Tag Archives: Behavioral Finance

Don’t Be Euphoric Over Two Months Of Gains

Stocks are up big this year, and that means it’s time to be skeptical.

Warren Buffett says you should be greedy when others are fearful and fearful when others are greedy. That doesn’t mean stocks are ready to give up all their January and February gains immediately or even eventually. But it means the right psychological disposition to have is one of doubt and skepticism. If we get the decline, you’ll be ready for it. And being ready for declines, so that they don’t surprise you and cause you to sell, is the most important thing in investing.

Here are the numbers. Domestic and foreign stock are all up between 9% and 12% for the opening two months of the year. Mid-caps and small-caps are up even more, with the Russell 2000 up an eye-watering 17%. Junk bonds are up more than 6% and REITs are up more than 12%. Balanced indices are up between 7% and 8%, depending on whether they have foreign stocks or not.

It’s okay to be happy about this, but it’s also good to temper that happiness with some skepticism. Stocks don’t usually go up this much in two months. In fact, they don’t usually go up this much in a year. If you’re thinking that the current move is justified because of how much stocks declined in the last quarter of 2018, you still may be fooling yourself with too much optimism. Stocks have been up like gangbusters for the past decade. (Incidentally, if you panicked at the end of last year, and sold, you know how prone  you are to make moves at the exact wrong moment.)

None of this means you should run for the hills and sell all your stocks in a fit of contrarianism. But it means you should temper your expectations. (And trimming some gains might not be a bad idea. Rebalancing, especially in a tax-advantaged account is reasonable after a run like this.) It’s just as likely that stocks could drop from here as it is that they could tread water or keep going up. Nobody knows.

The end of last year is instructive about trying to time short-term moves. At the end of last year, longer term moving averages indicated that there was more downside, while shorter term moving averages indicated that the markets were “oversold,” and that a least a few days of upside were in the cards. It turned out that when things looked bleakest, on Christmas Eve or quickly thereafter, the market bottomed, and stocks have been off to the races ever since.

In other words, both the long term indicators and the short term indicators from the end of last year look foolish right now. We didn’t get a few days’ worth of gains in response to being “oversold;” instead we’ve gotten eight solid weeks of boffo returns. That’s what the market does — it makes everything look foolish sometimes. Sure, stocks might decline from here, proving the longer term indicators from late last year correct. But these two months show how hard short term timing is. It’s possible to argue that U.S. Federal Reserve Chairman Powell indicating that the rate-hiking regime would end was a wild card at the end of last year. That’s true, but it doesn’t damage the thesis that short term trading is difficult.

Being successful in the stock market isn’t so much a function of what system you follow as much as it is a function of whether you can follow a system and whether you can keep your emotions in check. Every system – buy-and-hold, buy-and-rebalance, moving average – will look foolish at times. It will deliver losses or look lackluster when others are making gains. Take Bill Bernstein’s advice in this weekend’s Wall Street Journal, and consider your financial assets (stocks and bonds) as future assets and not present assets. In other words, “mentally vaporize 75% of your assets; imagine you don’t even have them.” That can help you get through market declines. You don’t own stocks to buy groceries tomorrow, after all. Remembering that, and having the right psychological disposition can make a big difference in helping you let financial assets work for you — instead of letting them work you over.

The Importance Of Having An Investment Discipline

In investing, it’s necessary to have a system. Even if you’re a buy-and-hold investor, that’s a system. In fact, buy-and-hold investors have to do a little more than buy and hold – they have to rebalance their portfolios periodically. That involves a decision about whether to rebalance quarterly, semi-annually, or annually. And once you’ve made that decision, you have to follow through and do it. You can’t say, “Gee, the market is running so hard; I don’t want to take some money of the table now.” Or, “This decline is so painful; I can’t bear to throw more money at stocks now.” But you won’t be successful if you don’t stick to the discipline you established.

Other investors, who want to be more tactical or “enterprising” as Benjamin Graham called them, should have rules too. It can be overwhelming to try to apply valuation metrics and momentum metrics to asset classes, sectors, currencies – anything that moves – every single day, and to decide which metric to emphasize and which to jettison. I’ve seen more smart people mismanage money because they couldn’t boil down their intelligence into a system, or, once they did, follow it. Investing isn’t about intelligence as much as it’s about controlling your emotions.

Let’s say you follow momentum in the stock market. You might apply the 200-day moving average to tell you if the market is in an uptrend or a downtrend. Michael Batnick wrote an excellent post about this recently where he showed how a simple system or backtest using the 200-day moving average could beat the market with lower volatility – at least since 1997. But simple to understand doesn’t mean simple to execute for a variety of reasons. As he notes, there have been plenty of times since 1997 when simply owning stocks when they were above the 200-day moving average and exchanging them for bonds when they were below would have tested your patience. He asks rhetorically if someone would have been able to follow all the 160 signals the indicator produced over the 20-year period, if someone would have been able to take the 10 signals it delivered in 30 trading sessions, and, finally, if someone would have been able to stick with it when it was badly underperforming the S&P 500 Index.

Not following that simple rule – owning stocks above the 200-day moving average and exchange them for bonds below — wouldn’t have been the result of a lack of intelligence. It would have been the result of not being disciplined enough or not believing in the indicator when it was failing – or, more likely, convincing yourself that there’s another indicator you should be following just this one time because yours was failing. St. Augustine was noted for praying, “Lord, make me chaste, but not yet.” That’s the way many investors wind up operating. “I’ll follow my model or indicator, but not yet. Something else looks more attractive or like it’s working right now; so I’m going to go with that.”

