More Money Is Lost Waiting for Corrections Than in Them

We have data for 91 calendar years (or 1,092 months) of U.S. investment returns over the period 1927 through 2016. The average monthly return to the S&P 500 has been 0.95%, and the average quarterly return was 3.0%. With that background, here’s a short, four-question quiz:

1. If we remove the returns from the best 91 months (an average of just one month a year and 8.5% of the entire period), what is the average return of the remaining 1,001 months?

2. What is the average return of those best-performing 91 months?

3. If we remove the returns of the best-performing 91 quarters (an average of one quarter a year and 25% of the entire time period), what is the average return of the remaining 273 quarters?

4. What is the average return of those best-performing 91 quarters?

What many investors don’t know is that most stock returns come in very short and unpredictable bursts. Which is why Charles Ellis offered this advice in his outstanding book, “Investment Policy”: “Investors would do well to learn from deer hunters and fishermen who know the importance of ‘being there’ and using patient persistence—so they are there when opportunity knocks.”

It also is likely why, in his 1991 annual report to shareholders, legendary investor Warren Buffett told investors: “We continue to make more money when snoring than when active,” and “Our stay-put behavior reflects our view that the stock market serves as a relocation center at which money is moved from the active to the patient.” Later, in his 1996 annual report, Buffett added: “Inactivity strikes us as intelligent behavior.”

Returning to our quiz, the answers are:

1. While the average month returned 0.95%, if we eliminate the best-performing 91 months, the remaining 1,001 months provided an average return of virtually zero (0.1%). In other words, 8.5% of the months provided almost 100% of the returns.

2. The best-performing 91 months, an average of just one month a year, earned an average return of 10.5%.

3. While the average quarter returned of 3.0%, if we eliminate the best-performing 91 quarters, the remaining 273 quarters (three-fourths of the time period) actually lost money, providing an average return of -0.8%. In other words, just 25% of the period provided more than 100% of the returns.

4. The best-performing 91 quarters, an average of just one quarter a year, earned an average return of 14.3%.

Despite this type of evidence, which makes clear how difficult market timing must be, one of the most popular beliefs held by individual investors is that timing stock markets is the winning strategy. After all, who doesn’t want to buy low, right at the end of a bear market, and sell high, just before the next bear market begins. Unfortunately, an idea is not responsible for the people who believe in it.

Pros Bad At Prediction

The evidence is very clear that professional mutual fund managers cannot predict the stock market. For example, in his famous book “A Random Walk down Wall Street,” Burton Malkiel cited a Goldman Sachs study that examined mutual funds’ cash holdings for the period 1970 through 1989.

In their efforts to time the market, fund managers raise cash holdings when they believe the market will decline and lower cash holdings when they become bullish. The study found that, over the period it examined, mutual fund managers miscalled all nine major turning points.

Legendary investor Peter Lynch offered yet another example. He pointed out that an investor who followed a passive investment strategy and stayed fully invested in the S&P 500 over the 40-year period beginning in 1954 would have achieved an 11.4% rate of return.

If that investor missed just the best 10 months (2% of them), his return fell 27%, to 8.3%. If the investor missed the best 20 months (or 4% of them), his return dropped 54%, to 6.1%. Finally, if the investor missed the best 40 months (or just 8% of them), his return declined 76%, all the way to 2.7%.

In a September 1995 interview with Worth magazine, Lynch put it this way: “Far more money has been lost by investors in preparing for corrections, or anticipating corrections, than has been lost in the corrections themselves.”

Investors should keep the preceding evidence—as well as advice against trying to time the market offered by investment legends such as Ellis, Buffett and Lynch—in mind whenever they hear warnings from “gurus” that the market is overvalued and a correction is surely coming.

This wisdom is especially timely with the Shiller CAPE 10 at 31 as I write this, almost double its long-term average. However, I would note that calls for a correction are nothing new.

For example, back in February 2013, with the CAPE 10 then at 22, Jeremy Grantham, a respected market strategist at GMO, wrote that “all global assets are once again becoming overpriced” and that some securities were “brutally overpriced.”

