Archive | Behavioral finance

Are Investors Really This Clueless?

Franklin Templeton recently released its 2013 Global Investor Sentiment Survey, which polled 9,518 people from 19 countries. The survey found that 81% of Canadian investors “expressed optimism about reaching their financial goals.” However, many of the other results suggest this optimism may be misplaced.

I want to stress this wasn’t a random survey conducted on street corners, where you would expect some respondents to be oblivious teenagers or people without money to invest. All of them were at least 25 years old and owned a significant amount of stocks, bonds or mutual funds, ensuring they had “a knowledge base from which to answer the survey questions.”

Here’s the first head-slapper: 52% of Canadians in the survey believed the stock market declined or was flat in 2012. In fact, the S&P/TSX Composite was up 7.2% last year. That’s a remarkable lack of awareness that shows how many investors still refuse to believe we’ve been enjoying a bull market for more than four years. Even more amazing, almost a third of US investors also said the market was flat or down in 2012, despite a rip-roaring 16% return for the S&P 500.

Given these misperceptions,

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The Power of Simple Portfolios

Carl Richards, author of The Behavior Gap, wrote an insightful article in February called Why We Fear Simple Money Solutions. “People say they want things to be simpler—investing, life insurance, retirement planning, etc.,” he observed. “But when a simpler (and effective) option is proposed, they reject it as too simple.”

I recently came face to face with this idea when working with a client of PWL Capital’s DIY Investor Service. Barbara had a portfolio of dozens of stocks and ETFs that followed no rhyme or reason. She admitted she enjoyed making trades and was inclined to buy simply buy stocks she had read about in the media. There were some blue-chip dividend payers, a couple of precious metal ETFs, plus a few random penny stocks thrown in for good measure. In other words, the portfolio was a complicated mess.

To Barbara’s credit, she realized this sort of seat-of-the-pants strategy wasn’t working: with about half a million in her RRSP and retirement approaching quickly, she knew she needed a more disciplined plan. That’s why she came to us.

After we reviewed Barbara’s spending patterns, pension income and other factors,

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Scary When They’re Down, Scary When They’re Up

It’s been barely a month since Alexander Green remarked that we’re currently enjoying “the most disrespected bull market in history.” Green described how investors who were shell-shocked by 2008 were still pulling money out of equities and taking shelter in fixed income and cash. And until very recently, the financial media were fanning the flames of pessimism: a Wall Street Journal reporter called 2012 “another very difficult year for investors” even though the MSCI World Index was up over 16%.

I’m ready to declare this trend is reversing. I have no hard data, but in the last couple of weeks I’ve noticed a dramatic shift in the tone of reader emails. For almost three years, the common refrain was “I’m nervous about getting into stocks because the markets have been terrible lately.” But since the New Year, that’s changed to, “I’m nervous about getting into stocks because the markets have been so good lately.”

In case you missed the irony, let me hit you over the head with it: instead of being afraid because stocks fell sharply in 2008, investors are now afraid because they’ve risen sharply since 2009.

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Does a 60/40 Portfolio Still Make Sense?

For as long as I can remember, the traditional balanced portfolio has been 60% equities and 40% bonds. Indeed, all of my own model portfolios use that overall asset mix as a starting point. But a lot of industry folks are arguing that a 60/40 blend no longer makes sense.

In a recent article from the Associated Press, one fund manager put it this way: “One reason I’m skeptical about 60/40 is that it’s probably not aggressive enough, at least for a 40-year-old investor. You need to invest more in assets that are riskier than bonds if you want to meet your investment goals without having to save an extremely large percentage of your income.”

Historically, there’s no question this allocation served investors well. According to Vanguard, a portfolio of 60% stocks and 40% bonds would have returned 8.6% annualized from 1926 through 2011. Even if you subtract a full percentage point for costs, that rate of return would have been adequate to meet any reasonable retirement goal.

But that figure is based on an 86-year period where bond returns averaged 5.6%. In Canada, a diversified bond portfolio returned over 9% annually during the last 30 years as interest rates trended steadily downward,

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What Investors Can Learn From Weather Forecasts

I’ve never made a secret of my opinion that acting on market forecasts is destructive to investors. Nate Silver’s fascinating new book, The Signal and the Noise: Why So Many Predictions Fail—But Some Don’t includes some telling examples from the world of finance, but he drives home this idea even more forcefully with his insights about the weather.

