Friday, April 1, 2011

Buy, sell or hold: Making investment decisions.

The post today is based on a feature in the ScotiaMcLeod Investment Portfolio Quarterly (IPQ) from the Summer of 2010: Investment Pitfalls and Opportunities: Replacing Psychology with Discipline

This feature was written by:
  • Justin Kusinskis, CFA – Associate Director, Portfolio Advisory Group, Fund Research
  • Carolyn Tsai – Associate, Portfolio Advisory Group, Fund Research
Kusinskis and Tsai wrote:

"We continue to live in interesting times – and it seems the times in which we live get more interesting with each passing month. From a high-level perspective, the world (at least economically speaking) is not in great shape."

Over the last couple of years investors, skittish after financially taking a bruising beating in the crashing market of 2008, have been largely avoiding equity funds. Money market funds were used heavily in mid-2008, then they, too, were redeemed in the fall as confidence collapsed lockstep with the Lehman collapse. These money market funds were later repurchased.

As the market recovered, people redeemed their money market funds, but instead of going into pure equity funds, they chose balanced funds and bond funds. The trend was towards a more conservative approach to investing.

Kusinskis and Tsai concluded:

  1. Investors have not had the confidence to return to pure equity funds, even as the market
    experienced a recovery from March 2009. This is not consistent with previous up markets where
    investors would pile into equities as the market was rising.
     
  2. Further, the investment choices of balanced funds and bond funds are
    considered less risky options. Given the significant volume of flows into balanced funds and
    bond funds over the last two years, investors have clearly indicated they have a reduced appetite
    for risk compared to previous periods.
     
  3. It seems investors are reacting more quickly to negative market activity, perhaps an indication of suffering with the last market decline in late 2008 and early 2009, and not wanting this to happen again.

Is any of this ringing a bell? Does it sound like the closing bell of the stock market? I know that I have rejigged my own portfolio allocation to reflect a full 15 percent investment in the TD Monthly Income fund and another full 15 percent in the CIBC Monthly Income fund. 30 percent of my money now resides in these two balanced funds. I freely admit these two funds are my security blanket as I invest the other 70 percent of my portfolio in equities, mostly Canadian but about 26 percent is invested outside the country.

I had no idea I was part of a financial stampede. According to the authors:

"Standard economic models assume individuals are rational and will try to maximize their benefits and minimize their costs."

However, studies have shown that investors are not always rational. Stampedes aren't rational. Investors can be driven by a strong aversion to loss, driven by herd mentality and by something the authors call availability bias.

Loss Aversion: the intense emotional response individuals feel when confronted with losses versus
gains of equal magnitude. Generally, the pain of a loss is approximately double the pleasure generated by a gain.

This is why investors pull out of the market after suffering a loss and hestitate before re-entering. We see the effects of loss aversion when investors grow timid about equities, deciding to sit on large cash balances. Enjoying the "comfort" of the sidelines has a significant cost in missed investment opportunities. Comfort doesn't come cheap.

Kusinskis and Tsai  write:

"Investors must realize that staying invested is crucial in helping them meet their long-term financial goals."

Another symptom of loss aversion behaviour is the tendency of investors to realize gains quicker than
losses. Whoa! Does this sound familiar. All too often I've bailed on a good investment after holding on for eons while it flailed about lost in the financial wilderness. This predisposition toward "get-evenitis" can take a real toll on a portfolio.

Folk like to say that a loss is not a loss until you sell and lock in your loss. Not completely true. Sell a dog and take the money from the sale and invest in a winner and you will have far more in the end than simply holding on and hoping desperately to "get your investment back."

It took my financial adviser at the ScotiaBank to make realize that I should dump the Yellow Pages Fund and move on. I did and have never looked back. I took my money and bought Trinidad Drilling (TDG). It was about five bucks to get in and I got out when it pushed eight. If I had held a few more months, I'd have gotten nearly ten dollars. As it was, I got my Yellow Page money back; I just didn't use the Yellow Pages to do it.

It turns out it is not just me who finds it difficult to accept losses. The tendency to sell winners too soon and to hold on to losers too long, is widespread. Everybody wants to at least get even despite the fact that the original rationale for purchasing the stock no longer appears valid. Take your licking like a man and cut your losses.