By November of that year, with the CAPE 10 at 24.6, he wrote: “The S&P 500 is approximately 75% overvalued.” But the market ignored Grantham, as well as other pessimists such as John Hussman and Marc Faber (Dr. Doom). From February 2013 through September 2017, the S&P 500 Index returned 14.2% (well above its long-term return of 10.0%) and posted a total return of 85.6%.

Cost Of Waiting

Elm Partners provided some valuable insight into the question of whether investors should wait to buy equities because they believe valuations are too high. Looking back at 115 years of data, Elm asked: “During times when the market has been ‘expensive,’ what has been the average cost or benefit of waiting for a correction of 10% from the starting price level, rather than investing right away?” It defined “expensive” as the occasions when the stock market had a CAPE ratio more than one standard deviation above its historical average.

Elm noted that while the CAPE ratio for the U.S. market is currently hovering around two standard deviations above average, there aren’t enough equivalent periods in the historical record to construct a statistically significant data analysis.

It then focused on a comparison over a three-year period, a length of time beyond which they felt an investor was unlikely to wait for the hoped-for correction. Following are its key findings:

  • From a given “expensive” starting point, there was a 56% probability that the market had a 10% correction within three years, waiting for which would result in about a 10% return benefit versus having invested right away.
  • In the 44% of cases where the correction doesn’t happen, there’s an average opportunity cost of about 30%—much greater than the average benefit.
  • Putting these together, the mean expected cost of choosing to wait for a correction was about 8% versus investing right away.

The takeaway is this: Even if you believe the probability of a correction is high, it’s far from certain. And when the correction doesn’t happen, the expected opportunity cost of having waited is much greater than the expected benefit.

Elm offered the following explanations for why it thought the perception exists among investors that waiting for a correction is a good strategy: “First, while a correction occurring is indeed more likely than not, investors may confuse the chance of a correction from peak-to-trough with the lower chance of a correction from a fixed price level. For example, the historical probability of a 10% correction happening any time during a 3-year window is 88%, significantly higher than the 56% occurrence of that correction from the market level at the start of the period. Second, the cost of waiting and not achieving the correction is a ‘hidden’ opportunity cost, and we humans have a well-documented bias to underweight opportunity costs relative to realized costs. Finally, investors may believe they can wait indefinitely for the correction to happen, but in practice few investors have that sort of staying power.”

Elm repeated its analysis with correction ranges from 1% to 10%, time horizons of one year and five years, and an alternate definition for what makes the market look “expensive” (specifically, waiting for a correction from times when the market was at an all-time high at the start of the period).

The firm found that “across all scenarios there has been a material cost for waiting. The longer the horizon that you’d have been willing to wait for the correction to occur … the higher the average cost.”

Summary

Noted author Peter Bernstein provided this insight: “Even the most brilliant of mathematical geniuses will never be able to tell us what the future holds. In the end, what matters is the quality of our decisions in the face of uncertainty.”

And we certainly live in uncertain times. But that’s always the case. To help stay disciplined, it’s important to keep in mind that the market already reflects whatever concerns you may have.

Finally, remember this further advice from Warren Buffett: “The most important quality for an investor is temperament, not intellect.”

The inability to control one’s emotions in the face of uncertainty, and clarion cries of overvaluation, help explain why so few investors earn market rates of return and thus fail to achieve their objectives.

This commentary originally appeared October 18 on ETF.com

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2017, The BAM ALLIANCE

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Iconic Report Supports Index Investing

Since 2002, S&P Dow Jones Indices has published its S&P Indices Versus Active (SPIVA) scorecards, which compare the performance of actively managed equity mutual funds to their appropriate index benchmarks. The 2017 midyear scorecard includes 15 years of data.

