Archive for June, 2018

Investment Strategies Aren’t Consistent–But Yours Should Be

Posted by Emmett Maguire III, CFA®

How to Avoid the Behavior Gap with an Investment Strategy That’s Not Trendy, but Tailored

In 10+ years of evaluating investment strategies of all kinds I’ve found precisely zero that work 100% of the time. Sometimes, value outperforms growth. Sometimes, it doesn’t. There are years when hedge funds outperform public market indices–and there are years when they don’t. Large buyout private equity funds have had great historical returns, but that doesn’t mean they will in the future.

What do these inconsistencies mean? That trying to chase the hottest strategy is a losing battle. Yet, chasing the hottest strategy is exactly what many investors do.

The Behavior Gap

This pattern is displayed over and over in what is referred to as the behavior gap[1]. This categorization is quantified in Dalbar’s 23rd Annual Quantitative Analysis of Investor Behavior.

Investment Strategies Aren’t Consistent–But Yours Should Be

The average equity investor underperformed the S&P 500 Index by a margin of 4.70% in 2016. At the same time, the average holding period for equity funds decreased, from 4.1 years to 3.8 years. During the 20 years ending December 2016, the average equity investor trailed the S&P 500 by 2.89% annualized by trading in and out of five different funds. That’s a difference of $184,323 on initial investments of $100,000 after 20 years of compounding.

The equity analysis from Dalbar’s work is just one example of this persistent and problematic issue in financial services. These statistics are consistent across fixed income and asset allocation funds as well. Turning over your portfolio and jumping from strategy to strategy is potentially the worst approach to managing your investments.

What Diets and Investing Have in Common: Jumping from Strategy to Strategy

If jumping from strategy to strategy is a good way to decrease your odds of success, then avoiding that mistake will help increase your odds of success. In other words, the best strategy for you is the one you are most likely to stick with over the long term.

A recent NY Times article makes the same point in reviewing what leads to success in dieting. The yearlong study examined low-carb versus low fat diets across individuals with different genetic make-ups. At the end of the well-designed 12-month trial, the data was examined across those variables. Ultimately, the different diets didn’t create statistically different results. But the biggest explanatory variable in weight loss results was having the discipline to stick to the diet, regardless of which diet it was. The best diet for you is the one you are most likely to stick with.

Have Some Grit

An alternative model for thinking about this concept comes from Angela Duckworth, who is best known for her work on “grit”, which is the personality trait of perseverance that is used to explain that success of individuals and teams across a wide swath of activities. Grit is a combination of long-term thinking, having a growth mindset, and remaining steadfast–despite delays or difficulties in achieving success.

As many of us are told from a young age, success isn’t a straight line. There are setbacks and triumphs along the way to achieving your ultimate long-term goals. Managing an investment portfolio is no different. Staying the course is imperative, but not easy. The hard part is how you deal with the setbacks.

Performance versus Expectations

In an investment context, setbacks boil down to unmet expectations.

Expectations versus actual results play a large part in either achieving satisfaction or a lack thereof. Consider this scenario: The last time your expectations were not met (by your spouse, a product you purchased, or your portfolio, for example) were you disappointed? I’d be willing to bet that you were.

The behavioral finance point of view on this topic starts with what is known as loss aversion. All of us, myself included, experience loss more drastically than we experience a gain of an equal amount. Behavioral economists have estimated that the severity of loss experience to gain experience is a ratio of roughly 2 to 1. So, losses hurt 2 times as much as gains are enjoyed.

The effects of this experience aren’t constrained to losses in an absolute sense. The same dynamic plays out on a relative basis, which is where expectations versus actual results creep back into the picture and why you get disappointed when your expectations are not met. It’s all about your frame of reference. If your expectations are not met, you will be disappointed, and having poorly-calibrated expectations can lead to disappointment when it’s not called for. Without an understanding of what you can realistically expect from your portfolio relative to another asset, you run the risk of disappointment.

In a nutshell, if you expect to have the best-performing strategy each year, you’re falling victim to the precise problem outlined in the first section of this article: It’s not a realistic expectation and is detrimental to your returns.

Reframing Your Investment Expectations

It’s hard to overstate the importance of a clearly-defined objective. Clear, agreed-upon goals set the stage for success in a variety of situations. Research on high-performing teams indicates that alignment on objectives is one of the main ingredients that sets a high-performing team apart from the average. Similarly, spousal relationships can come undone when partners aren’t aligned on the long-term goals for their family. You must be pulling in the same direction. Without a mutual understanding of the goal, a relationship is built on a shaky foundation.

Your relationship with your advisor is no different. The best advisors available to you aren’t focused on selling you the next performance-leading strategy. They’re focused on customizing their investment process to meet your specific and unique objectives.

