Saturday, April 9, 2016

Short Takes: Investing Overconfidence, Market Averages, and more

Here are my posts for the past two weeks:

Should We Plan to Spend Less as We Age in Retirement?

Bonds vs. an Annuity in Retirement

Revisiting the 4 Percent Rule
The Essential Retirement Guide: A Contrarian’s Perspective

Here are some short takes and some weekend reading:

Gary Belsky explains why we think we’re better investors than we are. This article gives some of the clearest explanations I’ve seen about how we screw up investing.

Boomer and Echo bring us some expert takes on why index investing doesn’t mean settling for average returns. I may be biased in liking this article because I was quoted.

Tom Bradley at Steadyhand gives an important lesson in where investors should focus their attention.

The Blunt Bean Counter gives his take on the 2016 federal budget.

Big Cajun Man explains why he doesn’t trust anyone claiming to show him how to get rich.

My Own Advisor lays out how he plans to invest during retirement. Having an indexed pension certainly makes a big difference.


  1. Get rich quick schemes always worry me, thanks for the inclusion this week.

  2. Michael
    Here is the link to an article by Wade Pfau that I think you and your readers would find interesting. It is called "Eight Core Ideas to Guide Retirement Planning:.

    1. @Garth: That's an interesting article. I agree that we need to consider a range of possible solutions in retirement, including mixed solutions. The challenge I see is finding some way to quantify things to make sensible choices.

    2. @Michael: Here is a new article by Michael Kitces that might help to quantify things...

  3. The other effect has to do with the distribution of returns. To see this, imagine a group of investors who start with $10,000 each. Over 25 years, say the index grows 10x. Let’s ignore costs for the moment and suppose that on average these investors get the market return. So, their average portfolio size after 25 years is $100,000. However, half of them trail the market average by 4% per year.

    Many people think this means the other half must have outperformed by 4% each year. However, this isn’t true. If we do the math, we see that the other half only outperform by 2% per year. The reason for this is that the higher return investors are growing ever-larger pots of money. That means that more than half the money attracts the higher returns.

    For one investor to outperform strongly, it takes several investors to perform poorly. In the end, you get a lot of investors who lose to the index and just a few who beat it. And the margin by which the good (or lucky) investors beat the average tends to be small. Then when we take off all the extra portfolio costs, many of these formerly outperforming investors are now trailing to the index. This leaves only a lucky few who outperform over the long term.

    The end result is that over long periods of time, index investor returns place very highly in the range of active investor returns.”

    I've never seen this argument before, but it is an excellent one.

    Despite that, I"m thinking about becoming a value investor. Why? I seem value investing as a form of risk management. My greatest fear as an investor is a prolonged bear market. Examples would be the Japanese stock market since then end of 1989 or the US stock market from 1965-1982. In both cases, I've seen data that value investors have done considerably better than the indices.

    1. For me, the greatest weakness of index investing is its susceptibility to bubbles. I saw data showing that the 68 largest stocks are 40% of the market cap of the total US stock market of about 4500 stocks. So an index investor's portfolio is dominated by megacaps/large caps.

      Any stock can become overpriced. But for some forms of investing, there is some ceiling as to how overpriced they can become. For example, there is a limit on how much small cap value can become overpriced. If a small cap value stock becomes overpriced, it becomes a large cap stock or a growth stock. But there's no ceiling on how much a large cap growth stock can become overpriced. Examples would be the FANG stocks. A specific example would be amazon, with a PE ratio of 479.

      The appropriate response is that even in an overpriced stock market, the index investor will stick do better long term than the good majority of other investors.

      That's true, but it's cold comfort to an index investor that their results are miserable, but just less miserable than most other investors.

      If you think that's irrelevant, ask a Japanese investor who retired on January 1990.

      The present CAPE of the American stock market is 25.86. That's higher than the CAPE of 1965, which was followed by 17 years of zero real total returns.

      Admittedly, I think it very likely that stocks will do well in the long run. But the time span of many investors is such that 17 years of zero return or 25+ years of below zero returns (Japanese stock market since end of 1989) make this issue relevant.

    2. @Anonymous: There is quite a wide range of people who call themselves value investors. I suppose I could do the same because I have 20% of my portfolio in Vanguard's ETF VBR, which hold U.S. small cap value stocks. Even people who own nothing but a couple of Canadian banks might call themselves value investors. There are good ways to be a value investor and there are very risky ways to be a value investor.

