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Commentary

Wednesday
Dec072011

Individual Investors Have Poor Instincts

In our last access blog we discussed risk aversion among Generation Y and other investors.  This month we are going to take a deeper look into the sources and rationale for fear among investors, and discuss how letting our emotions take control of our investment strategy can often do more harm than good.

Let’s start with an anecdote from famed mutual fund manager Peter Lynch.   During his 23 year tenure managing Fidelity’s Magellan Fund, Lynch earned an annualized return of about 29%.  Despite the outstanding long term performance of his fund, Lynch estimated that most investors in the fund actually lost money. 

So how did most investors in one of the most successful mutual funds in history end up losing money?  And if so many investors lost money, how come Lynch had such a strong reputation? 

The answer is that poor performance was not Lynch’s fault, it was the investors’.

Lynch was an extremely successful manager, but like the rest of the market, he saw ups and downs.  The average investor in the Magellan fund came into the fund after its strongest periods (lured in by the hopes of getting rich quick) and left after its weakest periods (for fear of losing even more money).   Because they let their greed and fear get the best of them, investors have a strong tendency to buy high and sell low – the exact opposite of what they likely set out to do.

Just as we attributed risk aversion to psychological factors, this tendency to buy high and sell low may be somewhat hardwired into our brains.  Studies have shown that if we see a chart showing a stock on the rise, we have a tendency to assume that the trend will continue.  Conversely, if we see a stock taking a plunge, our intuition is that its value will continue to plummet.  Unfortunately, these tendencies do not play out in real life, and as every investment professional is required to tell you, past performance is no guarantee for future performance.

And it is not just lay investors that fall prey to their emotions.  Each week the American Association of Individual Investors polls the sentiment of its members (not professional investors, but individuals who are very in tune to the goings on of the market).  When markets reach extreme levels (the times our emotions are likely to run highest), these investors become extremely poor at forecasting what lies ahead.  Most recently, in the wake of the financial collapse and the subsequent market decline of 2008-9, AAII members became extremely pessimistic.  Their pessimism reached its highest level in history in the March 5, 2009 survey.  If their intuition was right, markets were in for some nasty times.  Instead, four days later markets bounced off their lows and never looked back.  The S&P 500 index finished this past month up 88% from its March 9, 2009 low.

Investors, however, are not doomed by their intuition.  Careful planning and an adherence to a disciplined investment approach can help even the most anxious investors succeed.  In next month’s blog we will discuss how even the most plain-vanilla investment approach could have earned you money in the recent “lost decade.”

Tuesday
Oct252011

Are Young Investors on the Right Track?

This entry is part of a monthly finance blog I will be writing for Access Tallahassee (a division of the Greater Tallahassee Chamber of Commerce).  You can view the post on their website, alongside other blogs from the region's young professionals.

 

In a timely report this September, MFS Investment Management published a sentiment survey focused on Generation Y investors (age 18-30 may relate to anyone). MFS found that younger investors are anxious about their investments, and as a result they are investing conservatively. I had already guessed as much gauging from conversations with my peers, but the report puts some hard numbers behind my worrisome suspicions.

So why does it worry me that Gen Y investors are being conservative with their money? In short, if investors want a comfortable retirement, they need to grow their money, and most likely they will need to grow their money at a faster rate than a conservative portfolio will accommodate.

There is a general consensus among the investment community that the younger an investor is, the more risk that investor should be willing to take with their investments. This theory relies on a few basic tenets of investing, primarily the idea that, over time, investors are rewarded for taking on risk. The more risk an investor takes, the higher their expected returns should be.

Of course, investors who will need to access their money sooner rather than later do not want to take on significant risk (rightfully), so they lower their risk in exchange for lower expected returns. Younger investors, however, are typically great candidates for taking on risk for two very straightforward reasons:

  • They have plenty of time to make back any losses, and
  • Their current savings likely make up only a small slice of their total life savings (so even if you are risking 100% of your current savings, perhaps you are only risking 5% of your lifetime savings)

Unfortunately, today’s young professionals are setting aside these ideas and choosing to be significantly risk averse. While most advisors suggest that individuals become more conservative as they age, MFS finds that Gen Y investing habits already resemble those of their Baby Boomer parents. In fact, on average Gen Y investors have more cash in their portfolios than any other age group in the survey.

