Behavioural Economics

The Market Fox interviews a Wise Owl of the Australian Investment Industry

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This is worth sharing, a Podcast interview by Daniel Griolio with Jack Gray, an Australian investment industry veteran.

This is a great interview for those new and old to the industry.

 

Although Jack is wise, he is not silent like an owl.  Jack is well known to many within the industry for his forthright views, okay strong opinions.  Which is great, we need more of this to challenge the status quo and to have intellectually honest debates.  Not to make things more complicated but to challenge some of the industry practices.  Jack touches on the downside of holding strong beliefs and being willing to share them in the Podcast, it comes with a cost.  It is who he is, he calls out if he believes things are wrong.

Jack joined the investment industry later in life after a career in Academia, he talks about how he had to learn things from scratch, there are some great insights here e.g. what advice would you give to a young Jack Gray starting out?

The interview is wide ranging and Daniel does a great job keeping it flowing, with lots of good discussion, stories, and introspection.

Topics include:

  • thinking about probabilities;
  • heuristics;
  • you don’t need a lot of maths to be comfortable investing;
  • IQ vs temperament in investing successfully;
  • the short term focus of the industry;
  • industry agency issues;
  • investment firms learning to play to their strengths and being different;
  • IA; and
  • Robo Advice.

 

Happy investing.

Please see my Disclosure Statement

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

 

Shortcomings of Target Date and Life Cycle Funds

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Target Date Funds, also referred to as Glide Path Funds or Life Cycle Funds, reduce the equity allocation in favour of more conservative investments, fixed interest and cash, as the investor gets closer to retirement.

They do this on the premise that as we get older we cannot recover from financial disaster because we are unable to rebuild savings through human capital (salary and wages).  These Funds follow a rule of thumb that as you get closer to retirement an investor should be moved into a more conservative investment strategy.  This is a generalisation that does not take into consideration the individual circumstances of the investor nor market conditions.

Target Funds are becoming increasingly popular.  Particularly in situations where the Investor does not want or can afford investment advice.  The “Product” adjusts the investor’s investment strategy throughout the Life Cycle for them, no advice provided.

 

All good in theory, nevertheless, these “products” have some limitations in their design which are increasingly being highlighted.

No, it is not that they are moving investors into cash and fixed interest at a time of record low cash returns and over-valued fixed interest markets.  This is an issue, but a topic for another Blog.  Albeit this is touched on below from a slightly different angle.

 

Essentially, Target Date Funds have too main short comings:

  1. They are not customised to an individual’s consumption liability, human capital or risk preference e.g. they do not take into consideration future income requirements or likely endowments, level of income generated up retirement, or the investors risk profile, appetite for risk, or risk tolerance.
  • They are prescribed asset allocations which are the same for all investors who have the same number of years to retirement, this is the trade-off for scale over customisation.
  1. Additionally, the glide path does not take into account current market conditions.
  • Risky assets have historically shown mean reversion (i.e. asset returns eventually return back toward the mean or average return, prices display volatility to the upside and downside.
  • Therefore, linear glide paths, most target date funds, do not exploit mean reversion in assets prices which may require:
    • Delays in the pace of transitioning from risky assets to safer assets
    • May require step off the glide path given extreme market risk environments

 

Therefore, there is the risk that some Target Date Funds will fall short of providing satisfactory outcomes and meeting the key requirement in retirement of sufficient income.

 

Target Date Funds, Life Cycle Funds, focus on the investment horizon without protecting investors’ retirement needs, they focus on one risk, market risk.

The focus is not on producing retirement income or hedging risks in relation to investment risk, inflation risk, interest rate risk, and longevity risk.

As noted above, most target date funds don’t make revisions to asset allocations due to market conditions.  This is inconsistent with academic prescriptions, and also common sense, both of which suggest that the optimal investment strategy should also display an element of dependence on the current state of the economy.

 

The optimal target date or life cycle fund asset allocation should be goal based and multi-period:

  • It requires customisation by goals, of human capital, and risk preferences
  • Some mechanism to exploit the possibility of mean reversion within markets

 

All up, this requirements a more Liability Driven Investment approach, Goal Based Investing.

My first blog outlines the revolution required within the industry to Mass Customisations.

