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The Leap Year Approach To Investing

This year (2016) marks another special year for those who happened to have a significant event, like a birthday or wedding anniversary, fall on February 29th. The Leap Year, which is that extra day that we get every 4 years to help align our calendar year with an actual solar year (which happens to be 365.25 days), is upon us yet again. While many of us might just see this as just “another day,” there are some real advantages to having four-year intervals in our lives. We propose that one of them is looking at your investment performance, assuming you are in a target date fund or have a passive advisor handling rebalancing, tax-loss harvesting and a glide path strategy for you. Now this might sound a bit loony, but there is some real truth into what we are proposing. First of all, it allows investors to drown out the daily “noise” that the prognosticators, the “professionals,” and the entertainers are delivering across the many media outlets. These outlets have become experts in delivering second by second accounts of random news stories and extrapolating them into “advice” with an overlay of overconfidence, as if their ability to estimate market values and future events has the same precision as a Swiss watch. Unfortunately, many soothsayers are more often wrong than they are right , but the short-term attention and amnesia that affects all of us humans allows us to forget and repeat. Once we take a big step back from the second by second clutter, we are able to take a deep breath and really see the irrelevance of it all. A Leap Year approach to investing is the embracing of this emancipation. Now there is nothing unique to this approach in which we are trying to find some long-term market-timing trend that will allow you to outperform the market. Quite the contrary! This is about resetting your internal investment clock to be thinking in years — many years, that is — instead of seconds. It could have easily been the 10-Year High Reunion approach to investing or a welcome to a new decade approach to investing. But let’s be reasonable. At the end of the day, what we are really talking about is the benefit of time diversification. So what does this actually look like? Let’s assume that an investor decided to start investing back on March 1, 1928 and made an agreement with their investment advisor to not discuss nor look at any performance figures until February 29th of the next Leap Year. May seem very unrealistic, but not as much as one would think. Unless something dramatic changes in somebody’s financial situation (this does not include fear due to a short-term downturn in the market), then it doesn’t seem so unrealistic that a 4-year window to chat and reassess could be practical. There may be things going on in the background like rebalancing and tax-loss harvesting, but we are just talking about looking at performance and reassessing financial goals. Using historical performance data for IFA Index Portfolio 100 from March 1, 1928 through February 29, 2016, we have 22 independent 4-year time periods ending on a Leap Year (see table below). We know that past performance is no guarantee of future results, but we are going to be speaking more about the overall trend versus specific numbers. For example, over all 22 4-year periods, the average 4-year annualized return was 11.50%. The lowest 4-year period was during the Great Depression (1928-1931) where we saw an annualized return of -23.50%, or a painful total loss for the 4 years of 65.74%. This was subsequently followed by the highest 4-year annualized return (1932-1936), where we saw a 32.48% annualized return, which amounts to a total return of 208.06%. This would have gotten an investor back to the original investment amount from March 1, 1928 (8 years earlier). The third lowest Leap Year annualized return ended on February 29, 2012, which included the global financial crisis of 2008-2009, but still ended up with a 12.6% total return for the period. Let’s digress on this just a little bit. If we were to focus on the day-to-day news stories and volatility during that time, which included the fall of Bear Stearns and Lehman Brothers as well as the bailout of the biggest financial institutions in the world, like AIG, and the economy had lost 800,000 jobs per month, we would have expected a much different story. It was a warzone. But once we expand our view, even during a very distressing time like 2008, it was just a blip. Out of the 22 independent Leap Year periods, there were only 2 (9%) that had negative returns (both in the 1928 to 1940 period) and no negative Leap Year period returns since 1940. Leap Year Returns of IFA Index Portfolio 100 88 Years (1/1/1928 to 12/31/2015) 22 Leap Years 4-Year Leap Year Periods Annualized Return Total Return March 1, 2012 – February 29, 2016 6.18% 27.09% March 1, 2008 – February 29, 2012 3.02% 12.64% March 1, 2004 – February 29, 2008 10.54% 49.33% March 1, 2000 – February 29, 2004 9.82% 45.43% March 1, 1996 – February 29, 2000 12.12% 58.04% March 1, 1992 – February 29, 1996 13.92% 68.44% March 1, 1988 – February 29, 1992 13.82% 67.81% March 1, 1984 – February 29, 1988 22.54% 125.46% March 1, 1980 – February 29, 1984 18.49% 97.09% March 1, 1976 – February 29, 1980 21.46% 117.63% March 1, 1972 – February 29, 1976 3.23% 13.56% March 1, 1968 – February 29, 1972 9.55% 44.05% March 1, 1964 – February 29, 1968 18.29% 95.77% March 1, 1960 – February 29, 1964 9.09% 41.65% March 1, 1956 – February 29, 1960 10.39% 48.49% March 1, 1952 – February 29, 1956 19.22% 101.99% March 1, 1948 – February 29, 1952 18.44% 96.78% March 1, 1944 – February 29, 1948 13.81% 67.77% March 1, 1940 – February 29, 1944 13.32% 64.88% March 1, 1936 – February 29, 1940 -3.14% -11.98% March 1, 1932 – February 29, 1936 32.48% 208.06% March 1, 1928 – February 29, 1932 -23.5% -65.74% Source: ifacalc.com , ifabt.com , Index Fund Advisors, Inc. We could also take a look at the monthly rolling 4-year returns from 1928 to 2015. This would include 1,009 4-year monthly rolling periods. The median annualized return across all 1,009 4-year periods was 13.42%. The lowest 4-year period was 06/1928 to 05/1932, where we saw an annualized return of -36.73%. Similarly to our observation before, the highest 4-year return came soon thereafter (03/1933 – 02/1937) where we saw a 56.22% annualized return. Click to enlarge Click to see the full interactive chart on IFA.com . The Leap Year Review approach to investing is our way of resetting our investors’ internal investment clocks. Investing is not about thinking in seconds, minutes, hours, days, weeks, months, or even 4 years. There is too much randomness to extract anything of benefit from these types of time periods. Having a broader focus allows investors to tune out the irrelevant. This will help to protect investors from becoming victims of their own emotions. We have shown using historical data the benefits of time diversification . Of course this doesn’t mean that the future will be so bright, but remember, from 1928 to 2016 there have been multiple wars, conflicts, economic booms and busts, stagflation, and differing economic policies (think FDR versus Ronald Reagan). Through all of this, markets have rewarded the patient investor. Believing that somehow this is going to change in the future is pure speculation. Happy Leap Year! Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