Another problem besides multiple indicators that can distract you or seduce you away from the main one, is applying your indicator to many different things. Are you doing something like Batnick’s simple example of a moving average to the S&P 500 and bonds? Or are you applying the indicator to foreign stocks too? And what about emerging markets stocks. And how about different sectors and industries of the stock market and different areas of the bond market like corporates, Treasuries, mortgages, high yield, and emerging markets? And are you trying to build a portfolio from many asset classes to which you’re applying one or multiple indicators? Things can get complicated and dizzying in a hurry.

Any system you set up will disappoint you at times. No system exists that’s 100% foolproof. The trick is if you can keep using the system when it disappoints so that you’ll still be using it when it starts working again. This isn’t about how smart you are; it’s about how emotionally intelligent and focused you are.

Robert Shiller: Worried About Housing Again

This past weekend in the NYTimes, Nobel-laureate economist Robert Shiller sounded the alarm on housing again. For those who don’t know, Shiller called the stock market bubble of the late 1990s and the housing bubble of the following decade. He is famous for his house price index and for his method of stock market appraisal called the “Shiller PE,” which judges price relative to past 10-year average real earnings, even if this latter metric comes from the great market analyst Benjamin Graham.

Shiller doesn’t use the word “bubble” in his article, but he argues that since around 2012 we have been experiencing one of the great housing booms in history. And this one is on the heels of the previous great boom and bust. (The third and more benign boom coincided with the great post-war Baby Boom).House prices are now 53% higher than they were in early 2012, meaning they have appreciated at least 7% annualized. Inflation, measured by CPI, since 2012? Less than 2%. That’s a big gain on CPI-adjusted grounds. The excellent graphic below from my colleague, Jesse Colombo, in a Forbes article, tells the price-CPI discrepancy story.

How is it that house prices can surge higher than inflation when median household income is mostly stagnant? Shiller places great importance on the psychological aspects of large price movements. He doesn’t think single economic factors typically tell the story — or the whole story. Therefore, he is skeptical that low interest rates are the primary cause of home price increases. There is some merit to blaming low rates, according to Shiller, and they have been present at the last two bubbles, but rates have actually been going up since 2012, while prices have continued to surge. As Shiller puts it, “The housing market does not react as directly as you might expect to interest rate movements. Over the nearly seven years of the current boom, from February 2012 to the present, all major domestic interest rates have increased, not decreased. So, while interest rates have been low, they have moved the wrong way, yet the boom has continued.”

Another possible explanation is economic growth. But house prices didn’t surge from 1950 through 2000 despite GDP roaring ahead sixfold during that time. And it’s not quite correct either to say prices are normalizing, because they are higher now than at the bubble peak.

Perhaps the home price increases are now a self-fulfilling prophesy, says Shiller. In other words, prices have been going up so people expect them to keep going up. Shiller quotes Keyenes saying, “people seem to have a “simple faith in the conventional basis of valuation.” If the conventional basis is now that home prices are going up 5 percent a year, then sellers, who would otherwise have no idea what to ask for their houses, will just put a price based on this convention. And likewise buyers will not feel they are paying too much if they accept the convention. In the United States, we may believe that the process is all part of the “American dream.”

The price surge can’t go on forever, but Shiller explains that nobody knows when it will stop. All we know now is that prices have surged  as they have only two other times in recorded history. Let buyers and sellers beware. And if you have questions on our views of stock and bond markets, please contact us here.

Managing “Mr. Market” With Howard Marks

I went on a long distance drive for Thanksgiving – Houston to Southern California and back. I don’t recommend doing that unless you have two full weeks. It’s 1500 miles each way, which means you should allocate six days to driving.

I didn’t allocate my time well, because I had around 10 days, not two full weeks. That meant I spent more time driving than visiting. But on the drive I managed to catch up on some podcasts, and one that stands out is Meb Faber’s interview of Howard Marks. Marks is a legendary investor and has a new book out called Mastering the Market Cycle. A few things stand out about the interview. Cycles are related to risk-taking and behavior, and they are often debt-driven. A rising stock  market often occurs simultaneously when lending standards relax. That’s why junk bonds and real estate often move in tandem with the stock market in what have come to feel like “risk-on, risk-off” trends.

Can anyone master these trends? First, don’t expect to time things exactly right. Marks raised an $11 billion fund in 2007-2009 that capitalized on bonds and other instruments of near-bankrupt companies. He’s frank with Faber that he didn’t know what was happening with CDOs or mortgage-backed securities; he didn’t have the precise insight that Michael Burry or Steve Eisman did, for example, in shorting mortgage-backed CDOs. But he saw deals being done everyday that didn’t make sense to him and reflected an increasing indifference to risk. In late 2008, he started putting money to work, buying distressed debt without knowing where the bottom was. Investors trying to time market cycles should understand that capturing tops and bottoms isn’t the goal. Buying on the way down and selling on the way up are difficult enough – and they will allow you to reap plenty of reward.

Another lesson for individual investors is that they should lessen their moves. Stop trying to be all in or all out of the market. Stop trying to be precise about timing; seeking precision can get you into trouble. As things get more expensive, your bias should be toward selling; as they get cheaper, your bias should be toward buying. It’s all about putting probabilities on your side, not timing full entries and full exits precisely. This part of the interview reminds me of Ben Graham’s discussion of the “enterprising investor” in his classic book The Intelligent Investor.

The enterprising investor doesn’t maintain a balanced or 60% stock / 40% bond mix at all times. Instead, he calibrates upward or downward between 75% stocks and 25% stocks. In other words, Graham counsels the most adept and studious investors never to be all in or all out, and Marks basically does the same thing. One has to be humble in trying to manage Mr. Market, Graham’s fictional, manic-depressive fellow one should think about when assessing markets.

