How to Invest Money. Why Investors That Learn to Play Defense Win at the Investing Game

How to Invest Money. Why Investors That Learn to Play Defense Win at the Investing Game

In learning how to invest money we can look to sports for useful metaphors to guide investors.

 

There are sayings in sports such as “Offense wins games and defense wins championships” or “A great offense is a great defense”.  In truth, every great team must have both a solid offense and defense but the importance of the defensive team cannot be understated.

 

In football, a good defense that can keep the opposing team from scoring makes it easier for the offensive team to win. A strong defense often leads to controlling the ball more often and having better field position.  And then there is the psychological advantage that a dominant defense can have when it shuts down the opposing team’s offense.

 

In baseball, there is the example of the no-hitter –  a complete game in which a pitcher yields no hits to the opposing team.

 

In hockey, a team can win by only scoring one or two goals, but it is very rare that a team wins when the other team puts up four or five.  One has to look no further than the recent Stanley Cup series between the Blues and the Bruins for this example.

 

When it comes to investing, however, most investors are of the mindset to be constantly playing offense.  Yet, investment markets spend most of their time declining and recovering from those declines. A powerful fraction of time is spent creating new capital or making new money.  A study by Morningstar Direct for time period 1/1/1994 to 12/31/2018 revealed that U.S. stocks spent only 19% of that time creating new capital. The other 81% of the time was spent in decline and recovery.   

 

 

For international stocks, the time spent creating new capital was even less; only 11%

 

Given these facts, then why do so few investors have a defensive strategy?  Why do most investors only consider playing “offense”?

 

Without an effective risk management strategy, a portfolio may spend excess time in decline and recovery, rather than creating new wealth.

 

The math of losses

 

It’s also important to understand that any loss, requires a greater gain to recoup the loss.  As the following table illustrates, a 20% loss requires a 25% gain to get back to breakeven. For a 50% loss, similar to what investors witnessed in 2008-2009, it requires a 100% return to breakeven!

The other side of this coin is time.  While an investor may eventually recover financially from a market loss, what is never recovered and is forever lost, is the time that it takes for the portfolio to return to breakeven.  

 

And this assumes that (a) an investor has the mental resolve to stick it out and doesn’t panic and sell somewhere along the way, and (b) that the investor is not having to liquidate portfolio holdings in order to maintain living expenses.   

 

In the former example, I know of several investors who panicked and sold,  one after the dot.com crash in 2002 and others after the credit bubble crash in 2008,  and they NEVER got back in the market! One can not overestimate the psychological scar that large market losses can inflict.  

 

In the latter example, market losses can compound as a result of investors being forced to sell holdings at lower prices often resulting in a permanent loss of capital.

 

I have previously discussed the importance that sequence of return risk plays in retirement portfolios.

 

For retirees especially, having a defensive strategy should be considered a top priority since both resources and time are diminishing and market losses may increase the chance of running out of money.

 

For younger investors, market losses will have an impact on the sum of money that they can accumulate.  It sounds silly to say “you can’t compound your losses”, yet few investors understand the importance of keeping losses small.  

 

A quick lesson in math

 

In school, we are taught that an arithmetic average is calculated by taking the sum of the units being measured and then dividing by the number of units.

 

For example, if we wanted to know the “average” height of the students in a classroom, we would simply add up the height of all of the students and then divide by the number of students.

 

The arithmetic average is effective in situations where each of the items being measured is independent of one another. The height of one student does not have any impact on the heights of the other students.

 

By contrast, in the world of investment returns, the results of one year are related to the results of the next, because both are being compounded on a dollar amount that grows in year 1 (by the returns of that year) before being reinvested (or continuing to be held for investment) in year 2. As a result, a simple arithmetic return fails to capture the compounding effects that occur from a sequence of investment returns.

 

In other words, the fact that each year’s return carries over to impact the balance being invested into the subsequent year means it’s not enough to merely add up the returns of each year and divide by how many there are, to determine the average rate of growth the portfolio actually experienced. Instead, the actual average return is somewhat lower, to account for the fact that there were both higher and lower returns that compounded along the way. This is known as the geometric mean or the geometric average return.

 

The following table illustrates this:

The difference created between arithmetic average returns versus the actual results experienced by the investor is also referred to as “volatility drag”.  The greater the volatility in the return stream, the greater the variance will be between the “average” return and the actual portfolio’s measured return.  

