NAVigating Your Year-End Investment Statement’s Change in Market Value

If you’re like many, this is the time of year you are wading through the stack of mail that has accumulated following a busy holiday season. Credit card bills, tax statements, and, yes, your brokerage and investment statements are now probably getting some much-needed attention.

If you are like me, you opened your investment account statement as if you were unwrapping a late holiday gift, full of anticipation to see how great the numbers would look after the December “Santa Claus” rally. But to your dismay, you are shocked when you view the “change in market value” column and it is negative for the month of December.

You may be thinking: What? How could that be? The Dow and S&P 500 were up for December! Why do I have a decline in my portfolio’s market value?

Your initial reaction may be to pick up the phone and inquire of your advisor why your statement’s market value is down when the market has been climbing. But upon further inspection, when you look at your beginning account balance and compare it to your ending account balance, you see there actually was an increase.

The culprit of this odd phenomenon? Mutual fund dividend and capital gain distributions.

Most investors these days own mutual funds, which generally offer greater diversification potential than holding individual stocks. However, by design, mutual funds are required to distribute at least 95 percent of any gains they may have realized throughout the year to their shareholders. For most funds, this typically occurs in the month of December.

Mutual funds trade at what is called a Net Asset Value, or NAV. That value is the total value of the fund’s underlying investments’ market value, plus any income it received from dividends and any capital gains it may have realized from selling securities less the fund’s operating expenses. Any time a mutual fund makes a dividend payment or capital gain payment, it reduces the value of the fund (that is, the NAV) by that amount.

For example, let’s say you have $1,000 invested in 100 shares of a mutual fund that has a NAV of $10 per share. The fund makes a capital gain distribution of $1 per share. Because you have 100 shares, you receive $100 in cash for the distribution. The NAV of the fund is now $9 per share, so your fund’s market value is now $900, but you also have $100 in cash for a total investment value of $1,000.

Some investors may elect to have their dividends and capital gains automatically reinvested in the fund upon distribution. In the preceding hypothetical, your $100 cash payment would go to buy more shares at $9 per share, which would get you an additional 11.111 shares. Now you would have 111.11 shares at $9 per share for a total value still of $1,000 ($999.999 due to rounding). If you are one of these investors, then you most likely did not see this process affect the “market value” section of your investment statement.

But many investors elect to receive their dividend and capital gain distributions in cash. This is helpful because said investors can use the cash for rebalancing their portfolios or for covering any distributions they might be taking from it. It also helps keep the number of lots comprising the cost basis of the fund to a minimum.

The bottom line is that, whichever method you may choose to receive your dividend and capital gain distributions, the markets in general offered investors a nice December and 2017. Hopefully, it will make you feel better when paying off those December credit card bills with all of your holiday shopping on them!

Learn more about Bland Garvey Wealth Advisors

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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.

© 2018, The BAM ALLIANCE

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Don’t Write Off Value

Recency bias—the tendency to give too much weight to recent experience and ignore long-term historical evidence—underlies many of the mistakes commonly made by investors. It’s particularly dangerous because it causes investors to buy after periods of strong performance (when valuations are high and expected returns low) and sell after periods of poor performance (when valuations are low and expected returns high).

Recency can lead even investors with well-developed plans to abandon them. And it can also lead to other mistakes, such as overconfidence and the penchant to treat unlikely outcomes as impossible. It’s one of the reasons studies have found that investors tend to underperform the very mutual funds in which they invest.

Recency and Value

A great example of the recency problem involves the performance of value stocks. For the nine years from 2007 through 2015, the value premium (the annual average difference in returns between value stocks and growth stocks) was -3.4%. Cumulative underperformance for the period was 28%.

This type of underperformance often leads to selling. Unfortunately for investors who sold, 2016 turned out to be a year in which the value premium turned strongly positive (20.7%), although it turned negative again in the first 10 months of 2017 (-11.2%).