A corollary to these lessons is that cycles can last longer than you think, and Marks is honest again that his caution in recent years has cost him. That’s not a reason to dismiss his wisdom; it’s just an acknowledgment that you shouldn’t seek precision. The current rally in stocks, corporate bonds, and real estate has gone on for almost a decade now. It feels long in the tooth, but that doesn’t mean it can’t go on longer. I’ve noted that the Shiller PE (stock prices relative to past 10-yr average earnings), for example, is in the low 30s, levels seen only in the run-ups to 1929 and 2000. But in 2000, the metric hit 44. There’s no law saying it can’t do that again — or even go higher this time. Marks mentions that it feels like the 8th inning now. But he also notes that final innings can last a long time, and games can go into extra innings. Again, a lot of patience is required whether you keep a steady allocation or whether you manipulate your allocation according to your understanding of cycles.

Marks says investors should set target allocations. But then they can deviate from them – as long as they know what they’re deviating from. So a classic balanced (60% stocks, 40% bonds) investor can go down to 50% or 40% stocks at this point, for example. Last, nobody should try timing cycles without being a keen student of market history. Too many investors try to time markets without having seen even one full market cycle. They don’t understand that things play out a little differently each time, and that they need to have patience. Timing market cycles isn’t easy even for Marks, and he’s had a 50-year career at this point. Everyone will have to calibrate to their own taste and temperament, but everyone should resist the temptation to make extreme moves. My own opinion is that smaller investors should also do this under the guidance of a professional. Don’t misallocate your assets the way I misallocated my time for this Thanksgiving trip. And call us if you have questions about how we allocate portfolios.

Lessons From Thanksgiving Dinner

Talking to friends and family at Thanksgiving dinner made me realize how unprepared for volatility investors are. The gathering I attended was filled with a wide mix of investors, from the young and novice interested in technology stocks and (somehow still) in Bitcoin to older, seasoned veterans. The veterans, however, didn’t exhibit much more savvy than the novices; everyone was spooked by the recent volatility.

Based on my Thanksgiving Dinner experience, here’s what I think investors need to learn now.

Re-Set Your Expectations

First, I think investors are spooked because they are being unduly influenced by the market action of 2017. But that was an unusually calm year that saw a 22% gain in the S&P 500 without a down month. That’s a Bernie Madoff-like performance — straight up every month like clockwork with no hiccup to the downside. That kind of performance usually only occurs when someone makes it up. Investors should realize that 2017 is an anomaly and that volatility is part of investing. Financial markets are rarely that smooth and stable. Do your best to expunge 2017 from your memory.

Below is a monthly chart of how the S&P 500 Index performed in 2017 and for the first 10 months of 2018. It may surprise you to see that the index was still in positive territory at the end of October. A $100 investment in the index at the start of the year was still worth more than $102 on Halloween. As of this writing (Nov. 23), the index was still in positive territory, albeit barely ((0.19% for the year, including dividends).

I don’t point out that the market is still positive to give investors encouragement to take more risk though, or to argue that markets have delivered solid returns this year. I do so in order to impress on you that large cap U.S. stocks are still positive, and that your sense of markets might be warped. This year feels awful to investors, but the returns really haven’t been bad. There’s a disconnect between the year’s returns and what the year has felt like. That’s because 2017 was so strange in the index posting positive gains for every month.

Reconsider Your Allocation

I also don’t mean to encourage investors to think they can time markets perfectly. The point is not to dance in and out of stocks adroitly, missing losses and capturing gains; it’s having an allocation that gives you enough of the upside and allows you to live with the downside without shaking you out of your investments. If the recent volatility makes you want to sell, chances are you have too much stock exposure, or you have to re-calibrate your expectations from financial markets.

I think most investors I meet with have more stock exposure than they can handle. Or at least they strike me as being badly prepared for declines either because they don’t have advisors or because they have incompetent advisors who don’t disclose risks and historical volatility. When declines come, many of them will bail out at or near the bottom despite the fact that Morningstar’s most recent “investor return” numbers suggest investors are getting better at mistiming markets. Instead of falling into that trap you should reassess your allocation now, before any damage has occurred. That’s not a prediction that a crushing decline is around the corner; I wish I could be that clairvoyant. But you should always be prepared for one. And you should have an allocation that encourages you to buy after a big market decline, not sell.

Hold Extra Cash, But Avoid Bunker Mode

Having just given all those warnings about market timing, I still think it’s fine to hold some extra cash. Every reasonable market valuation metric, including the Shiller PE and Tobin’s Q, is flashing expensive. None of these indicators are good at forecasting short term market moves; markets can get (and have been) more expensive. But they are good are forecasting the next decade’s worth of returns. Returns will likely be low from current valuations. That means holding some extra cash is warranted. But, for goodness sake, don’t go to 100% cash with long term assets, thinking you’ll time your reentry perfectly. The paradox of sidestepping a decline is that if the market crashes, there’s a good chance that you’ll feel so good for having missed the decline that you’ll have a lot of trouble getting back in. But 10% or even 20% more cash or shorter term U.S. Treasuries than usual for long term assets isn’t unreasonable either.

Rules For Managing Volatility

Volatility is back. Your success as an investor is based on how you’ll deal with it. Here are some rules to help you cope.

First, reconsider your allocation. If you have 50% or 60% stock exposure in what’s often called a ‘balanced” portfolio, and you can’t handle a 5% or 10% portfolio hiccup, you’re probably in the wrong allocation. After all, a correction (stock market decline of 10%) will take your portfolio down around 5% and a bear market (stock market decline of 20% or more) will take your portfolio down 10% or more.

