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An Extraordinary Edge You Have As A Small Investor

It goes without saying that capital allocation is a CEO’s most important job. How he allocates capital over the long run is what determines the value he creates for the business and its shareholders. But the reason many CEOs fail in profitably allocating capital is their incentives, which are aligned to what they can do in the next 1-2 years than what they must do in the next 7-10 years. This is also how most investors and money managers work – especially after a period of good performance, they would rather go for the kill in the next few months or maybe 1-2 years, than build portfolios that would do well over a 10+ year period. “Who wants to get rich in old age?” goes the thought process. “Why not gun for a 30-40% return and retire rich in the next 10 years?” After all, this is what simple math suggests. If you can invest Rs 5,000 per month and do that every month for 25 straight years, and at an annual rate of return of 30%, you will have almost Rs 34 crores after 25 years. On the other hand, if you earn just 20% annually, and everything else remains same, the amount in your bank after 25 years would be just Rs 4 crores. That’s a difference of a huge Rs 30 crores. Now most people would wonder, “Who would want to earn 20% and be left with just Rs 4 crores when you can go for the kill (read, 30%) and end with Rs 30 crores extra before you get old?” This is perfect reasoning, my dear friend. But, if you are not a full-time investor with a great knack of pulling out winner after winner, aiming for 30% annual return from the stock market is akin to starting your climb up Mt. Everest with a dash. Especially when you start in a bull market – and a lot of the 30-percenters of the last 4-5 years have started in the bull market – and consider that you may after all be a distant cousin of Usain Bolt, it’s easy to fall for the ‘go for the kill’ mindset. I’m sure a lot of stock market pros reading this would want to shut me up here, because they do believe they have the capabilities to earn such great returns, and sustainably. I have nothing to offer them here, but best wishes. But if you aren’t a pro, and if you are not very old, I would suggest you to take note of the only thing you can control in your investment journey – which also happens to be your biggest advantage as an individual investor in your pursuit of creating wealth from the stock market. And what’s that? It’s surely not the amount of return you want to earn, however much you try. That’s not in your control. But the only thing you are in complete control of is… Time! As an entrepreneur, here is what I count amongst the best advice I ever received on the concept of how managers can make best profitable capital allocation decisions for significant value creation. This comes from Amazon’s Jeff Bezos – If everything you do needs to work on a three-year time horizon, then you’re competing against a lot of people. But if you’re willing to invest on a seven-year time horizon, you’re now competing against a fraction of those people, because very few companies are willing to do that. Just by lengthening the time horizon, you can engage in endeavors that you could never otherwise pursue. At Amazon we like things to work in five to seven years. Note the big idea here – “Just by lengthening the time horizon, you can engage in endeavors that you could never otherwise pursue.” This is also true when you are investing in the stock market. Just by lengthening the time, you stay with good quality businesses – or businesses that remain good – you can create wealth you could have never thought of, and by the time you need that wealth. Like the CEO of a privately held company who can make decisions for the future without worrying about next quarter’s earnings, you can use time arbitrage to benefit from time-tested investment processes without the worry, and often financial damage that comes from recklessly chasing quick returns. Your Biggest Edge There are three main sources of edge you may have as an investor – Informational – What you can know that others don’t know Analytical – How you can process what is known better than others Behavioural – How sensibly you can behave as compared to others Now, it’s rare to possess all the three edges. It’s not impossible, but rare. In markets that are mostly efficient, having an informational edge is difficult. Many people are doing all they can to talk to customers, suppliers and industry experts to glean further insight into a company or an industry and profit from anomalies. And then, if you claim to possess too much of an informational edge, you run the risk of a face-off with the stock market regulator on the issue of insider information. Then, as far as analytical edge is concerned, it can be obtained through extreme smartness and hard work. Having such an edge means that even if you have the same information as everyone else, you’ll be able to process it better than others and see what the market doesn’t see. But having such an edge is also really hard, because there are a lot of very smart people motivated to analyze things better and faster than you. You will realize this if you are intellectually honest. So the high degree of analytical competition renders this edge a non-edge in the long run. Michael Mauboussin addresses this concept in his book, The Success Equation , where he writes – The key is this idea called the paradox of skill. As people become better at an activity, the difference between the best and the average and the best and the worst becomes much narrower. As people become more skillful, luck becomes more important. That’s precisely what happens in the world of investing. Anyways, that leaves the final source of edge an investor can have i.e., behavioural, or how you behave. So, while many investors may have the same information as others, or have the same analytical rigour, they behave differently. And most of how you behave is determined by how patient you are in real life and whether you have adequate time and staying power available with you. Most people are not patient when it comes to the stock market, and despite knowing the pitfalls of behaving badly. Now, when it comes to staying power, here is how Prof. Sanjay Bakshi defined it in his recent post – From the vantage point of the investor, staying power comes from: 1. Large number of years left to invest. 