Subtract taxes and fees and it becomes easy to see why many investors fail to achieve their desired wealth goals.

 

Lessons for investors

 

The lessons for investors from all of this are:

 

  • Investors need to think in terms of playing both offense (being in the market) and defense (protecting capital).
  • Aside from cash, CDs and the like, no investment strategy is without the potential for losses.  Given that the geometric return will ultimately determine the amount of spendable money accumulated, investors should strive for achieving consistent returns.  Investment strategies that provide low drawdowns and more consistent returns will likely outperform strategies where there is a wide dispersion between annual returns.
  • Investors should seek out strategies that are dynamic and that can rotate between offense and defense as necessary.  The goal should be to maximize gains during optimal market periods and to protect capital during suboptimal periods.

 

Popular, traditional investment approaches that keep investors fully invested at all times fail to recognize both the nature of the markets and the mathematics of growing wealth.   

Investor Quiz

Investor Quiz

In 2015, the FINRA Investor Education Foundation conducted the National Financial Capability Study and a follow-up study to investors who invest outside of retirement accounts.  Part of the survey included a 10 question multiple choice quiz.  Only 10% of the respondents were able to answer 80% right and only 1% answered all 10 questions correctly.  

 

1. In general, investments that are riskier tend to provide higher returns over time than investments with less risk.

a.  True

b.  False

 

2.  If you buy a company’s stock…

a.  You own part of the company

b.  You have lent money to the company

c.  You are liable for the company’s debts

d.  The company will return your original investment to you with interest

e.  Don’t know

 

3.  If you buy a company’s bond…

a.  You own a part of the company

b.  You have lent money to the company

c.  You are liable for the company’s debts

d.  You can vote on shareholder resolutions

e.  Don’t know

 

4.  Over the last 20 years in the U.S., the best average returns have been generated by:

a.  Stocks

b.  Bonds

c.  CDs

d.  Money market accounts

e.  Precious metals

f.  Don’t know

 

5.  If a company files for bankruptcy, which of the following securities is most at risk of becoming virtually worthless?

a.  The company’s preferred stock

b.  The company’s common stock

c.  The company’s bonds

d.  Don’t know

 

6.  Which of the following best explains why many municipal bonds pay lower yields than other government bonds?

a.  Municipal bonds are lower risk

b.  There is a greater demand for municipal bonds

c.  Municipal bonds can be tax-free

d.  Don’t know

 

7.  What has been the approximate average annual return of the S&P stock index over the past 20 years (not adjusted for inflation)?

a.  -10%

b.  -5%

c.  5%

d.  10%

e.  15%

f.  20%

g.  Don’t know

 

8.  You invest $500 to buy $1,000 worth of stock on margin.  The value of the stock drops by 50%.  You sell it.  Approximately how much of your original $500 investment are you left with in the end?

a.  $500

b.  $250

c.  $0

d.  Don’t know

 

9.  Which is the best definition of “selling short?”

a.  Selling shares of a stock shortly after buying it

b.  Selling share of a stock before it has reached its peak

c.  Selling share of a stock at a loss

d.  Selling borrowed shares of a stock

e.  Don’t know

 

10.  Which of the following best explains the distinction between nominal returns and real returns?

a.  Nominal returns are pre-tax returns; real returns are after-tax returns

b.  Nominal returns are what an investment is expected to earn; real returns are what an investment actually earns

c.  Nominal returns are not adjusted for inflation; real returns are adjusted for inflation

d.  Nominal returns are not adjusted for fees and expenses; real returns are adjusted for fees and expenses

e.  Don’t know

 

 

 

Answers

1 – a

2 – a

3 – b

4 – a

5 – b

6 – c

7 – d

8 – c

9 – d

10 – c

What diets and investing have in common.

What diets and investing have in common.

Choose your investment plan carefully.

Type “diet” into Google and you will get over 1 billion pages.  There are popular diets like the Meditterian diet, Paleo diet, Keto diet, and the Atkins diet.  There are low-carb diets, low-fat diets, diets for weight loss, diets for weight gain and everything in between.   

Which diet is best for you is determined by many factors but probably the most important is:

What diet can you and will you stick to?  