In 2008, balanced portfolios dropped around 20%, and that’s what I tell balanced portfolio investors to anticipate. We’ve had two 50% drawdowns in the stock market since 2000, and there’s no reason why we can’t have another one. It’s true, we may not. But we just as easily might. Now is a good time to do a gut check or reconsider your allocation.

It’s possible that you can handle more volatility, but are just unaccustomed to it right now, so it feels particularly bad. Think about what it will be like to see your portfolio down 20% or 25%. And put a dollar value on that. Most people don’t think of their money in terms of percentages. That will help you figure out if you’re reasonably allocated or not.

Second, don’t be ashamed to admit you can only handle so much volatility. Financial planners are always pushing clients to invest more in stocks. But I think they do their clients a disservice because the advisors are neglecting to consider carefully whether the clients can handle the volatility of owning stocks. Sure, planners give clients risk questionnaires. But those only go so far. Nobody really knows hows they’ll react to stress until it arrives.

Also, advisors are human, and they probably have a more attractive view of themselves and their skills than they should. That means they think they’ll be able to soothe you better than they probably will when the market goes down. Advisors like to think that they can soothe clients, but if the client wants to leave, the advisor will do what the client says rather than lose the client. So don’t let an advisor push you into more stock exposure than you can handle. The best advisors work hard to find out what the best allocation is for you; they don’t try to push you into an allocation or make you feel badly for not having more stock exposure.

Third, if you have to sell, don’t get all out of stocks with your long term money. It’s a mistake to sell everything, even if you think the market will keep going down, and it does. That’s because it will be harder to get back in. You won’t know where the bottom is (nobody ever does), and you’ll be too scared to dribble money in if you’re all out.

If you maintain some modicum of stock exposure, you’ll at least have that capturing gains when the market delivers them again. But you might be wrong about when the market will turn, so keep 25% of stock exposure as a hedge against your inability to call at bottom — or act after prices drop a lot.

Investment legend Benjamin Graham said “enterprising investors,” those who study the markets and investments carefully, can toggle between 25% and 75% stock exposure, but no more and no less on either end. You might want your bands to be more narrow depending on your age, etc… Try toggling between 60% and 30%.

Personally, I think valuations are insane, but I have for a long time. And the market just keeps running. That doesn’t mean I may not be correct eventually, but eventually can be a very long time. Have some humility. You need it in this game.

Fourth, don’t assume changing your allocation is easy . If you go down to 25% or 30% stock exposure, but that’s not really optimal for you, it may be hard to get back in. That’s because the criteria you might wait for – a cheap P/E ratio or some technical indicator – may never materialize or stick around long enough for you to act.

Fifth, even if you do get an opportunity, remember there’s never a time when “the coast is clear.” Whenever stocks drop a lot, it feels bad to buy them, even if that’s what you should be doing. That’s why having a system is so important. Simply responding to market moves in an ad hoc manner probably won’t go well.

Sixth, see an advisor if you can’t settle non an asset allocation or handle market moves well.

Learning Emotional Control From This Year’s Market Moves

Labor Day Weekend has ended, and the year is two-thirds over That means it’s a good time to assess what has happened and where we stand in the markets. It’s also a good time to remember what you might have been feeling earlier in the year when asset classes were behaving differently.  Understanding your emotions is a big part of successful investing, and can help you deal with market volatility in the future.

US Stocks In 2008 – Up, Down, and Up

The S&P 500 Index ended August up 9.94% for the year. But that seemingly happy statistic doesn’t indicate what an investor might have felt at various points during the year. After a blistering January during the first three weeks of which it gained nearly 10%, the market melted down in February and March during which it gave back the January gains.

It’s hard to remember now, but many investors were euphoric in January and terrified in March. If you examine our phone logs, they will bear that out. We always get more calls from clients and prospective clients when things look difficult, and our phones were silent in January and ringing non-stop in March. My colleague Danny Ratliff and I also fielded a memorable call on our radio show from an investor in his mid-50s with a balanced allocation whose portfolio was down 5% from its peak. This person was unnerved by that decline, but it didn’t occur to him that he should expect that routinely from a balanced portfolio.


The first lesson investors can learn from this year’s market moves is that short term (say, month-to-month) forecasting is virtually impossible. Don’t even try it. We try to manage risk as much as any advisory firm, but no advisor can deliver all of the market’s upside and none of its downside or time every wiggle and squiggle in all asset classes. Some of the burden of achieving good returns falls on you and your ability to control your behavior and to be realistic about volatility.

The person who called in to our radio show probably wasn’t just upset by the 5% decline in his portfolio, but also by the prospect that the declines would continue. And he was right to be thinking about that. Investors should always contemplate a 50% stock market drawdown because that’s how big the last two stock market drawdowns were. That implies a loss in a balanced portfolio on the order of 25%. Accepting volatility is the price of admission to the financial markets. the good news is you can choose how much to accept. Nobody is forcing you to have a lot of stock exposure.

The second obvious lesson is not to get lulled into a false sense of security. The market’s blistering run in January – after a nearly 22% gain in 2017 when the S&P 500 Index experienced no down months – caused investors to be shocked by the February-March declines. But it shouldn’t have. A run like that should have made you suspicious and girded you for volatility. Now that the markets have been calm again through the summer, you should be prepared for volatility again. Nobody knows for sure when it will arrive; the calm may continue for a while longer. But after such calm you’d be foolish to be surprised by turbulence. Stop getting fooled by the same things, and by thinking markets will calm down once and for all at some point. They never calm down once and for all. The calmer they are, and the longer the calm lasts, the more suspicious you should be. You should think that the next big decline is always at hand — and that’s because, often enough, it is. That’s just the way markets work.