Silver explains that meteorological forecasts are quite accurate if they’re made just a few days in advance, but the further out you go, the less helpful they become. Forecasts made eight days in advance are useless, and beyond that they’re actually harmful: “They are worse than what you or I could do sitting around at home and looking up the table of long-term weather averages,” Silver writes. Yet despite being aware of this evidence, The Weather Channel and AccuWeather make forecasts for 10 days and 15 days into the future, respectively.

The book also describes how for-profit weather services are more concerned with the perception of accuracy than with accuracy itself. This gives them an incentive to be bolder than they should be. If their models forecast a 50% likelihood of rain,

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A Market Forecaster’s Report Card

As 2011 came to a close, the usual army of market gurus began making predictions for 2012. I’ve often criticized market forecasters for their embarrassing track records, so this year I made a point of saving a few articles so I could see how accurate their crystal balls would turn out to be.

The first one I bookmarked was called 10 market predictions for 2012—and how to profit from them, in The Globe and Mail. The guru is a portfolio manager for the GMG Defensive Beta Fund, based in New York. Let’s see how accurate his calls turned out to be, and whether you should have acted on them.

1. The S&P 500 will rise by at least 10%.

This probably seemed wildly optimistic a year ago, but it was correct. In fact, the S&P 500 is up about 16% so far in 2012. Unfortunately, the tactical advice was less helpful: “If you have a lot of conviction this prediction will come true, you might consider buying the Russell 1000 High Beta ETF. If you think the election will work its magic,

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Don’t Invest in the Rear-View Mirror

Investors face many behavioral biases—that’s just part of being human. Perhaps the most difficult to overcome is recency bias: the tendency to believe what has happened in the immediate past is likely to continue in the future.

Although experienced investors understand short-term market movements are random, once patterns develop over three to five years the gurus start calling them new paradigms. Then they urge us to change that stodgy old strategy that isn’t appropriate anymore and encourage us to adapt to the new normal.

Problem is, while this sounds wise, it’s little more than performance chasing. What happened over the last five years cannot help you during the next five years—in fact, investing in the rear-view mirror is almost certain to produce disappointing results. To see why, let’s turn back the clock five years to the autumn of 2007, when investors were enjoying a full-on bull market following the tech wreck of the early 2000s. Imagine sitting down for a meeting with your advisor who shows you the following performance numbers:

Annualized returns: Five years ending October 2007

S&P/TSX Composite
20.99%

Russell 3000 (in USD)
14.83%

Russell 3000 (in CAD)
3.91%

MSCI EAFE (in CAD)
11.95%

MSCI Emerging Markets (in CAD)
26.97%

US dollar versus Canadian dollar
-9.51%

Source: Dimensional Returns 2.0

These results are pretty dramatic: Canada absolutely pummeled the US even when performance is measured in local currency.

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Should You Buy Stocks For Your Kids?

If you’re a parent, how can you set your child on the road to investing success?

One popular way is to buy young kids shares in companies familiar to them—maybe Disney, Apple, or McDonald’s. The idea is to get them excited about owning businesses that make their favourite products and services, with the hope that will turn them on to investing. I’m sympathetic to this idea, and it may work for some families—I’m certainly not trying to be a judgmental parent here. But I do wonder whether the best way to teach young people about investing is to turn them into stock pickers. I’ll offer three arguments against it:

It’s the wrong priority. On the list of key ingredients in an investment plan, picking the right stocks (or funds) isn’t even in the top five. At the top of the list is a commitment to regular saving. After that comes choosing the appropriate risk level for your goal, diversification, low cost, and minimizing taxes. Focusing on the stocks themselves is emphasizing the wrong part of the process. It’s like teaching your child to play hockey by buying him a cool stick rather than showing him how to pass,

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Why RESPs Should Be Kept Simple

In the last couple of weeks I’ve received two questions from readers who were trying to figure out the right strategy for their children’s education savings accounts. Both were smart questions that stemmed from things they had read on this blog, and I was eager to help. But as I thought about how to respond, I began to worry about the danger of making some investing goals too complicated.

The first question came from Karen, who had opened an RESP for her nine-year-old. Karen had read my post on bond duration, where I explained that investors should try to match the duration of their bond fund to their time horizon. She wondered if XBB (which has a duration of about seven years) would still be suitable once her child was 11 or 12. If not, what’s the best way to shorten your bonds’ duration as your child approaches university age?

The second came from Bryan, who has an RESP for his five-year-old and a second child on the way. His brokerage, TD Waterhouse, allows only family RESPs, which means he can only open a single account for both children.

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