Selecting an investment approach is really no different.  There are about as many approaches to investing as there diets.   Each has tradeoffs. But just as in selecting a diet, the best investment approach is the one that you can stick to.   

In the book, “Global Asset Allocation”, author Meb Faber outlines some of the most popular investment approaches used by investors today.  What is interesting is that while each of the approaches varies by allocation, in the end, the results are all quite similar.  

Recently Meb had this to say about the strategies:  

While in the long run, each of the strategies has provided investors with essentially similar results, the interim results of each strategy varied widely.  

How many investors would change approaches the minute they began to underperform the market or after suffering a 20% or more loss in portfolio value?

Pain or pleasure?

In the wealth of research by psychologists, Amos Tversky and Daniel Kahneman about decision-making heuristics, one of the better-known biases is loss aversion. Their studies in prospect theory found that the pain of a loss was approximately twice as strong as the pleasure from a gain.

Loss aversion may explain why people sell into a decline if their gains on holdings are dwindling toward zero. If a position is already in the red, the fear of larger losses might draw them into the stampede. It also inhibits buying back in even though the lower price has reduced valuation risk.

Every investment strategy will have periods of loss and underperformance.   That is inevitable. There are no free lunches when it comes to investing. Everything you do is a tradeoff.

Further, a study by Charles Schwab showed the willingness of investors to invest has a very high correlation as to how well they are presently doing.  In the study, they demonstrate that fund flows match very closely with the rolling percent change in the markets.

Said another way, investors show a willingness to invest when times are good but reduce their investing during periods of weakness.  If the goal is to buy low and sell high, this is the exact opposite behavior required to achieve that goal!

If a sound strategy has been chosen and future success is determined by the total amount accumulated, then consistency in contributing to the investment account is important.

Remove emotions.

Because human behavior plays such a significant role in investing, anything that can be done to minimize emotional decision making works in your favor.    

And because loss aversion can have such a significant impact on investors’ behavior and long term success, it is my belief that the best approach for many investors is those approaches that attempt to minimize losses.  

In fact, one of the very first things I do when reviewing a strategy is to look at the maximum drawdown percentage and the Sharpe and Sortino ratios.  

The maximum drawdown reflects how much a given investment strategy has declined from a peak in equity to a low, before beginning to recover.  

I believe that the greatest emotional harm comes once this number begins to exceed -20%.  Further, remember that a 20% loss requires a 25% gain just to get back to even.

By looking at the Sharpe and Sortino ratios, we get a to see how well a strategy provides returns relative to the risk of the strategy.  The higher the number, the better the investor experience.

Enjoy the ride.

I believe that the experience along the way is just as important as arriving at the destination.   

The North Yungas Road is stretch of road in Bolivia also know as the “Death Road” where a combination of single track roads, 900m high cliffs, rainy weather, limited visibility, rockfalls, and lack of guardrails, has resulted in many motorists plummeting to their death.  

While you might be lucky enough to survive the travel experience, chances are you would never do it again.

Similarly, for investors who suffered 50-60% losses in the Tech Bubble of 2001-2002 or the Credit Crisis of 2008-2009, many chose not to continue investing.  The pain of the experience became greater than the reward of success which would have come by sticking to a plan.

Again, I want to stress that every investing approach has its pluses and minuses.  

The popular approach of passive indexing suits investors just fine if the goal is simply to do as well as the market.   It’s also a good approach to take if the desire is to keep expenses as lows as possible and to minimize taxes.

As Meb Faber detailed, the long-term results very little despite different asset-allocations.  

That said, this approach has some negatives:

  • It ignores valuations.  The results of this approach when investing when market valuations are high has resulted in decade long periods of little to no return.  
  • This approach leaves the future entirely to chance as the future is unknown.  An investor may or may not earn an adequate return to meet their financial goals.
  • The approach is prone to “sequence of return risk” where the order in which the returns come is just as important as the returns themselves.
  • Buy and hold subjects the investor to holding through periods of market declines which may be both emotionally difficult to withstand as well as mathematically difficult to recover from.
  • Large losses (drawdowns) often require prolonged periods of time to recover from.  While the money of market losses may eventually be recovered, the time it takes will never be.  Additionally, if the drawdown occurs during a period of required capital withdrawal, more of the portfolio must be liquidated or the distribution size reduced, each of which may have negative consequences.