The third lesson is to have an asset allocation you can live with. Don’t count on any risk management system to save all your bacon all the time. Investing means taking periodic losses – at least on paper. Get used to it. It’s part of the game. If you’re near retirement or in retirement, and you can’t tolerate losses, there’s nothing to be ashamed of about that. Get yourself into an allocation that will inflict less volatility on you. Reduce your stock exposure for goodness sake. The right amount of stock exposure is the amount you can live with and that will not cause you to sell if the stock market goes down by half. If you’re tempted to sell during declines, you have too much stock exposure. Take this opportunity to think hard about your allocation, and whether it will cause you to do something stupid like sell hard into a decline.

The Case of REITs

REITs have also had a year of distinctly opposite moves. Unlike the rest of the stock market which roared in January, REITs opened the year poorly. They dropped around 10% in January and February on interest rate fears. REITs are required to pay 90% of their net income as dividends, which gives them some bond-like qualities. That means when rates rise REITs can go down, even if they are the stocks of companies that can pass inflation costs on to tenants in the form of higher rents eventually.

After their 10% drop, REITs began to rebound in late February, and they haven’t looked back since. They are now up around 5% for the year or more than 15% from their lows. But the lessons are the same as with the broader stock market’s moves this year. Don’t try to time every wiggle and squiggle. And now that REITs have put together a strong run, be more suspicious than excited about them. Last, get exposure to them that you can tolerate. Chances are, you won’t time big moves into and out of them well. Make an appointment with us if you need help identifying a reasonable asset allocation.

Why We Trumpet Our Worry

Many clients and prospects who meet with us ask why we’re so pessimistic. There are a couple of reasons. First, although we don’t set out trying to be pessimistic, we report economic numbers and security valuations the way we see them. Bonds are giving poor yields, and stocks are at nosebleed valuations on any reasonable metric — Price/Sales, Shiller PE, etc… Consumer debt is high, as the middle class tries to maintain it standard of living on stagnating wages by borrowing. Economic growth since the last recession has been tepid. There’s no way to sugar-coat that, so we don’t try. We owe our clients our honest opinions.

The other answer has to do with managing investors’ behavior. We have a lot of collective experience in the financial services business, and we’ve seen investors make a lot of mistakes. And, yes, we’ve made a few ourselves, because we’re not perfect. Undoubtedly, we’ll make more. But our experience tells us that investors sell at bottoms. Everyone in our business knows this is a classic problem. Morningstar investor returns data often show that there is a 2 percentage point gap between mutual fund returns and the returns fund investors capture, though the last report Morningstar issued on this subject was admittedly more hopeful. If we are pessimistic it’s because we are trying to let investors know the stock market usually provides a bumpy ride, and tests your patience. It delivers gut-wrenching declines at times, and we prefer to see investors not sell during those declines. In fact, we want to prepare our clients so well for declines that they have a bias towards buying stocks when markets swoon.

All advisers want what we want; we are not unique in wanting to see our clients not sell at the bottom. The question, then, is how to combat the inherent urge to sell at the bottom. One possible tactic is to inculcate a buy-and-hold mentality in investors, and that’s a reasonable approach. But, although it doesn’t have to entail this, that approach often glosses over how painful declines can be, or just counsels investors to fight through them. That’s likely what investors should do, but telling them to grit their teeth may not be the best strategy to get them to do that. The buy-and-hold message emphasizes that investors usually come out better on the other side of a big market decline at the expense of focusing investors’ attention on how they might feel during the decline when they are likely to do the most damage to themselves.

We’d rather focus investors’ attention on how they might feel during the depths of a decline, and say to them,

The last two market declines have consisted in 50% drawdowns, so forget about the market’s long-term 18% standard deviation. You will be inclined to behave badly when you see your portfolio value declining, if you don’t think hard about that moment now when you’re more calm. You will want to sell everything to stop the losses instead of buying at cheap prices. And that will lock in your losses and potentially cause you to miss the eventual upswing. You will likely do yourself permanent damage. You will focus on how much your account has declined instead of focusing on how cheap stocks might be at that moment, and if you get too much stock exposure now you will not be inclined to buy at that moment. You will want to fire us as advisers, and you will never want to invest in stocks again. Or you will find an unrealistic and/or unscrupulous adviser who will tell you they can deliver all the market upside with none of the downside.

Try to remember how you felt and behaved in 2008-9, and then consider how much stock exposure you really want to have. We will do our best to manage your downside, but much of your success depends on your choosing an appropriate amount of stock exposure to begin with. That amount is usually less than you think it is, especially after a 9-year bull market.”

We think saying these things, and working hard to assess a new client’s risk tolerance, are more effective than emphasizing coming out on the other side of a bear market. Coming out on the other side isn’t the problem; the decline is the problem. Investors can’t see their way to coming out on the other end in the middle of a bear market, and encouraging them to do that at that moment isn’t helpful. We’d rather address bad behavior at a moment when investors — especially retirees, who are most vulnerable to fluctuating account — are in a better psychological state to listen.

We encourage investors to access the fear they’ve felt during past declines, before the next one ensues, and we never shame them into owning more stocks than they can handle. We think a lot of advisers subtly shame investors into owning more stocks because of how stocks have performed over the last century or so relative to bonds. Much of these gains owe to a price multiple expansion that was likely a one-time event during the 1908s and 1990s, as Rob Arnott and Peter Berstein have argued. And there are long periods when stocks have delivered poor returns.

