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We Eat Dollar Weighted Returns – VII

Photo Credit: Fated Snowfox I intended on writing this at some point, but Dr. Wesley Gray (an acquaintance of mine, and whom I respect) beat me to the punch. As he said in his blog post at The Wall Street Journal’s The Experts blog: WESLEY GRAY: Imagine the following theoretical investment opportunity: Investors can invest in a fund that will beat the market by 5% a year over the next 10 years. Of course, there is the catch: The path to outperformance will involve a five-year stretch of poor relative performance. “No problem,” you might think-buy and hold and ignore the short-term noise. Easier said than done. Consider Ken Heebner, who ran the CGM Focus Fund, a diversified mutual fund that gained 18% annually, and was Morningstar Inc.’s highest performer of the decade ending in 2009 . The CGM Focus fund, in many respects, resembled the theoretical opportunity outlined above. But the story didn’t end there: The average investor in the fund lost 11% annually over the period. What happened? The massive divergence in the fund’s performance and what the typical fund investor actually earned can be explained by the “behavioral return gap.” The behavioral return gap works as follows: During periods of strong fund performance, investors pile in, but when fund performance is at its worst, short-sighted investors redeem in droves. Thus, despite a fund’s sound long-term process, the “dollar-weighted” returns, or returns actually achieved by investors in the fund, lag substantially. In other words, fund managers can deliver a great long-term strategy, but investors can still lose. That’s why I wanted to write this post. Ken Heebner is a really bright guy, and has the strength of his convictions, but his investors don’t in general have similar strength of convictions. As such, his investors buy high and sell low with his funds. The graph at the left is from the CGM Focus Fund, as far back as I could get the data at the SEC’s EDGAR database. The fund goes all the way back to late 1997, and had a tremendous start for which I can’t find the cash flow data. The column marked flows corresponds to a figure called “Change in net assets derived from capital share transactions” from the Statement of Changes in Net Assets in the annual and semi-annual reports. This is all public data, but somewhat difficult to aggregate. I do it by hand. I use annual cash flows for most of the calculation. For the buy and hold return, I got the data from Yahoo Finance, which got it from Morningstar. Note the pattern of cash flows is positive until the financial crisis, and negative thereafter. Also note that more has gone into the fund than has come out, and thus the average investor has lost money. The buy-and-hold investor has made money, what precious few were able to do that, much less rebalance. This would be an ideal fund to rebalance. Talented manager, will do well over time. Add money when he does badly, take money out when he does well. Would make a ton of sense. Why doesn’t it happen? Why doesn’t at least buy-and-hold happen? It doesn’t happen because there is an Asset-Liability mismatch. It doesn’t matter what the retail investors say their time horizon is, the truth is it is very short. If you underperform for less than a few years, they yank funds. The poetic justice is that they yank the funds just as the performance is about to turn. Practically, the time horizon of an average investor in mutual funds is inversely proportional to the volatility of the funds they invest in. It takes a certain amount of outperformance (whether relative or absolute) to get them in, and a certain amount of underperformance to get them out. The more volatile the fund, the more rapidly that happens. And Ken Heebner is so volatile that the only thing faster than his clients coming and going, is how rapidly he turns the portfolio over, which is once every 4-5 months. Pretty astounding I think. This highlights two main facts about retail investing that can’t be denied. Asset prices move a lot more than fundamentals, and Most investors chase performance These two factors lie behind most of the losses that retail investors suffer over the long run, not active management fees. Remember as well that passive investing does not protect retail investors from themselves. I have done the same analyses with passive portfolios – the results are the same, proportionate to volatility. I know buy-and-hold gets a bad rap, and it is not deserved. Take a few of my pieces from the past: If you are a retail investor, the best thing you can do is set an asset allocation between risky and safe assets. If you want a spit-in-the-wind estimate use 120 minus your age for the percentage in risky assets, and the rest in safe assets. Rebalance to those percentages yearly. If you do that, you will not get caught in the cycle of greed and panic, and you will benefit from the madness of strangers who get greedy and panic with abandon. (Why 120? End of the mortality table. Take it from an investment actuary. We’re the best-kept secret in the financial markets.) Okay, gotta close this off. This is not the last of this series. I will do more dollar-weighted returns. As far as retail investing goes, it is the most important issue. Period. Disclosure: None

An Interest Hike Doesn’t Mean That Gold Price Must Crash