Investors who know their financial history understand that this type of what we might call “regime change” is to be expected. In fact, even though the value premium has been quite large and persistent over the long term, it’s been highly volatile. The annual standard deviation of the premium, at 12.7%, is 2.7 times the size of the 4.7% annual premium itself (for the period July 1926 through October 2017).

As further evidence, the value premium has been negative in 37% of years since 1926. Even over five- and 10-year periods, it has been negative 22% and 14% of years, respectively. Thus, periods of underperformance like the one we have seen recently should not come as any surprise.

In fact, they should be expected (the only thing we don’t know is when they will pop up), because periods of underperformance occur in every risky asset class and factor.

The following table, taken from my latest book, “Your Complete Guide to Factor-Based Investing,” which I co-authored with Andrew Berkin, provides evidence demonstrating this point.

Underperformance Happens

Each of the factors in the table has been shown to have an economically large, persistent and pervasive premium. In addition, there are intuitive risk- or behavioral-based explanations for why we should believe the premiums are likely to persist in the future, and they are robust to various definitions as well as implementable (meaning they survive trading and other costs).

But each of them, including market beta, also experience long periods of underperformance. That is a good reason to diversify risk across factors rather than concentrating it in any single factor, including market beta.

However, a long period of underperformance should not cause investors to abandon a well-developed plan. Nor should it cause them to question the existence of the value premium any more than it should have caused them to question the market beta premium when it was negative for 3% of the 20-year periods from 1927 through 2016, as the table shows.

As I point out in my book, “Think, Act, and Invest Like Warren Buffett,” one of the great ironies today is that while investors idolize Buffett, many not only ignore his advice but tend to do exactly the opposite of what he recommends (like never trying to time the market).

For example, we know Buffett did not abandon his belief in the value premium following the 10-year period ending in 1999, when it posted an annual average return of just 0.5% and produced a cumulative return of -5.2%. And I suspect he has not abandoned his faith in it given its recent relatively poor performance. While this surely is the case, many investors still question the continued existence of the value premium.

Why Value Still Matters

There are various reasons you should continue to expect an ex-ante value premium. The first is that risk cannot be arbitraged away. And the research provides us with many simple and intuitive risk-based explanations for the persistence of the value premium, as I have written about before.

Second, if, as many people believe, the publication of findings on the value premium has led to cash flows that have caused it to disappear, we should have seen massive outperformance in value stocks as investors purchased value stocks and sold growth stocks. Yet the last 10 years have witnessed the reverse in terms of performance.

In addition, as David Blitz demonstrated in his February 2017 paper, “Are Exchange-Traded Funds Harvesting Factor Premiums?”, while some exchange-traded funds are specifically designed for harvesting factor premiums, such as the size, value, momentum and low-volatility premiums, other ETFs implicitly go against these factors.

Specifically, Blitz found that “from a factor investing perspective, smart-beta ETFs tend to provide the right factor exposures, while conventional ETFs tend to be on the other side of the trade with the wrong factor exposures. In other words, these two groups of investors are essentially betting against each other.”

The bottom line is that, despite what many investors believe, there has not been a massive net inflow into value stocks relative to growth stocks.

Third, academic research has found that valuation metrics, such as the earnings yield (E/P) or the CAPE 10 earnings yield, and valuation spreads have predictive value in terms of future returns. In other words, the higher the earnings yield, the higher the expected return, and the larger the spread in valuations between growth and value stocks, the larger the future value premium is likely to be—and it holds across asset classes, not just for stocks.

For example, the 2007 study “Does Predicting the Value Premium Earn Abnormal Returns?” by Jim Davis of DFA found that, despite book-to-market ratio spreads containing information regarding future returns, style-timing rules did not generate high average returns because the signals are “too noisy” (they don’t provide enough information to offer a profitable timing signal).

The October 2017 study “Value Timing: Risk and Return Across Asset Classes,” authored by Fahiz Baba Yara, Martijn Boons and Andrea Tamoni, offers further support that valuation spreads provide information.