 

Please see my Disclosure Statement

US Equity Market 9 Years of Advancement

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The US equity market recently celebrated 9 years of advancement without a bear market (a Bear market is defined as an equity market decline of greater than 20% from its peak).

This 9 year Bull market is closing in on the historical record of 9 years and five and half months.  The longest post-war Bull market stretched from 11 October 1990 to 24 March 2000.  To break that record the current Bull market will have to continue until the last week of August 2018.

The US equity market experienced a “correction” in February 2018 (a correction is defined as a fall in market value of between 10 and 20%) on inflation and higher interest rate concerns.  I wrote about this in this blog and also put into historical perspective here and here.  

 

Bull markets end with a Bear market.  Bear markets usually coincide with recession.  Very rarely has there been a Bear Equity Market without recession.  Nevertheless, there have been bear markets without a recession.

Fortunately the global economy has good momentum and recession does not look imminent. Most economic forecasts are for economic growth throughout 2018 and into 2019.

Albeit, the current Bull market does face some risks.  Key amongst those risks are:

  • Earnings disappointment in 2019. Earnings momentum is vulnerable this late in the economic cycle
  • Economic data disappoints – global equity markets are priced for continuation of the current “Goldilocks” economic environment, not too hot and not too cold.
  • Inflation data surprises on the upside
  • Policy mistake by a Central Bank given the extraordinary policy positions over the last 10 years of very low interest rates and Quantitative Easing, e.g. US Reserve Bank needs to raise short term interest rates more quickly than currently anticipated
  • Longer term interest rates rise much higher than currently expected

 

Therefore, lots to consider as the year progresses.

 

I enjoyed this quote from Howard Marks “there are two things I would never say (since they require far more certainty than I consider attainable): “get out” and “it’s time.”  It’s rare for the market pendulum to reach such an extreme that views can properly be black-or-white.  Most markets are far too uncertain and nuanced to permit such unequivocal, sweeping statements.”

Well worth thinking about when making portfolio investment decisions.

 

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The Buffet Bet

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Receiving much attention from the 2017 Berkshire Hathaway shareholder letter has been “The Bet”.

To recap, “The Bet” was with Protégé Partners, who picked five “funds of fund” hedge funds they expected would outperform the S&P 500 over the 10 year period ending December 2017.

The bet was made in December 2007, when the market was reasonably expensive and the Global Financial Crisis (GFC) was just around the corner.

Needless to say, Buffet won.  The S&P 500 easily outperformed the Hedge Fund selection over the 10 year period.

 

I have some sympathy with this well written article.

 

Firstly I’d like to make three points:

  1. I’d never bet against Buffet!
  1. I would also not expect a Funds of Fund hedge Fund to consistently outperform the S&P 500, let alone a combination of five Funds of Fund.

This is not to say Hedged Funds should not form part of a “truly” diversified investment portfolio.  They should.

Nevertheless, I am unconvinced their role is to provide equity plus returns.

  1. Most, if not all, investor’s investment objective(s) is not to beat the S&P 500. Investment Objectives are personal and targeted e.g. Goal Based Investing to meet future retirement income or endowments

 

Albeit, as the article points out (A Rhetorical Oracle?), key investment points are missed by the media’s focus on the drag race over a 10 year period.

Now, I have no barrel to push here, except advocating for the building of robust investment portfolios consistent with meeting your investment objectives. The level of fees also needs to be managed across a portfolio.

 

In this regard and consistent with the points in the article:

  1. Having a well-diversified multi-asset portfolio is paramount.

Being diversified across non-correlated or low correlated investments is important.  Adding low correlated investments to an equities portfolio, combined with a disciplined rebalancing policy, will add value above equities over time.

The investment focus should be on reducing portfolio volatility through true portfolio diversification so that wealth can be accumulate overtime.  If you like, minimising loses results in higher returns over time.  A portfolio that falls 50%, needs to gain 100% to get back to the starting capital.  This means as equity markets take off, as they have over the last 24 months, a well-diversified multi-asset portfolio will not keep up.  Nevertheless, the well diversified portfolio won’t fall as much when the inevitable crash comes along.

It is true that equities are less risky over the longer term.  Nevertheless, not many people can maintain a fully invested equities portfolio, given the wild swings in value (as highlighted by Buffett in his recent Shareholder Letter, Berkshire can fall 50% in value).