Equity

Following are some of the highlights from the report:

  • Over the five-year period, 82% of large-cap managers, 87% of midcap managers and 94% of small-cap managers lagged their respective benchmarks. Note that the performance of active managers was the worst in the very asset class they claim is the most inefficient.
  • Over the 15-year investment horizon, 93% of large-cap managers, 94% of midcap managers, 94% of small-cap managers and 82% of REIT managers failed to outperform on a relative basis. Again, note the poor performance in small-caps, as just 6% of active funds outperformed their benchmark index.
  • Over the 15-year horizon, on an equal-weighted (asset-weighted) basis, active large-cap managers underperformed by 1.5 percentage points (0.9 percentage points), active midcap managers underperformed by 1.9 percentage points (1.3 percentage points), active small-cap managers underperformed by 2.3 percentage points (1.6 percentage points) and active REIT managers underperformed by 0.8 percentage points (0.5 percentage points). Note that multicap managers, who have the supposed advantage of being able to move across asset classes, underperformed by 1.3 percentage points (0.4 percentage points). Again, the worst performance was in the supposedly inefficient small-cap space.
  • Over the 3-, 5-, 10- and 15-year investment horizons, managers across all international equity categories underperformed their respective benchmarks. Over the 15-year horizon, 85% of active global funds underperformed, 92% of international funds underperformed, 83% of international small-cap funds underperformed and, in the supposedly inefficient emerging markets, 95% of active funds underperformed.
  • Over the 15-year horizon, on an equal-weighted (asset-weighted) basis, active global funds underperformed by 0.8 percentage points (0 percentage points), active international funds underperformed by 2.0 percentage points (0.6 percentage points) and active international small funds underperformed by 1.1 percentage points (0.3 percentage points). Emerging market funds produced the worst performance, underperforming by 2.5 percentage points (1.4 percentage points).
  • Highlighting the importance of taking into account survivorship bias, over the 15-year period, more than 58% of domestic equity funds, 55% of international equity funds and approximately 47% of all fixed-income funds were merged or liquidated.

While I believe the preceding data is compelling evidence of the active management industry’s failure to generate alpha, it’s important to note that all the report’s figures are based on pretax returns.

Given that actively managed funds’ higher turnover generally makes them less tax efficient, on an after-tax basis, the failure rates would likely be much higher (taxes are often the highest expense for actively managed funds).

Fixed Income

The performance of actively managed funds in fixed-income markets was just as poor. The following results are for the 15-year period:

  • The worst performance was in long-term government bond funds, long-term investment-grade bond funds and high-yield funds. In each case, just 2% of active funds beat their respective benchmarks. On an equal-weighted (asset-weighted) basis, long-term government bond funds underperformed by a shocking 3.5 percentage points (3.0 percentage points), long-term investment-grade bond funds underperformed by 2.6 percentage points (2.2 percentage points) and high-yield funds underperformed by 2.3 percentage points (1.7 percentage points).
  • For domestic bond funds, the least poor performance was in intermediate- and short-term investment-grade funds, where 76% and 71% of active funds underperformed, respectively. On an equal-weighted basis, their underperformance was 0.5 percentage points and 0.7 percentage points, respectively. However, in both cases, on an asset-weighted basis, they outperformed by 0.3 percentage points. This result possibly could be explained by the funds having held longer maturities (taking more risk) than their benchmarks.
  • Active municipal bond funds also fared poorly, with between 84% and 92% of them underperforming. On an equal-weighted (asset-weighted) basis, the underperformance was between 0.6 percentage points and 0.7 percentage points (0.2 percentage points and 0.4 percentage points).
  •  Emerging market bond funds also fared poorly, as 67% of them underperformed. On an equal-weighted basis, the underperformance was 1.4 percentage points. On an asset-weighted basis, the underperformance was 0.4 percentage points.

Summary

The SPIVA scorecards continue to provide powerful evidence on the persistent failure of active management’s ability to generate alpha (risk-adjusted outperformance). In particular, they serve to highlight the canard that active management is successful in supposedly inefficient markets like small-cap stocks and emerging markets.

The scorecards also provide compelling support for Charles Ellis’ observation that, while it’s possible to win the game of active management, the odds of doing so are so poor that it’s not prudent to try—which is why he called it “the loser’s game.” And it’s why we continue to see a persistent flow of assets away from actively managed funds.