The authors found that “returns to value strategies in individual equities, commodities, currencies, global government bonds and stock indexes are predictable by the value spread …. In all asset classes, a standard deviation increase in the value spread predicts an increase in expected value return in the same order of magnitude (or more) as the unconditional value premium.”

Is Value Still Value?

Given that valuation spreads have been shown to have predictive value, we can examine current valuation spreads to see if they have shrunk in a way that would be expected to eliminate the value premium.

As a simple test, using data from Ken French’s website, I took a look at the spread in book-to-market (BtM) values of the top and bottom three deciles in 2008 and compared them to where they were at the end of October 2017, the latest data available. This should tell us whether cash flows over the last 10 years have altered the very nature of the value premium.

The methodology used to compute BtM ratios is this: Take the book value of the stocks as of December 31 of the prior year and then the market value of the stock as of June 30 of the following year. For 2008, the BtM ratios were 0.21 (deciles 1-3) and 0.92 (deciles 8-10), for a value spread of 0.71. For 2017, the BtM ratios were 0.16 and 0.83, respectively, for a value spread of 0.67—virtually unchanged from 10 years earlier.

Note that the value premium from 1926 through 2007 was 5.6%. Thus, at least in terms of valuation spreads, there doesn’t seem to be any evidence to support the idea that the value premium has disappeared.

To help you avoid mistakes involving recency, keep the following example handy. The stock risk premium has been large, almost 8% a year. However, it’s also highly volatile, with an annual standard deviation of about 19% (about 2.5 times the size of the premium itself).

The premium is large because there’s a large amount of risk involved in equity investing, and investors demand it to take that risk. Because it’s a risk premium, the chance that investors may experience very long periods of underperformance must exist. In fact, the premium may never be realized. If such a risk did not exist, there really wouldn’t be any risk (and thus no premium).

As proof, consider that from 1969 through 2008, U.S. large-cap growth stocks returned 7.8% and underperformed long-term (20-year) Treasury bonds, which returned 9.0%. That’s a 40-year period in which investors took all the risks of stocks and underperformed long-term U.S. Treasuries. Should that have convinced investors the strategy of believing in a stock risk premium was wrong? Of course not.

The logic is still the same. Stocks are riskier and must have higher expected returns. It’s just that the risk involved showed up for this very long period. Those who abandoned their plans and sold stocks because they confused strategy and outcome may have missed out on the bull market that followed—the greatest since the 1930s.

What’s important to understand is that the premiums for the market overall, small stocks and value stocks have been earned only by those investors disciplined enough to stay the course through the periods when the asset classes (and factors) they have invested in underperform.

As we have seen, the periods can be quite long, long enough to test even the most disciplined of investors. That is, perhaps, why Warren Buffett has stated that his favorite holding period is forever. He has also said that successful investing has far more to do with temperament than intellect.

This commentary originally appeared December 11 on

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 Elephant in the Room: How the Financial Industry’s Shunning of Emotions Fails Its Clients

I don’t think professor Richard Thaler is going to return my calls anymore. Sure, he was gracious enough to give me an interview after his most recent book, Misbehaving, a surprisingly readable history of the field of behavioral economics, was published. But now that he’s won a Nobel Prize, something tells me I’m not on the list for the celebration party.

(Although, if that party hasn’t happened yet, professor, I humbly accept your invitation!)

But I’m still celebrating anyway, because Thaler is a hero of mine and I believe that the realm of behavioral economics–and behavioral science more broadly–can and should reframe the way we look at our interaction with money, personally and institutionally, as well as the business of financial advice.