100% in equities is often not consistent with meeting ones investment objectives.  Buffet himself has recommended the 60/40 equities/bond allocation, with allocations adjusted around this target based on market valuations.

In fact, I’d never suggest someone to be 100% invested in equities for the very reason of the second point in the article.

 

  1. Investment Behavioural aspects.

How many clients would have held on to a 100% equity position during the high level of volatility experienced over the last 10 years, particularly in the 2008 – 2014 period.  Not many I suspect.

 

A well-diversified portfolio, that lowers portfolio volatility, will assist an investor in staying the course in meeting their investment objectives.

An allocation to alternative strategies, including a well-chosen selection of Hedge Funds, will result in a truly diversified Portfolio, lowering portfolio volatility.  See earlier Post

Staying the course is the biggest battle for most investors.  Therefore, take a longer term view, focus on customised investment objectives, and maintain a truly diversified portfolio.

This will help the psychological battle as much as anything else!

 

I like this analogy of using standard deviation of returns as a measure of risk, average volatility:

“A stream may have an average depth of five feet, but a traveler wading through it will not make it to the other side if its mid-point is 10 feet deep. Similarly, an overly volatile investing strategy may sink an investor before she gets to reap its anticipated rewards.”

 

 

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Investment Mistakes to avoid

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In an earlier post we talked about the short volatility (VIX) products that had added to the recent global equity market volatility.

 

The experience of these products prompted a good article from Barry Ritholtz, Five Rules to Help Avoid Investing Disaster.

The Inverse Volatility Products will enter history along-side CDO’s. It is likely that 95% of the wealth invested in these Products will be wiped out when they are finally wound up/terminated.  Well worth following developments here.

 

I am somewhat bewildered from an investment strategy perspective why these exposures would end up in Portfolios at this time. It is a prime example of chasing historical returns. It is always a good idea to be guided by value.  The cost of buying volatility protection was very low. Therefore there was no value shorting market volatility, as these Products did. It is also a good idea to have a counter-cyclical bias in your investment approach: when markets are at historical extremes, i.e. historically low volatility, it is a good idea to reduce the exposure to that market extreme. Markets revert from extremes toward averages – often violently as we have recently witnessed.

This is basis of portfolio risk management and consistent with focusing on managing risk rather than trying to time markets and chase historical returns. I think most of the funds management industry was working out how to go long volatility given the over-brought nature of the global equity markets in January, not short it!  Some form of market correction was widely anticipated, the timing was just unknown.

 

Anyway, ………… the rules outlined to avoid making investment mistakes:

  1. Avoid new products – if they are a good investment no need to hurry – e.g. the Buffet rule in relations to Initial Public Offerings (IPOs)
  2. Learn from history – markets are volatile never get complacent – Hubris before the fall
  3. Never buy anything you don’t understand – another Buffet rule
  4. I would say get good investment advice i.e. wholesale products vs retail product comments, in fact considerable value can be added to client portfolios in this area and costs reduced by accessing appropriate investment strategies not readily available
  5. Greater returns always comes with greater risk – this is a fundamental axiom of investing, never forget it.  If it is too good to be true, it probably is.  There are never “easy” sustainable returns in investing.

 

Happy investing.

 

Please see my Disclosure Statement

 

History of Sharemarket corrections – An Anatomy of equity market corrections

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There has been lots written placing the current US stockmarket correction into a historical context.

The analysis of this blog draws on recent analysis undertaken by Goldman Sachs.

As you know, 2018 started out as the strongest start for global sharemarkets in over 30 years. The S&P 500 was up over 7% at one stage during January 2018.

The US equities bull market has been going since March 2009. This is amongst the longest period in history without the US sharemarket entering a bear market. The US sharemarket is up over 300% since 2009.

A bear market is usually considered to have occurred when sharemarkets fall by more than 20% in value.

A sharemarket correction is a fall in value of between 10% and 20%.

Volatility was at historically low levels over 2017. The US sharemarket, as at the end of January 2015, was up for 15 consecutive months and endured the longest period since 1929 without falling in value of more than 5%.

The fall in early February ended 499 trading days of the market not incurring a fall in value of more than 10%, which is amongst the longest stretch in history.

