Traditionally, most portfolio optimization has focused on total-return analysis to the exclusion of income-oriented portfolios. Given the change in investor risk appetite as a result of the 2008 financial crisis, increased market volatility, demographic shifts, and the belief that growth rates will be lower going forward, the need and interest in income-focused portfolios is increasing.
Needing to use the income the portfolio generates while preserving the principal, investors who are at or near retirement are increasingly seeking income-generating portfolios and focusing on more predictable returns. Total-return portfolios may generate some income but may not be ideal for these investors. Yet there is only modest guidance available on how to build an efficient income-generating portfolio compared with the guidance available for total-return portfolios.
As the US population continues to age and people’s ability to accept risk (income volatility) diminishes, the demand for efficient income-oriented portfolios is becoming increasingly important. While total-return optimization is important, income-generating portfolios become more important as investors reach retirement. Read my entire CFA Digest abstract article here. - Paul R. Rossi, CFA
Differences in individual investor behavior stem from genetic predispositions and environmental factors. Several determinants play a critical role in why some individuals become value-oriented investors and others become growth-oriented investors.
Experiences in early adulthood can have profound implications on preferences later in life according to social psychology in neuroscience. A person's core beliefs seem to crystallize during this early period of great neuroplasticity and those beliefs remain consistent throughout a persons life. Researchers have shown that neural pathways and synapses can dramatically change during these formative years as a result of a persons environment, behavior, emotions and even injury.
Significant macroeconomic events that investors experience can also have long-term and persistent effects on that individual's behavior much later in life. The research shows that individual investors who experienced difficult economic conditions and crew up in lower income homes develop a more value-oriented investment style later in life. For example, people who grew up during the Great Depression subsequently favored value-oriented or 'cheaper' portfolios. These investors hold portfolios with than average P/E that is 11% lower than the median. The research also reveals that the timing of an individual's entrance into the labor market can affect that individuals future investment decisions. If an investor intern is the labor market during a severe recession, they favor more value oriented portfolios in the future.
Conversely, investors with more education with more disposable income and whose income is correlated with GDP favor growth investments. Additionally, investors who exhibit mora behavioral biases, such as the overconfidence bias, opt for growth investments. Individuals who exhibit more behavioral biases are found to have portfolios with a 10% higher P/E ratio than the medium.
Several studies contribute to and supports the growing body of evidence regarding behavioral finance, which demonstrates that life experiences, behavioral biases, and genetics have a dramatic impact on investors behavior. Click here to read my entire abstract article published by the CFA Digest. - Paul R. Rossi, CFA
CFA Institute, the global association of investment management professionals, will recognize May as the third annual Putting Investors First Month. This annual month-long, global initiative focuses on promoting the needs and rights of investors with the end goal of uniting investment professionals in a commitment to place investor interests above all others.
Throughout the month of May, many of the organization’s 147 member societies worldwide will host local events and call attention to the needs and rights of investors by sharing the Statement of Investor Rights, a list of ten rights that any investor should expect from financial service providers. In addition, the organization will spotlight A Difference That Matters, a global advertising campaign, which features CFA charterholders from around the world and aims to build a better investment management profession by raising investors’ awareness of what makes CFA charterholders different.
“Putting the investor first is critically important because investing is, and always has been, deeply personal,” said Paul Smith, CFA, president and CEO, CFA Institute. “Behind every investment transaction, there is an individual whose hopes and dreams depend on this capital, whether it’s putting the kids through college, paying the mortgage, or saving for retirement. Investment is about people, and that focus is more important now than ever before. We have an incredible opportunity as an organization; our foundation is built upon placing the interests of our clients first, second, and last, and we must never forget this.”
Putting Investors First Month Aims to Create Impact by Encouraging Ethical Behavior
According to a recent report from CFA Institute, From Trust to Loyalty: A Global Survey of What Investors Want, we see that investor loyalty remains fragile showing that the need to put investors first is greater than ever. A central focus of Putting Investors First Month is the Statement of Investor Rights, which investment management professionals are encouraged to share with their clients and communities. The list applies to financial products and services such as investment management, research and advice, personal banking, even insurance and real estate, and is intended to help investors demand that financial professionals abide by these rights. The document includes rights that investors are entitled to expect such as objective advice, disclosure of conflicts of interest, and fair and reasonable fees. To complement the Statement, CFA Institute has produced Realize your Rights: Using the Statement of Investor Rights, which provides the questions and considerations that will allow investors to evaluate the ethical commitment of their financial service providers and to ensure that their interests come first.
