Archive | Behavioral finance

Is a Pullback Really a Buying Opportunity?

The Canadian, US and international markets all fell more than 5% last week, the sharpest weekly drop we’ve seen in almost four years. Then on August 24, global markets plunged even further. If you were waiting for a pullback to give you a buying opportunity, you just got it. But if you’re sitting in cash and paralyzed with fear, you’ve just learned how you can get into trouble when you invest without a plan.

Let me be clear before we go further: I’m not recommending that investors hoard cash and wait for big drops like this one. Let’s remember that the last time we saw a sharper one-week decline was September 2011. The opportunity cost of being uninvested—even for a couple of months, let alone four years—can be enormous. So if your savings are coming from a regular paycheque, you are better off setting up an automatic investment plan that removes the emotion from your decision making.

However, If you recently came into a large lump sum—from an inheritance, the sale of a property or business, or a pension payout—things are a little different. You are still likely to be better off investing the lump sum immediately rather than spreading it out over a year or two: studies have consistently shown that the all-in move delivers better results about two-thirds of the time.

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The Folly of Forecasts

The new year has arrived, which means hangovers, doomed resolutions to lose weight, and a host of forecasts from the gurus in the financial media. I’m not sure which will cause more suffering.

The attention investors give to market forecasts remains one of the great mysteries of human psychology. The evidence is overwhelming that no one possesses the ability to consistently call the direction of the stock market, bond yields, or currency rates. Yet every year the media invites experts to do what we know they can’t do. And every year investors listen to them, act on their recommendations and suffer the consequences.

One reason this is allowed to go on is that forecasters are celebrated when they’re right but rarely held accountable for their bad calls. So last year I clipped several articles that included forecasts for 2014 so we could evaluate how accurate they turned out to be.

Let’s start with Outlook 2014 by CIBC World Markets, which included the following forecasts for equities, bonds and currencies:

“US equities are hardly cheap given their run-up in 2013, but the Canadian market would appear to have more room to run … Within the equity market,

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Three Reasons to Ignore Market Downturns

“Long-term investors shouldn’t worry about daily or weekly blips in the markets.” How many times have you heard that? It’s true of course, but most investors don’t heed the advice. And to be fair, it’s hard to ignore the financial markets when there’s non-stop commentary in the news and on social media.

Since markets began falling early last month—the S&P/TSX Composite Index shed more than 11% in the six weeks following September 3—some investors are starting to get spooked. As one wrote to me recently: “A word of encouragement would be appreciated for those of us who recently began the Couch Potato plan and are now seeing our ETFs going down.”

Words of encouragement are helpful, but “don’t worry, be happy,” doesn’t cut it. So here are three specific reasons why a falling stock market shouldn’t shake your confidence in a balanced index portfolio.

1. Downturns are ridiculously normal. A reasonable expected rate of return for a global equity portfolio might be about 7% to 8%. But this is an annualized average over the very long term. In any given year, equity returns are likely to be much lower or much higher.

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Do You Really Know Your Risk Tolerance?

Almost 75 years after it was written, Fred Schwed’s Where are the Customers’ Yachts? remains one of the most entertaining books ever written about the investment industry. Here’s one of its best remembered lines: “There are certain things that cannot be adequately explained to a virgin either by words or pictures. Nor can any description I might offer here even approximate what it feels like to lose a real chunk of money that you used to own.”

As Schwed recognized all those years ago, no one can really gauge their risk tolerance by filling out a questionnaire, or by pondering standard deviations. It’s easy to say that you have a long time horizon and you won’t panic in a downturn. But the fact is, no one really knows how they will react until they have actually lived through a devastating bear market.

And if you only started investing in the last few years, you haven’t been tested yet.

According to a Bloomberg article published earlier this month, the S&P 500 has now gone more than 1,000 days without a correction of 10%. The last time investors enjoyed a run like this was a 1,127-day period that ran from July 1984 to August 1987,

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Why Practice Doesn’t Make Perfect in Investing

In almost everything we do—whether it’s learning the violin, playing chess or excelling in sports—practice makes us better. In his bestselling book Outliers, Malcolm Gladwell popularized the “10,000 hour rule.” It says no matter how talented one might be, becoming a virtuoso musician, a chess grandmaster, or an elite athlete typically requires approximately 10,000 hours of practice.

