Tag Archives: contests

Why You Should Question ‘Buy And Hold’ Advice

I recently received an email from an individual that contained the following bit of portfolio advice from a major financial institution: “Despite the tumble to begin this year, investors should not panic. Over the long-term course of the markets, investors who have remained patient have been rewarded. Since 1900, the average return to investors has been almost 10% annually…our advice is to remain invested, avoid making drastic movements in your portfolio, and ignore the volatility.” First of all, as shown in the chart below, the advice given is not entirely wrong – since 1900, the markets have indeed averaged roughly 10% annually (including dividends). However, that figure falls to 8.08% when adjusting for inflation. Click to enlarge It’s pretty obvious, by looking at the chart above, that you should just invest heavily in the market and “fughetta’ bout’ it.” If it was only that simple. There are TWO MAJOR problems with the advice given above. First , while over the long term the average rate of return may have been 10%, the markets did not deliver 10% every single year. As I discussed just recently , a loss in any given year destroys the “compounding effect”: “Let’s assume an investor wants to compound their investments by 10% a year over a 5-year period. The “power of compounding” ONLY WORKS when you do not lose money. As shown, after three straight years of 10% returns, a drawdown of just 10% cuts the average annual compound growth rate by 50%. Furthermore, it then requires a 30% return to regain the average rate of return required. In reality, chasing returns is much less important to your long-term investment success than most believe.” Here is another way to view the difference between what was “promised,” versus what “actually” happened. The chart below takes the average rate of return, and price volatility, of the markets from the 1960s to present and extrapolates those returns into the future. Click to enlarge When imputing volatility into returns, the differential between what investors were promised (and this is a huge flaw in financial planning) and what actually happened to their money is substantial over the long term. The second point, and probably most important, is that YOU DIED long before you realized the long-term average rate of return. The Problem With Long Term Let’s consider the following facts in regards to the average American. The national average wage index for 2014 is 46,481.52, which is lower than the $50,000 needed to maintain a family of four today. 63% of can’t deal with a $500 emergency 76% have less than $100,000, and 90% have less than $250,000 saved. If we assume that the average retired couple will need $40,000 a year in income to live through their “golden years” they will need roughly $1 million generating 4% a year in income. Therefore, 90% of American workers today have a problem. However, what about those already retired? Given the boom years of the 80s and 90s that group of “baby boomers” should be better off, right? Not really. 54% have less than $25,000 in retirement savings 71% have less than $100,000, and 83% have less than $250,000. (Now you understand why “baby boomers” are so reluctant to take cuts to their welfare programs.) The average American faces a real dilemma heading into retirement. Unfortunately, individuals only have a finite investing time horizon until they retire. Therefore, as opposed to studies discussing ” long-term investing ” without defining what the ” long term ” actually is – it is ” TIME ” that we should be focusing on. When I give lectures and seminars, I always take the same poll: “How long do you have until retirement?” The results are always the same in that the majority of attendees have about 15 years until retirement. Wait… what happened to the 30 or 40 years always discussed by advisors? Think about it for a moment. Most investors don’t start seriously saving for retirement until they are in their mid-40s. This is because by the time they graduate college, land a job, get married, have kids and send them off to college, a real push towards saving for retirement is tough to do as incomes, while growing, haven’t reached their peak. This leaves most individuals with just 20 to 25 productive work years before retirement age to achieve investment goals. Here is the problem. There are periods in history, where returns over a 20-year period have been close to zero or even negative. Click to enlarge Click to enlarge This has everything to with valuations and whether multiples are expanding or contracting. As shown in the chart above, real rates of return rise when valuations are expanding from low levels to high levels. But, real rates of return fall sharply when valuations have historically been greater than 23x trailing earnings and have begun to fall. But the financial institution, unwilling to admit defeat at this point, and trying to prove their point about the success of long-term investing , drags out the following long term, logarithmic, chart of the S&P 500. At first glance, the average investor would agree. Click to enlarge However, the chart is VERY misleading as it only looks at data from 1963 onward and there are several problems: 1) If you started investing in 1963, at the end of 1983 you had less money than you started with. (20 Years) 2) From 1983 to 2000 the markets rose during one of the greatest bull