Living on the Edge
Digital innovation has democratised access to financial information to the point where anyone with a smartphone, a few apps and real-time news and data feeds can be like a pro trader. But who wants to do that? And do you need to? In the world of information flows, speed is barely an issue anymore. And the old hierarchies, where professionals with state of the art systems had priority access to breaking news, have been progressively dismantled.
For instance, a $500 smartphone with a 1.3 gigahertz processor is more than a thousand times faster than the Apollo guidance computer that sent astronauts to the moon nearly half a century ago. Its internal memory is 250,000 times bigger.
The upshot is that financial and other information comes at us faster and in greater volumes than ever. We no longer have to wait for the six o’clock TV news to know what happened in markets today. Our apps notify us in real time. But amid this era of always-on news flow, the big question for most of us is not about our access to real-time information; it’s about whether we actually need to be so plugged in to have a successful investment experience. Dealing with that question starts with reflecting how much of an investment “edge” you get by having access to information that is so freely available.
Returning to the problem
On that score, there’s an old concept in economics called the law of diminishing returns. It essentially says that adding more and more of one input, while keeping everything else constant, gives you progressively less bang for your buck.
At the industrial end of this technology arms race, you have the high frequency traders who spend a fortune on advanced communications infrastructure to try to take advantage of split second changes in millions of prices. On the evolutionary scale, these computer programs make smart phones look like ploughshares. So against that background it’s not clear that adding the latest market-minder app to your iPhone is necessarily the path to investment success.
The second question to ask is what you are trying to achieve. Are you trying to “beat” the market by finding mistakes in prices and timing your entry and exit points? If so, and given the competition above, you might want to review your information budget.
The truth for most of us is that investment is not an end in itself, but a means to an end. We want to save for a house or put our children through school or look after aging parents or give ourselves a good chance of a comfortable retirement.
In this context, the most relevant information is about our own lives and circumstances. How much do we spend? How much can we save? What’s our risk appetite? What are our future needs? And how much of a cash buffer do we need?
This is the value an independent financial advisor can bring—not in trying to second-guess the market or using forecasts to gamble with your money—but in understanding the life situation of each person and what each of them needs.
Ultimately, markets are so competitive that we really are wasting our own precious resources by trying to game them. What most of us need is to secure the long-term capital market rates of return as efficiently as possible. So our limited resource is not speed or access to information, but our own time. We only have a short window to live the lives we want. And that means we should start any investment plan with understanding ourselves.
That’s where the edge is.
Waiting for Certainty?
A frequent complaint from would-be investors is that “uncertainty” is what keeps them out of the financial markets. “I’ll stay in cash until the direction becomes clearer,” they will say. So when has there ever been total clarity? Alternatively, people who are already in the market after a strong rally, as we have seen in recent years, nervously eye media commentary about possible pullbacks and say “maybe now is a good time to move to the sidelines”. While these kneejerk, emotion-driven swings in asset allocation based on market and media commentary are understandable, they are also unnecessary. Strategic rebalancing provides a solution, which we will explain more of in a moment.
But first, think back to March, 2009. With equity markets deep into an 18-month bear phase, the Associated Press provided its readers with five signs the stock market had bottomed out and followed that up with five signs that it hadn’t.1 The case for a turn was convincing. Volumes were up, the slide in the US economy appeared to be slowing, banks were returning to profitability, commodity prices had bounced and many retail investors had capitulated and gone to cash.
But there also was a case for more pain. Toxic assets still weighed on banks’ balance sheets, economic signals were patchy, short-covering was driving rallies, the Madoff scandal had knocked confidence and fear was still widespread. Of course, with the benefit of hindsight, that month did mark the bottom of the bear market. In the intervening period of just over five years, major equity indices have rebounded to all-time or multi-year highs.
This table below shows the cumulative performance of major indices in the 18 months or so of the bear market from November, 2007 and then the cumulative performance in the subsequent five-year recovery period. You can see there have been substantial gains across the board since the market bottom. And while annualised performance over the six-and-half years from November 2007 is not impressive, the pain has been a lot less for those who did not bail out in March, 2009.