Even more important, you need to receive useful feedback during your practice. In Thinking Fast and Slow, the psychologist Daniel Kahneman explains that learning to drive is one activity where feedback is immediate and clear. When you’re taking curves, you instantly know whether you’ve turned the wheel too sharply or applied the brakes too hard. This makes it relatively easy to improve as a driver. By contrast, a harbour pilot learning to guide large ships experiences a longer delay between his actions and their outcomes, so the skill is harder to acquire.

Now consider how these ideas apply to investing. Someone who has little experience is likely to make many mistakes—which is normal in any new activity. They might think they’re well diversified even if they own just five Canadian stocks, or they may choose a bond based solely on its yield,

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How One Investor Found Inner Peace

Most people who embrace index investing are attracted to the low fees and the proven performance compared with a majority of active strategies. But another advantage sometimes gets overlooked, and that’s the peace of mind that comes from a long-term plan that allows you to ignore the distractions of daily market movements.

I recently received an email from a long-time reader named Steve, who described his investing journey. “I’m curious if my experience of ‘inner investing peace’ is unique or typical,” he says, so with his permission I’ll share some of the details.

“I’m in my mid-40s and I was already familiar with the theory behind passive investing when your blog was becoming popular back in 2010,” Steve writes. “I’d already had run-ins with expensive mutual funds, and I had already done a fair amount of (unsuccessful) investing in individual stocks as well. I had a friend who traded options, and I even dabbled in that. I then moved on to dividend growth investing for a while. My problem was I was never patient enough: I wanted results immediately.”

Shortly after the crash of 2008–09, Steve began reading about indexing and the evidence won him over,

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When the Smart Money Does Dumb Things

Investors can a learn a lot from pension funds, particularly when it comes to diversification, risk management and long-term thinking. But it seems professional money managers are not immune from the behavioural challenges that plague retail investors.

Doug Cronk, who writes a useful blog called Institutional Investing for Individual Investors, recently pointed me to a couple of industry articles that make it clear the pros are just as human as the rest of us. (I interviewed Doug last fall for an article called “Invest like a pension fund manager” in Canadian Business.)

In a February article in Pensions & Investments, a strategist explains that many pension funds have an investment plan that calls for them to increase their allocation to bonds when their plan is well funded. This is what investors might call “taking risk off the table”: the idea is that if equity markets have been strong and you believe you’re comfortably on track to meet your goals, you can afford to reduce the risk in your portfolio. However, the strategist says many fund managers are reluctant to carry out this plan: “According to their glidepath they should be starting to shift asset allocation now,” he says.

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The Failed Promise of Market Timing

I’ve long believed the most difficult part of being a Couch Potato investor is resisting temptation. Index investors are asked to be content with market returns, but they are bombarded daily by fund companies, advisors and market gurus who promise more.

Back in May 2012, I wrote about one of these enticing strategies, described in The Ivy Portfolio by Mebane Faber and Eric Richardson. The so-called Global Tactical Asset Allocation (GTAA) strategy grew out of Faber’s widely read research paper, A Quantitative Approach to Tactical Asset Allocation, first published in 2007. It begins with a diversified portfolio inspired by the Yale and Harvard endowment funds, combining traditional and alternative asset classes. The “tactical” part involves using market timing to move in and out of these asset classes based on 10-month moving averages.

Faber updated the paper in early 2013 and it now includes four full decades of data. From 1973 through 2012, the GTAA strategy shows exactly one negative year: a modest loss of –0.59% in 2008. And over those 40 years, the GTAA delivered an annualized return of 10.48% with a standard deviation of 6.99%,

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The Powerful Pull of Possibility

If the evidence in favour of passive investing is so strong, why isn’t the strategy more popular? I hear that question all the time, and there are several answers, including effective marketing by investment firms and a general lack of awareness. But there’s another reason that affects even those who are well aware of the research. It’s the deep emotional appeal that comes from the possibility—however small it might be—of achieving market-beating returns.

I thought about this recently during a conversation with an investor who was considering moving from his current advisor (who used a highly active strategy) to an indexed approach. Robert had been with his advisor for more than 10 years, and it was clear his portfolio had lagged the indexes over that period. He also complained the advisor was providing no financial planning and no tax management: there was only active investment management, and it had failed for more than a decade. Why, then, did Robert find it so hard to break free?

As we spoke, the answer became clear: Robert wasn’t disputing that indexing had a higher probability of success. He just wanted to hold onto the possibility of outperformance.

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