive sedans and sports cards stranded this way.

Farther on, our front-wheel drive SUV with new truck tires began to shimmy and slide.  I grew up in Montana and have driven in snowy conditions since I was 14 years old.  I know how to drive in the snow, but things were so bad that day that even my skills were sorely tested.  It turns out that the snow began to stick to the tires of many vehicles (ours included), effectively making the tread (and front-wheel drive) almost useless.

At one point, we thought maybe a side road would be somewhat faster than the snowbound beltway.  For a while we felt great about our choice – the roads were in better condition, there was less traffic and we were moving at higher speeds.  We were even able to stop at one point and clear some of the ice from our windshield and hood that was hurting our visibility a bit.

Alas, our good luck would not last.  We realized that we still needed to cross the river, and to do that we needed to get back on 495.  We did so with little fanfare, but soon found the road strewn with even more cars stuck in the muck.  It reminded us a little of some kind of disaster movie.

The balance of the trip featured still slow speeds, but less drama and perceived danger.  We were overjoyed as we pulled on to our garage – home safe!  Our return trip had taken over 3 hours.

 

As I reflected on this experience, I realized that it contains a number of parallels to investing.  Let me offer a few:

1)   We thought we could predict the outcome.  We knew snow was coming, but underestimated its impact on us.  Too many investors are still trying to time the market.  Too many people think they have saved enough to retire. Too many people are surprised by the volatility of the market.

2)   We got lost.  Too often people get confused by conflicting statements about the capital markets, which investment style is best, etc.  It is complicated, and it’s easy to get lost without a roadmap, which in my view is a financial plan. Investing simply “to make money” is not a good idea.

3)   We took a time out to clear our vision.  Sometimes, especially when the market is volatile, it may be useful to take a step back and remember why you’re investing.  The future is always uncertain, but having solid goals in mind will help you stay on the path when the going gets rough.  Studies show that too many people still do the exact wrong thing at exactly the wrong time.

4)   Lots of expensive cars struggled.  Even if you have a solid investment plan, it may struggle from time to time. No one investment style works all the time.  There will be set backs and disappointments.  This is simply the nature of the capital markets.  Changing investment styles based on recent performance has shown to be just about the worst thing an investor can do, and unfortunately an all-too-common occurrence.

5)   Unexpected developments.  The snow buildup on the tires was something I had not seen in a long time, and never in this part of the country.  Sometimes things happen somewhere in the world that surprise all investors.  These developments are also part of the complex nature of the capital markets.  Here too, a financial plan and consistent investment approach can prove invaluable.

6)   Some “experts” were of no help.  The road crews were trying to help, but the volume of vehicles on the road made it impossible.  The media folks were offering good advice to those listening at home, but for us on the road, not so much.  I am still shocked and amazed that any sane person would take investment advice from journalists.  Or think that “free” investment advice from “experts” is given for altruistic reasons.  If you need professional help (most people probably do), hire someone who can offer a financial plan and a sensible investment strategy.  Oh, and always carry some extra food and water in your car even if you think the trip will be short!

Do You Have MLA?

I don’t know about you, but whenever I learn about a new disease or personality disorder, I’m immediately convinced that I have some of the symptoms.  Taking a psychology class in college nearly did me in – during the course, I felt sure that I was paranoid, schizoid, and maybe even a bit crinoid!  I don’t think I’m a hypochondriac, but I might be.  Luckily for me, these fears that I may be abnormal or may be coming down with the latest bug last only for a brief moment.  When the Ebola virus hit our shores, I did check myself for fever and other flu-like symptoms, but all seems well so far…

Then I read about a truly horrifying malady that affects more Americans than any exotic virus ever will – Myopic Loss Aversion (MLA).  Over the last few decades psychologists have been identifying behavioral biases that cause us humans to make irrational choices.  Newer studies have applied some of this work to how we use our brains when we invest.  Despite how rational we may think we are in times of market calm, we generally become less rational in the face of declining stock prices.

The relatively new science of behavioral economics has revealed that the pain people feel from a financial loss (even a paper one in the case of a falling stock price) is about twice as strong as the pleasure felt from a similar financial gain.  In practical terms, this means that many people are willing to give up more potential upside in order to avoid losses.  This preference of avoiding losses versus making gains seems to be hard wired into us.

Our good friends at Fidelity Investments brought our attention to a more damaging strain of loss aversion – MLA.  This form of loss aversion can affect investors who frequently evaluate their portfolio’s performance.  The more one looks at portfolio performance, the more likely one is to see a loss.  Because this causes more anxiety than the gains provide joy, the investor may want to “do something” in response to the loss.  In most cases, this means selling the losing asset class.  We saw this in full bloom during the 2008-2009 period.  We saw a smaller version of this during the week ending October 24th, where $7 billion fled the equity market in response to the recent correction.

In the extreme, MLA can lead a person to have a lower exposure to the equity market than they should, given their age, wealth, etc.  The chart below shows this.

This graphic shows that investors in this study who made decisions on a monthly basis had far less stock exposure than those who gazed at their portfolio statements once a year.  This suggests that some portion of the investing public has a lower allocation to stocks (and hence lower long-term returns) simply because they frequently look at their portfolios!