So those who got out of the market at the peak of the crisis and waited for “certainty” have realised substantial losses. But keep in mind, also, that these past five years of recovery in equity markets have also been marked by periods of major uncertainty.
In 2011, Europe was gripped by a sovereign debt crisis. Across the Atlantic, Washington was hit by periodic brinksmanship over the US debt ceiling. In Asia, China grappled with the transition from export-led to domestic-driven growth. Around any of these events, there were a broad range of views about likely outcomes and how these possible scenarios might impact on financial markets. The big question for the rest of us is what to do with all this commentary.
The fact is even the professionals struggle to consistently add value using analysis of macro-economic events, as we see repeatedly in surveys of fund-versus-index returns. And history suggests that those looking for “certainty” around such events before investing could set themselves up for a long wait.
There is always something to fret about. Recently, the focus has been on low volatility, particularly when compared to the days of 2008-09. Sage articles muse over whether risk is being appropriately priced and whether volatility is being unnaturally suppressed by central banks’ explicit forward guidance about policy.2 Just as in March 2009, one does not have to look far to find well-reasoned discussion in support of why the market has topped out, alongside equally compelling reasons of why the rally might continue for some time.
What is the average investor supposed to make of all this conjecture? One way is to debate the market implications of news and to try to anticipate what might happen next. But whom do you believe? We’ve seen there are always cogent-sounding arguments for multiple scenarios.
An alternative approach is much simpler. It begins by accepting the market price as a fair reflection of the collective opinions of millions of market participants. So rather than betting against the market, you work with the market.
That means building a diversified portfolio around the known dimensions of expected return according to your own needs and risk appetite, not according to the opinions of media and market pundits about what happens next month or next week.
It also means staying disciplined within that chosen asset allocation and regularly rebalancing your portfolio. Under this approach, you sell shares after a solid run-up in the market. But the trigger for this rebalancing is not media speculation, but the need to retain your desired asset allocation.
Say you have chosen an allocation of 60% of your portfolio in equities and 40% in fixed income. A year goes by and your equity allocation has rallied strongly so that the balance between the two has shifted to 70-30. In this case, it makes absolute sense to take some money out of shares and move it to bonds or cash.
It works the other way, too, so that if shares have fallen in relation to bonds, you can take some money out of fixed income cash and buy shares. Essentially this means buying low and selling high. But you are doing so based on your own needs rather than on what the armies of pundits say will happen in the market next. Of course, this doesn’t mean you can’t take an interest in global events. But it does spare you from basing your long-term investment strategy on the illusion that somewhere, at some time, “certainty” will return.
Jim Parker: Dimensional
1. ‘Five Signs the Stock Market Has Bottomed Out and Five Signs It Hasn’t’, Associated Press, March 15, 2009
2. ‘When Moderation is No Virtue’, The Economist, May 22, 2009
Jim Parker provides a great piece exploring the delusions that investors can suffer. Importantly he notes we aren’t wired for discipline… which is one of the benefits of using an adviser with proper processes.
The Art of Delusion
The philosopher Ludwig Wittgenstein once said that nothing is as difficult for people as not deceiving themselves. But while most self-delusions are relatively costless, those relating to investment can come with a hefty price tag. We delude ourselves for a number of reasons, but one of the principal causes is a need to protect our own egos. So we look for external evidence that supports the myths we hold about ourselves and we dismiss those facts that are incompatible.
Psychologists call this tendency to select facts which suit our own internal beliefs as “confirmation bias”. A related ingrained tendency, known as “hindsight bias”, involves seeing everything as obvious and predictable after the fact. These biases, or ways of protecting our egos from reality, are evident among many investors everyday and are often encouraged by the media. Here are seven common manifestations of how investors fool themselves:
7 Investor Delusions
1. “Everyone could see that market crash coming“. Have you noticed how people become experts after the fact? But if “everyone” could see a correction coming, why wasn’t “everyone” profiting from it? You don’t need forecasts.
