Investment Strategies and short-term turmoil: sometimes it is better not to watch!

Maybe the last few days of investment market turmoil need to be put in the same category along with legislation and sausage – that you don’t to watch while it’s being made….

You investments will ultimately provide returns, but you probably did not need to watch as the stock markets slid last Thursday and again Friday, bounced around Monday and then shot back up on Tuesday

It may have been confusing or even scary. However, as you always hear us say, the key is sticking to your investment allocation and long-term strategy… that is what works over time.

Here is an interesting example of why investment allocation is so important.

* On Monday, many investments were down, but not all. There are funds we use that were up significantly on that day.

* The same funds were also up on Tuesday

In contrast, if you panicked and sold some time on Friday to sit in cash or gold, you missed the upswing of the last few days. Staying invested worked better than any timing attempts.

Therefore, diversification by asset class, and staying with your strategy, can provide positive results even in times of turmoil.

Let me know if you have questions or comments …. and good luck!

Faults of the Individual Investor to Avoid (Reasons for Impartial Advice)

Individual investors historically act as a contrary indicator. That is, looking at recent events, they assume that a market going up will continue to go up, or that a falling market will continue to fall. The individual investor fixates on the past, as if it will continue, rather than gauging the future. With this perspective, the behavior of the individual investor is to buy at the peak and sell at the trough, hence making them a contrary indicator to what will really occur. Countering this behavior takes substantial discipline, experience and information, and usually a good advisor.

A good advisor should add value through asset allocation and fund selection, but foremost by guiding you to counter bad investment behaviors. You need to stay invested when you fear a fall and sell when you are convinced of sure upswings. Advisors need to provide value-added guidance that will:
(1) avoid giving any serious weight to short-term indicators;
(2) avoid trying to pick “winners”;
(3) closely examine expenses, as high costs result in much lower net returns;
(4) investigate riskier classes as a component of a good overall asset allocation (e.g., emerging markets);
(5) look for funds that stick to their own goals, rather than trying to match any index, as such discipline pass off over time;
(6) take a contrarian view at times because too often a fund doing well at a given time will ultimately revert to the mean of all funds; and
(7) be clear with clients on the risks being taken (that is, measure the risks for say a bond differently than stocks).
All these are ways in which advisors increase the chance that you achieve good investment returns over time.

Recent history provides a good example. With the crash in 2008, we spoke to many clients and started a flow of e-mail updates and strategy suggestions. This became our newsletter on our web site. The key advice was that, if you have a good allocation, and good investments, stick to your long-term plan, do not sell. Those of our clients who followed the advice returned to their pre-crash peak values by last year, something none of us thought would be possible so soon. However, those that sold were selling as investments declined in value. Moreover, they had no clear signal in mind as to when to reinvest. That meant that most missed the rise of greater than 11% in the beginning of 2009. That upswing can never be regained. Therefore, they sold at a low point and were forced to buy back in at a higher point.

How could those that stayed invested be back to their peak when most indices have not returned to their all-time highs? A well-managed portfolio, employing good asset allocation, will not drop as much so it will have less to recover to be “whole.” Therefore, it could regain its peak value more easily, and with less risk. Again, this points to all that we have published before on the need for asset allocation analysis and diversification within each investment type as well as among investment types. It also makes clear how important not losing capital is: losing 50% requires a 100% gain to recover, while losing 25% takes only a 33% gain.

Good investing will lead you to avoid the behaviors that constitute what Carl Richards dubbed the “Behavior Gap” (April/May issue of Morningstar Advisor), meaning the gap between investment returns and investor returns. Simply opting for index funds is not a quick fix that works. Instead, individual investors require guidance. They can have the best possible investment approach “only to blow it up completely with one big behavioral mistake at the wrong time.” He goes on to write that all approaches are tested over time, so the advisor’s role is one of helping “rid the world of negative behavioral alpha, to close the Behavior Gap.”

In another article, he writes that “ … if 83% of mutual fund investors are getting advice from advisors and are doing poorly, maybe we advisors are part of the problem. (See First, Do No Harm by Carl Richards 02-10-11) To state the opposite side, “Still the trend seems clear. Investors who were inclined to invest for the long term were likely to have better returns. A look at how the markets have worked during the past 10 years illustrates why that is. We had two bear markets and two dramatic rallies. Those who sold equities in the bear market missed out on the rally and therefore nearly all would have been better off riding out the bear market.” (Inside the Vanguard Science Project Vanguard’s more-patient shareholders outperformed the rest. by Russel Kinnel 05-05-11)

Investors doing all the work with no advisors have access to good tools, such as E-Z Planner for retirement planning, but that can be dangerous. Again, the risk of bad input, generating bad outcomes, comes from the same issues of perspective and bad investment behavior. With an objective source to counter your own bias or “bad investment behavior,” this can be avoided. For example, in addition to the investment issues reviewed above, most individuals understate spending. “Oh, yes, we did buy [something] last year, but that was a one-time event.” Each year will have “one-time” events. Building a good plan takes some means by which tough questions like cash flow and investment risk are addressed. Otherwise, the best software will produce results with erroneous conclusions.

