The Deep End

Solomons-financial-advisor-guest-blogger-Jim-Parker

The Deep End

Have you ever seen a child standing tentatively at the edge of a swimming pool? She’s torn between her desire to join the gang in the water and her fear of diving in. In committing to the market, investors can be like that.

You can always find a reason for not investing. “Perhaps I should wait till after interest rates rise?” goes one line of the thinking. “Or maybe I should delay till there’s more clarity on China? Or hold back until after earnings season?”

Emotions and assumptions usually underlay this indecision. The emotion can be anxiety about “making a mistake” or fear of committing at “the wrong time” and suffering regret. The assumption is that there is a perfect time to invest.

Obviously, the ideal solution would be to enter the market just as it bottoms and exit the market right at the top.

But the reality is that precisely timing your exit and entry is close to impossible. If it were easy, millions would be doing it and getting very rich in the process. Instead, the only ones who tend to consistently make money out of market timing are those who write books about it.

The financial media certainly love market timing stories. For one thing, there is always some event or variable they can peg it to—like a decision on interest rates or upcoming earnings or a chart indicator. For another, the idea of timing the market is a powerful one and tends to get readers’ attention.

For example, one high-profile US forecaster in early 2012 predicted a 50-70% equity market decline over the following two-to-three years. It was to be a replay of the 2008-09 crisis, he said, but with an even deeper recession.1

Timing the market… or time in the market?

That turned out to be a bad call. Global equity markets, as measured by the MSCI World Index, delivered a total positive return in Australian dollars of 93% from the end of 2011 to the end of 2014.² In USD, it was 53%.

Others advocate more elaborate timing strategies. For instance, one recent academic paper suggested the stock market delivers better returns relative to Treasury bills in the second, fourth and sixth week after each of the US Federal Reserve’s policy-setting meetings in a given year.³

The idea here is that the Fed leaks information about its interest rate intentions in such a predictable way that, even without the information, savvy investors can make money by just buying stocks in certain periods.

While these theories can be fascinating, it is arguable how many of us have either the time or inclination to try them out. And even if we did, this does not take account of the costs of all the required trades or the possibility that as soon as we implemented the idea it would be arbitraged away.

So ahead of a central bank meeting, some would-be investors fret about whether they should hold off until they see how the market reacts. Others already invested worry whether they should take their money out.

What really matters

The truth is that for long-term investors, these issues should be irrelevant. What matters is how their portfolios are structured and how they are tracking relative to their chosen goals. Markets will go up and down, security prices will change on news and it makes little sense to second guess them.

But while no one yet has come up with a consistently successful strategy for timing the market to perfection, there are some things that everyone can do to help ease the anxiety they feel about investing.

One is to realise that it does not have to be a choice between being 100% in the market and 100% outside. Ideally, an investor should stick to their strategic asset allocation—be it 70/30 or 60/40 or 50/50 equity/bonds.

Another is that this strategic allocation can be combined with periodic, disciplined rebalancing, in which the investor shifts assets from well performing asset classes to those less favoured. This is a good way of controlling risk without necessarily trying to time the market.

A third option is that there is nothing wrong with investors taking into account the returns they have already enjoyed and adjusting their asset allocations if they are on course to meet their goals. So, for example, for some investors it might make perfect sense to lock in returns after a good period and put the money into short-term fixed income if that meets their needs.

Yet another option is dollar-cost averaging. This is a method where an individual invests small amounts of an available pool of cash into the market over a period, rather than investing a lump sum in one go.

A useful contribution on this subject comes from Ken French, Professor of Finance at the Tuck School of Business at Dartmouth College. In his role as an academic, Professor French says the optimal decision is to invest it all at once. But while this might give an individual the best investment outcome, he says it might not be the best investment experience.⁴

This is because people tend to feel regret more strongly when it results from things they did do than from things they did not. So, for instance, it feels much more painful to buy stocks now and see the price go down than it is to neglect to buy stocks and the price goes up.