Behavioral Economics In Action

Of course, even if you’re meeting Thaler for the first time, his work likely has already played a role in your life in one or more of the following ways:

  • Historically, your 401(k) (or equivalent) retirement savings plan has been “opt-in,” meaning you proactively had to make the choice–among many others–to do what we all know is a good idea (save for the future). But our collective penchant for undervaluing that which we can’t enjoy for many years to come led most of us to default to inaction. Thanks largely to Thaler and Cass Sunstein’s observations in the book Nudge, more and more companies are moving to an “opt-out” election, automatically enrolling new employees in the plan with a modest annual contribution.
  • Better yet, many auto-election clauses gradually increase an employee’s savings election annually. Because most receive some form of cost-of-living pay increase in concert with the auto-election bump, more people are saving more money without even feeling it!
  • Additional enhancements, like a Qualified Default Investment Alternative (QDIA), help ensure that these “invisible” contributions are automatically invested in an intelligently balanced portfolio or fund instead of the historical default, cash, which ensures a negative real rate return.
  • Some credit card awards now automatically deposit your “points” in an investment account while some apps, like, “round up” your electronic purchases and throw the loose virtual change in a surprisingly sophisticated piggy bank.

No, you’re not likely to unknowingly pave your way to financial independence, but thanks to the work of professor Thaler and others, many are getting a great head start without making a single decision.

What is most shocking to me, however, is the lack of application–or the downright misapplication–of behavioral economics in the financial services industry.

Misusing Behavioral Economics

What, exactly, is being missed or misapplied?

Well, if I had to summarize the entirety of what we’ve learned from behavioral economics, finance and the scientific findings that apply to managing money, it would be the following gross oversimplification of the seminal work from Thaler’s predecessor, Daniel Kahneman, in his book Thinking, Fast and Slow:

1. The brain’s “operating system” for processing information is actually two systems–“System 1 is fast, intuitive, and emotional; System 2 is slower, more deliberative, and more logical,” he writes.

2. Confoundingly, most of our financial (and other) decisions are made with System 1, not System 2.

Even though we may prefer to access the deliberative, logical, quantitative processor in our brain when making financial choices, the science suggests that we’re still using the intuitive and emotional part of our brain to reach those decisions. Let’s say it’s broken down 80/20 into System 1/System 2, emotional/logical, qualitative/quantitative.

However, the financial planning process more often taught and most often practiced is almost entirely System 2–even though the science suggests they’re basically two different neurological languages, and that we struggle to solve a System 2 dilemma with System 1 logic.

(Perhaps this is the reason that more than 80% of the recommendations made by financial planners are not implemented?)

The Elephant (and the Rider) in the Room

This reality is the proverbial elephant in the room, and that’s a perfect analogy because the metaphor that has helped us comprehend Systems 1 and 2 is, indeed, the loveable pachyderm.  Author Jonathan Haidt ascribed System 1 with qualities represented by the elephant, while suggesting System 2 may be characterized by the elephant’s rider.

(I asked professor Thaler a couple years back if he thought this was a fitting and proportionate analogy, and he said it was.)

But a friend reminded me recently that another interesting phenomenon is taking place concurrently. That is, as financial advisors and institutions have been exposed to the science, they’ve been quick to (erroneously) conclude that they are the rational rider and their clients are the emotionally wayward elephant!

Nevermind for a moment that the financial services industry at large has proven its own self-preservative instinct has for too long overwhelmed its nagging feeling that it should put its clients ahead of itself. But to the degree the industry has acknowledged the apparent elephant/rider conundrum, it has chosen to presume that the elephant is a big, stupid animal to be locked outside while the rider reflects self-importantly over a fine, single-malt Scotch at a mahogany board-room table.

“7 Behavioral Biases that May Hurt Your Investments,” “5 Biases that Hurt Investment Returns” and “Investors 10 Most Common Behavioral Biases” are just a few of the first-page search engine results that berate the elephant for its illogical tendencies and seem to encourage the rider to abandon his only form of transportation.

But that’s where we’re reminded half-truths are often the best lies. It certainly is true that we’re prone to all the biases illuminated by the field of behavioral economics. It’s also true that some of these biases lead to poor financial decisions.