2. “I only invest in ‘blue-chip’ companies.” People often gravitate to the familiar and to shares they see as ‘solid’. But a company’s profile and whether or not it is a good investment are not necessarily correlated. Better to diversify.
3. “I’m waiting for more certainty.” The emotions triggered by volatility are understandable. But acting on those emotions can be counter-productive. Uncertainty goes with investing. In the long term, discipline is rewarded.
4. “I know about this industry, so I’m going to buy the stock.” People often assume that success in investment requires specialist knowledge of a sector. But that information is usually already in the price. Trust the market instead.
5. “It was still a good call, but no-one saw this coming.” Isn’t that the point? You can rationalise a stock-specific bet as much as you like, but events or external influences can conspire against you. Spread your risk instead.
6. “I’m going to restrict my portfolio to the strongest economies.” If an economy performs strongly, that will no doubt be reflected in stock prices. What moves prices is news. And news relates to the unexpected. So work with the market.
7. “OK, it was a bad idea, but I don’t want to sell at a loss.” We can put too much faith in individual stocks. And holding onto a losing bet can mean missing opportunities elsewhere. Portfolio structure is what determines performance.
This is by no means an exhaustive list. In fact, the capacity for us as human beings to delude ourselves in the world of investment is never ending.
But overcoming self-deception is not impossible. It just starts with the idea of recognising that as humans we are not wired for disciplined investing. We will always find one way or another of rationalising an emotional reaction to market events. But that’s why even experienced investors engage advisors who know them, and who understand their circumstances, risk appetites and long-term goals. The role of that advisor is to listen to and acknowledge our very human fears, while keeping us in the plans we committed to at our most lucid and logical.
We will always try to fool ourselves. But to quote another great philosopher, the essence of self-discipline is to do the important thing rather than the urgent thing.
Jim Parker: Vice President Dimensional
Jim Parker is back, discussing why diversification is vital in any sensible portfolio, with lessons from the Chinese and wine industry. Jim…
One Green Bottle
In investment, risk and return are related. In other words, the price of earning a return is accepting some level of risk. But not every risk is worth taking. And one of those is the risk associated with individual stocks or sectors. Economists call this idiosyncratic risk. It relates to the peculiar, individual influences on a particular stock or industry. And the general rule is the less diversified your portfolio, the more you are exposed to these granular risks.
Lessons from China
Treasury Wine Estates (TWE) is the second-largest publicly traded wine maker in the world. This Melbourne-based company, created in 2011, is home to such brands as Penfolds in Australia and Beringer in the US Napa Valley. One of TWE’s fastest growing markets has been China, which is now the biggest market for red wine in the world. In fact, China’s drinkers last year consumed 1.86 billion bottles of red wine, an increase of 136% on five years before.1 However, that pattern started to change recently as China’s president Xi Jinping announced an austerity drive and a crackdown on corruption. (Wine is frequently used to grease the wheels of business deals in China.) In January this year, TWE downgraded its earnings guidance, saying the crackdown on official gift giving in China was hurting sales volumes. The market response was dramatic, with the company’s shares dropping 20% in a single session. This wasn’t just felt in Australia. In Europe, French drinks giant Rémy Cointreau announced in April, 2014 that sales of its cognac had slumped by more than 30% due to the crackdown on corruption in China.2
Think sideways – diversify
So how do investors protect themselves against these idiosyncratic risks like these? The most obvious way is to diversify. That means holding a large number of stocks and being exposed to a broad number of sectors. In a portfolio of just one stock or even five, TWE’s sudden fall from favour has an outsized impact. But in a portfolio of several hundred or even several thousand stocks, the idiosyncratic fortunes of a single company mean less. Think of it in terms of the apocryphal single green bottle sitting on the wall. When it falls, the game is over. But with 10 or 100 green bottles, it’s going to hurt less.