Professor French says that by dollar cost averaging, people can diversify their “acts of commission” (the stuff they did do) as opposed to their “acts of omission” (the stuff they didn’t do).

“The nice thing is that even if I put my finance professor hat back on, it’s really not that damaging to your long-term portfolio to just spread it out over three or four months,” he says. “So if you as an investor find that’s much more tolerable for you, you’re not really doing much harm.”

So, in summary, it’s always difficult to choose exactly the right time to get into or out of the market. For instance, it would have been nice to get out in late 2007 and back in around early March 2009.

But most mortals are unable to finesse it to that degree. The good news is that there are other options than just staying out of the market altogether and plunging back in.

These include maintaining a long-term strategic asset allocation in the first place, periodically rebalancing, taking money off the table if retirement goals are on track and dollar-cost averaging if that provides comfort.

The underlying philosophy in all these options is that individual investors are making decisions based on their own needs and risk appetites, not according to someone else’s opinion as to what the market does next.

Uncertainty will always be an integral part of investment (and life). But there are many things we can control. And this is where a good adviser comes in.

1. “Get Set for a Crash, Forecaster Says”, Globe and Mail, 10 January 2012

2. MSCI World Index (net div, AUD), Returns Program

3. “Want to Play the Market? Count the Fed Leak Weeks: Study”, Reuters 21 November, 2015

4. Fama/French Forum, “Dollar Cost Averaging”, 23 June, 2009

Jim Parker

Vice President, Dimensional

You can read more articles about Pensions, Wealth Management, Retirement, Investments, Financial Planning and Estate Planning on my blog which gets updated every week. If you would like to talk to me about your personal wealth planning and how we can make you stay wealthier for longer then please get in touch by calling 08000 736 273 or email info@solomonsifa.co.uk

The Deep EndDominic2023-12-01T12:19:39+00:00

The Patience Principle

Global markets are providing investors a rough ride at the moment, as the focus turns to China’s economic outlook. But while falling markets can be worrisome, maintaining a longer-term perspective makes the volatility easier to handle.

A typical response to unsettling markets is an emotional one. We quit risky assets when prices are down and wait for more “certainty”.

These timing strategies can take a few forms. One is to use forecasting to get out when the market is judged as “over-bought” and then to buy back in when the signals tell you it is “over-sold”.

A second strategy might be to undertake a comprehensive macro-economic analysis of the Chinese economy, its monetary policy, global trade and investment linkages and how the various scenarios around these issues might play out in global markets.

In the first instance, there is very little evidence that these forecast-based timing decisions work with any consistency. And even if people manage to luck their way out of the market at the right time, they still have to decide when to get back in.

In the second instance, you can be the world’s best economist and make an accurate assessment of the growth trajectory of China, together with the policy response. But that still doesn’t mean the markets will react as you assume.

A third way is to reflect on how markets price risk. Over the long term, we know there is a return on capital. But those returns are rarely delivered in an even pattern. There are periods when markets fall precipitously and others where they rise inexorably.

The only way of getting that “average” return is to go with the flow. Think about it this way. A sign at the river’s edge reads: “Average depth: three feet”. Reading the sign, the hiker thinks: “OK, I can wade across”. But he soon discovers the “average” masks a range of everything from 6 inches to 15 feet.

Likewise, financial products are frequently advertised as offering “average” returns of, say, 8%, without the promoters acknowledging in a prominent way that individual year returns can be many multiples of that average in either direction.

Now there may be nothing wrong with that sort of volatility if the individual can stomach it. But others can feel uncomfortable. And that’s OK too. The important point is being prepared about possible outcomes from your investment choices.

Markets rarely move in one direction for long. If they did, there would be little risk in investing. And in the absence of risk, there would be no return. One element of risk, although not the whole story, is the volatility of an investment.

Look at a world share market benchmark such as the MSCI World Index, in US dollars. In the 45 years from 1970 to 2014, the index has registered annual gains of as high as 41.9% (in 1986) and losses of as much as 40.7% (2008).