markets in history due to a unique collision of variables, falling interest rates and inflation and consumers leveraging debt, which supported a period of unprecedented multiple (valuation) expansion. (18 years) 3) From 2000 to Present – the unwinding of the stock market bubble, excess credit and speculation have led to very low annual returns, both a nominal and real, for many investors. (15 years and counting). So, as you can see, it really depends on WHEN you start investing. This is clearly shown in the chart below of long-term secular full-market cycles. Click to enlarge Here is the critical point. The MAJORITY of the returns from investing came in just 4 of the 8 major market cycles since 1871. Every other period yielded a return that actually lost out to inflation during that time frame. The critical factor was being lucky enough to be invested during the correct cycle. With this in mind, this is where the financial institutions commentary goes awry with selective data mining: “Among the key findings: On average, participants who kept contributing to their retirement plans throughout the 18-month period (October 2008-March 2010) had higher account balances than those who stopped contributing; Participants who maintained a portion of their retirement plan asset in equities throughout the entire period ended up with higher account balances than those who reduced their equity exposure amid the peak period of market distress. Click to enlarge Thus, retirement investors who kept contributing to their plan and who maintained some exposure to equities throughout the period were better off throughout the market’s 18-month bust-boom period than those who moved in and out of the market in an attempt to avoid losses. Retirement investors who kept exposure to equities amid the peak of the global financial crisis ended up with higher account balances on average than those who reduced their equity exposure to 0%.” The main problem is the selection of the start and ending period of October 2008 through March 2010 . As you can see, the PEAK of the financial market occurred a full year earlier in October 2007. Picking a data point nearly 3/4th of the way through the financial crisis is a bit egregious. In reality, it took investors almost SEVEN years, on an inflation-adjusted basis, to get ” back to even. ” Every successful investor in history from Benjamin Graham to Warren Buffett have very specific investing rules that they follow and do not break. Yet Wall Street tells investors they CANNOT successfully manage their own money and ” buy and hold ” investing for the long term is the only solution. Why is that? There is a huge market for ” get rich quick ” investment schemes and programs as individuals keep hoping to find the secret trick to amassing riches from the market. There isn’t one. Investors continue to plow hard earned savings into a market hoping to get a repeat shot at the late 90s investment boom driven by a set of variables that will most likely not exist again in our lifetimes . Most have been led believe that investing in the financial markets is their only option for retiring. Unfortunately, they have fallen into the same trap as most pension funds which is that market performance will make up for a ” savings ” shortfall. However, the real world damage that market declines inflict on investors, and pension funds, hoping to garner annualized 8% returns to make up for the lack of savings is all too real and virtually impossible to recover from. When investors lose money in the market it is possible to regain the lost principal given enough time, however, what can never be recovered is the lost ” time ” between today and retirement. ” Time ” is extremely finite and the most precious commodity that investors have. With the economy on a brink of third recession this century, without further injections from the Fed to boost asset prices, stocks are poised to go lower. During an average recessionary period, stocks lose on average 33% of their value. Such a decline would set investors back more than 5-years from their investment goals. This leads to the real question. “Is your personal investment time horizon long enough to offset such a decline and still achieve your goals?” In the end – yes, emotional decision making is very bad for your portfolio in the long run. However, before sticking your head in the sand, and ignoring market risk based on an article touting ” long-term investing always wins, ” ask yourself who really benefits? As an investor, you must have a well-thought-out investment plan to deal with periods of heightened financial market turmoil. Decisions to move in and out of an asset class must be made logically and unemotionally. Having a disciplined portfolio review process that considers how various assets should be allocated to suit one’s investment objectives, risk tolerance, and time horizon is the key to long-term success. Emotions and investment decisions are very poor bedfellows. Unfortunately, the majority of investors make emotional decisions because, in reality, very FEW actually have a well thought out investment plan including the advisors they work with. Retail investors generally buy an off-the-shelf portfolio allocation model that is heavily weighted in equities under the illusion that over a long enough period of time they will somehow make money. Unfortunately, history has been a brutal teacher about the value of risk management.

