By Jim Parker, Vice President, DFA Australia Limited
Human beings love stories. But this innate tendency can lead us to imagine connections between events where none really exist. For financial journalists, this is a virtual job requirement. For investors, it can be a disaster.
“The Australian dollar rose today after Westpac Bank dropped its forecast of further central bank interest rate cuts this year,” read a recent lead story on Bloomberg.
Needing to create order from chaos, journalists often stick the word “after” between two events to imply causation. In this case, the implication is the currency rose because a bank had changed its forecast for official interest rates. Perhaps it did. Or perhaps the currency was boosted by a large order from an exporter converting US dollar receipts to Australia or by an adjustment from speculators covering short positions. Markets can move for many reasons.
Likewise from another news organization, we recently heard that “stocks on Wall Street retreated today after an escalation of tensions in the Ukraine.” Again, how do we know that really was the cause? What might have happened is a trader answered a call from a journalist asking about the day’s business and tossed out Ukraine as the reason for the fall because he was watching it on the news.
Sometimes, journalists will throw forward to an imagined market reaction linked to an event which has yet to occur: “Stocks are expected to come under pressure this week as the US Federal Reserve meets to review monetary policy settings.”
For individual investors, financial news can be distracting. All this linking of news events to very short-term stock price movements can lead us to think that if we study the news closely enough we can work out which way the market will move. But the jamming of often-unconnected events into a story can lead us to mix up causes and effects and focus on all the wrong things. The writer and academic Nassim Taleb came up with a name for this story-telling imperative: the narrative fallacy.1
The narrative fallacy, which is linked to another behavior called confirmation bias, refers to our tendency to seize on vaguely coherent explanations for complex events and then to interpret every development in that light. These self-deceptions can make us construct flimsy, if superficially logical, stories around what has happened in the markets and project it into the future.
The financial media does this because it has to. Journalists are professionally inclined to extrapolate the incidental and specific to the systematic and general. They will often derive universal patterns from what are really just random events. Building neat and tidy stories out of short-term price changes might be a good way to win ratings and readership, but it is not a good way to approach investment.
Of course, this is not to deny that markets can be noisy and imperfect. But trying to second-guess these changes by constructing stories around them is a haphazard affair and can incur significant cost. Essentially, you are counting on finding a mistake before anyone else. And in highly competitive markets with millions of participants, that’s a tall order.
There is a saner approach, one that doesn’t require you spending half your life watching CNBC and checking Bloomberg. This approach is methodical and research-based, a world away from the financial news circus. The alternative consists of looking at data over long time periods and across different countries and multiple markets. The aim is to find factors that explain differences in returns. These return “dimensions” must be persistent and pervasive. Most of all, they must be cost-effective to capture in real-world portfolios.
This isn’t a traditionally active investment style where you focus on today’s “story” and seek to profit from mistakes in prices, nor is it a passive index approach where you seek to match the returns of a widely followed benchmark. This is about building highly diversified portfolios around these dimensions of higher expected returns and implementing consistently and at low cost. It’s about focusing on elements within your control and disregarding the daily media noise.
Admittedly, this isn’t a story that’s going to grab headlines. Using the research-based method and imposing a very high burden of proof, this approach resists generalization, simplification, and using one-off events to jump to conclusions. But for most investors, it’s the right story.
1 Nassim Nicholas Taleb, The Black Swan: The Impact of the Highly Improbable, Penguin, 2008.
Want to see some great entertainment? Instead of patiently waiting for the much anticipated fight of the century between Floyd Mayweather Jr. and Manny Pacquiao or even hoping for a Mixed Martial Arts heavyweight rematch between Brock Lesnar (back in the WWE) and Cain Velasquez, why not watch two middle-aged, scrawny portfolio managers duke it out to see who wins the big prize? All kidding aside, the really big battle in the capital markets is on; it’s a battle between the Stock Bull and the Bond Bull. And quite frankly, our money is on the stock guy!
In this article, we explain why we believe that, despite the recent uptick in the price of interest-rate-sensitive assets in the first quarter 2014 (Q1), this tug-of-war between the stock bulls and bond bulls will ultimately be declared a victory for the equity guys as it plays out over the next several years.
We believe the recent snapback in bond proxies occurred because these assets harshly sold off in Q4 and were dramatically oversold. In a nutshell, markets don’t go straight up despite being in a secular bull market (stocks), and they don’t go straight down despite being in a secular bear market as is the case with bonds. Although most of our readers understand this, sometimes market noise takes us all off our sense of reason. We hope you enjoy our analysis documenting our bullish stance on equities and our bearish stance on bonds as we believe it to be based on solid footing.