“The CFA Institute community worldwide is committed to good stewardship, high ethical standards, and putting investors first,” continued Smith. “Through the Statement of Investor Rights we are educating investors on their rights to a service that puts their interests first. By supporting Putting Investors First Month, we want to inspire our community to make real impact and foster a market environment where investors can thrive.”
For more information about Putting Investors First Month, the Statement of Investor Rights, and From Trust to Loyalty: What Investors Want, visit www.cfainstitute.org.
Market corrections and more severe downturns called "bear markets" are normal and are necessary—basically they serve to “clean up” what are considered prior economic excesses. Many times these downturns and bear markets offer great opportunities to buy assets at substantial discount to fair value.
During a bear market or major correction it is only natural to ask and many investors want to know, “What’s my next move?” What investors should realize is 1. Various investable markets will be volatile and understand that they will be volatile and 2. that all markets whether bull or bear markets create opportunities—often very attractive opportunities. Long before any money is invested a sound financial plan should be in place that addresses what actions should be taken under various scenarios.
Successful investing is more often about the psychological aspects of managing your money and being able to adhere to a financial strategy. It is important to understand how market conditions can create euphoria or fear in people. Market corrections and bear markets will happen…it's how you react to them that will determine your investment success. As Warren Buffett says, "Be fearful when others are greedy, and be greedy when others are fearful". Remember: bear markets prepare the way for future bull markets.
It is the long-term picture that investors need to keep in focus. If your original investment goals haven't changed, whether accumulation for retirement or funding for college education, maintaining a well thought-out financial plan coupled with a properly built portfolio will help provide comfort during volatile markets. The wisdom of the day is to remain calm, keep your financial goals in mind and use what the market presents as an opportunity rather than fall pray to it.
Analysts disproportionally cover companies whose fundamentals correlate with industry peers. These firms, designated as bellwether companies, are shown to have significant stock price effects on companies with little to no analyst coverage within their same industry.
The paper offers two propositions. The first proposition states that companies whose fundamentals are similar to those of other companies in their industry attract more analyst coverage. The second proposition states that earnings estimates of companies with a large analyst following, or “bellwether firms,” influence the returns of companies with similar fundamentals but for which information is sparse because of limited analyst coverage. These ideas are shown to have a significant impact on return and volatility characteristics. Click here to read the entire abstract. Abstract Author - Paul R. Rossi, CFA
1. Expecting too much or using someone else’s expectations Investing for the long term involves creating a well-diversified portfolio designed to provide you with the appropriate levels of risk and return under a variety of market scenarios. But even after designing the right portfolio, no one can predict or control what returns the market will actually provide. It is important not to expect too much and to be careful when figuring out what to expect. Nobody can tell you what a reasonable rate of return is without having an understanding of you, your goals, and your current asset allocation.
2. Not having clear investment goals The adage, “If you don’t know where you are going, you will probably end up somewhere else,” is as true of investing as anything else. Everything from the investment plan to the strategies used, the portfolio design, and even the individual securities can be configured with your life objectives in mind. Too many investors focus on the latest investment fad or on maximizing short-term investment return instead of designing an investment portfolio that has a high probability of achieving their long-term investment objectives.
3. Failing to diversify enough The only way to create a portfolio that has the potential to provide appropriate levels of risk and return in various market scenarios is adequate diversification. Often investors think they can maximize returns by taking a large investment exposure in one security or sector. But when the market moves against such a concentrated position, it can be disastrous. Too much diversification and too many exposures can also affect performance. The best course of action is to find a balance. Seek the advice of a professional adviser.
4. Focusing on the wrong kind of performance There are two timeframes that are important to keep in mind: the short term and everything else. If you are a long-term investor, speculating on performance in the short term can be a recipe for disaster because it can make you second guess your strategy and motivate short-term portfolio modifications. But looking past nearterm chatter to the factors that drive long-term performance is a worthy undertaking. If you find yourself looking short term, refocus.
5. Buying high and selling low The fundamental principle of investing is to buy low and sell high, so why do so many investors do the opposite? Instead of rational decision making, many investment decisions are motivated by fear or greed. In many cases, investors buy high in an attempt to maximize short-term returns instead of trying to achieve long-term investment goals. A focus on near-term returns leads to investing in the latest investment craze or fad or investing in the assets or investment strategies that were effective in the near past. Either way, once an investment has become popular and gained the public’s attention, it becomes more difficult to have an edge in determining its value.