Records have been set and then broken!

 

With regards to bear markets and corrections, Goldman Sachs had some interesting analysis.

Corrections

There have been 22 corrections since 1945 of over 10%, and many more of less than 10%. The average correction is 13% over 4 months and takes 4 months to recover.

Bear Markets

There have been 14 bear markets, the average fall in value is 30% over 13 months and take 22 months to recover.

 

My own thoughts

Generally a bear market (i.e. 20% or more fall in value) does not occur without a recession (a recession is often defined as two consecutive quarters of negative economic growth).

The key forward looking indicators, such as an inverted yield curve, significant widening of high yield credit spreads, rising unemployment, and falling future manufacturing orders are not signalling a recession is on the horizon in the US.

Therefore, if you are playing the odds, the current correction might have further to run but it is unlikely to turn into a bear market.

 

Please see my Disclosure Statement

 

Equity Market declines in Perspective

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Far from Unprecedented: Nine Selloffs Like this, and Nine Rebounds.

The Bloomberg article has much prettier graphs than I can do, but I can provide the view from a wonderful ski field in New Zealand, in the spirit of the Winter Olympics, Treble Cone near Wanaka.

150

 

So, since the beginning of the bull equity market run in 2009 there have been nine significant declines in global equities. On each occasion global equity markets have come back.

The nine episodes are outlined in the Table below. They make for interesting reading and are distant memories.

Now of course we maybe only partway through the decline of the current “correction” and it could be different this time i.e. no bounce

 

Market movements are in relation to the US S&P 500 Index.

Date Level of Decline Trigger
January 2016 -11% of three weeks Concerns over economic slowdown and mounting Chinese debt
August 2015 -11% over six sessions China’s shock devaluation of the Yuan
October 2014 -5.0% over week Spread of Ebola virus, concern over end of US Quantitative Easing and tensions in the Middle East
January 2014 -3.6% over the month Emerging markets equities and currencies sold down
October – November 2012 -7.2% US Election uncertainty between Obama and Romney
March – June 2012 ~-10.0% US Federal Reserve indicating it will likely hold back on further monetary Policy easing e.g. Quantitative Easing
July – August 2011 -17% US Credit downgrade and weaker than expected jobs report, Greece
January 2010 -8% Market correction uncertainty as to global growth outlook, particularly Europe
April – July 2010 -16% Similar reasons and the infamous flash crash
January 2018 -10.1% Rising longer dated interest rates, inflation concerns, Fed tightening, negative feedback loop of short volatility Products

 

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Global Equity Markets Meltdown – Don’t Panic Sell

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Worried About Your Retirement Investments? Don’t Panic Sell was published prior to the big drop in the markets on Tuesday.

Nevertheless its messages are still very relevant given further market weakness over the last week.

I like how the article starts with the behaviour economics aspect of market volatility. Unfortunately we feel the pain of losses much more than the pleasure of market gains.  The 24 hour cycle of news headlines does not make the feeling of portfolio loses any better!

As the article highlights, equity markets are back to levels they were at a couple of months ago. Unless you have a portfolio of 100% equities (which is unwise in most circumstances – particularly if you are saving for a house deposit) your portfolio loses are unlikely to be as great as those posted by the equity market indices. The benefits of diversification.

Diversification does work. Having said this, the recent daily market activity has witnessed loses in both fixed interest (bonds) and equities on the same day. This is where allocations outside of equities and fixed interest such as alternative strategies adds another layer of true portfolio diversification.

The article makes the very valid point of having an Investment Policy Statement (IPS). This is a critical and important document. At times like this it is worth referencing this document, accessing appropriateness of goals, objectives, and long term strategic asset (risk) allocations. Of course this exercise should be undertaken formally and frequently (yearly) irrespective of market conditions. The continued focus should be on what needs to be done to reach longer term investment objectives. Outcomes should be measured against these objectives not market indices.

 

Rebalancing Policy

An essential component to adding value over time and increasing the chances of meeting investment objectives is to have a well-articulated and documented Rebalancing Policy. This assists in managing the risks that build up within portfolios over time, such that market movements like the recent one do not have an outsized impact relative to expectations and risk tolerance levels.

 

There are lots of other points to consider in the article, namely don’t try and time markets.

 

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