How did the first quarter align with our expectations? The overall stock market returns for Q1 were in line with our expectations; however, what did come as a surprise was the drop in the 10-Year Treasury rates from 3.01% to 2.50% allowing assets whose prices were tied to long-term interest rates to rise fairly substantially in Q1. We view this only as a short-term trading opportunity as last year these assets were hit hard and, if you look at their trailing one-year returns, they are quite muted. Consider these examples:
In our humble opinion, this market behavior can best be described as a “dead cat bounce.” No offense to those of us who love cats, but the so-called “dead cat bounce” is a snapback reaction that occurs when assets are extremely oversold. When the bounce occurs, assets attract bottom-fishers and over time the rally fades away.
- Although long-dated Treasuries as measured by the ETF ticker symbol TLT are up 7.83% on a year-to-date basis, they are down 6.39% when measured for the trailing one year period.
- Although Real Estate as measured by ETF ticker symbol IYR is up 9.82% for the year-to-date period, it is essentially flat at 0.63% when measured for the trailing one year.
- Although the Utility Sector as measured by ticker symbol XLU is up a robust 9.90% for the year-to-date period and up 11.17% for the trailing one year period, that is only half the S&P 500’s return at 21.22%.
You can think of the battle between stocks and bonds as a boxing match. In the Blue Corner, we have the Bond Bull who believes that the economy is sputtering and that interest rates will remain muted for some time. In the Red Corner, we have the Stock Bull who believes that the bond market is in the early stages of a decades-long bear market and that the Q1 results will be a short-lived phenomenon. Because bonds have outperformed stocks year-to-date, Round 1 definitely goes to the Bond Bulls. The following chart developed from data published by Yahoo Finance illustrates the fight quite clearly.
The battle takes shape in Q1 as highlighted by the yellow highlights: As the stock market dropped, the bond market picked up steam and vice versa. We note five different points in 2014 when the blue (bond) and red (stock) lines move in opposite direction as the battle rages on. We gather from this that the classic risk-on, risk-off trade environment is before us much like it has been over the past five years as Treasuries have served as a “bunker” for capital (as described by Bespoke) whenever the investment landscape has shown signs of tension. This has been the case whether it was caused by geopolitical uncertainty (i.e., Ukrainian Crisis) or economic uncertainty (chronic U.S. long-term unemployment). Then after cooler heads prevailed and the so-called crises moved to the back page of the newspaper, investors rotated out of treasuries and back to stocks. The result of this risk-on/risk-off trade has been that rising yields have coincided with rising investor confidence and hence rising stock prices.
The chart below (based on data collected from Bespoke Investment Group) shows a rather amazing picture of how the S&P 500 has performed in periods of both rising and falling interest rates over the last five years (3/9/2009-04/23/2014). In total, we can identify 12 periods over the last five years when rates have been either falling (6 times) or rising (6 times) more than 20%. In each instance when rates have risen, the S&P 500 has always had a positive return and had a median increase of 15% in aggregate. (Note that we did not calculate average due to the abnormal 75% return in the first scenario.)In the six periods where rates have fallen over the last five years, the S&P 500 has been positive only three of the six periods or 50% of the time. Moreover, the median rate of return for those periods has been negative -2.60%. And although the market did rise during those three times when rates were falling, the returns were a paltry 2.7%, 2.2%, and 1.4%.
What this tells us is that a healthy, gradual rise in interest rates will be a very good sign for stocks, and this is what we believe will happen over the next several years. We have documented previously that, based on the historical tie between Nominal GDP and the 10-Year Treasury Rate, today’s yield should be closer to 4% if you add 2.5% GDP to 1.5% CPI. An even more amazing stat is that the historical average of the 10-Year Treasury Note over the last 50 years has been 6.7%. Ironically, that is the Equity Earnings Yield on the market when the Price-Earnings ratio is 15X.How long will it take to get to 4% or even 6.7% interest rates? Nobody knows, of course. But what we do know is that asset prices tend to revert to their mean after periods of significant price increases, which is what we have had in the bond market over the last three decades. So who wins the big tug of war?
Our money is on the stock guy (large boxer in the picture nearby) to win this battle and to win it convincingly!
Thanks for partnering with us.
By Jim Parker
Vice President, DFA Australia Limited
When the media raises the subject of beating the market through astute stock picking, the name Warren Buffett is usually cited. But what does this legendary investor actually say about the smart way to invest?
Buffett is considered to have such a track record of picking stock winners and avoiding losers that his annual letter to shareholders in his Berkshire Hathaway conglomerate is treated as a major event by the financial media.
What does he think about the Federal Reserve taper? What could be the implications for emerging markets of a Russian military advance into Ukraine? What does an economic slowdown in China mean for developed markets?