      If you're very concerned about prolonged bear markets and you're close to retirement, a more direct way to protect yourself would be to invest a fraction of your assets in bonds or in a simple annuity (preferably with payments rising by some percentage each year).

      The Japanese experience is worth some attention, but I think the more important lesson to draw is to avoid having too strong a home country bias.

  4. WADR, bonds are not a long term investment. Look at real rolling 20 year rates of returns from 1947-2004 for US intermediate term bonds. If one divides by months, there are 691 rolling 20 year periods. In those 691 rolling return periods, 206 had negative returns. The average real return for all 691 rolling return periods was 1.32%. For US long term bonds, the results are worse. That doesn't include costs, and it certainly doesn't include taxes. If your marginal tax rate is on the higher side, I don't see how someone can have a positive return after inflation and taxes with bonds. For such individuals, bonds are not an investment, but are a form of risk management.

    Fixed income is a good way to deal with bear market risk that lasts 3-10 years. But I'm not sure how well it deals with prolonged bear markets

    An example would be investing $1 in US long term government or US intermediate term government or US 30 day T bills on December 1931. The following are real total returns. In December 31/84, your $1 would be $0.97, $1.42 and $0.81 respectively. And that ignores taxes. But if invested in US stocks at the peak in 1929, you would have gotten back your money back by 1945.

    As Jeremy Siegel writes in his book "Stocks For The Long Run", stocks show long term mean reversion; however, bonds show long term mean aversion. It's difficult for bonds to overcome unexpected inflation, unless they're inflation indexed bonds.

    I agree with you about home country bias. But investing outside Canada is more tax inefficient and often more costly. Also, you're taking on currency risk. If you look at recommended portfolios for Canadian investors, it is common to recommend 60%+ of one's stocks to Canadian and US stocks. If US stocks do poorly, I wouldn't be surprised if Canadian stocks also did. Also, look at Vanguard's VT fund, which is a world stock market index fund. Right now, US stocks are 53.4% of it. By CAPE, the US stock market is one of the most expensive in the world. Once again, an indexer is overweight on expensive stocks.

    1. @Anonymous: It appears you are seeking low risk and high return. It doesn't exist. If you fear a long-term bear market, any effective action you take to protect yourself will come at the expense of lower expected returns. Any investment can be criticized either for being too risky or having too low returns.

      I own no bonds myself because I don't like the low expected returns. But that exposes me to the risk of a long-term bear market. I don't believe that any variant of value investing will change this.

    2. Between Dec 31/65 and Dec 31/82, the S&P500's real rate of total return was zero. But stocks in the Fama/French Large Value Index had a real total return of 4.90% in the same time period.

      "The Hong Kong University of Science and Technology Value Partners Center for Investing has examined the performance of value stocks in the Japanese stock market over the period January 1975 to December 2011. They have also broken out the performance of value stocks during Japan’s long-term bear market over the 1990 to 2011 period, when the stock market dropped 62.21 percent.

      The white paper Performance of Value Investing Strategies in Japan’s Stock Market examines the performance of equal-weight and market capitalization weighted quintile portfolios of five price ratios–price-to-book value, dividend yield, earning-to-price, cash flow-to-price, and leverage-to-price—excluding the smallest 33 percent of stocks by market capitalization.

      The portfolios were rebalanced monthly over the full 37 years...

      The returns diminished over the 1990 to 2011 period. The value quintile of equal-weighted portfolios book-to-market, dividend yield, earning-to-price, cash flow-to-price, and leverage-to-price generated monthly returns of 0.84 percent (10.6 percent per year), 0.78 percent (9.8 percent per year), 1.31 percent (16.9 percent per year), 1.13 percent (14.4 percent per year) and 0.0 percent (0.0 percent per year) in the 1990–2011 period, respectively. In contrast, the Japanese stock market lost 62.21 percent.

      They find similar results for market capitalization-weighted portfolios sorted by these measures, as well as for three-, six-, nine-, and twelve-month holding periods (excluding the leverage-to-price ratio)."

      In the above 2 secular bear markets, value investing worked.

      I'm not saying it will work for every prolonged bear market. An example would be the 1929 crash. But 1929 may no longer be relevant in 2016. The 1929 crash was followed by significant deflation. Value stocks don't do well during deflation, as they tend to be more levered than growth stocks. But we're no longer on the gold standard and instead have fiat currencies. With fiat currencies, deflation has historically been much less of an issue.