Summary The Fed chairwoman Janet Yellen stated that the U.S. economy is strong enough for the Fed to start raising the benchmark interest rate. The pace of the U.S. GDP growth and the inflation rate don’t indicate that there is any need to raise the interest rate. Any interest rate hike will be probably only symbolical and it won’t be followed by another interest rate hike anytime soon. History shows that gold and GLD prices often react on the interest rate changes in contrary to the theory and general expectations. Gold price has been in a strong downtrend for the last couple of weeks. The SPDR Gold Trust ETF (NYSEARCA: GLD ) reached a new multi-year low, just shy of the $100 level. It represents a more than 10% decline since the middle of October. The decline was driven by increased expectations that the Fed will raise the key interest rate as soon as in December. The probability was further supported by a very strong October job report . Although the November data are a little weaker and some of the economists, including Peter Schiff claim that the state of the U.S. economy is worse than the numbers show, statements of the Fed representatives still indicate that the interest rate may be hiked this month. According to Janet Yellen, chairwoman of the Fed, the U.S. economy is strong enough for the Fed to start raising the benchmark interest rate. Is an interest rate hike needed? The probability of a December interest rate hike is high, although I don’t see any good reason why to raise it. Yellen explained why the Fed wants to raise the interest rate when she stated : Were the FOMC to delay the start for too long, we would likely end up having to tighten policy relatively abruptly to keep the economy from overshooting. Such an abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into a recession. Yes, the reason is good. The above-mentioned statement makes sense. But the officially-presented data don’t indicate any risk of an overshooting anytime soon. The annual pace of the GDP growth rate is only slightly above 2% and the inflation rate is at 0.2%! Actually, the deflation is much more probable than overheating of the economy, according to the official data. There are a lot of discussions about the accuracy of the officially-presented data. For example, according to John Williams and his website Shadowstats.com , the current inflation rate is close to the 4% level using the 1990 methodology, and it is around 7.5% using the 1980 methodology. In this case, we can start to speak about overheating of the economy. It really seems that the Fed publicly presents one set of macroeconomic data and it makes policy decisions based on another one. (click to enlarge) Source: Trading Economics Moreover, raising the interest rate too much may damage the U.S. economy. The strong USD already has a negative impact on the U.S. exporters. It may also damage the foreign economies, as a lot of the companies around the world have big USD-denominated debts, and they are dependent on revenues denominated in other currencies. As the value of these currencies falls, the companies will have more and more problems with the debt service. There are a lot of reasons why to expect that if there is any interest rate hike this December, it will be only symbolical and it will probably take quite a lot of time before another hike will occur. There are various economists who have the same opinion and they don’t see any good reason to increase the interest rate right now. One of them is Peter Schiff who expects that the Fed will leave the interest rate unchanged or it will raise it by 0.25%. He assumes that both of the outcomes will be positive for gold, as the markets have already factored in substantially more than a 0.25% interest rate growth. How did GLD share price react in the past? Although theory says that GLD price should decline after an interest rate hike and it should grow after an interest rate cut, history shows that this anticipation is often wrong. The financial markets always try to predict the future development, and the interest rate change is often reflected by the asset prices before the rate change itself is officially announced. And if there was a strong trend before the rate change, the trend may get disrupted for some time, although it tends to resume after the dust settles down. 22 interest changes occurred since the inception of GLD. In 12 cases, the interest rate was increased and in 10 cases it was decreased. The table below shows the development of GLD share price 20, 10 and 5 trading days before the rate change and 5, 10 and 20 days after the rate change. It is interesting that on average, GLD price grew before the interest rate change and it was in a slight decline 5 and 10 trading days after the rate change. But 20 trading days after the rate change, it was back in green numbers. Only in 4 out of 12 cases (33.33%), the GLD price recorded any losses 20 trading days after the interest rate hike. It declined by 4.73% on average. On the other hand, in 66.66% of cases, the GLD price recorded gains (5.08% on average). In 4 cases (33.33%), the GLD price just kept on growing, without any reaction on the interest rate hike. After the Fed started to cut the interest rates, GLD was down in 50% of the cases after 20 trading days. After the interest rate cuts on March 18, 2008, October 8, 2008 and December 16, 2008, a strong growth trend turned into a steep decline. It shows that GLD often reacts contrary to the theory not only after interest rate hikes but also after interest rate cuts. (click to enlarge) Source: own processing, using data of Yahoo Finance and the Fed Conclusion If the Fed hikes the interest rate during its meeting on December 15/16, it doesn’t mean that gold and GLD prices must crash. The official macroeconomic data don’t indicate that the U.S. economy should start to overheat anytime soon; moreover, a too strong USD may hurt not only the U.S. economy. Any rate hike will be only symbolical and it will probably take a long time before another one will occur. The markets may actually welcome that the more than a year long saga is finally over, and the GLD price may react positively. As the not-so-distant history shows, it wouldn’t be the first time when GLD price grows after an interest rate hike. Adding to it the problems the gold miners have to face at the current gold prices and the high demand for physical gold, GLD presents an interesting contrarian opportunity.