This commentary originally appeared September 27 on ETF.com

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2017, The BAM ALLIANCE

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Protecting Your Finances Following the Equifax Data Breach

Equifax, one of the major credit reporting bureaus, has announced that on July 29 it discovered a data breach affecting as many as 143 million U.S. consumers. Tim Maurer goes on NBR to discuss some steps you can take next if you think your information was compromised.

View the video

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2017, The BAM ALLIANCE

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Active Management Falls Short With Bonds, Too

In a July 2017 Q&A with WealthManagement.com, Western Asset Management CIO Ken Leech asserts that passive investing is unlikely to play as large a role in fixed income as it does now in equities, because active managers outperform their benchmarks much more in the bond market than they do in the stock market.

While the trend toward passive/index investing has been just as strong in the bond market as it has in the stock market, with passive bond mutual funds and ETFs experiencing a net inflow of $185.8 billion during the 12 months through May, according to Morningstar data cited in the article, Leech claims we’ve “been fortunate that the record of active beating passive is strong in fixed income.”

He added: “The index is around the bottom quartile of the active community, in terms of performance. We’re hopeful that evidence is compelling, and that active management will continue to play a dominant role.”

When asked why active strategies have done better in the bond market than in the stock market, Leech responded: “Government and government-sponsored agency bonds make up more than half of indices. Most studies suggest that overweighting high-quality bonds with higher yields than Treasuries gives you a powerful advantage over time compared to indices.”

Let’s see if Leech’s claims hold up to scrutiny, or if they are—like most claims about the success of active management—nothing more than what journalist and author Jane Bryant Quinn called “investment porn.”

Checking In With SPIVA

While the poor performance of actively managed equity funds is well-known, the performance of actively managed bond funds tends to receive less attention. To check Leech’s assertions, we will look to the S&P Dow Jones Indices year-end 2016 SPIVA U.S. Scorecard, which has 15 years of performance data on actively managed bond funds.

Following is a summary of the report’s findings:

  • The worst performance was in long-term government bond funds and long-term investment-grade bond funds, as just 3% of active funds in those categories beat their respective benchmarks. On an equal-weighted (asset-weighted) basis, active funds underperformed the index by a shocking 3.3 percentage points (2.7 percentage points) and 2.2 percentage points (2 percentage points), respectively. Active high-yield funds didn’t fare much better, with just 4% outperforming. On an equal-weighted (asset-weighted) basis, the outperformance was an also-shocking 2 percentage points (1.7 percentage points).
  • For domestic funds, the least-poor performance was in intermediate investment-grade and short-term investment-grade bond funds. In both these cases, “only” 73% of actively managed funds underperformed. On an equal-weighted basis, the underperformance in both categories was 0.3 percentage points. However, on an asset-weighted basis, they managed to outperform by 0.7 percentage points and 0.3 percentage points, respectively. That is possibly explained by their holding longer maturities and/or holding lower-rated bonds (taking more risk) than the benchmarks. A factor regression would provide us with that evidence.
  • Domestic high-yield bond funds performed almost as poorly as long-term government bond funds and long-term investment-grade bond funds, with just 4% of actively managed funds outperforming their benchmarks. On an equal-weighted basis, the underperformance was 1.9 percentage points. On an asset-weighted basis, they managed to outperform by 1.6 percentage points.
  • Emerging market bond funds also fared poorly, as 76% of them underperformed. On an equal-weighted basis, the underperformance was 1.4 percentage points. On an asset-weighted basis, the underperformance was 0.2 percentage points.

Believe Vs. Evidence

Contrast the actual performance of active fund managers with Leech’s assertion that indexes were in the bottom quartile of performance: Leech was right about one thing—the evidence is compelling, just not in the direction he meant.

Even though the SPIVA scorecards clearly provide powerful evidence on the persistent failure of active management’s ability to generate alpha (risk-adjusted outperformance), active managers continue to claim otherwise.

As author Upton Sinclair noted: “It is difficult to get a man to understand something when his salary depends upon his not understanding it.” The claim that active management works in the bond markets is just as much a canard as the claim that it works in emerging markets (as I show in another recent article) or, for that matter, any other market.