Multialternative Funds: Best And Worst Of December

Multialternative funds averaged a 1.20% loss in December, dropping their returns for 2015 to -2.39% versus a 2015 loss of 1.79% for the Morningstar Moderate Target Risk TR USD Index (the Index). For the three years ending December 31, the category averaged annualized returns of 1.77% versus 5.60% for the Index, with a beta relative to the Index of 0.51 and a Sharpe ratio of 0.38. On a beta adjusted basis, the funds underperformed the Index with -1.01% annualized alpha over the three-year period. The top-performing multialternative funds and ETFs in December posted gains of as much as 3%, and two of the top-three performers from 2015’s final month had one-year returns of greater than 8%. But of the six funds reviewed this month – the three best and the three worst – only one from each stack launched early enough to have three-year track records, and both underperformed the category averages in terms of returns, Sharpe ratio, and volatility. Click to enlarge Top Performers in December The three best-performing multialternative mutual funds and ETFs in December were: QSPIX and EXD both generated December returns in the +3% range, with QSPIX gaining 3.01% and EXD 2.94% for the month. Both funds were similar in terms of their annual returns, too, with QSPIX gaining 8.76% in 2015 and EXD adding 8.55% for the year. But only EXD, a closed-end fund that launched in June 2010, had three-year data available: its annualized returns stood at an unappealing -1.26%, and its seemingly good-looking -0.30 beta actually resulted in losses, as is evident from the fund’s three-year alpha of +2.86%. In all EXD’s three-year Sharpe ratio was only 0.20, and its three-year standard deviation of 5.87% was the highest of all qualifying funds reviewed this month. AQR’s QSLIX rounds out December’s top three. The fund, which launched September 2014, returned +1.82% in December and +4.02% for the year. Worst Performers in December The three worst-performing multialternative mutual funds and ETFs in December were: SANAX was December’s worst-performing ’40 Act multialternative fund, returning -4.16% for the month. For the year, the fund lost 8.18%, which dropped its three-year annualized gains to just 0.74%. Through December 31, the fund had a three-year beta of 0.52, but generated alpha of -2.12% with 5.21% annualized volatility. As such, its Sharpe ratio for the period stood well below the average for its peers at 0.16. QSTAX and the Transamerica Global Multifactor Macro Fund both launched in 2015 and thus didn’t have three- or even one-year return data as of December 31 of that same year. In December they lost 4.11% and 3.96%, respectively. Past performance does not necessarily predict future results. Jason Seagraves and Meili Zeng contributed to this article.

