Volatility

3 Ways to Avoid 9 Mistakes

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Yesterday, the Dow Jones Industrial Average fell 1.2%, the S&P 500 shed 1.5%, and the Nasdaq Composite dropped 1.9%. It marked the end of a 63-day stretch where volatility has been remarkably absent. In fact, the last time we saw a streak of trading days with fewer 1% moves in either direction was in 1995.

Whether this is the start of a new period of increased volatility, or just a temporary blip on the screen, the tendency can be to react. That’s why it can be helpful to also study the history of mistakes that investors tend to make and the lessons we have learned.

Back in 2010, the Library of Congress’s Federal Research Division prepared a report titled Behavioral Patterns and Pitfalls of US Investors. The report identified common investment mistakes as cited by academics and professionals across several fields including business, economics, finance, psychology, and sociology.

The report identified nine common mistakes, which were also used as the basis for an Investor Bulletin from the SEC in 2014. The good news is that I think you can avoid making all nine of these mistakes in three relatively easy ways.

First, let's look at the mistakes.

The Mistakes

  1. Active Trading:  An investor using an active trading investment strategy engages in regular, ongoing buying and selling of investments.  This kind of investor purchases investments and continuously monitors their activities in order to take advantage of profitable conditions in the market.  The Report concludes that active trading generally results in the underperformance of an investor’s portfolio.
  2. Disposition Effect:  The disposition effect is the tendency of an investor to hold on to losing investments too long and sell winning investments too soon.  In the months following the sale of winning investments, these investments often continue to outperform the losing investments still held in the investor’s portfolio.
  3. Focusing on Past Performance of Mutual Funds and Ignoring Fees:  When deciding to purchase shares in a mutual fund, the Report indicates that some investors focus primarily on the mutual fund’s past annualized returns and tend to disregard the fund’s expense ratios, transaction costs, and load fees, despite the harm these costs and fees can do to their investment returns.
  4. Familiarity Bias:  Familiarity bias refers to the tendency of an investor to favor investments from the investor’s own country, region, state or company.  Familiarity bias also includes an investor’s preference for “glamour investments;” that is, well-known and/or popular investments.  Familiarity bias may cause an investor’s portfolio to be inadequately diversified, which can increase the portfolio’s risk exposure.
  5. Manias and Panics:  Financial “mania” or a “bubble” is the rapid rise in the price of an investment, reflecting a high degree of collective enthusiasm or exuberance regarding the investment’s prospects.  This rapid rise is usually followed by a contraction in the investment’s price.  The contraction, or “panic” occurs when there is wide-scale selling of the investment that causes a sharp decline in the investment’s price.
  6. Momentum Investing:  An investor using a momentum investing strategy seeks to capitalize on the continuance of existing trends in the market.  A momentum investor believes that large increases in the price of an investment will be followed by additional gains and vice versa for declining values.
  7. Naïve Diversification:  Naïve diversification occurs when an investor, given a number of investment options, chooses to invest equally in all of these options.  While this strategy may not necessarily result in diminished performance, it may increase the risk exposure of an investor’s portfolio depending upon the risk level of each investment option.
  8. Noise Trading:  Noise trading occurs when an investor makes a decision to buy or sell an investment without the use of fundamental data (that is, economic, financial, and other qualitative or quantitative data that can affect the value of the investment).  Noise traders generally have poor timing, follow trends, and overreact to good and bad news in the market.
  9. Inadequate Diversification:  Inadequate diversification occurs when an investor’s portfolio is too concentrated in a particular type of investment.  Inadequate diversification increases the risk exposure of an investor’s portfolio.

Three Ways to Avoid Them

1. Let the markets work for you. Outsmarting other investors is tough, especially when you add in transaction costs. Invest in the broad markets, keep your transaction costs down, and structure your portfolio around expected dimensions of returns.

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2. Diversify smartly. Diversification reduces risk that don't add to expected returns. Nearly half of the world's opportunities are outside the US.

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3. Have a plan. Investors are people that are subject to normal emotions. Having a plan in place that you can review when the going gets tough can make the difference in achieving your goals or not. Markets reward discipline.

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That's it, employ those three solutions and you will be well on your way to being a successful investor. Need help? Get in touch for a free review of your plan and portfolio.

Would You Like Insurance? A Look at the Cost of Hedging

Have you ever played blackjack when the dealer flips over an Ace and asks, “Would you like insurance?” It seems like a reasonable wager. The dealer, with an Ace showing, only needs a 10 or a face card to complete an unbeatable hand. By wagering half of the amount of the bet you already have placed, you are assured that if the house hits blackjack, you will at least break even.

But the odds against the dealer hitting blackjack are 9:4. In other words, for each 4 dollars you wager, you should win 9 dollars if the house’s next card is a 10, Jack, Queen, or King. Put another way, the dealer has a 69.23% chance of NOT hitting blackjack and collecting your insurance premium. But remember, the payout is just 2:1. Paying out 2:1 when the odds are 9:4 are a great business model for a casino, but not so much for a bettor, or an investor.

Clients frequently ask about insurance. Life, disability, and long-term care are probably the most common topics of conversation. But when the market is roaring, such as been the case since the end of the Great Recession, an increasingly popular question has centered on methods of insuring, or hedging, against portfolio declines.

There are a couple of ways to approach this topic. One is to look at statistical models to try and understand what the odds of a particular market outcome may be.  I discussed models in last week's Accountable Update. I also found a couple of 2016 articles, one in Forbes magazine and another on the blog Six Figure Investing, that discuss specific statistical models for calculating probabilities of different market outcomes.