The actual evidence provides compelling support for Charles Ellis’ observation that while it’s possible to win the game of active management, the odds of doing so are so poor that it’s imprudent to try—which is why he called it the “loser’s game.”

This commentary originally appeared August 7 on ETF.com

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2017, The BAM ALLIANCE

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The Characteristics of Value versus Growth Investors

One of the great debates in finance is whether the source of the value premium is risk-based or behavioral-based. Extensive empirical literature on the value premium, which provides support for both explanations, has focused primarily on stock returns and the manner in which they are related to macroeconomic and corporate variables.

Value/Growth Investor Demographics

Sebastien Betermier, Laurent Calvet and Paolo Sodini, who contribute to the literature on this issue with the study “Who Are the Value and Growth Investors?”, published in the February 2017 issue of The Journal of Finance, took a different approach. Their paper investigated value and growth investing among Swedish residents over the period 1999 through 2007.

Following is a summary of their findings:

  • Households are not heavily tilted toward stocks in their employment sector. The average direct stockholder allocates 16% of their stock portfolio to professionally similar companies.
  • Value investors are substantially older, more likely to be female, have higher financial and real estate wealth, and have lower leverage, income risk and human capital than the average growth investor—investors with high human capital and high exposure to macroeconomic risk tilt their portfolios away from value.
  • Men, entrepreneurs and educated investors are more likely to invest in growth stocks.
  • These patterns are evident in both stock and mutual fund holdings.
  • The explanatory power of socioeconomic characteristics is highest for households that invest directly in at least five companies, a wealthy subgroup that owns the bulk of aggregate equity and may therefore have the greatest influence on prices.
  • Over their life cycles, households progressively shift from growth to value investing as they become older and their balance sheets improve, with 60% of the value ladder explained by changes in age, 20% due to changes in the balance sheet and 20% due to changes in human capital.
  • Households with high financial wealth, low debt and low background risk tend to invest their wealth aggressively in risky assets and select risky portfolios with a value tilt.
  • Households with high current income and high human capital levels tend to tilt their portfolios toward growth stocks. So do households with high income volatility and a self-employed or unemployed head. Further, households with members working in cyclical sectors tend to reduce their portfolios’ value tilts.

Betermier, Calvet and Sodini concluded that their findings “appear remarkably consistent with the portfolio implications of risk-based theories. The strong negative relationship between a household’s value loading and its macroeconomic exposure provides direct support for the hedging motive. Households in cyclical sectors go growth, which reduces their overall exposure to aggregate income risk.”

They add: “The value ladder [increasing exposure to value as investors age] provides further validation of the hedging motive. Over the life cycle, the household becomes less dependent on human capital and its hedging demand should get progressively weaker.”

Further Conclusions

The authors also found that sound balance sheets have positive effects on portfolio value tilts, providing further support for the risk-based explanation of value. This aligns with portfolio theory, as more financially secure households generally should be better able to tolerate investment risk.

Betermier, Calvet and Sodini note that their findings were not all one-sided in favor of a risk-based explanation. For example, overconfidence—which is more prevalent among men than women—is consistent with their finding of a growth tilt among male investors. They also found that, as “attention theory predicts, a majority of direct stockholders hold a small number of popular stocks.”

In addition, some of their evidence can be explained by complementary risk-based and psychological stories—the growth tilt among entrepreneurs, for instance, can be attributed to marked overconfidence in own decision-making skills.

Summary

While the results of their study provide strong support for a risk-based explanation of the value premium, as the authors observe, it’s not a one-sided story. In other words, their results, while providing support for the idea that the value premium is not a free lunch, also offer support for the idea that it just might be at least a free stop at the dessert tray.

There’s one last point to consider. Their finding of a value ladder, combined with the aging demographics of the U.S. investor population, might indicate we should expect an increased demand for value stocks. All else equal, that would lead to a larger realized value premium.

This commentary originally appeared July 5 on ETF.com

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2017, The BAM ALLIANCE

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Posted by:

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