No adviser knows exactly when bottoms and tops occur, but an adviser with experience can often judge the psychological temperature of clients well. An experienced adviser can often surmise how clients will react under different market conditions better than clients themselves. Clients are notoriously poor judges of how they will behave under adverse market conditions. They tend to block out how they felt in 2008, for example. And they are poor judges of how much stock exposure they can handle.

Clients will have to assess for themselves which approach and which kind of adviser will help them withstand market volatility, and help them buy — or at least not sell — into steep declines. The buy-and-hold approach, after all, is really a buy-and-rebalance approach, and investors adhering to it must rebalance in down market by purchasing stocks.

We are grateful to the clients who have entrusted us with the management of their capital, and we look forward to meeting new ones who seek an alternative approach. Click here to schedule an appointment with us if you are interested in hearing about our approach to asset management and financial planning.

The Two Rules Of “Stockbroker Economics”

How an advisor should talk to clients and what rhetoric leads to big sales are often at odds. It can be death to an advisory business if the advisor is negative. Clients tend to want reassurance from an optimistic advisor. That’s why economist Andrew Smithers refers to broker happy talk asstockbroker economics.”

The two rules of stockbroker economics are:

1. All news is good news, and;

2. It’s always a good time to buy stocks.

On the role of news, a strong economy fills clients will all the optimism and willingness to buy that they need. A weak economy simply prompts a broker to say that falling interest rates and future rising profits are good for stocks, never mind that profits and prices had only moved in tandem 54% of the time when Smithers wrote his 2006 article. On the second rule, nothing has succeeded as well as what Smithers calls the “bond yield ratio,” another name for which is the “Fed Model.” That model compares bond yields to the earnings yield of the stock market (the reciprocal of the P/E ratio or E/P). This ratio worked from 1977 to 1997, but didn’t from 1948 to 1968. Using the full dataset shows no relationship between bond yields and earnings yields, according to Smithers.

Other forms of nonsense used to support the second rule include using a current P/E ratio to appraise stocks. Of course, a current P/E ratio has little ability to forecast long-term returns. It sometimes shows stocks are expensive when they are actually cheap, and vice versa.

A third piece of nonsense that Smithers doesn’t mention is the assertion that all forecasting is bunk. While forecasting next year’s returns might be bunk, metrics like the Shiller PE and Tobin’s Q have strong records in forecasting future long-term returns. Even if the Shiller PE has been elevated for the past 25 years, the S&P 500 Index has delivered tepid returns (5.4% annualized) from 2000 through 2017 with the entirety of that return occurring only in the last 5-years.

All of this means the first rule for investors judging their advisors is whether their advisors engage in too much happy talk – especially about future returns. If an advisor says a balanced portfolio should deliver a 7% annualized return for the next decade with starting 10-year U.S. Treasury yields at 3% and stocks at a 32 CAPE, be wary.

Second, investors should avoid advisors who avoid making forecasts to the point where they disparage anyone who does. That’s because it’s not hard to make a bond forecasts. With high-quality bonds, yield-to-maturity will get you close to the total return. Although stocks are harder, the Shiller PE can help. And, the more it’s stretched by historical standards, the more accurate it gets. No advisor should be dogmatic about pinpointing future returns; anyone who thinks they can be precise is crazy. But it’s also outlandish to expect long term historical returns from the stock market when valuations are as stretched as they are today. Stock market forecasts are hard, but don’t let your advisor squirm out of them completely.

Making a forecast is also necessary for constructing a financial plan. And, while it’s true that an accurate forecast doesn’t have to be available just because advisors and clients need one, decade-long projections are easier, if imperfect, than guessing what next year’s market move might be. When the Shiller PE stretches to more extreme levels, low future returns become more likely. So, when you hear an advisor making fun of something, that should raise warning flags.

We think advisors with integrity aren’t afraid to tell clients stocks are expensive even when it might hurt the advisor’s business. An advisor constructing a financial plan owes you an honest assessment of future returns. Currently, the Shiller PE is at 32. And while nothing is impossible, it’s very unlikely that stocks will deliver more than a 2% real annualized return for the next decade.

Third, consider if your advisor goes beyond the risk questionnaire he gives you. Nearly every financial advisory firm has a risk questionnaire that it gives to prospects and clients. The questionnaire often has many questions about how much risk the investors think they can handle and what portion of their assets they’d like to put at risk in exchange for possibly getting a higher return than a low risk investment will deliver. But risk questionnaires ask about percentages, and most people don’t think in percentages. Consider if your advisor asks you how you might feel if you opened up your statement and your account was down by a certain dollar amount. That’s more meaningful than a percentage question. Consider it a positive thing if your advisor pursues this line of questioning a bit, including asking you how you felt and how you reacted to the market plunge in 2008.

Risk often boils down to how much of a portfolio decline a client can tolerate before selling out, and everyone has a point at which they sell. This is important because it shows how investors do themselves damage. The tendency should be to buy stocks when they get cheaper, not sell them. But investors rarely think of buying when the prices of their holdings are declining.

Advisors have other ways of trying to train clients about how to treat price declines in their portfolios. Many advisors focus on long–term asset class returns, trying to persuade investors that they can overcome declines if they have the willpower to stay the course and not be discouraged. Other advisors do the opposite, focusing on how severe declines can be and trying hard to get clients into allocations that they can live with at the outset and to prepare them for the difficulty that lies ahead in the inevitable downturns.

The advisors who emphasize long term returns often come close to shaming clients into owning stocks. In my experience, such has made some clients feel inadequate for not wanting to assume more risk – or have encouraged clients to take more risk than they would have for fear of being deemed inadequate in the eyes of the advisor. Make sure your advisor isn’t shaming you into owning more stocks than you can handle.