Your Brain Is Killing Your Returns

Every year, Dalbar releases their annual “Quantitative Analysis of Investor Behavior” study which continues to show just how poorly investors perform relative to market benchmarks over time. More importantly, they discuss many of the reasons for that underperformance which are all directly attributable to your brain. (click to enlarge) George Dvorsky once wrote that: The human brain is capable of 1016 processes per second, which makes it far more powerful than any computer currently in existence. But that doesn’t mean our brains don’t have major limitations. The lowly calculator can do math thousands of times better than we can, and our memories are often less than useless – plus, we’re subject to cognitive biases, those annoying glitches in our thinking that cause us to make questionable decisions and reach erroneous conclusions .” Cognitive biases are an anathema to portfolio management as it impairs our ability to remain emotionally disconnected from our money . As history all too clearly shows, investors always do the “opposite ” of what they should when it comes to investing their own money. They “buy high” as the emotion of “greed” overtakes logic and “sell low” as “fear” impairs the decision-making process . Here are 5 of the most insidious biases that will keep you from achieving your long-term investment goals. 1) Confirmation Bias As individuals, we tend to seek out information that conforms to our current beliefs. If one believes that the stock market is going to rise, they tend to only seek out news and information that supports that position . This confirmation bias is a primary driver of the psychological investing cycle of individuals as shown below. (click to enlarge) The issue of “confirmation bias” also creates a problem for the media. Since the media requires “paid advertisers” to create revenue, viewer or readership is paramount to obtaining those clients. As financial markets are rising, presenting non-confirming views of the financial markets lowers views and reads as investors seek sources to “confirm” their current beliefs. Individuals want “affirmation” that their current thought process is correct. As human beings, we hate being told that we are wrong, so we tend to seek out sources that tell us we are “right.” 2) Gambler’s Fallacy The “Gambler’s Fallacy” is one of the biggest issues faced by individuals when investing. As emotionally-driven human beings, we tend to put a tremendous amount of weight on previous events believing that future outcomes will somehow be the same . The bias is clearly addressed at the bottom of every piece of financial literature. Past performance is no guarantee of future results .” However, despite that statement being plastered everywhere in the financial universe, individuals consistently dismiss the warning and focus on past returns expecting similar results in the future. This is one of the key issues that affect investor’s long-term returns. Performance chasing has a high propensity to fail continually causing investors to jump from one late cycle strategy to the next . This is shown in the periodic table of returns below. “Hot hands” only tend to last on average 2-3 years before going “cold.” (click to enlarge) I traced out the returns of the Russell 2000 for illustrative purposes but importantly you should notice that whatever is at the top of the list in some years tends to fall to the bottom of the list in subsequent years. “Performance chasing” is a major detraction from investor’s long-term investment returns. 3) Probability Neglect When it comes to “risk taking” there are two ways to assess the potential outcome. There are “possibilities” and “probabilities.” As individuals, we tend to lean toward what is possible such as playing the “lottery.” The statistical probabilities of winning the lottery are astronomical, in fact, you are more likely to die on the way to purchase the ticket than actually winning the lottery. It is the “possibility” of being fabulously wealthy that makes the lottery so successful as a “tax on poor people.” As investors, we tend to neglect the “probabilities” of any given action which is specifically the statistical measure of “risk” undertaken with any given investment. As individuals, our bias is to “chase” stocks that have already shown the biggest increase in price as it is “possible” they could move even higher. However, the “probability” is that most of the gains are likely already built into the current move and that a corrective action will occur first. Robert Rubin, former Secretary of the Treasury, once stated; As I think back over the years, I have been guided by four principles for decision making. First, the only certainty is that there is no certainty. Second, every decision, as a consequence, is a matter of weighing