With growing life expectancies, rapidly rising health costs, an expanding political will to dismantle social safety nets, and the need to keep up with inflation, young investors will likely need to save at least as much as the generations before them, and will likely need to save even more. Unfortunately, with 38% of them living paycheck to paycheck, it does not look like they are on track to do so.

We can cut this generation some slack, however. Another recent study indicates their risk aversion is a byproduct of the times. In the paper “Depression Babies: Do Macroeconomic Experiences Affect Risk-Taking?” by Stefan Nagel and Ulrike Malmendier, they concluded that experiencing negative economic events leads investors to be more risk averse. Gen Y investors have experienced two major market crashes in the last 12 years, and few are likely to recall the booming markets of the 80s and 90s. This leads them to be more risk averse than their parents and grandparents. This same phenomenon was evidenced in those who came of age during the Great Depression.

Today’s investors have an advantage over the “Depression Babies,” and that is knowledge. An awareness of how our psychology affects our actions gives us the power to invest rationally and objectively. Younger investors are informed, innovative and optimistic, and though they may be off to a slow start, they have the tools to be successful.

 

Tuesday
Aug232011

GOLD RUSH!

Well folks, Gold has finally done it.  It has attained a hallmark of many asset bubbles.  Gold has gone parabolic.

Additionally, GLD, the most popular gold ETF, just surpassed SPY (which tracks the S&P 500) as the largest ETF, as measured by net assets.

This provides a great time to reflect on gold's value as an investment and the contemporary arguments for gold investing.

The latest gold rally picked up steam in the middle of the last decade.  The trend picked up in popularity as stocks began to stumble in 2007-8.  The primary argument for gold at this point was that inflation was on its way, and gold is an excellent hedge for inflation.  Setting aside the fact that no other assets were indicating high inflation, we should ask, is gold really a good hedge for inflation?  The answer is that it has not been for the last 25 years.  In fact, gold is still 25% away from it's inflation-adjusted high... which was set 30 years ago.  So in real (inflation adjusted) terms, gold has lost value. 

Of course, that statistic cherry picks the start date as the excessive highs of 1980, but gold has had a very low correlation with inflation since.  Look at the most recent rally.  Gold has nearly tripled in value, but we have been in a period of rather modest inflation.  We can also go back and look at the entire 1990s.  The decade was an economic boom.  Stocks quadrupled in value.  Inflation was up over 30%.  What happened to gold prices?  They lost value.  They didn't keep up with stocks, and failed to even maintain their purchasing power.  The relation between gold prices and inflation is tenuous.

If I wanted to hedge for inflation, I would simply invest in short term Treasury Bills, which not only do a great job of keeping up with inflation, but outperform stocks and bonds in high inflationary environments.  Or, if I were determined to hedge with commodities, I would focus on those commodities whose prices actually work their way into inflation, such as oil, food, and metals which have industrial utility, such as copper.  Or, I could just stick with stocks, which, unlike gold, have compensated me for inflation over the past 30 years.

Inflation aside, the reason du jour for investing is gold is that it is a "currency" with no government around to erode its value.  This is certainly true, as central banks cannot yet print gold.  It is conversely true, however, that there is no gold-based economy to strengthen it's value.  At least in Tallahassee, grocery stores just will not accept doubloons.  Ignoring the fact that currency values are relative, if interest rates rise and economies recover, currencies strengthen, but there is no similar argument for gold.  The currency based gold trade is reliant on weak global economies and continued devaluation of major currencies.  However, the need and political will for economic stimulus is waning.  According to this argument, gold's rally is over once recovery begins.  Additionally, there is very little cementing gold's place as the alternative currency.  Should investors decide to abandon gold in favor of sea-shells or rai stones, there is little from stopping them. 