You need terrific discipline or good advice to resist psychology of risk aversion and the urge to use recent events as a gauge for what will occur next. Otherwise, your investor returns will fail to match investment returns over time.

Having said that, what is the Next Step:
First, review how your portfolio performed in recent times, did you react from fear and leave your strategy or hold on?
Second, review your portfolio; does it fit your risk tolerance and financial goals?
Third, take a second look at your portfolio, but from a contrary perspective; did your answer on risks match the actual investments made? (For example, someone claiming worry about the economy should not be 80% in US stocks.)
Finally, check to see if the portfolio, with any on-going savings, will be sufficient to achieve your financial goals. If you are not certain, then advice from an objective source could make a substantial, and very important, difference.

Need help? Contact us!

Long-term investing pays off

What does it mean, in today’s world, to invest long-term, that is to buy and hold funds or managers for years? The question is a serious one in that investment performance is measured over very short periods and then comparisons are made. Such analysis fails to account for whether a strategy has had time to realize its goals, let alone whether competing strategies have had a chance as well.

The short-term rating of investments has two serious problems: it forces many managers to push for short-term results, often leading them to drift from their announced strategy (or turn over their portfolios each year, which increases transaction costs and taxes due), and it leaves investors looking for results too soon, so that they may end up selling what may be a great long-term investment because a competitor looks better in the short run.

How do you guard against this? First, understand that the volatility you see in the short term dampens down over time. That is, swings in the stock market could be plus or minus 30% in a year but come down to plus or minus say 5% for a 5 year annualized return. Second, realize that you are giving your strategy a fair chance by waiting, rather than panicking or responding on impulse. Third, realize that the real way to ultimately achieve good returns from the market is by waiting. The uncertainty built into the market means that it rewards those who can wait, and they are the ones with lower trading costs and less taxes due.

How do you find managers to help you invest this way? Look for those with low turnover of key people, who invest in their own funds, and who have the conviction to stick to their strategy even when it is out of favor. They often buy a stock that continues to go down in price before it ultimately turns up, over time.

So be a contrarian, invest for the long term!

Let us know if you have questions or comments. Thanks,


Investments: the right fund does not have to be a winner

When building your portfolio, what criteria do you use to select the component investments? With the recent market dive, and then the surge this year, how do you know what works?

The Moringstar article reprinted below responds to the idea some investors have of trying to find The Best fund or manager by saying: “But the real question is why even try. Investing is about identifying options that help fulfill goals, not about finding that lone fund that is superior to all others. Splitting hairs in a quest for one be-all-and-end-all fund has diminishing returns and often can do more harm than good”

This is why financial planners and investment advisors build a portfolio to meet long-term goals. Much of the return generated over time comes from your asset allocation, not the specific fund selection. Having a winner in one year may mean having a loser in another. It is better to have good, steady performance over time in order to meet your goals.

Here is an example of how the goal drives the fund selection: We all know that money market funds have very low yields now, so it is tempting to use short-term bond funds as an alternative. However, if the money is for a big purchase, such as a car, or for college tuition, the risk of a loss even in a short-term bond fund is too great – the goal says stick with the money market fund.

Let me know if have questions on investment selection and portfolio construction.



Seek the Right Fund, Not the ‘Best’ Fund

by Eric Jacobson | 01-14-10

With such extreme returns over the past couple of years it’s worth reiterating some basic tenets of fund evaluation that can be overlooked when the market is zooming back and forth.

The Highest Return Does Not the Best Manager Make
During short time periods, some funds stand out with such remarkable gains that those returns alone appear to be proof positive of a manager’s superior talent. However, there are plenty of reasons such numbers don’t guarantee superior management. The most obvious and important is that single periods are reflective of factors that may not be repeated the next time around. Many funds with outstanding 2009 returns could serve as an example. One of the clearest is the closed-end Eaton Vance New York Muni EVY, now appearing prominently on 2009 leaders’ lists. This fund’s NAV went up 62% in 2009 while its market price soared an incredible 94%. But the firm’s own executives say those gains were largely the flip side of a harrowing 48% 2008 loss–one of its category’s worst declines–that was in part due to the same portfolio leverage that fueled it in 2009. Therefore, only by evaluating the fund’s performance over a much longer period of time could one reasonably evaluate its managers’ true abilities. Just as important: Banking on this fund to again produce anything close to the kind of returns it earned in 2009 would be a mistake.

Longer Periods Can Prove Arbitrary and Thus Misleading
Is a single calendar year any more relevant to judging the skill of an investor than a period of a different length? Are one-, three-, and five-year trailing periods any more valid than those covering two-, four-, and six-year returns? The investment industry uses the first set of specific periods out of convention and convenience, and for the purposes of comparison they have some utility. But short periods can easily cause unusual distortions even in longer-term performance numbers; a fund’s history of trailing returns can shoot up or crumble in the face of a severe short-term gain or loss. For this reason, looking only at a few select periods doesn’t fully reflect the investor experience over time. We see the effects of this problem every so often whenever the debate over indexing versus active management heats up. At any given time historical returns may confirm what everyone knows, which is that indexing beats active management–except during all those times when the opposite is proved.