Emotions Aren’t the Problem and May Be the Solution

But those who choose to demonize the elephant and elevate the rider do so at their own peril, because it’s also true that:

1. System 1–the elephant–can’t be suppressed. It’s impossible. When the elephant and rider are in conflict, the elephant wins. Period.

2. The elephant is the primary source of our passion, vision and resolve. It can be enlisted to help us accomplish our financial goals.

Those of us who’ve been financial advisors for any length of time know this. If you ask a room of 100 advisors with at least five years of experience how many of them have had a client cry in their office, likely every hand will go up.

We’ve known intuitively for years that personal finance is more personal than it is finance, but Kahneman, Thaler and others have proven it a scientific fact. Others, like Chip and Dan Heath, have helped explain that, perhaps surprisingly, “the Elephant also has enormous strengths and that the Rider has crippling weaknesses.”

In their book, Switch, they continue, “To make progress toward a goal…requires the energy and drive of the Elephant. And this strength is the mirror image of the Rider’s great weakness: spinning his wheels.”

Is that not what we see in personal finance, where financial improvement is one of the top-three failed resolutions every New Year? A lot of wheel spinning? An abundance of talk and an absence of action? A lot of money being made by a financial industry that fails to usher willing clients with means to a beneficial end?

Life Planning and Elephant Training

There is a small niche within the true financial planning profession, which is itself a stunning minority of the broader financial product-pitching machine, dedicated to elephant training. Known by monikers such as “financial life planning” or simply “life planning,” the pioneer in this field is George Kinder.

I recently had the privilege of joining Kinder for his two-day intro course and five-day immersive, experiential advisory training, and I’d coarsely summarize these as intensive training in recognizing, understanding and then enlisting emotions, primarily through compassionate, yet strategic, empathy.

An example of something I learned? When that client (or friend, or family member, or anybody you don’t hate) is overcome with emotion and begins to tear up, you should not–I repeat, not–give them a tissue or (in most cases, but especially with clients) even place your hand on their shoulder.

Why? Because it signals to them that you’re uncomfortable with their emotional expression and want them to stop. We’ve learned that emotions function much like waves that rise, peak and crest, and that we should never avert our eyes–even as a pensive client naturally will–so that when the swell subsides, our appreciative, compassionate, unmoving gaze signals it was totally normal (even welcome) for them to experience that in our presence.

(Then, by all means, give them a stinking tissue!)

And that was just the answer to a common, but isolated, question. In a larger sense, the Kinder Institute has honed this art to a science, giving advisors a deliberate five-step process, and even more importantly (to me), a method for guiding any and every meeting toward the most productive exchange possible.

But Kinder has been influencing the financial planning community for more than 30 years and has trained Kinderites in more than 30 countries. He’s been joined by other respected industry voices, like our five-day co-trainers, Ed Jacobson, Ph.D., and Louis Vollebregt. Others have taken up the torch with their own unique life planning manifestations, such as the late Dick WagnerCarol AndersonRick KahlerDrs. Ted and Brad KlontzSusan BradleyMichael KayMitch Anthony and others.

Every bit of their wisdom that I’ve consumed over the past 15 years has been additive, and I’ve seen financial advisory practices transformed by bolstering their qualitative skills–their elephant training.

Financial Planning Done Right

So, why is it still a niche? Why don’t we see any huge financial firms adopting it? Why don’t we see the Certified Financial Planner™ Board of Standards adding a substantive element of qualitative training to the educational requirements for newly minted CFP® practitioners?

I can only conclude that, in general, the profit motive is still a stronger force within the financial services industry than the desire to put a client’s interest ahead of the firm’s.

But hopefully, with yet another Nobel Prize being handed to a behavioral economist, the qualitative-planning, life-planning, elephant-training movement will continue to grow. And as the growing profession of financial planning begins to separate itself from the sales engine of the larger industry, this is vitally important because life planning isn’t so much a niche or specialty–it’s simply financial planning done right.

This commentary originally appeared November 15 on

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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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.”


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

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.


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.


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

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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.

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