Buffett has a neat way of parrying these questions from journalists and analysts. Instead of offering instant opinions about the crisis of the day, he recounts in his most recent letter annual a folksy story about a farm he has owned for nearly 30 years.
Has he laid awake at night worrying about fluctuations in the farm’s market price? No, says Buffett, he has focused on its long-term value. And he counsels investors to take the same sanguine, relaxed approach to liquid investments such as shares as they do to the value of their family home.
“Those people who can sit quietly for decades when they own a farm or apartment house too often become frenetic when they are exposed to a stream of stock quotations,” Buffett said. “For these investors, liquidity is transformed from the unqualified benefit it should be to a curse.”
While many individuals seek to ape Buffett in analyzing individual companies in minute detail in the hope of finding a bargain, he advocates that the right approach for most people is to let the market do all the work and worrying for them.
“The goal of the non-professional should not be to pick winners,” Buffett wrote in his annual letter. “The ‘know-nothing’ investor who both diversifies and keeps his costs minimal is virtually certain to get satisfactory results.”
As to all the predictions out there about interest rates, emerging markets, or geopolitics, there will always be a range of opinions, he says. But we are under no obligation to listen to the media commentators, however distracting they may be.
“Owners of stocks… too often let the capricious and irrational behavior of their fellow owners cause them to behave irrationally,” Buffett says. “Because there is so much chatter about markets, the economy, interest rates, price behavior of stocks, etc., some investors believe it is important to listen to pundits—and, worse yet, important to consider acting upon their comments.”
The Buffett prescription isn’t rocket science, as one might expect from an unassuming, plainspoken octogenarian from Nebraska. He rightly points out that an advanced intellect and success in long-term investment don’t necessarily go together.
“You don’t need to be a rocket scientist,” he has said. “Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ.”
Diversification neither assures a profit nor guarantees against loss in a declining market. Investing involves risks including potential loss of principal and fluctuating value.
All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products or services.
Global diversification gives investors a valuable tool for managing risk and volatility in a portfolio. But smart diversification has an important side effect. It requires maintenance.
In a given period, asset classes experience divergent performance. This is inevitable and, in fact, desirable. A portfolio that holds assets that do not perform similarly (i.e., with low return correlation) will experience less overall volatility. That results in a smoother ride over time. However, dissimilar performance also changes the integrity of your asset mix, or allocation—a condition known as “asset drift.” As some assets appreciate in value and others lose value, your portfolio’s allocation changes, thereby affecting its risk and return qualities. If the allocation drifts far enough away from your original target, you end up with a different portfolio. That’s why, at True North Capital Alliance, we advocate analyzing and rebalancing our clients’ portfolios periodically.
Once we design and construct your portfolio to match your current investment goals and risk tolerance, we monitor performance to preserve the portfolio’s structural integrity because asset allocation accounts for most of a portfolio’s return.1 To efficiently pursue your investment goals, we must manage asset drift.
Rebalancing is the remedy. In general terms, rebalancing involves selling assets that have risen in value and buying more assets that have dropped in value. The purpose of rebalancing is to move a portfolio back to its original target allocation. This restores strategic structure in the portfolio and puts you back on track to pursue long-term goals.
“Buffet Warns of Liquidity Curse,” Bloomberg, Feb 25, 2014.
Berkshire Hathaway Inc. shareholder letter, 2013, www.berkshirehathaway.com/letters/2013ltr.pdf.
“The Wit and Wisdom of Warren Buffet,” Fortune
, November 19, 2012, management.fortune.cnn.com/2012/11/19/warren-buffet-wit-wisdom/.
At first glance, rebalancing seems counter-productive. Why sell a portion of outperforming asset groups and acquire a larger share of underperforming ones? Intuition might suggest that selling previous winners may hinder returns in the future. This logic is flawed, however, since past performance may not continue in the future, and there’s no reliable way to predict future returns.
Equally important, remember that your original asset allocation was selected because it reflected your risk-return priorities. Rebalancing realigns your portfolio to these priorities by using structure, not recent performance, to drive investment decisions. Periodic rebalancing also encourages dispassionate decision-making, which is an essential quality during times of market volatility. Moreover, if and when your overall financial goals or risk tolerance changes, we have a foundation for making adjustments. In the absence of a plan, adjustments are a matter of guesswork.
Challenges and Decision Factors
Portfolio allocations are usually complex, incorporating not only fixed income and equity, but also multiple asset groups within equity investing. The more complex a portfolio’s allocation, the greater is the need for maintenance.