Know the limits – recommended daily allowance
But what if an individual investor has strong convictions about potential returns to the wine industry from increasing China consumption? The best answer to that question is to pose another question: You don’t think the market already knows that? In publicly traded and competitive markets, prices move on news. Any professional journalist will tell you that news is defined as the unexpected or unusual. ‘Dog Bites Man’ does not clear the hurdle of compelling news. ‘Man Bites Dog’ does.
To use our wine example, the statistics on China’s changing drinking habits were well known. Western wine makers like TWE and Rémy Cointreau moved to exploit them. And markets discounted the higher expected cash flows from those efforts. The ‘news’ in this case was the Chinese government’s move to reduce the level of corruption by outlawing gifts of expensive wine or spirits. Markets responded to the news because this changed their expectations for future cash flows. Unless you have found a way of predicting news, it is unlikely you will work out what will happen to stock prices. But you can protect yourself against these idiosyncratic risks by diversifying across stocks, sectors countries and asset classes.
Drinking in moderation is fine. But when it comes to investing, one green bottle is never enough.
Jim Parker. Vice President Dimensional
1. ‘China Becomes Biggest Market for Red Wine’, The Guardian, Jan 30, 2014
2. ‘Rémy Cointreau Sees China Crackdown Hurt Profits’, WSJ, April 17, 2014
What’s the story?
Human beings love stories. But this innate tendency can lead us to imagine connections between events where none really exist. For financial journalists, this is a virtual job requirement. For investors, it can be a disaster.”Needing to create order from chaos, journalists often stick the word “after” between two events to imply causation. In this case, the implication is the currency rose because a bank had changed its forecast for official interest rates. Perhaps it did. Or perhaps the currency was boosted by a large order from an exporter converting US dollar receipts to Australia or by an adjustment from speculators covering short positions.
Markets can move for a myriad of reasons. Likewise from another news organisation recently we heard that “stocks on Wall Street retreated today after an escalation of tensions in the Ukraine.” Again, how do we know that really was the cause? What might have happened is a trader answered a call from a journalist asking about the day’s business and tossed out Ukraine as the reason for the fall because he was watching it on the news. Sometimes, journalists will throw forward to an imagined market reaction linked to an event which has yet to occur: “Stocks are expected to come under pressure this week as the US Federal Reserve meets to review monetary policy settings.”
Narrative fallacy… i.e. BS
For individual investors, financial news can be distracting. All this linking of news events to very short-term stock price movements can lead us to think that if we study the news closely enough we can work out which way the market will move. But the jamming of often unconnected events into a story can lead us to mix up causes and effects and focus on all the wrong things. The writer Nassim Taleb came up with a name for this story-telling imperative. He calls it the “narrative fallacy”.1
The narrative fallacy, which is linked to another psychological tendency called ‘confirmation bias’, refers to our tendency to seize on vaguely coherent explanations for complex events and then to interpret every development in that light. These self-deceptions can make us construct flimsy, if superficially logical, stories around what has happened in the markets and project it into the future.
The financial media does this because it has to. Journalists are professionally inclined to extrapolate the incidental and specific to the systematic and general. They will often derive universal patterns from what are really just random events. Building neat and tidy stories out of short-term price changes might be a good way to win ratings and readership, but it is not a good way to approach investment. Of course, this is not to deny that markets can be noisy and imperfect. But trying to second guess these changes by constructing stories around them is a haphazard affair and can incur significant cost. Essentially, you are counting on finding a mistake before anyone else. And in highly competitive markets with millions of participants, that’s a tall order.
Sanity is available
There is a saner approach, one that doesn’t require you spending half your life watching CNBC and checking Bloomberg. This other approach is methodical, evidence-based and scientific – a world away from the financial news circus. The alternative consists of looking at data over long time periods and across different countries and multiple markets. The aim is to find factors that explain differences in returns. These return “dimensions” must be persistent and pervasive. Most of all they must be cost-effective to capture in real-world portfolios.