At Clarity Financial, we focus on the growth of savings and on the minimization of emotional duress that can lead to poor investment decision-making.

Don’t Be A Victim of Recency Bias

Is it possible that stocks aren’t overpriced? Financial adviser Josh Brown raises the possibility, arguing that earnings can grow into their prices. After all, Amazon, Netflix, and Nvidia have seemed overpriced to investors for a long time, but their economic performance keeps improving. As Brown puts it, with all of these stocks in the recent past, “[t]he fundamental stories grew up to justify the valuations investors had already been paying (Brown’s emphasis).”

And this can also happen to entire markets. Five years ago, the market’s cyclically adjusted P/E ratio (CAPE or Shiller PE) was higher than it had been in 87% of all readings up until that point. But the stock market has been up 90% since then. “No one could have known that the fundamentals would arrive to back up the elevated valuations for stocks eventually,” according to Brown.

This last statement is odd. In May of 2013, the S&P 500 carried a CAPE of 23. Now its CAPE is 31. It’s not clear from this simple valuation metric that stock earnings have grown into their new, elevated prices. Past ten-years’ worth of earnings ending in 2013 were $78, according to Robert Shiller’s data. For the most recent ten-year period, they are $84. Ironically, one could make the argument that earnings have grown into the 2013 price five years later, but not the 2018 price. It we apply the May 2013 price to the past decade’s worth of earnings ending today, we get a CAPE of around 21. That’s much more reasonable than the current one of 31.

In fact, if we agree that the long-term historical average CAPE of nearly 17 is outdated, and that the new average should be around 20 or 22, then the 2013 price of the market relative to the past decade’s worth of earnings ending today is roughly the correct valuation. That also means all the price advances the market has made since 2013 do not reflect underlying economic reality or earnings power value of the market. In other words, earnings have increased, but stock prices have increased much more so that the market should be trading at 2013 prices given the past decade’s worth of earnings.

Brown’s point, of course, is that the earnings growth of the past decade can repeat over the following decade. But that also means that for stocks to deliver robust returns, the current 31 CAPE valuation must reappear 10 years from now. That’s possible, but investors and advisers must contemplate how they would like to bet and what they must tell clients if they are behaving as fiduciaries.

It’s possible that we could wake up to a 31 CAPE in a decade, and that U.S. stocks will have delivered 7% or so nominal returns (2% dividend yield plus 4%-5% EPS growth). It’s also possible that earnings-per-share can increase at a greater clip than they have historically. Nobody should say those things are simply impossible. But if you are managing your own money, or advising others in a fiduciary capacity (which means you must treat their money with all the care you do your own), how reasonable is it to expect that as what forecasters might call a “base case?” At best, assuming we’ll all wake up to a 31 CAPE in a decade must be a very rosy, low-probability scenario.

There’s an irony to Brown warning against those who carry on about backward looking valuation metrics. One of the most well-known observations of behavioral finance is that human beings can be seduced by recent patterns, including recent securities price movements. We tend to assume, without any evidence other than the recent pattern, that price trends will continue. Everyone will have to decide for themselves whether deriving encouragement from a 90% stock price move without a commensurate earnings increase, as Brown does, reflects proper attention to simple arithmetic or our susceptibility to extrapolate recent stock price movements and returns into the future.

Volatility Is Back

After a bad week in early February when the S&P 500 Index dropped 10% to meet acknowledged definition of a correction, the market has rebounded and investors have mostly regained confidence. On Monday, March 5, the Index bounced over 1% higher making its year-to-date return over 2% — a perfectly respectable return in the early days of March.

However, one can’t help but have an uneasy feeling that it’s a different market environment in 2018 than it was in 2017 when, for the first time in history in one calendar year, the market posted positive gains in every month. Using the S&P 500 Price Index (not including dividends), The market was so anesthetized in 2017 that it posted only 8 days of gains greater than 1% or losses more severe than -1% from the previous day’s close. This year, the market has already posted 16 days of gains greater than 1% or losses more severe than -1% from the previous day’s close.

Moreover, the index experienced no one-day 2% gains or losses in 2017. It has already had three such days in 2018, all of them to the downside.

Another way to look at volatility is to measure the average daily volatility, using absolute value of daily changes. As our chart shows, over the roughly five year period from the start of 2013 through March 5, 2018, the S&P 500 Price Index moved an average of 0.54% on a daily basis. For 2017, that number shrank to 0.30%.

It’s also useful to look at standard deviation, a statistical measure that indicates the range of most, though not all, moves from an average. For the five year period, the standard deviation of the index was 0.77%, while for 2017 the standard deviation was 0.42%.

Lessons for Investors

Investors should learn from this graph that the low volatility of 2017 was unusual and that it’s not reasonable to expect that environment to persist. Investors should also take the opportunity to review their asset allocations. The fact that markets have rebounded since their declines in early February shouldn’t be so much cause for joy as an opportunity to reassess how much volatility is tolerable.

If an investor was unnerved by the market drop in early February, that likely means their allocation was inappropriate. Too many investors have piled into stocks because bond yields are low and long-term historical stock returns promise to make up the difference for under-saving for retirement. But century-long or longer stock returns mask the fact that stocks go through decade-long and two decade-long fallow periods, especially when valuations are as high as they are now.

Investors tend to forget how they feel during bear markets, especially when those bear markets are in the distant pass. We tend to have what behavioral finance professors call an “empathy gap” regarding our own feelings and behavior in stressful markets. But since early February isn’t that far away, investors should use it as an opportunity to reassess how a downturn might make them feel. If you wanted to sell stocks instead of stay put or buy them as prices got cheaper, it’s time to reassess your allocation – while you still can without having to change it after a decline.