The best assessment of a manager or strategy has to involve looking at multiple periods over time, sometimes slicing them up to better understand the effects of market moves, and to include as many as possible. Rolling returns are good for this purpose and provide insights unavailable in trailing or calendar-based periods.

Certainty Is Elusive
There’s a clear desire for many of us to come to final conclusions that one fund or style is demonstrably and conclusively better than another. That’s understandable, because that search is almost always undertaken when preparing to make an investment decision. For such an important task, it makes perfect sense to seek out conclusive proof that the decision you’re about to make is the right one.

But while one can do a pretty good job of narrowing down a big universe of investment choices to a handful of good options–ideally sifting out most of the truly bad and many of the mediocre ones–identifying the “best” fund of any particular kind is a lot more difficult.

Aside from the time-period factors, there’s a fundamental issue that in the mutual fund world, in particular, there’s a surprising variety of differences when it comes to the actual investment mandates and parameters of funds. Even two with almost identical names in the same category may have quite different management styles. On the equity side, for example, we often see this most starkly among value funds. A fairly conventional one might define its approach primarily in terms of selecting stocks that are demonstrably cheaper by some measures than, say, the average name in the S&P 500. Another might be a much “deeper” value player, though, or even one that focuses on companies in distressed situations.

The differences among bond funds might be less obvious, but two otherwise conventional intermediate-term bond funds can have very similar mandates, use the same benchmark, and still differ meaningfully. One that pursues a so-called core-plus strategy (a tag common to the institutional market), for example, might do so by including as much as 15% or 25% in high-yield bonds. Another might do so by focusing a similarly sized bucket on high-quality, non dollar bonds. And yet others might reserve a bucket eligible for either and perhaps even throw in some emerging-markets debt.

One can reduce lists of funds down to a handful of demonstrably very good managers yet find it almost impossible to conclusively determine that one is objectively “better” than the others given the variations in their styles.

But the real question is why even try. Investing is about identifying options that help fulfill goals, not about finding that lone fund that is superior to all others. Splitting hairs in a quest for one be-all-and-end-all fund has diminishing returns and often can do more harm than good.

Eric Jacobson is a mutual fund analyst with Morningstar.

Let us know if you have questions or comments. Thanks,


When Peter Lynch investment ideas don’t work

Remember when Peter Lynch, then of the Magellan Fund, said that sometimes you can find a great investment by just looking around you?

The article below shows that there are serious pitfalls in sticking to companies you know and like. That worked once for Starbucks, but it is no longer a good stock in which to invest (others in that market are doing better).

Sometimes you can find real value, but as with any other investment, you need to do your homework….



Familiarity Can Breed Bad Investment Decisions

by Mike Taggart | 10-27-09 |

When considering stocks to invest in, many investors gravitate toward well-known companies. Whether blue-chip stocks, longtime favorites, or companies that are often in the news, there seems to be something inherently comfortable about investing in a well-known stock. However, this comfort can be at best superficial and at worst catastrophic to portfolio performance. The reason behind the comfort is what’s known as the illusion of knowledge.

Most of us know someone who has won a bet on a sporting event after basing his decision on nothing more than the teams’ colors. This goes against our intuition. How can such a basis for decision-making beat out other bettors who are well-schooled and more knowledgeable about the sport? It’s not simply luck. It’s that our intuition can fool us. The illusion of knowledge tells us that having more information about something, like a stock or a publicly traded company, will increase our predictive accuracy about future events. Studies have shown, however, that more information can actually decrease predictive accuracy and, simultaneously, increase our confidence. In other words, I think I know more about something than I actually do, so I believe that I can more accurately predict future events around this subject and I am extremely confident in my belief.

How does this fallacy appear in investing? One example could be placing stocks of local companies in client portfolios. After all, they are local companies. We read about them in the local press daily. We know people, maybe even executives, who work at the firm. Maybe a client works there or has friends or family who do. We seemingly know how well the firm is performing by collecting information from the newspapers or from social encounters. Such methods of collecting information for an investment can lead to anecdotal bias. (We collect a few anecdotes about a firm and extrapolate that evidence onto a broader frame, not understanding the missing pieces of our knowledge.)

At Morningstar, we provide equity research coverage on about 2,000 companies. As stock analysts, we are not immune to behavioral finance issues. In fact, we deal with them everyday. Our awareness, however, has led us to certain processes in our routines to ensure that we are not succumbing to biases. Performing scenario analysis on every stock we cover, for example, forces us to take a broad view of likely outcomes. And while we do speak with company management teams, we curb the anecdotal bias by corroborating data against regulatory filings and other management teams’ comments within the same industry. Battling our own behavioral biases is tough work, but we guard against it vigilantly. [The article goes on to discuss screening stocks by location, competitive advantages, and who in the company is running it and for whom, their own reward or shareholders?]

Let us know if you have questions or comments. Thanks,