Another approach is to use low-cost index funds but within the context of a rules-based process.  

The pros of such a strategy include:

  • Avoiding large drawdowns during periods of market weakness through the use of downside loss rules.  This keeps losses smaller which is easier on both the account and the emotions.
  • More consistent gains with smaller losses along the way make it easier to reach your financial goals because compounding is more consistent.  In the long run, this can lead to a greater cumulative return than a pure buy and hold approach.
  • Allocating to the sectors, industries and asset classes that are performing well and avoiding those that are not can help accumulate returns in excess of market returns.
  • Since the buy and sell rules are predetermined by the system, investors are less likely to let their emotions sabotage their own success.

While these are certainly positives, remember that there is no perfect approach.  Every investment approach has it’s positive and its negatives.

Risk never is completely eliminated but rather is transferred into another form.  

A purely passive index approach assumes market risk whereas the rules-based approach assumes process risk.  This may include:

  • An approach that actively mitigates risk may go through periods where it underperforms the market.   
  • More transactions increase transactions costs.
  • More transaction decreases the tax efficiency making them more suitable strategies for tax-qualified accounts such as IRAs and qualified plans.

Just as in selecting a diet, the key to selecting an investment approach should be based upon the desired outcome and the individual.   

In the end, what matters most is your ability to consistently stick to the plan.    

 

We have met the enemy and he is us.

We have met the enemy and he is us.

Investors Predictably Underperform

Investors face three primary challenges:  Behavior biases; loss of compounding from large portfolio losses; and the opportunity cost of being too conservative.  This article looks at behavioral biases.   

Boston-based DALBAR, Inc has been studying investor behavior since the late 1970’s. Each year, DALBAR’s annual Quantitative Analysis of Investor Behavior (QUAIB) has measured the gap between leading indicators of investment performance and what investors actually earn from mutual fund investing.  

The study measures the effects of an investor’s decision to buy, sell, and switch in and out of various mutual funds over different time frames. And the results consistently show that the average investor earns less, in many cases much less than the returns reported in the mutual fund’s performance report.

Their research proves that individual investors wait to buy until the market has gone up and then they sell after it drops. Of course, no one would want to admit that they invest like this, by the research shows time and again that investors do the EXACT OPPOSITE of what they need to do to be a successful investor.

In 2018, DALBAR reported that the 20-year annualized S&P return was 7.20% while the 20-year annualized return for the average equity mutual fund investor was only 5.29%, a gap of nearly 2% per annum.

And when you look even closer, it doesn’t matter what the time frame is, individual investors still underperform.  

Another interesting piece of Data gleaned from the DALBAR data has to do with retention rates.  Even though many investors would say that they are investing for the “long term”, the average retention rate for most mutual funds is less than five years – hardly long term.   

Why is this? How could investors do so poorly even during periods of strong economic prosperity?

Human emotion.  

It’s the emotions of fear and greed with a healthy dose of herd behavior (individual investors acting collectively as a whole without central direction) that have long been seen as main drivers of investor behavior and irrational investment decisions.

Investors are constantly in search of the “story” stock or for the latest “hot fund” and are willing to jump in with both feet when it feels right.  

Worse yet, when things go south, investors start to feel awful and they end up liquidating their investments at the worst possible time.

You are your own worst enemy.

It’s nothing personal.  Truth is, I’m no exception.  When it comes to investing putting money at risk we are all our own worst enemy.

Why? Because we’re human.

And as well intended as we may be … we can all behave irrationally.

This has given rise to a new field of study called behavioral finance.  Don’t worry, I’m not going to go off on some tangent here, you just need to know that the effects of human emotion are so powerful, there are entire subsections of economic research devoted to trying to understand it.

In short, behavioral finance attempts to provide an explanation for why people make irrational financial decisions. It tries to understand that when your money is on the line, riding the market’s peaks and valleys, why do we have a natural tendency to do the opposite of what we should be doing.

The human brain is capable of incredible things, but it’s also extremely flawed at times.

Science has shown that we tend to make all sorts of mental mistakes, called “cognitive biases”, that can affect both our thinking and actions. These biases can lead to us extrapolating information from the wrong sources, seeking to confirm existing beliefs, or failing to remember events the way they actually happened!