What Makes A Stock Go Up (Or Down)?

When it comes to the stock market, one thing is for certain: stocks go up and stocks go down. The question is: what makes a stock go up or down? What makes a stock go up or down is determined by the recent operating results of a business and its future expectations. This means stock prices reflect both fundamentals (operating results) and emotions (future expectations). When either one or both of these change for a particular stock, its price will be affected. What Makes A Stock Go Up (Or Down)? It’s impossible to pinpoint exactly what makes a stock go up or down on a daily basis. To borrow a phrase from The Princess Bride , “Anyone who says differently is selling something.” On the other hand, it’s quite simple to see what makes a stock go up or down over time. Stock prices are based on how investors think a company will perform in the future compared to how the company is performing now. In any investment, investors are betting on the future. Because the future is uncertain, stocks cannot be priced based on a business’s current operating results alone. They must be valued by predicting future performance. Price Ratios In order to quantify these predictions, investors use price ratios. Price ratios are simple tools which show how a stock is priced compared to its recent operating results. For example, a Price-to-Earnings (P/E) ratio of 10 says that a stock is valued 10 times higher than its current earnings. This does not mean that investors expect the company’s earning to increase by a multiple of 10 in the near future. It merely means that if the earnings were to stay constant, investors would break even on their initial investment after 10 years. In other words, the earnings yield on the principal is 10% (10/100 = 0.1). Say a stock has a P/E of 50 and investors still expect to receive an earnings yield of 10%. Paying 50 times earnings only makes sense if the company’s earnings are expected to increase substantially over time. Multiple Futures No matter how badly stock analysts pretend to be fortune tellers, no one can accurately forecast a company’s future performance (especially on a consistent basis). Charles Duhigg, in his book Smarter, Faster, Better: The Secrets of Being Productive in Life and Business , summarizes the reality of what the future is. Duhigg says, “The future isn’t one thing. Rather, it is a multitude of possibilities that often contradict one another until one of them comes true.” These multitude of possibilities are what cause price ratios to fluctuate so often for any one stock. Although there are countless numbers of possible futures when considering a stock investment, there are really only three general scenarios. Scenario #1: A company’s operating results will increase. Scenario #2: A company’s operating results will remain constant. Scenario #3: A company’s operating results will decrease. The level of a stock’s price ratios is determined based on which scenario investors anticipate will come true for that particular stock. Scenario #1: High price ratios. Scenario #2: Average price ratios. Scenario #3: Low price ratios. Operating Results Before getting too focused on price ratios, it’s important to remember that change in operating results is the second half to determining what makes a stock go up or down. Say a stock is reporting earnings per share (EPS) of $5 and has a P/E of 10. The stock would be valued at $50 per share ($5 x 10 = $50). Then, the company unexpectedly reports EPS of $5.50. If the P/E stays at 10, the stock is now valued at $55 per share. To summarize, stock prices go up or down depending on changes in operating results and the levels of its price ratios. The interesting thing is that changes in operating results most often trigger changes in price ratios. Because the future is hard to predict, operating results often differ (sometimes greatly) from what investors expect them to be. When a surprise like this happens, future expectations are reconsidered and price ratios are modified. Impact of Surprises In David Dreman’s book, Contrarian Investment Strategies: The Psychological Edge , he notes the impact of such surprises. Here is Dreman discussing the market’s reaction to unexpected results: Several researchers have found that when a company reports an earnings surprise (that is, a figure above or below the consensus of analysts’ forecasts), prices move up when the surprise is positive and down when it is negative.” It makes intuitive sense that stock price adjustments correlate with positive or negative surprises. Not only do the surprises reveal a change in operating results, but the change in operating results affect the future expectations of the company. This explains why value stocks (low price ratios) outperform growth stocks (high price ratios) over time. Value Goes Up, Growth Goes Down