But over that full period, the index delivered an annualised rate of return of 8.9%. To earn that return, you had to remain fully invested, taking the unsettling down periods with the heartening up markets, but also rebalancing each year to return your desired asset allocation back to where you want it to be.

Timing your exit and entry successfully is a tough ask. Look at 2008, the year of the global financial crisis and the worst single year in our sample. Yet, the MSCI World index in the following year registered one of its best-ever gains.

Now, none of this is to imply that the market is due for a rebound anytime soon. It might. It might not. The fact is no-one can be sure. But we do know that whenever there is a great deal of uncertainty, there will be a great deal of volatility.

Second-guessing markets means second-guessing news. What has happened is already priced in. What happens next is what we don’t know, so we diversify and spread our risk to match our own appetite and expectations.

Spreading risk can mean diversifying within equities across different stocks, sectors, industries and countries. It also means diversifying across asset classes. For instance, while shares have been performing poorly, bonds have been doing well.

Markets are constantly adjusting to news. A fall in prices means investors are collectively demanding an additional return for the risk of owning equities. But for the individual investor, the price decline only matters if they need the money today.

If your horizon is five, 10, 15 or 20 years, the uncertainty will soon fade and the markets will go onto worrying about something else. Ultimately what drives your return is how you allocate your capital across different assets, how much you invest over time and the power of compounding.

But in the short-term, the greatest contribution you can make to your long-term wealth is exercising patience. And that’s where your adviser comes in.

Jim Parker

Vice President, Dimensional

The Patience PrincipleDominic2023-12-01T12:19:59+00:00

The China Syndrome

The recent severe volatility in China’s share markets has raised questions among many investors about the causes of the fall and about the wider implications for the global economy and markets generally.

The Shanghai Composite index, the mainland stock market barometer and one dominated overwhelmingly by retail investors, more than doubled in the year from mid-2014, only to lose more than 30% of its value in a month.

The volatility was much less in Hong Kong, where foreign investors tend to get their exposure to China. The Hang Seng index fell about 17% from April’s seven-year high, though it had a more modest run-up in the prior year of about 25%.

Nevertheless, the speed and scale of the fall on the Chinese mainland markets unsettled global markets, fuelling selling in equities, industrial commodities, and allied currencies like the Australian dollar and buoying perceived safe havens such as US Treasuries and the Japanese yen.

The decline in Chinese stocks triggered repeated interventions by China’s government, which has been seeking to transition the economy from a long-lasting export-led boom toward more sustainable growth based on domestic demand.

Investors naturally are concerned about what the volatility in the Chinese market means for their own investments and what it might signify for the global economy, particularly given the rapid growth of China in the past 20 years.

SHARE MARKET VS ECONOMY

Measured in terms of purchasing power parity (which takes into account the relative cost of local goods), the Chinese economy is now the biggest in the world, ranking ahead of the USA, India, Japan, Germany and Russia.1

Yet, China’s share market is still relatively small in global terms. It makes up just 2.6% of the MSCI All Country World Index, which takes into account the proportion of a company’s shares that are available to be traded by the public.

The Chinese market is also not a large part of the local economy. According to Bloomberg, it is capitalised at less than 60% of the country’s GDP. By comparison, the US equity market represents more than 100% of the US economy.

China is classified by some index providers as an emerging market. These are markets that fall short of the definition of developed markets on a number of measures such as economic development, size, liquidity and property rights.

China’s stock market is still relatively young. The two major national exchanges, in Shanghai and the other in the southern city of Shenzhen, were established only in 1990 and have grown rapidly since then as China has industrialised.

With foreign participation in mainland Chinese markets still heavily restricted, many foreign investors have sought exposure to China through Hong Kong or through China shares listed on the New York Stock Exchange.

As a consequence, domestic investors account for about 90% of the activity on the Chinese mainland market. And even then, the participation is relatively narrow. According to a China household finance survey, only 37 million or 8.8% of Chinese families held shares as of June 2015.2 As a comparison, just over half of all Americans own stocks, according to Gallup. In Australia, the proportion is 36%.