    3. @Anonymous: As I said before, I have a small-cap value tilt, so I am with you, but only to a point. Japan has a very different political structure from that in the U.S. This difference permitted a much longer denial of reality than could happen in the U.S. IMO. Torturing some data may or may not produce insights useful for Japan's future. These insights are less likely to be useful across the rest of the world's stock markets.

      All that said, it's possible that being a value investor will save you somewhat in an extended bear market. But it's also possible that your portfolio would perform worse than the index. The important thing is to make sure you'll be OK in either scenario.

    4. Stocks are the only way I can have an expected positive return after taxes and costs.

      Once again, the problem I have with stocks is protracted bear markets. Fixed income will get me through a run of the mill bear market.

      I agree that value investing may underperform index investing. But what I'm more interested in absolute, rather than relative, return. I'm increasingly thinking that value investing may increase my chance of a positive aftertax real return.

    5. @Anonymous: Maybe value investing will increase your chances of a positive real return and maybe it won't. However, the way you do it matters. There are different ways to do value investing and their costs differ.

      I suggest you read opinions from those who disagree with you. Maybe Bogle is a start. Munger says you should be able to argue the point of view opposite to your own. At the very least this will moderate enthusiasm a little.

    6. This is a quote from the Ben Carlson article linked below. "Basically, we humans are a walking contradiction. We are affected by both loss aversion and overconfidence. We have both afear of missing out on future gains, and a fear of taking part in future losses"

  5. re: average index returns -- the problem with this is accepting the return (and risk) the markets give you instead of the return you actually require. Your reasoning to choose the index route is because you do not want to be part of the statistical losing group; the entire article was focused on expounding the virtues of the losing 90%. You might be doing the right thing, but for the wrong reason -- check the article on biases. Like choosing 1 because it's not 0 (even though Munger says this is a good thing).

    What if your portfolio needs a return greater than the index average (and exactly which index?)? What if you actually require a lower return to achieve your goals? Still willing to expose your money to higher return risk?

    I guess indexing would be a fair strategy in which to park your money until such time you figure out what you actually need.

    (Side note: has anyone looked at the actual data sets on which the '90% lose' is based? Forgive the forgetfulness on the source name, it's compiled from actual investment account information, but it's mutual fund investments. Any data on ex-MF investment returns?)

    1. @SST: The idea that there is some specific income that we need makes little sense to me. I am adaptable. I could easily get by on nothing more than CPP and OAS. But I can also make good use of more money (and I intend to do this). I will seek to balance reaching for more income against the risk of ending up with less.

      However, even if we accept that each of us has a specific needed income, "indexing" is not synonymous with a 100% stock portfolio. "Indexing" means that whatever fraction of your portfolio you wish to have in stocks goes into stock indexes. Similarly, your bond allocation goes into bond indexes. Choose whatever mix you like, perhaps throwing in an annuity if it suits you.

      Odean and Barber collected a lot of data. Others have done so as well -- I'd suggest reading some of Swedroe's writing to find references. I'd be shocked if only 90% of non-mutual fund investors lost to market averages over the long run. I'd also be shocked if less than 90% of stock pickers admitted to losing to indexes.

    2. What I'm saying is that you either have an investment goal or you do not, and to choose an investment strategy merely because it beats a different strategy instead of matching the two is just as dangerous.

      If I need $1 million to retire, but only have $200,000, a $50,000 income, and 10 years before retirement...well, accepting average index returns isn't going to get me there; I require something different.

      If I have no idea how much I will require in retirement but put all my savings into indexing, how will I know if I'm going to hit my mark? I have to know what I'm hunting before I choose the applicable weapon.

      Or, a real life example, a family member is going to retire at the end of 2016. He is selling his business and already collects all applicable public payments. To support the same lifestyle, he will require a 2% return on his money. He could invest in a handful of bonds that have a lower risk profile than a bond index, he has no need to chase the average return.

      Accepting average index returns is definitely not a cure all, and in some instances, not preferred.

    3. @SST: Not knowing inflation in advance, locking in a 2% return is dangerous. I could possibly see locking in a real-return bond, but a much more sensible strategy would be to buy an annuity that pays for the desired lifestyle level and invest the rest of the lump sum in indexes for the next generation. I just don't see your scenario coming up much.

  6. re: "By CAPE, the US stock market is one of the most expensive in the world. Once again, an indexer is overweight on expensive stocks."

    Google "countercyclical indexing" if you are looking for an antidote.

  7. Thanks for the mention Michael.

    There are no guarantees in life which is why I think we need to invest outside our pension. It's not the gold-plated kind but we'll gladly take it - we are lucky to have any type of pension.