Recently a study identified 188 cognitive biases, systematic patterns of behavior and irrational thinking that the human brain performs.

To be sure, this is all part of being human – but such cognitive biases can also have a profound effect on our endeavors, investments, and life in general.

But, once you see the proven patterns of our “behavioral tendencies”, you can remove an enormous amount of human emotion by using a systematic and formulaic process.

Systematic investing demands a level of rigor, clarity, and consistency beyond industry standards of asset management. The framework calls for a set of precise mathematical or quantitative methodologies that differ from more commonly used fundamental processes built on narratives and forecasts.

When investors have a structured, rules-based process to invest with, it leaves less room for any of these 188 biases to interfere.   

Just what rules to use and how to adopt a rules-based process will be the topic of a future post.   

 

Systems are everywhere…so why aren’t they in your portfolio.

Systems are everywhere…so why aren’t they in your portfolio.

Why systems should be part of your investment process.

Systems exist everywhere. In nature, we find almost an infinite number of hierarchical, interconnecting ecosystems that play key roles by which energy is transported and transformed. These natural systems can have a profound impact on our activities. Consider how the weather and climate systems affect our daily lives.  

Even our bodies are collections of intricate systems each performing a function critical to our survival.  

There are legal and political systems designed to create order and keep the peace.

Many systems operate in concert with our daily lives.

In society, we find that systems can provide for organization and guidance for human interactions. Take for instance how we drive. We follow a precise system.  

Here in the U.S., we drive on the right. We stop on red. We accelerate on a green.  And by everyone following this system, we are able to transport ourselves safely from one destination to another.

Or think about how when we arrive home at night and turn on the lights, we take for granted the electrical system that allows for energy to be converted to light.  These systems are so common we never once question their existence.

We have formed legal systems so as to provide a systematic, orderly and predictable system by which we can resolve conflict and provide for our general safety.

We have formed political systems so as to organize around various ideologies and to allow an orderly process to govern.

Without systems, we would live in a state of anarchy.

And systems are designed to provide a certain degree of predictability.

Yes, systems exist everywhere we look — except in most investors’ approach to investing.  

Why not have systems for investing?

When we examine the typical approach of many investors, we often find that it is completely random. Tips, newsletters, sound bites from financial media, advisor recommendations, friends and family, and the Internet all are the typical sources of investor “information.”

Pure entropy.

Without systems, there can be no order.

Without systems, there can be no degree of predictability.

Imagine if every time we flipped on the light switch we had to hope that it worked — that the outcome was completely random. How frustrating would that be?

Yet, that is exactly how most investors invest.  

The future is unknown.  That is one certainty about life in general, investing is no exception.

But imagine if we invest using rules and systems that are designed to be more predictable in their application. And imagine that the rules never deviate. Now, no matter what the markets provide investors, we are suddenly in control because of the structure provided by a systematic approach.

Systems provide a more predictable process to unpredictable information.

So what kinds of systems might an investor want to consider and how does an investor go about implementing a systematic approach?

These are the topics of much deeper explorations in future posts, but for now, consider the following:

What if we had a systematic way to determine the best asset-classes that deserve the attention of our funds based on current information and just as importantly, we knew where not to be placing our hard earned money?

In a similar fashion, we can use systems to determine the best industry and sectors and equally important to avoid those sectors and industries performing poorly.  

Through the use of systematic screening and ranking processes that are 100% definable and data-driven, we can quickly sift and sort through thousands of stocks to find the very best ones that meet our criteria.   

Systems can also be used to gauge the general health of the financial markets. Just as we use instruments to define weather conditions, we too can use the systematic application of measuring tools to define the general health of the market.  

Know your expected outcome before you trade.

Perhaps one of the most important benefits of applying systems to money management is the idea of expectancy — how an investor can practically know the expected outcome of a trade.   

That is the power of using systems and why every investor should consider using them.

But before we get to that, we need to understand perhaps the most important reason to use systems and that is this: Most investors are hard-wired to fail.  

Systems help us overcome this by providing a means for investors to minimize the involvement of their emotions.  We’ll dive into this deeper into how this works in future posts, but for now, we’re simply highlighting what you already intuitively know: Systems are everywhere, and without them, we’re left with chaos.