2. Ability to handle volatility through financial strength – low or no debt and significant disposable income preventing the need to liquidate portfolio during inappropriate times. 3. A frugal nature. 4. Ability to handle volatility through psychological strength. 5. A very long-term view about investing. 6. Structural advantages – investing your own money or other people’s money who will not or cannot withdraw it for a long long time. 7. Family support during tough times. As you can see from the list above, most factors that create staying power for you as an investor are related to how you behave. And the reason this is a great edge you have against the big, institutional investors – who otherwise may have analytical and informational edges – is that your behaviour is completely under your control as against the latter who often behave (frequently irrationally) how their clients want them to behave. If Mr. Market and its other participants are discounting things 12-15 months down the line, and if you can look out 5-10 years, you will have a time arbitrage advantage, which is a structural advantage to have. In short, as an individual, small investor, if you are… Not chasing unreasonable returns, and Invest money that you won’t need for the next 8-10 years … you are perfectly placed to benefit from time arbitrage and take opportunities handed to you by others who are… Chasing unreasonable returns and are thus more prone to making serious mistakes (if their expectations are not met), Investing borrowed money that they must return, even if the markets are bad, and Investing under an institutional setup and thus suffer from institutional compulsions like short-term incentives. How bigger and better an edge can you have? To quote Warren Buffett – The stock market is a no-called-strike game. You don’t have to swing at everything – you can wait for your pitch. The problem when you’re a money manager is that your fans keep yelling, “Swing, you bum!” That’s about swinging (buying a good quality business) when the price is right. And then you let time take over. To quote Buffett again… Time is the friend of the wonderful company, the enemy of the mediocre. Time is also your wonderful friend, dear investor. You only need to trust in it, and let its magic work. If you can spot a great value (you can learn to do that), you just need to buy it and then sit still as long as it remains good value (difficult, but very much possible). This is the single-most profitable form of investing in the world. It’s Not Easy, but Very Effective I will be honest here. Time arbitrage is not easy. A few months of a falling market or seeing your stocks going nowhere can feel like years. The impulse to “do something” can be overwhelming. Unfortunately, that impulse, more often than not, would hurt your long-term returns. Time arbitrage, on the other hand, yields tremendous financial and psychological benefits for those with the discipline to hold fast against the noise. This is an edge worth cultivating. It costs nothing but time and can be applied by anyone, including you. I would leave you with this chart of how Buffett compounded during his 50+ years at Berkshire… Note from the chart that his compounding began to show after he crossed 50 years of age, and after investing through Berkshire for 20 years. When you imagine yourself at 85, like Buffett is today, you may not see yourself come even a distant close to what he has achieved over these years. But like he did, if you can start early and keep at it, when you are 40 or 50, you would realize that you did yourself a great deed by giving your wealth time to grow, and a lot of it. If you are not dependent on investing for your living, please don’t try to go for the kill. Be bold at your work so that you earn more, save more, and thus invest more. Don’t try to act bold in the stock market. As Howards Marks said… There are old investors, and there are bold investors, but there are no old bold investors. You got the point, right?

The Low Volatility Anomaly And The Delegated Agency Model

Summary This series offers an expansive look at the Low Volatility Anomaly, or why lower risk stocks have historically produced stronger risk-adjusted returns than higher risk stocks or the broader market. This article hypothesizes that the combination of a cognitive bias and an issue around market structure could contribute to the Low Volatility Anomaly. This article covers a deviation between model and market that may contribute to the outperformance of low volatility strategies. In the last article in this series , I demonstrated that the aversion of certain classes of investors to employing leverage flattens the expected risk-return relationship as leverage-constrained investors bid up the price of risky assets. In addition to the inability to access leverage for long-only investors, the typical model of benchmarking an institutional investor to a fixed benchmark (i.e. the S&P 500 represented through SPY ) could also potentially produce a friction to exploiting the mispricing of low volatility assets (represented through SPLV ). If a security with a beta of 0.75 produces the same tracking error as a security with a beta of 1.25, investors may be more willing to invest in the higher beta security with the belief that it is more likely to generate higher expected returns per unit of tracking error. In this framework, if the investor believes that the higher beta security is going to deliver 2% of alpha and that the higher and lower beta assets are going to have the same tracking error relative to the index, then the investor would not purchase the lower beta asset unless it was expected to earn alpha of more than 2%. An undervalued low beta stock with a positive expected alpha, but an alpha below the expected alpha of a higher beta stock with an equivalent expected tracking error, would be a candidate to be underweight in this framework despite offering both higher expected return and lower expected risk than the broad market. This investor preference results in upward price pressure on higher beta securities and downward price pressure on lower-beta securities that could be a factor in the lower realized risk-adjusted returns of higher beta cohorts depicted in the introductory article in this series . In a foreshadowing of the next article on the potential influence that cognitive biases have on shaping the relationship between risk and return, the