This isn’t a traditionally active investment style where you focus on today’s “story” and seek to profit from mistakes in prices. But nor is it a passive index approach where you seek to match the returns of a widely followed benchmark. This is about building highly diversified portfolios around these dimensions of higher expected return and implementing consistently, reliably and at low cost. It’s about focusing on elements within your control and disregarding the daily media noise.
Admittedly, this isn’t a story that’s going to grab headlines. Using the scientific method and imposing a very high burden of proof, this approach resists generalisation and simplification and using one-off events to jump to conclusions. But for most investors, it’s the right story.
1. Nassim Nicholas Taleb, ‘The Black Swan: The Impact of the Highly Improbable’, Penguin, 2008
The Devil Wears Nada
Another guest blog from Jim Parker, vice president of Dimensional, with a particularly witty and pertinent take on the way the financial services industry attempts to mimic the fashion industry, but leads investors astray. Over to you Jim…
The global fashion industry is fickle by nature, pushing and then pulling trends to keep hapless consumers forever turning over their wardrobes. Much of the financial services industry works the same way. Fashion designers, manufacturers and media operate by telling consumers what’s in vogue this year, thus artificially creating demand where none previously existed. What turns up in the boutiques is hyped as hip by the glossy magazines. So you “have” to buy it.
Likewise, much of the media and financial services industries depend on fleeting trends and built-in obsolescence to keep investors buying new “stuff”. Driving this industry aren’t so much the real needs of individuals but manufactured wants with short shelf-lives.
Just as in fashion, consumers jump onto an investment trend just as it’s peaking and when the market has moved onto something else. So their portfolios are full of mismatched, costly and impractical creations such as hybrids, capital protected products and hedge funds. These products tend to be created because they can sell. So in early 2005, Reuters wrote of how banks were manufacturing exotic credit derivatives for investors looking for ways to boost yield at a time of narrowing premiums over risk free assets.1
Four years later, in the midst of the crisis caused partly by those same derivatives, the shiny new things were “guaranteed” or “capital protected” products as financial institutions rolled out a new line of merchandise they thought they could sell to a ready market.2
Some investors made the mistake of swinging from one trend to the other, ending up with overly concentrated portfolios – like a fashion buyer with a wardrobe full of puffy blue shirts. Now while some of these investments may well have found a viable market, it’s worth asking whether the specific and long-term needs of individuals are best served by the design and mass marketing of products built around short-term trends.
Luckily, there is an alternative. Rather than investing according to what’s trendy at any one moment, some people might prefer an approach based on long-term evidence and built upon principles that have been tried and tested in many market environments. Instead of second guessing where the market might go next, this alternative approach involves working with the market, taking only those risks worth taking, holding a number of asset classes, keeping costs low and managing one’s own emotions.
Instead of chasing returns like an anxious fashion victim, this approach involves investors trusting the market to offer the compensation owed to them for taking “systematic” risk or those risks in the market that can’t be diversified away. Instead of juggling investment styles according to the fashion of the moment, this approach is based on dimensions of return in the market that have been shown by rigorous research and evidence as sensible, persistent and pervasive.
Instead of blowing the wardrobe budget on the portfolio equivalent of leg warmers, this approach spreads risk across and within many different asset classes, sectors and countries. That’s a tried and true technique called diversification.
And instead of paying top dollar for the popular brands at the expensive department stores, this approach focuses on securing good long-term investments at prices low relative to fundamental measures. Buying high just means your expected return is low.
Most of all, instead of focusing on off-the-rack investments created by the industry based on what it thinks it can sell this week, this approach delivers long-term, made-to-measure results based on each individual’s own needs, goals and life circumstances.
To paraphrase the legendary designer Coco Chanel, investment fashion changes but style never goes out of fashion.
1. ‘Demand for Exotic Derivatives Seen Growing – Bankers’, Reuters, Jan 18, 2005
2. ‘Investing: Storm Shelters’ – Money magazine, Oct 1, 2009
Thanks Jim, for those that don’t get the title reference, here’s the trailer for an amusing and allegedly accurate portrayal of life in the fashion industry.