One needs a well honed sell discipline as well as a solid buy discipline.

Herding: the tendancy to follow others. Often this is a response to uncertainty and a belief that the
crowd is better informed than we are. All too often we lack confidence in ourselves. Symptoms of herding:

  • Making investment decisions frequently.
  • Investing in hot stocks/funds because they’re “popular” and selling them when they’re “out of favour”. (This leads to “buying high and selling low”.)
  • Basing investment decisions solely on the opinions of others. You must look under the hood before you buy the latest and greatest hot-rod stock.
"It is easy to get caught up with a particular investment opportunity, particularly when people see
friends/relatives making a lot of money on a particular stock or fund. The idea that the individual is 'missing out' on the opportunity can be too much to bear, causing them to buy the investment while (more often than not) it is expensive."

For multiple reasons, herding is probably one of the worst investment approaches to take.

Availability Bias: is an overreaction to the latest news. Investors suffering from availability bias give too much weight to readily available information. Symptoms of availability bias:

  • Choosing mutual funds that are heavily advertised or stocks of companies that are frequently in the
    news.
  • Overreacting to good/bad news.
  • Believing an “opinion” to be factual.

So, how can we avoid being our own worst enemy? In a word: discipline. Don't be a loss averse investor, or a herd follower but instead one must be a disciplined investor. The disciplined investor follows a systematic investment process which interestingly utilizes the same financial inputs as the loss averse investor, and the herd follower.

A research study by Kusinskis and Tsai looked at how these three types of investors, each with a portfolio of a hundred grand, would fare when confronted with a real life investment situation. For the full details, read the report in the IPQ, starting on page 24.

The loss averse investor did not rebalance on schedule and sold equity and bond investments to purchase  a money market fund near the trough of the market, with the result that the loss averse investor had $110,485 after five years for an annualized return of just 2.01 percent.

The herd follower used all available cash to buy equities as the equities were rising. In other words, this investor bought high. As equities continue to climb, they sold their bonds to buy more equities. They were buying even higher. When the market soured, they followed the herd, sold all their holdings and moved into a money market fund where they joined the loss averse investor, with the result that the herd follower only had $92,622 after five years for an annualized return of -1.73 percent. With no investment plan, no rebalancing, and continuing to buy when the market became increasingly expensive, this investor fell into the classic “buy high and sell low” trap.

The disciplined investor decided on a portfolio allocation before anything else. They created a portfolio that adhered to the plan with 60 percent equity and 40 percent bonds. They systematically rebalanced every Dec. 31 each year. With their financial bed carefully made, they were content to sleep on it. They accepted their losses as an expected part of investing and stayed invested for the entire five years. They didn't deviate from their 60/40 allocation.

The big surprise was the magnitude of the outperformance experienced by the disciplined investor versus the others. The disciplined investor had $139,537 at the end for a 5-year annualized return of 6.89 percent.

The disciplined investor had established the appropriate asset mix right at the start and stayed invested throughout the five years, systematically rebalancing once per year back to the 60/40 split. For example, in one of the years, equities appreciated in value to make up 66% of the portfolio, with the bond side of
the portfolio comprising 34%. At rebalancing time, the investor sold the overweight in equities (selling while equities were higher), and used that capital to purchase more bonds (buying while bonds were comparatively lower). Over time, the disciplined investor systematically was buying low and selling high.

One other interesting point, with our disciplined investor they were able to generate virtually the same
return as the market with about half the volatility (given the 60/40 mix as opposed to the market’s 100%
equity weighting) – the result – better risk-adjusted returns.

Bailing completely out of a collapsed market and staying out is the killer.

Kusinskis and Tsai summarized their work: 

"Ultimately, most of us are aware of the benefits of disciplined investing. Numerous historical studies by notable academics have been well-documented, and more times than not, have supported the employment of disciplined investment processes. Unfortunately, human nature can be a powerful inhibiting force to sound logic.

Our advice: Do your homework up front . . . and systematically rebalance at regular intervals. Revisit your objectives on a regular basis, and try not to get caught up with shorter-term performance – use times of weakness and uncertainty to add value to your portfolio."

If this review interested you, check out the complete report. Click here.

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