While the Chinese stock market is about 30% off its June highs, it nevertheless is still about 80% higher than it was a year ago. As such, much of the pain of the recent falls will have been felt by people who have entered the market in the past year.

A final point of perspective is that while the Chinese economy has been slowing, it nevertheless is still expanding at around 7% per annum, which is more than twice the rate of most developed economies.

The IMF in April projected growth would slow to 6.8% this year and to 6.3% in 2016. Still, it expects structural reforms and lower oil and commodity prices to expand consumer-oriented activities, partly buffering the slowdown.3

While such forecasts are subject to change, markets have priced in the risk of a further slowdown to what was previously expected, as seen in the renewed fall in the prices of commodities like copper and iron ore, which recently hit six-year lows.

DRIVERS OF THE BOOM

The Chinese share market boom of the past year cannot be attributed to a single factor, but certainly two major influences have been the Chinese government’s promotion of share ownership and investors’ increased use of leverage.

The government has been seeking to achieve more sustainable, balanced and stable economic growth after nearly four decades of China notching up heady annual growth rates averaging 10% on the back of an official investment boom.

But the transition to a shareholding economy has created its own strains. The outstanding balance of margin loans on the Shanghai and Shenzhen markets had grown to 4.4% of market capitalisation by early July, according to Bloomberg.4

Under a margin loan, investors borrow to invest in shares or other securities. While this can potentially increase their return, it also exposes them to the potential of bigger losses in the event of a market downturn.

When prices fall below a level set by the lender as part of the original agreement, the investor is called to deposit more money or to sell stock to repay the loan. These margin call liquidations can amplify falling markets.

Chinese regulators, mindful of the potential fallout from the stock market drop, have instituted a number of measures to curb the losses and cushion the impact on the real economy.

These have included a reduction in official interest rates, a suspension of initial public offerings and enlisting brokerages to buy stocks backed by cash from the central bank. In the latest move, regulators banned holders of more than 5% of a company’s stock from selling for six months.

The government also has begun an investigation into short selling, which involves selling borrowed stock to take advantage of falling prices. In the meantime, about half of the companies listed on the two major mainland exchanges were granted applications for their shares to be suspended.

While such interventionist measures may seem alien to people in developed market economies, they need to be seen in the context of China’s status as an emerging market where governments typically play a more active role in the economy.

Whether the intervention works in the long term remains to be seen. But the important point is that this is a relatively immature market dominated by domestic investors and prone to official intervention.

SUMMARY

The re-emergence of China as a major force in the global economy has been one of the most significant drivers of markets in the past decade and a half.

China’s rapid industrialisation as the population urbanised drove strong demand for commodities and other materials. Investment and property boomed as credit expanded and as people took advantage of gradual liberalisation.

Now, China is entering a new phase of modernisation. The government and regulators are seeking to rebalance growth and bring to maturity the country’s still relatively undeveloped capital markets.

Nevertheless, China remains an emerging market with all the additional risks that this status entails. Navigating these markets can be complex. There can be particular challenges around regulation and restrictions on foreign investment.

We have seen those risks appearing in recent weeks as about a third of the sharp rise in the Chinese mainland market over the previous year was unwound in a matter of weeks, prompting intense government intervention.

Markets globally are weighing the wider implications, if any, of this correction. We have seen concurrent weakness in other equity markets and falls in commodity prices and related currencies.

Yet it is important to understand that the stock market is not the economy. China’s market is only about 2.6% of global market cap and its volatile mainland exchanges are for the most part out of bounds for foreign investors anyway.

For individual investors, the best course in this climate, as always, is to maintain diversification and discipline and to remember that markets accommodate new information instantaneously.