Investors should also consider that bonds, though offering lower than normal historical yields, still have a place in portfolios. Their stabilizing influence is often most welcome when investors have written them off as boring next to stocks, their more exciting cousins. As other investors forget risk and unnerve their brokers and advisors with extreme bullishness, it might be a good time to be cognizant of just how much excitement you can tolerate. Investors feeling themselves capable of accepting more risk should also consider the words of investor Howard Marks, — “The truth is, risk tolerance is antithetical to successful investing. When people aren’t afraid of risk, they’ll accept risk without being compensated for doing so, and risk compensation will disappear.”

Why Recent Volatility Is a Gift For Investors

Warren Buffett’s teacher, Benjamin Graham, once wrote:

“The investors chief problem – and even his worst enemy – is likely to be himself.”

The market’s recent volatility can give investors an opportunity to reflect on some common psychological pitfalls and not be their own worst enemies.

Investors damage themselves mostly by selling stocks when they get cheap and buying them when they get expensive. Morningstar’s most recent investor returns study shows that investors in diversified stock funds are giving up nearly one percentage point of returns annually due to bad trading. While the numbers don’t tell us what’s causing investors to lag the returns of their funds, it may well be due to certain behavioral problems. Advisors see the behavior constantly in their practices. And advisors aren’t immune from the behavior themselves.

Behavior Gap

Damaging though it can be, it’s understandable why investors sell low and buy high. Nobody likes to see their portfolio declining, so the inclination is to sell when stocks are going down. And nobody likes to see their neighbor making more money than they are, so the inclination is to buy when stocks are going up. The fear of losing money permanently and the fear of missing out on gains (which may really be just greed) are always at play.  Of course, if you’re supposed to adhere to a target allocation, you must sell when stocks go up to maintain your allocation. And you must buy when stocks go down to maintain your allocation. But investors forget that in times of euphoria or panic.

Sometimes being in the right parts of the market can help, whether you’ve emphasized the right sectors or the right parts of the world. But, as this Morningstar article notes, there were few places to hide during the stock market’s recent unpleasantness. And that may be the case next time as well, since all asset classes seem to have risen in tandem after the financial crisis.

That leaves the question of owning more bonds. From February 1st through February 9th the S&P 500 Index dropped around 7%, not including dividends. Over that period, the iShares 10-20 Year Treasury Bond ETF (TLH) lost only around 1% in price – a considerable improvement over stocks. And, of course, cash didn’t lose anything.

An Opportunity To Reassess Risk Tolerance & Allocation

The lesson investors should take from the recent market turbulence is to think about whether it frightened them and how much it frightened them. After all, an investor’s bias should be to buy when the market is going down. That’s not to say the roughly one-week correction we had is all the downside we’ll see, and that buying stocks while it was happening would have guaranteed rock-bottom purchase prices. But an investor should be inclined to buy when markets are falling, not sell. Similarly, the bias should be toward trimming stock from a portfolio during market surges. Use the recent turbulence to take the temperature of your emotions. What were you inclined to do when you saw your portfolio’s value declining?

When investors complete the risk questionnaires that their advisors give them, it’s difficult for them to remember how they felt during the last bear market. Behavioral finance calls the inability to access old feeling the “empathy gap.” As a result, many investors indicate on risk profile questionnaires that they are more risk-tolerant than they really are. Don’t’ squander the gift last week’s recovery gave you to think about how the week before felt. If you wanted desperately to sell, you probably have the wrong allocation.

I talked to an investor during the correction whose portfolio was down around 5%. We surmised he probably had a balanced – roughly half stocks and half bonds – allocation, and that’s normally considered reasonable for his age (early 50s). But he was rather disturbed by this volatility, and we couldn’t help but conclude that his allocation was too aggressive for his personal taste and comfort.

Advisors tell clients that a 5% decline isn’t much. It’s really the price of admission into the stock market, which experiences 10% drops with great regularity. That may be true, but many investors don’t realize what it will feel like when they see their account decline. Many investors indicate that they can handle a 20% decline in their portfolios on risk questionnaires. But a 5% decline, after all, will reduce a $500,000 portfolio by $25,000. That’s usually not catastrophic, but it’s unnerving for someone who hasn’t experienced it before. And it can push them to sell stocks at lower prices. A full 20% decline will reduce a $500,000 portfolio by $100,000, and the older you are, the more unnerving that can be.

A balanced portfolio (50%-60% in stocks) should a reasonable one for many people 15 years from retirement into early retirement, but many investors are unaccustomed to its volatility, and many advisors are unaware of how unaccustomed their clients are to its volatility. Investors should use this opportunity to decide if they need to reduce their stock exposure, and advisors need to reassess how well they’re preparing clients for inevitable downturns. Advisors don’t like to be negative. They think, with some justice, that negativity will make it harder to attract and retain clients. But they must focus on the downside and educate clients better. It’s arguably their fiduciary duty, and it will make for better client experiences in the long run.

Think In Dollar Terms, Not Percentage Terms

Investors should do at least one more thing in response to the recent volatility. Think in dollar terms, not percentage terms. Most investors don’t know what a 5%, 10%, or 20% decline really means for their portfolios. They’re not used to thinking in percentage terms. Go through the exercise of thinking about what each of these declines means in dollar terms for your portfolio. It will help you understand how much risk you’re taking and whether you can tolerate it. We’ve had two 50% top-to-bottom stock market drawdowns within the past 20 years. Valuations are stretched now, and there’s nothing to say we can’t have another one – though, as always, there’s no certainty that we will have one. The time to prepare is now – after the gift the market just gave you in dropping a lot, but then recovering a lot.