probabilities. Third, despite uncertainty we must decide and we must act. And lastly, we need to judge decisions not only on the results, but on how they were made. Most people are in denial about uncertainty. They assume they’re lucky, and that the unpredictable can be reliably forecast. This keeps business brisk for palm readers, psychics, and stockbrokers, but it’s a terrible way to deal with uncertainty. If there are no absolutes, then all decisions become matters of judging the probability of different outcomes, and the costs and benefits of each. Then, on that basis, you can make a good decision .” Probability neglect is another major component to why investors consistently “buy high and sell low.” 4) Herd Bias Though we are often unconscious of the action, humans tend to “go with the crowd.” Much of this behavior relates back to “confirmation” of our decisions but also the need for acceptance. The thought process is rooted in the belief that if “everyone else” is doing something, then if I want to be accepted I need to do it too. In life, “conforming” to the norm is socially accepted and in many ways expected. However, in the financial markets the “herding” behavior is what drives market excesses during advances and declines. As Howard Marks once stated: Resisting – and thereby achieving success as a contrarian – isn’t easy. Things combine to make it difficult; including natural herd tendencies and the pain imposed by being out of step, since momentum invariably makes pro-cyclical actions look correct for a while. (That’s why it’s essential to remember that ‘being too far ahead of your time is indistinguishable from being wrong.’ Given the uncertain nature of the future, and thus the difficulty of being confident your position is the right one – especially as price moves against you – it’s challenging to be a lonely contrarian.” Moving against the “herd” is where the most profits are generated by investors in the long term. The difficulty for most individuals, unfortunately, is knowing when to “bet” against the stampede. 5) Anchoring Effect This is also known as a “relativity trap” which is the tendency for us to compare our current situation within our own limited experiences. For example, I would be willing to bet that you could tell me exactly what you paid for your first home and what you eventually sold it for. However, can you tell me what exactly that you paid for your first bar of soap, your first hamburger or your first pair of shoes? Probably not. The reason is that the purchase of the home was a major “life” event. Therefore, we attach particular significance to that event and remember it vividly. If there was a gain between the purchase and sale price of the home, it was a positive event and, therefore, we assume that the next home purchase will have a similar result. We are mentally “anchored” to that event and base our future decisions around a very limited data. When it comes to investing, we do very much the same thing. If we buy a stock and it goes up, we remember that event. Therefore, we become anchored to that stock as opposed to one that lost value. Individuals tend to “shun” stocks that lost value even if they were simply bought and sold at the wrong times due to investor error. After all, it is not “our” fault that the investment lost money; it was just a bad stock. Right? This “anchoring” effect also contributes to performance chasing over time. If you made money with ABC stock but lost money on DEF, then you “anchor” on ABC and keep buying it as it rises. When the stock begins its inevitable “reversion,” investors remain “anchored” on past performance until the “pain of ownership” exceeds their emotional threshold. It is then that they panic “sell” and are now “anchored” to a negative experience and never buy shares of ABC again. In the end, we are just human. Despite the best of our intentions, it is nearly impossible for an individual to be devoid of the emotional biases that inevitably lead to poor investment decision making over time. This is why all great investors have strict investment disciplines that they follow to reduce the impact of human emotions. Take a step back from the media and Wall Street commentary for a moment and make an honest assessment of the financial markets today. Does the current extension of the financial markets appear to be rational? Are individuals current assessing the “possibilities” or the “probabilities” in the markets? As individuals, we are investing our hard earned “savings” into the Wall Street casino. Our job is to “bet” when the “odds” of winning are in our favor. With interest rates at abnormally low levels and now beginning to rise, economic data continuing the “muddle” along and the Federal Reserve extracting their support; exactly how “strong” is that hand you are betting on?