In a nutshell, progress toward your objectives serves as a better reference point for assessing results.

Customization = Confidence

While there is no single “best” strategy in the investment business, there is one that is best for you, and it’s the one you’re most likely to stick with over the long term. Even then, you’ll still have to weather periods of disappointing returns from time to time without falling victim to the behavior gap. As everyone has their own world view and experiences that form their expectations, you need the right strategy to help you set sensible expectations and manage them accordingly.

The right strategy, is unique to each family and requires an advisor who understands their clients. This is why our process at Lake Street Advisors starts with questions. A thorough understand of your unique needs is the launching point for building bespoke portfolios designed to help you handle setbacks and increase your odds of long term success. This approach allows us to account for your world view and values–it’s deliberately designed to meet your specific objectives.

The result is a long-term strategy that you understand and have confidence in–not because performance was great last year, but because it was built specifically for you.

[1] Behavior Gap art is copy written material and property of behaviorgap.com

The Theories That Drive Active and Passive Investment Strategies

Posted by Daniel J. Greenblatt, CFA®

A Comparison of the Efficient Market Hypothesis and the Adaptive Market Hypothesis

As our Director of Investments, Emmett Maguire III, mentioned in a past blog post, the decision between active and passive investing is not black and white.

Proponents of a purely passive approach often base their investment philosophy on the Efficient Market Hypothesis (EMH). The spirit of this theory can be gathered from the following age-old economics joke:

A hundred-dollar bill is lying on the ground. An economist walks past it. A friend asks: “Didn’t you see the money there?” The economist replies: “I thought I saw something, but I must’ve imagined it. If there had been $100 on the ground, someone would’ve picked it up.”

As the joke implies, the Efficient Market Hypothesis states that all information about a given company is incorporated and reflected in the price of its stock. If stocks are always trading at their fair value, investors would find it impossible to generate excess returns. Therefore, one should use index funds.

From a philosophical perspective, Lake Street does not fully agree with the Efficient Market Hypothesis. Instead, we are believers in the Adaptive Market Hypothesis (AMH), proposed by MIT Professor Andrew Lo, which is a cornerstone of our investment philosophy.

Adaptive vs. Efficient Markets – How They Drive Active vs Passive Investingt Markets

While there are varying degrees to the EMH theory, it predominantly assumes that market prices reflect all available information. In aggregate, investors are rational, and any new information is quickly absorbed by the market–the result being that investors generally cannot outperform the market on a risk-adjusted basis after fees, taxes, and transaction costs. Strict believers of the EMH feel traditional active management is largely a fool’s errand and will result in underperformance after externalities like fees are considered. A believer in the EMH would only use low-cost index funds and would strongly advocate for passive investing.

In contrast, the Adaptive Market Hypothesis takes the Efficient Market Hypothesis and adds a behavioral finance perspective. The AMH theory assumes that successful investors apply heuristics or mental rules of thumb until they no longer work. Alpha converges into Beta as mispricings get exploited. Investors are neither always rational nor irrational. Instead, investors are biological entities whose actions are shaped by the forces of evolution.

The AMH leads to these five conclusions:

  1. The relationship between risk and return is not perfectly stable. It changes over time as the competitive environment changes.
  2. Active management of investments can find opportunities to exploit inefficiencies from time to time
  3. Adaption and innovation are key to survival
  4. Survival is the only objective that matters
  5. No strategy will work all the time

What Does All This Mean for the Investor?

Most markets are efficient like the EMH predicts, but there are spaces where active management can have a clear advantage. Subsequently, both active and passive strategies have a place in an investor’s portfolio.

Revisiting our five conclusions from above, the first conclusion highlights that risk and return dynamics change over time, so simply looking at past performance is an inadequate strategy. It is for this reason that we must disclose “past performance is not an indication of future returns” at the bottom of this post.

Instead of purely focusing on past performance, Lake Street’s investment process places a strong emphasis on what we call continuous improvement, which we define as efforts made to increase competitive edge(s) or reduce cognitive mistakes. This method is directly related to conclusions three and five from above­–both of which require active management to innovate to outperform their peers.

The concept of continuous improvement is less concrete than quantitative figures like past returns or standard deviation, but we would argue is that it’s more important in the process of selecting outperforming active managers. Evaluating the continuous improvement of a fund manager is largely determined by looking at their process and meeting with management. Doing so requires considerable resources, but ultimately is more valuable than any information one could gather from a pitch book.

To conclude, while many markets are efficient and should be indexed, there are still select opportunities for active management that will oscillate over time. By identifying active managers that place an emphasis on continuous improvement, we believe these opportunities can be exploited for the benefit of our clients’ personally tailored portfolios.

Sources
http://opim.wharton.upenn.edu/~sok/papers/l/JPM2004.pdf