Archive | Behavioral finance

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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Pulling Off the Bandage Quickly

Deferred sales charges (DSCs) may have been the mutual fund industry’s greatest marketing innovation. Back in the 1980s, it wasn’t unusual for funds to be sold with front-end loads of 5% or more. Then fund companies realized it’s a mistake to charge an entry fee that discourages people from buying your product. Better to draw them in for free and charge them dearly to leave: DSCs typically start at about 6% and continue on a sliding scale for six or seven years, with no time off for good behaviour.

For investors who have six-figure mutual fund portfolios, the cost of selling funds with DSCs is downright painful: in our DIY Investor Service we have worked with clients who have had to swallow more than $5,000. There are no doubt countless others who want to break free of a bad relationship and start fresh with a low-cost portfolio of index funds, but who just can’t bring themselves to fork over those DSCs. They’d prefer to sell their funds gradually over two or three years in order to reduce the upfront cost.

That’s understandable, but in most cases it’s probably the wrong decision. While there may be ways to make a gradual exit,

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More DIY Investing Challenges

In my last post, I looked at some of the biggest challenges faced by DIY investors. I came up with the list after working with clients of PWL Capital’s DIY Investor Service. The theory behind indexing is relatively straightforward, and it’s quite easy to set up a simple portfolio. But do-it-yourselfers often face obstacles when trying to implement their plan. Here are a few more that need to be overcome if you want to be a successful DIYer.

Unrealistic expectations. Anyone who works with an advisor completes a risk tolerance questionnaire, and the process is revealing. Investors often say they want an expected return of 6% to 7% (occasionally we get people who expect 8% or more) while also indicating they’ll accept no more than a 10% loss in any given year. Those goals are incompatible.

With bond yields under 3% today, a balanced portfolio of 60% equities and 40% fixed income probably has an expected return of about 5% before fees, and in a scenario like 2008–09 it could suffer a drawdown close to 20%. Unless investors understand these trade-offs they can’t hope to carry out a long-term plan.

Ignoring asset location.

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The Biggest DIY Investing Challenges

At the recent Canadian Personal Finance Conference in Toronto, I participated in a panel discussion that touched on a wide range of investing topics. My co-panelists were Michael James and financial planner Jason Heath, and we were moderated by the esteemed Big Cajun Man. The first question we were asked to address is whether it makes sense to use an advisor or to invest on your own.

That was a tough question to tackle in a room full of committed do-it-yourselfers. It’s also one I’ve struggled to answer honestly in the last couple of years. I’ve been an advocate of DIY investing for some time, and I still believe many investors with uncomplicated situations are capable of managing a simple index fund portfolio on their own. Indeed, I think anyone with less than $100,000 or so should seriously consider doing so, because it’s awfully difficult to find an unbiased, fee-based advisor unless your portfolio is larger. And unfortunately, it’s all too easy to find a commission-based mutual fund salesperson who will turn your wealth into his own.

But over the years, as I’ve corresponded with readers—and more recently started working with clients—I’ve learned that DIY investing is much harder than it sounds.

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Why Your Problem Is Not Your Funds

In Monday’s post I looked at “smart beta,” which promises to outperform cap-weighted indexing strategies. I’m frequently asked if I think Couch Potato investors should dump their traditional index funds in favour of these tempting alternatives. Here’s why my answer is no.

I could rhyme off technical reasons for being skeptical about the outperformance of alternative indexes: the research ignores costs and taxes, the strategies may not work in the future, and so on. But I won’t go down that road, because the most important reason is not technical, but behavioral.

Everything beats the market—except investors

To recap, two recent papers from Cass Business School in London looked at US stocks from 1968 through 2011, a period when a cap-weighted portfolio would have returned 9.4% annually. (Canadian stocks had an almost identical return over those 43 years.) The researchers examined 13 alternative strategies—which favoured value stocks, small-cap stocks or low-volatility stocks—and found all of them outperformed, with returns between 9.8% and 11.5%.

For many people, the takeaway from these findings is, “I should use alternative indexes, because I can beat the market by a point or two.” My reaction is different: I want to know how many investors earned even 9.4%.

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Does Dollar-Cost Averaging Work?

Many readers were surprised when I answered a recent Ask the Spud question by suggesting you’re usually better off investing a lump sum rather than using dollar-cost averaging (DCA).

DCA is popular technique that crops up all the time in personal finance books—David Chilton’s The Wealthy Barber was one of the first to popularize it back in the late 1980s. If you need a refresher, DCA is a strategy for investing a large sum gradually. For example, if you have $100,000 you might invest $25,000 today and the same amount in each of the next three quarters, or perhaps $5,000 at a time over 20 months.

The idea sounds appealing: if the markets plummet after you invest a lump sum, you’ll suffer a major loss and be filled with regret. However, by investing a little at a time you avoid putting all your money at risk immediately, and if markets decline you’ll benefit by making some of your purchases when prices are low.

Roy, the eponymous hero of The Wealthy Barber, made DCA seem like magic: “Dollar cost averaging is as close to infallible investing as you can get.

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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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