Determining when and how to effectively rebalance requires careful monitoring of performance and awareness of your tax status, cash flow, financial goals, and risk tolerance. Rebalancing also incurs transaction fees and potential capital gains in taxable accounts. Thus, while there are good reasons to rebalance, we firmly believe that we should only rebalance when the benefits outweigh the costs.
Given these challenges, we prefer to take a practical rebalancing approach using asset drift triggering points while leaving enough flexibility to manage costs effectively. Defining triggering points helps us decide when to rebalance. Most experts recommend rebalancing when asset group weightings move outside a specified range of their target allocations. This may be widely defined according to stock-bond mix, or more appropriately, according to a percentage drift away from target weightings for categories like small cap stocks, international stocks, and the like.
While rebalancing costs are unavoidable, several strategies can help minimize the impact:
Rebalancing incurs real costs that can detract from returns. Therefore we define ranges within which investment components can acceptably drift and adopt cost-saving strategies during rebalancing, paying particular attention to tax-sensitive transactions. In helping our clients rebalance, we strive to develop a structured plan that remains flexible to each individual’s unique blend of goals, risk tolerances, cash flow, and tax status.
No one knows where the capital markets will go—and that’s the point. In an uncertain world, investors should have a well-defined, globally diversified strategy, which their portfolios are managed to implement over time. Rebalancing is a crucial tool in this effort.
- Rebalance with new cash. Rather than selling over-weighted assets that have appreciated, we prefer to use new cash to buy more under-weighted assets. This reduces transaction costs and the tax consequences of selling assets.
- Whenever possible, we look for ways to rebalance in the tax-deferred or tax-exempt accounts where capital gains are not realized.
- Incorporate tax management within taxable accounts, such as cost basis management, strategic loss harvesting, dividend management, gain/loss matching, and similar considerations.
- Implement an integrated portfolio strategy. Rather than maintaining rigid barriers between component asset classes and accounts, we prefer to manage the portfolio as a whole.
1 Gilbert L. Beebower, Gary P. Brinson, and L. Randolph Hood, “Determinants of Portfolio Performance,” Financial Analysts Journal 42, no. 4 (July/August 1986): 15-29. Gilbert L. Beebower, Gary P. Brinson, and Brian D. Singer, “Determinants of Portfolio Performance II: An Update,” Financial Analysts Journal 47, no. 3 (May/June 1991): 40.
Bernstein, William (2001). The Intelligent Asset Allocator. New York: McGraw-Hill.
An in-depth look at asset allocation in passive and index portfolios. Bernstein makes a case that having a coherent asset allocation strategy is the key to long-term success in investing. A practicing neurologist, Bernstein uses his self-taught investment knowledge and research to teach independent investors how to build diversified portfolios.
Bogle, John C. (2007). The Little Book of Common Sense Investing. Hoboken, New Jersey: John Wiley & Sons.
A thorough examination of the benefits of index and passive investing written by the founder and former CEO of the Vanguard Group and creator of the world’s first index mutual fund. Bogle believes that investing is all about common sense and that owning a diversified portfolio of stock and holding it for the long-term in a winner’s game.
Lowenstein, Louis (2008). The Investor’s Dilemma: How Mutual Funds are Betraying Your Trust and What to Do About It.
Based on cutting-edge research by leading corporate critic Louis Lowenstein, The Investor’s Dilemma shines a harsh light on much of what is wrong with the mutual fund industry; it also outlines a value-oriented approach to this market that will allow individual investors to achieve investment success.
Malkiel, Burton G. (2011). A Random Walk Down Wall Street. New York: W. W. Norton & Company.
A Random Walk is a classic guide for the individual investor who wants insight into how markets really work. Malkiel covers the full range of investment opportunities and advances the premise that individual investors are better off buying and holding index funds than pursuing securities or actively managing mutual funds. Written for the financial layperson but bolstered by 30 years of research, A Random Walk, which is in its seventh printing, presents a thorough explanation of the benefits of passive investing.
Swedroe, Larry E (1998). The Only Guide to a Winning Investment Strategy You’ll Ever Need. New York: Dutton.
Swedroe provides an easy-to-read and informative introduction to passive investing and DFA-style allocation models. He describes the crucial difference between “active” and “passive” mutual funds and explains how investors can win the investment game through long-term investments in such indexes as the S&P 500 instead of through the active buying and selling of stocks.
Swedroe, Larry E (2001). What Wall Street Doesn’t Want You to Know. New York: St. Martin’s Press.
An easy-to-read introduction to passive investing. Swedroe gives the reader the “inside information” needed to understand the pitfalls of trying to pick stocks and time the market. He explains why active managers rarely add value to your portfolio over time and how index and passive investing can be advantageous.