Low price ratios anticipate negative futures (decreased profits) and high price ratios anticipate positive futures (increased profits). Therefore, stocks with low price ratios have more upside potential. On the flip side, stocks with high price ratios have nowhere to go but down. In Contrarian Investment Strategies , Dreman references several studies which show that positive surprises impact value stocks greatly but only minimally affect growth stocks. The studies similarly show that negative surprises impact growth stocks greatly but only minimally affect value stocks. Here’s Dreman explaining the impact that both positive and negative surprises have on growth stocks: Growth Stocks: Positive Surprises Since analysts and investors alike believe that they can judge precisely which stocks will be the real winners in the years ahead, a positive surprise does little more than confirm their expectations.” Growth Stocks: Negative Surprises Investors expect only glowingly results for these stocks. After all, they confidently – overconfidently – believe that they can divine the future of a ‘good’ stock with precision. Those stocks are not supposed to disappoint. People pay top dollar for them for exactly this reason. So when a negative surprise arrives, the results are devastating.” And here’s Dreman explaining the impact that both positive and negative surprises have on value stocks: Value Stocks: Positive Surprises Those stock moved into the lowest category precisely because they were expected to continue to be dullards. They are the dogs of the investment world and investors believe they deserve minimal valuations. A positive earnings surprise for a stock in this group is an event. Investors sit up and take notice. Maybe, they think, these stocks are not as bad as analysts and investors believed.” Value Stocks: Negative Surprises Investors have low expectations for what they believe to be lackluster or bad stocks, and when these stocks do disappoint, few eyebrows are raised. The bottom line is that a negative surprise is not much of an event.” Fundamentals Change Expectations These scenarios explain why value stocks have nowhere to go but up, and growth stocks can only go down. If a value stock’s fundamentals unexpectedly increase, not only will its operating results improve, but investors’ future expectations will be raised as a result. Contrarily, a growth stock’s fundamentals are already expected to increase. Any improvement in operating results is already priced into the stock. Decreased operating results are already priced into value stocks but not growth stocks. Unexpected poor performances wreak havoc on growth stocks, but not value stocks. Buy Value Stocks Because human emotion plays a critical role in what makes a stock go up or down during the short term, investors are wise to invest where expectations are low and positive surprises are likely. To paraphrase a line from The Wolf of Wall Street, “It doesn’t matter if you’re Warren Buffett or Jimmy Buffett, no one knows if a stock will go up, down, or sideways.” We can know, however, which stocks are more likely to go up. Buying stocks with low price ratios is a time-tested approach to achieving superior investment returns.

Popularity And Price Increase For ‘Low Vol’ Funds

“Low volatility” funds have surged in popularity recently as investors have poured nearly $10 billion into them so far in 2016, which has significantly increased their price. At the end of 2015, one such “low vol” fund (i.e., specializing in stocks that fluctuate less than the broader market) had a P/E ratio just above the market as a whole. By the end of April 2016, it was “nearly 10% more expensive than the market average,” reports a recent Wall Street Journal blog piece. Nardin Baker of Guggenheim Partners Asset Management, who has written on and managed such funds for decades, says that low volatility stocks have outperformed the market by an average of about 1 percentage point annual with roughly 30% less risk. Dan Draper, who manages a low volatility fund for Invesco Powershares, says that investors pay less in bull markets for stocks that don’t make big moves, which made them cheap. “But can unpopular investments continue outperforming after they become popular?” the article asks. Andrew Ang of BlackRock says that potential overvaluation is “a valid concern” and “excessive crowding of any strategy should send up a red flag of warning,” but that these stocks are not currently “at extreme values by any standard.” Although Baker says “anybody who’s in low vol right now, they’re not going to be hurt,”but Dave Nadig of FactSet says that “if everybody’s chasing the same stocks, eventually they will no longer be cheap and returns will regress to the mean.” Ang says investors should not “go into low vol to outperform the market,” but “to reduce your risk.”