As shocking as this sounds, we see evidence of this behavior often in real life. Consider October’s stock market correction.  As the market was falling, commentators were struggling to explain the cause of the move. Even Ebola was listed as a possible reason.  How likely was anyone who sold in the heat of the moment as prices were falling able to reinvest their cash on the way up?  More likely is that people who sold are still in cash waiting for the market to go back down.  We know people who did this in 2008 and are still holding cash waiting for the market to go down…

Now imagine the person who was on a month-long cruise without access to their portfolio.  The S&P 500 closed on September 30th at 1,972.29.  Today it closed at 2,018.  The person returning from the cruise would no doubt be pleased for the market’s 2.3% gain for the month and the positive impact for that person’s portfolio.  Who would you rather be – the person who fretted and felt compelled to do something as the market corrected, or the person on the cruise?

If you think you might be prone to contract MLA, don’t see your doctor.  Simply look less frequently at your portfolio.  Your long-term returns may thank you…

 

To Err is Human?

The Wall Street Journal did it again.  This weekend, Morgan Housel wrote an article bashing the individual investor.  His motivation in penning “The Three Mistakes Investors Make Over and Over Again” was no doubt to help individual investors from making these mistakes over and over again.  Yet at its heart, this article, and myriads just like it, do little to educate the investor (if they did, would we really be told how to avoid the mistakes we make over and over?), and probably just hurt people’s feelings.  In the name of full disclosure, I am equally guilty of trying to “educate” people about the capital markets.  I too probably tick off as many people as I help with my writings.  Still, there seems to be some underlying truth to the notion that we as humans are hard-wired in such a way that prevents us from naturally succeeding as investors on our own.

Let’s take a quick look at Mr. Housel’s three mistakes and please allow me to offer my perspective on them.

#1 – Incorrectly predicting your future emotions.  He writes “Too many investors are confident they will be greedy when others are fearful.  None assume they will be the fearful ones, even though somebody has to be, by definition.”  The stock market action in 2008 and early 2009 tested everyone’s resolve to be greedy when others were fearful.  All one has to do is recall the dominant feeling of those dark days – were you rubbing your hands together like McScrooge surveying a new pile of gold or were you worrying about losing all of your wealth?  I must say that I met very few people during that time who were not fearful.  When the market goes down, especially when it goes down a lot, it is NORMAL to feel fear.  Some may argue that selling when you are fearful is a NORMAL thing to do (lots of people did it back then), but I would argue that it is the worst thing you can do when you are fearful. Now that the climax of fear is well in the past, I am on the lookout for an abundance of greed.  The American Association of Individual Investors (AAII) sentiment survey is perhaps the best individual investment survey out there and suggests now that investor sentiment is somewhere in the middle – not too bearish (like in early 2009) and not too bullish (like in 1999).

#2 – Failing to realize how common volatility is.  He writes, “If you don’t understand how normal [there’s that word again – ed.] big market moves really are, you are more likely to think that a pullback is something unusual that requires attention and action.  It often doesn’t.”  I would add that most people don’t understand what volatility means. The mathematical definition deals with distribution of stock price fluctuation over time.  The great Howard Marks in a recent essay perfectly defined volatility – “… the possibility of permanent loss.”  People don’t fear stock volatility when prices are rising. They even might be able to hang in there during a mild and short correction.  What they truly fear is permanent loss.  I spoke to many rational people back in the 2008 and 2009 who truly believed that the stock market (or at least their portfolios) would go to ZERO, that they would lose ALL OF THEIR MONEY. Why would otherwise intelligent, well-adjusted and mature people feel this way?   Because they are NORMAL!  Owning a stock is unlike owning anything else.  Even if you can fully appreciate that a stock represents ownership in a real company (something that still feels very theoretical), you can’t hold it, you can’t see it, you can’t stick it in your basement with your doomsday supplies…  To most of us, it’s a bit ethereal – a number on a page, a ticker symbol on a website, a name without a face…  Yet, stocks are real, and have rewarded investors with the highest average return of any asset class over the years.  But their price volatility is common.

#3 – Trying to forecast what stocks will do next. He writes, “No matter how bad forecasts are, investors come back for more.”  He quotes Alan Greenspan, “We really can’t forecast all that well, and yet we pretend that we can.  But we really can’t.”  He quotes a 2005 study from Dresdner Kleinwort that looked at an aggregate of professional forecasts, “Analysts are terribly good at telling us what has just happened but of little use in telling us what is going to happen in the future.”  He goes on to suggest that a world without accurate forecasts need not be a scary place.  The legendary investor Benjamin Graham spoke often about the “margin of safety,” something that will help the investor weather the rough spots in the market.  He suggested that having a margin of safety in one’s investments would render “… unnecessary an accurate estimate of the future.”  Long-time readers of this blog will know that I am not a fan of forecasts.  I spend most of my time trying to measure value and discover undervalued stocks.  This is what Benjamin Graham did.  It’s what all value investors do.  It is not a NORMAL way to look at the world.  It requires a personality with a contrarian bent.  In my research, I am aware of what the Wall Street experts are saying and forecasting, but rarely do I let their opinions influence mine.  I say this not out of arrogance and with any sense of superiority, but simply due to the reality that so much of what I hear and see out there is of no use or consequence to how I approach the investment decision making process.

Mr. Housel ends his piece with a hopeful homily, “You have no control over what the market will do next. You have complete control over how you react to whatever it does.”  I suggest that he’s totally correct, unless you are NORMAL, in which case you are likely to 1) incorrectly predict your future emotions, 2) fail to realize how common volatility is and 3) try to forecast what stocks will do next…

My advice to NORMAL people is to find someone less NORMAL than you (like a value investor) to construct a portfolio that will serve you well in good times as well as bad, and will help you reach your long-term financial goals.  In other words, don’t try this at home – it’s a lot harder than it looks…