The Problem With Accounting Book Value

In our recent article on the flaws in return on equity , we showed how it has no correlation with several different measures of valuation. However, there is one valuation metric, price-to-book (“P/B”), that, at first, appears to correlate strongly with ROE. A more rigorous look reveals the relationship between the two variables is not as strong as it first appears. Major outliers can disproportionately skew correlations, and that’s what happens with a cursory assessment of the ROE versus P/B correlations. Removing those companies (just 3 in this case) that each had at least a 5% impact on the r-squared value, along with the companies that had negative book values, reveals a weak, 27%, correlation. See Figure 1. Figure 1: Correlation Is Not Actually That Significant Click to enlarge Sources: New Constructs, LLC and company filings. When not removing any of the major outliers hat skew the correlations, ROE and P/B can have an extremely high correlation. Figure 2 shows an r-squared value of 98%. Figure 2: Seemingly High Correlation Between ROE and P/B Click to enlarge Sources: New Constructs, LLC and company filings. As Figure 1 shows, changes in ROE actually explain just 27% of the difference in P/B between different companies. Neither metric is a consistently useful valuation indicator. Both are prone to significant deviation from underlying economic reality because they both rely on the same flawed accounting rules. Book Value Can Be Misleading Accounting book value suffers from a few major flaws when it comes to measuring valuation That book value can be written down at management’s discretion at any time. Businesses can hide both assets and liabilities off the balance sheet so that they are not reflected in accounting book value. Accounting rules are designed to give the best estimate of liquidation value for debt investors, not to measure the capital used to generate returns, which is what matters to equity investors. Since shareholder’s equity and accounting book value are the same thing, both ROE and P/B rely on this same accounting construct, making them both equally unhelpful for equity investors. The Threat Of Write-Downs Mergers and acquisitions represent some of the most common sources of artificial book value. When one company buys another company at a premium to its net asset value, the excess purchase price is recorded as goodwill. Goodwill is recorded as part of accounting book value, but often ends up getting written down if the acquisition underperforms expectations. Write-downs end up being very common. 53% of all acquisitions end up destroying value, and we’ve found tens of thousands of write-downs totaling over a trillion dollars in value in the filings we’ve parsed dating back to 1998. Figure 3: Book Value Disappears During Times Of Risk Click to enlarge Sources: New Constructs, LLC and company filings. They end up happening most often during market crashes, as shown in Figure 2. That means investors who thought they were in cheap stocks due to the P/B ratio come in for a nasty surprise when billions of dollars get wiped off the balance sheet. Hidden Assets And Liabilities We make several adjustments to get from reported net assets to invested capital because companies can hide assets and liabilities off of the balance sheet in the form of reserves , operating leases , deferred compensation , and many other techniques. These off-balance sheet arrangements meant that the shareholder’s equity line ignores a significant amount of the resources that a company uses in its operations. Liquidation Value Has Limited Value For Equity Investors Accounting book value is meant to measure the potential assets available to investors in the event of liquidation, and that’s simply not a very useful measurement for most equity investors. If the company you’re investing in gets liquidated, that’s almost always a failed investment. Even the idea that a low price to book limits your potential downside is flawed. Write-downs or hidden liabilities can send the stock price below book value, as can a company earning a negative return on invested capital ( ROIC ). Accounting rules were designed to be used by debt investors. Equity investors should not expect the financial statements generated by these rules to contain the numbers that accurately reflect their concerns. Measure Economic Book Value Instead of focusing on accounting book value, investors should be looking for companies that have a low price to economic book value ( PEBV ). Rather than relying on accounting rules, economic book value comes from after tax operating profit ( NOPAT ) and weighted average cost of capital ( WACC ). Instead of measuring the liquidation value of a company, it measures its zero-growth value, which is a better baseline for equity investors. Rather than looking at the flawed metrics of ROE and P/B, we’ve found that ROIC and PEBV tend to be better indicators of future performance. Recent examples of this phenomenon include: Nvidia (NASDAQ: NVDA ), our long idea on September 24. From an ROE and P/B perspective, NVDA looked like it was middle of the pack in the semiconductor industry. Our research showed that it was actually one of the most profitable and cheapest companies in the industry, with an ROIC above 30% and a PEBV of just 1.1, implying only 10% NOPAT growth for the rest of its corporate life. In the past two and a half months, NVDA is up 37% El Pollo Loco (NASDAQ: LOCO ), our Danger Zone pick from March. Non-operating items inflated GAAP net income, and off-balance sheet debt obscured the true amount of capital used in the company’s operations. This helped LOCO earn an ROE of 20%, much higher than its actual ROIC of just 6%. And while its P/B of 4.8 didn’t look cheap, it was still better than its PEBV of 5.2. LOCO has collapsed in recent months and is now down over 50% since our call. Looking at ROIC and PEBV help you to identify winners and losers because those metrics cut through the noise and artificial accounting constructs that are at the heart of the valuation methodologies used by many investors. Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, style, or theme.