The aspect of the gold hype that bothers me is the disregard for risk.  Gold has been among the strongest performing assets over the past 5 years, and too often that is misinterpreted as being one of the safest assets.  Gold is a risky asset.  In the aftermath of the 1980 gold bubble, gold lost over 65% of its value.  Some perspective for those investors who have been roiled by stocks lately:  stocks lost less than 60% during the financial crisis.  You only need to go back to 2008 to find the last time that gold lost over 20%.  Gold can be just as risky as stocks, perhaps even riskier.  The more modest gold pushers argue that there is a place for gold in every portfolio.   Of course, there is no asset suitable for every portfolio, and worryingly this is the same case being made for oil in 2008 as it climbed near $150/barrel (and before it collapsed below $40).

Personally, I don't invest in gold, largely because I just don't understand it.  In addition to the above points, I don't invest in gold because it doesn't do anything for me.  Gold doesn't pay me a dividend.  Gold doesn't innovate.  If gold is underperforming I cannot replace the management.  Gold doesn't adapt to new markets.  The developing world is not depleting our gold supplies.  The emerging Asian middle class is not eating more and more gold. In fact, I have to pay someone to store my gold for me!  The gold story just does not leave me very fulfilled.

*No information in this commentary is meant to be taken as investment advice. Please contact your financial advisor before making any investment related decisions to be sure they are suitable to your needs, goals and risk tolerance.

Tuesday
Aug162011

Some Delayed Musings on the U.S. Credit Downgrade

Less than two weeks ago, S&P downgraded the debt of the United States from AAA to AA+.

This is the scenario that politicians tried to warn us about and thought they would avoid by passing a debt compromise days earlier.  Obviously, their actions were not enough to satisfy the folks at S&P's sovereign rating desk.

So what has the fallout been?  So far nothing. 

Stocks put on a wild show.  Last Monday was the sixth worst point move in the history of the Dow.  Each day proved to be about just as wild as the last, and by Friday's close we had seen one of the most volatile weeks in market history.  Since no one likes dealing with the stress of daily volatility, let's pretend we took last week off.  We would have returned to find a market that was off about 1.8% from where we left it.  If we waited for Monday's close, markets would actually be up from their pre-downgrade close.

Of course, the downgrade was in regards to our national debt, so it is plausible that stocks may be resilient, but Treasuries would definitely feel the weight of S&P's move.  Instead Treasuries rallied!  Yields fell across all maturities (even before the Federal Reserve released their statement, more on that in a moment).  The media chorus called it a flight to safety, as money flew out of stocks.  Yet here we are 1 week later, stocks have recovered, yet interest rates remain low.  Stocks reversed course, but Treasuries did not.

There are two lessons we believe can be gleaned from this scenario:

First, we believe the S&P downgrade is largely meaningless in terms of U.S. debt.  S&P has largely admitted that the downgrade has little to do with our actual creditworthiness, and more to do with political discord.  Additionally, the value of credit ratings lies in their ability to summarize credit information for debt securities.  In a complicated world of illiquid securities and complex balance sheets, we need firms like S&P to sort out the quality from the junk.  But there is no more liquid, more scrutinized debt than that of the United States.  In this case, I believe the market is a much better judge of quality than any ratings agency, and this past week the market reaffirmed our AAA rating.

Second, perhaps the more important lesson is that the Federal Reserve, through their persistent low interest rate policy, is going to control short term interest rates, now maintaining that they will remain low for the next two years.  We have long maintained that the Fed's accommodative policy will be the strongest impetus for appreciating equity values, and nothing has happened to alter that opinion.

We believe the turbulence in the wake of the S&P downgrade was simply the result of a warranted correction for a market that had gotten ahead of itself.  The effects should be short lived, and we predict stocks will finish the year safely in the green.

One more historical note: The last major economy to lose it's top debt rating was Japan.  The downgrade did not cause a collapse in their debt.  Instead it proved to be an excellent buying opportunity.  One example is not a very significant data set, but it is a clear indication that there is no guarantee the debt downgrade will be disasterous.

 

*No information in this commentary is meant to be taken as investment advice.  Please contact your financial advisor before making any investment related decisions to be sure they are suitable to your needs, goals and risk tolerance.

 

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