For those that find the finer points of statistics more helpful for curing insomnia than finding your next investment, perhaps some real life examples of the cost of insurance will be helpful. We already looked at the raw deal a blackjack player receives at a casino, but another concept that just about anyone with a car probably understands, auto insurance, may provide a better comparison.

I shopped around on the internet and determined that insuring a $30,000 car with a good driving record in Texas will run about $1500 a year with a $500 deductible. While this was by no means a comprehensive study on those rates, it can provide us a guideline for how much insurance costs. In this case, it’s about 5% of the value of the vehicle to cover damages that exceed $500.

One of the most common ways of “insuring” an investment portfolio is to buy a put option. A put option, in simplest terms, is a contract that allows you to buy the right to sell a stock or index at a predetermined (strike) price at some point in the future. In other words, you can “put” it to the person who sold it to you, sort of like you put the body shop bill to the insurance company after a fender bender.

Say you have a $1,000,000 stock portfolio invested in a S&P 500® index fund that you wanted to hedge. The index closed yesterday at 2307.87. Let’s say you are concerned about a greater than 10% drop in market value over the next month or so.  A 10% drop would result in the index dropping to around 2078. Think of the 10% as your deductible, it is the losses in excess of 10% that we are concerned with protecting against. For the purposes of this example, I selected a put option at the 2080 level that expires on March 10.

To hedge a $1,000,000 position, you would first need to determine the number of contracts necessary to insure potential losses. The formula is to take your market value of your portfolio divided by the notional value of the index contract (Strike price x 100). An S&P 500® put option at 2080 x 100 = $208,000. $1,000,000/$208,000 = 4.8, which we’ll round up to 5 contracts.

5 contracts of the SPX 2080 Mar 10 Put would have cost about $1250 each, or $6,250 for the next 28 days of protection. If you repeated that each month over the next year, you would spend approximately $75,000 to insure your portfolio for a drop of more than 10%. In this example, the current cost of insuring your portfolio against greater than a 10% drop is about 7.5% on an annualized basis.

The difference between insuring your car versus your portfolio is that you can’t get around if your car isn’t working. If you aren't planning on touching your portfolio for a while, then you generally can withstand some volatility in exchange for higher expected returns.

On the other hand, if you will need to use your money in the near term, it likely is much less expensive to keep those funds in cash or bonds that are much less volatile. The tradeoff is that they earn less, but the net result is likely to be less expensive than buying protection on a stock portfolio.

This is why we advocate allocating enough of your portfolio to those less volatile assets to allow you to weather the occasional inevitable volatility. A 2.5% return may sound unappealing, until you compare it to the cost of portfolio insurance. Then, it doesn’t sound so bad.

Insurance is a necessary and useful tool to help manage risks in the right circumstances, but casinos and investors typically don't get rich by paying out more than they earn. Keep that in mind the next time you are pondering a hedge to your bets. Even better, get in touch to discuss your situation.

Bored? Keep your head up!

  Photo by JimTell

 

Photo by JimTell

I don't know who said it first, but many commentators have described certain activities (war, flying, baseball, etc) as "extreme boredom punctuated by moments of sheer terror." Recently I found myself quoting this adage to a group of 12 year old softball players that I'm coaching this summer.

The talk was in response to a couple of attention deficit moments where players were more interested in watching jet contrails than focusing on the game. The calm markets of the last couple of months may lead to similar listlessness for some. Just as a screaming line drive is sure to find the daisy picker in the outfield, the next market selloff will be an unpleasant surprise to the inattentive.

So, on this lazy summer day, take a moment to read one of my favorite poems by Rudyard Kipling. Even though it was written over a century ago, its message is as poignant today as ever. Whether you believe we are in the calm before the storm or the base camp below the summit ascent, remember that a sound plan is the best preparation for the inevitable joy or terror around the next corner. Get in touch to review your plan if you haven't done so recently.

Enjoy!

If -
By Rudyard Kipling 

If you can keep your head when all about you   
    Are losing theirs and blaming it on you,   
If you can trust yourself when all men doubt you, 
    But make allowance for their doubting too;   
If you can wait and not be tired by waiting, 
    Or being lied about, don’t deal in lies, 
Or being hated, don’t give way to hating, 
    And yet don’t look too good, nor talk too wise: 
 
If you can dream—and not make dreams your master;   
    If you can think—and not make thoughts your aim;   
If you can meet with Triumph and Disaster 
    And treat those two impostors just the same;   
If you can bear to hear the truth you’ve spoken 
    Twisted by knaves to make a trap for fools, 
Or watch the things you gave your life to, broken, 
    And stoop and build ’em up with worn-out tools: 
 
If you can make one heap of all your winnings 
    And risk it on one turn of pitch-and-toss, 
And lose, and start again at your beginnings 
    And never breathe a word about your loss; 
If you can force your heart and nerve and sinew 
    To serve your turn long after they are gone,   
And so hold on when there is nothing in you 
    Except the Will which says to them: ‘Hold on!’ 
 
If you can talk with crowds and keep your virtue,   
    Or walk with Kings—nor lose the common touch, 
If neither foes nor loving friends can hurt you, 
    If all men count with you, but none too much; 
If you can fill the unforgiving minute 
    With sixty seconds’ worth of distance run,   
Yours is the Earth and everything that’s in it,   
    And—which is more—you’ll be a Man, my son!