difference between absolute wealth and relative wealth could be an important distinction that influences the behavior of delegated investment managers. Richard Easterlin (1974) found that self-reported happiness of individuals varied with income at a point in time, but that average well-being tended to be very stable over long time intervals despite per capita income growth. The author argued that these patterns were consistent with well-being depending more closely on relative income than absolute income. This preference for relative outperformance rather than absolute outperformance may signal why some managers think of risk in terms of tracking error rather than absolute volatility. In perhaps a more salient example, Robert Frank (2011) illustrated the relative utility effect through an experiment that showed that the majority of people would rather earn $100,000 when peers were earning $90,000 than earn $110,000 when peers were earning $200,000. Among the assumptions underpinning CAPM is that investors maximize their personal expected utility, but these studies suggest that investors in effect seek to maximize relative and not absolute wealth. Similar to leverage aversion detailed in the last article, the preference for relative utility could be another CAPM violation that contributes to the Low Volatility Anomaly. Gauging performance versus a benchmark is a form of maximizing relative utility, and has become an institutionalized part of the investment management industry perhaps to the detriment of the desire to capture the available alpha in our low beta asset example. I am not trying to minimize tracking error in my personal account, I am trying to generate risk-adjusted returns to grow wealth over time. As I have demonstrated in this series, academic research has shown that low volatility stocks have outperformed on a risk-adjusted basis since the 1930s. Disclaimer My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon. Disclosure: I am/we are long SPLV, SPY. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Market Timing With Value And Momentum

By Jack Vogel, Ph.D. Yesterday, we wrote a post showing a potential way to time the market using valuation-based signals. In the past, we have also examined how to use momentum-based signals (moving average rules and time-series momentum) to time the market. A natural question is, what happens when we combine the valuation-based signals with the momentum-based signals? Here at Alpha Architect, we are big believers in Value and Momentum . We have written about how to combine Value and Momentum in the security selection process here and here . In this post, we examine what happens when we combine valuation-based (value) signals with momentum-based (MA rule) signals. Here is the setup, from yesterday’s post: Strategy Background: We use 1/CAPE as the valuation metric, or the “earnings yield,” as a baseline indicator; however, we adjust the yield value for the realized year-over-year (yoy) inflation rate by subtracting the year-over-year inflation rate from the rate of 1/CAPE. To summarize, the metric looks as follows if the CAPE ratio is 20 and realized inflation (Inf) is 3%: Real Yield Spread Metric = (1/20)-3% = 2% Some details: The Bureau of Labor Statistics (BLS) publishes the CPI on a monthly basis since 1913; however, the data is one-month lagged (possibly longer). For example, the CPI for January won’t be released until February. So when we subtract the year-over-year inflation rate from the rate of 1/CAPE, we do 1-month lag to avoid look-ahead bias. We use the S&P 500 Total Return index as a buy-and-hold benchmark. So the two signals we will use are the following: Valuation-based signal: 80th Percentile Valuation-based asset allocation: Own the S&P 500 when valuation < 80th percentile, otherwise hold risk-free. In other word, if last month's CAPE valuation is in the 80 percentile or higher (data starting 1/1924), buy U.S. Treasury bills (Rf); otherwise stay in the market. Momentum-based signal: Long-term moving average rule on the S&P 500 (Own the S&P 500 if above the 12-month MA, risk-free if below the 12-month MA). The results are gross of any fees. All returns are total returns, and include the reinvestment of distributions (e.g., dividends). Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Our backtest period is from 1/1/1934 to 12/31/2014. Baseline Results: Here we show the results for 4 portfolios: Valuation-based market timing: Own the S&P 500 when valuation < 80th percentile, otherwise hold risk-free. Momentum-based market timing: Own the S&P 500 if above the 12-month MA, risk-free if below the 12-month MA. Risk-free: Total return to owning U.S. Treasury bills. SP500: Total return to the S&P 500. (click to enlarge) The results are hypothetical, are NOT an indicator of future results, and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. As previously noted, both Valuation and Momentum-based timing models increase Sharpe and Sortino ratios, while decreasing drawdowns. Now, let's combine them. Combining Value and Momentum Timing models: Here we show the results for 4 portfolios: (50/50) Abs 80%, MA : Each month, allocate 50% of capital to the valuation-based timing model and 50% or capital to the momentum-based allocation model. (and) Abs 80%, MA: Each month, examine the valuation and momentum-based signals. If both say "yes" to being in the market, invest in the S&P 500; if either or both say "no" to being in the market, invest in risk-free. (or) Abs 80%, MA: Each month, examine the valuation and momentum-based signals. If either says "yes" to being in the market, invest in the S&P 500; if both say "no" to being in the market, invest in risk-free. SP500: Total return to the S&P 500. (click to enlarge) The results are hypothetical, are NOT an indicator of future results, and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. Takeaways: Combining the Value and Momentum-based signals makes sense when using the "50/50 model" and the "(or) model." Both of these have higher Sharpe and Sortino ratios compared to standalone value and momentum-based models. The "(and) model" does not work very well - you are out of the market too often. Conclusion: Of course, transaction costs and taxes (not shown in the results above) need to be considered. However, it appears that combing Value and Momentum in market timing is promising, and something we will examine more carefully in the future. Original Post