1. Source: IMF World Economic Outlook, April 2015

2. ‘China Households Raise Housing Investment in Q2’, Reuters, July 9, 2015

3. ‘World Economic Outlook’, International Monetary Fund, April, 2015

4. ‘China’s Stock Plunge Leaves Market More Leveraged than Ever’, Bloomberg, July 6, 2015

Jim Parker

Vice President, Dimensional

The China SyndromeDominic2023-12-01T12:20:01+00:00

Investing: Greece is the word

Greece is the Word

The world’s markets and media financial pages have been consumed by a single issue in recent weeks—the stand-off between debt-laden Greece and its international lenders over the conditions of any further bailout. For investors everywhere, both of the large institutional kind and individual participants, the story has been fast-paced and difficult to keep up with. More importantly, the speculation about possible outcomes has been intense.

Of course, no-one knows the eventual outcome or whether there will even be a definitive conclusion. After all, this is a story that has been percolating now for six years, since Greece’s credit rating was downgraded by three leading agencies amid fears the government would default on its debt.

Since then, the Greek situation has faded in and out of public attention as rescue packages came and went and as widespread social and political unrest gripped a nation known as the birthplace of democracy.

But there are a few points to keep in mind. Despite the blanket media coverage of Greece, this is a tiny economy, ranking 51st in the world by GDP in purchasing power parity terms (which takes into account the relative cost of local goods).

On this measure, Greece is a smaller economy than Qatar, Peru or Kazakhstan, none of which currently feature prominently in world news pages. Its economy is about half the size of Ohio in the USA or New South Wales in Australia and about a tenth of the size of the UK. Even within Europe, it is tiny, representing only about 2% of the GDP of the 19-nation Euro Zone.

Size is everything

As a proportion of global share markets, Greece is also a minnow. As of early July 2015, it represented about 0.32% of the MSCI Emerging Markets index and just 0.03% of the MSCI All Country World Index.

And while its total debt is large in nominal terms and relative to its GDP at about 180%, this still represents only about a quarter of 1% of world debt markets.

Of course, what worries investors is not so much Greece itself but the wider ramifications of the debt crisis for its European bank lenders, for the future of the single European currency and for the global financial system.

Yet, many of these concerns are already reflected in market prices, such as in Greek government bonds, the spreads of peripheral Euro Zone bonds, regional equity markets and the single European currency itself.

While no-one knows what will happen next, we can look at measures of market volatility as a rough guide to collective expectations. A commonly cited measure is the Chicago Board Options Exchange’s volatility index, sometimes known as the ‘fear’ index. This has recently spiked to around 18 from 12 in mid-June. But keep in mind the index was up around 80 during the peak of the financial crisis in 2008.

Of course, the human misery and dislocation suffered by the Greek people through this crisis should not be downplayed, neither should the financial risks. But from an investment perspective, there is still little individual investors can do beyond the usual prescription.

Perpective

That prescription is to remain disciplined and broadly diversified across countries and asset classes and to be mindful that markets accommodate new information instantaneously. So the risk in changing one’s portfolio in response to fast-breaking news is that you end up acting on events that are already built into security prices.

In summary, the events in Greece are clearly worrisome, but Greece is a very small economy and a tiny proportion of the global markets. Events are moving quickly and prices are adjusting as news breaks and investor expectations adjust.

For the individual investor, the best approach remains diversifying across many countries and asset classes, remaining focused on your own goals and, most of all, listening to your chosen advisor, who understands your situation best.

Jim Parker

Vice President, Dimensional

Investing: Greece is the wordDominic2023-12-01T12:20:12+00:00

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.

Time and Money

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?

Independent Advice

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.

Living on the EdgeDominic2023-12-01T12:40:03+00:00

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

Waiting for Certainty?Dominic2023-12-01T12:39:17+00:00

The Art of Delusion

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. thegreatgatsby

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

The Art of DelusionDominic2023-12-01T12:39:14+00:00

One Green Bottle

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

One Green BottleDominic2023-12-01T12:39:13+00:00

Whats the story?

Today Jim Parker highlights the need for a story as opposed to evidence.

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.

Jim Parker

1. Nassim Nicholas Taleb, ‘The Black Swan: The Impact of the Highly Improbable’, Penguin, 2008

Whats the story?Dominic2023-12-01T12:39:08+00:00

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.

The Devil Wears NadaDominic2023-12-01T12:39:00+00:00

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