6. Trading too much and too often When investing, patience is a virtue. Often it takes time to gain the ultimate benefits of an investment and asset allocation strategy. Continued modification of investment tactics and portfolio composition can not only reduce returns through greater transaction fees, it can also result in taking unanticipated and uncompensated risks. You should always be sure you are on track. Use the impulse to reconfigure your investment portfolio as a prompt to learn more about the assets you hold instead of as a push to trade.
7. Paying too much in fees and commissions Investing in a high-cost fund or paying too much in advisory fees is a common mistake because even a small increase in fees can have a significant effect on wealth over the long term. Before opening an account, be aware of the potential cost of every investment decision. Look for funds that have fees that make sense and make sure you are receiving value for the advisory fees you are paying.
All 20 tips are available to download for free (PDF), no email address required.
Thoughts to help investors stay focused
Every investor knows that his or her portfolio is at least partially at the mercy of the market itself, with overall market conditions playing a huge role in general gains and losses. Most investors have probably heard the terms "bull market" and "bear market" used to describe these conditions, but not all of them truly understand the difference between the two, or what to do when a bear market hits. Investors at any level should take note of these distinctions to make good investments and properly manage a portfolio as the market shifts over time.
The difference between the two types of markets is quite simple:
The first challenge when facing a bear market is recognizing it. Because short-term trends can't predict whether the overall market will continue to rise or fall, it can take a sharp eye and a keen investor's instinct to be truly confident in one's moves when looking at a short period of time (less than a few months, for example). Fortunately, most economists agree that this determination can be made by a percent change in multiple indexes. If the change is at least 20% in either direction (rising or falling), the market can more safely be declared bear or bull. Depending on how long an investor is willing to ride out the trend before making gut decisions, selling and buying comes at the risk of the market trending the opposite direction in the long term. The outcomes of such decisions sometimes feel arbitrary, making the old idiom of "playing the stock market" all too accurate.
Bear markets aren't caused by any one thing. Since the 1950s, there have been 9 bear markets brought on by a variety of issues. Some bear markets follow major political occurrences (formation of alliances, military actions, changes in federal financial regulations, etc.). Others are brought on by a combination of economic forces, rapidly rising stock prices and/or large-scale changes in investors' decisions as a result of the dot-com and housing bubble bursts, for example. Perhaps most interestingly, a bear market may even be brought on by the social consensus of investors themselves due to something called "investor psychology." For example, some investors may be compelled to sell when others are selling and buy when others are buying. By jumping on the proverbial bandwagon and following others' lead, investors can create a swirl of activity that drastically affects the market, even if things had actually been going rather smoothly.
Some small consolation to all this is that bear markets are usually shorter, lasting around 15-18 months--a mere fraction of the average duration of a bull market. Despite their shorter length, however, average losses are typically 40% or so, making the task of surviving even a particularly brief bear market seem like an investor's nightmare. The question is: should the average investor remain invested when a bear market rears its ugly head?
If you've got the staying power, sticking it out in a down market can be well worth it. If you are investing with a long-time horizon, especially, you can afford to be a bit more aggressive with your moves, as it allows more time to make up for short-term losses. If you lose an average of 40% over the course of 15-18 months but have several years left until your target of retirement, you have a significant amount of time to potentially make up those losses and continue to make substantial gains.
It's important to briefly note here the relationship and distinction between a bear market and a recession. While bear markets are some times accompanied by a recession, a recession is an economic trait, classified by at least two consecutive quarters of negative growth in the GDP. A bear market, on the other hand, is a market trait, generally defined by at least two consecutive months of decline in stock prices. Although the two measurements can be closely related, one is a measure of the country's overall economic stability while the other is a measure of trends in stock prices.
Whether you'll be able to wait out the bear market (or a recession) and rebuild your assets to your satisfaction depends upon what seems like a deluge of factors: the duration of the downward trend, the future of the market, the strength of your investments and the choices you make going forward. With careful planning, safe, long-term investments and a cool head, however, these obstacles can be surmounted. Ultimately, you as the investor will need to examine your own financial goals to make that call.
"What is investor behavior? The field of investor behavior attempts to understand and explain investor decisions by combining the topics of psychology and investing on a micro level (i.e., the decision process of individuals and groups) and a macro perspective (i.e., the role of financial markets). The decision-making process of investors incorporates both a quantitative (objective) and qualitative (subjective) aspect that is based on the specific features of the investment product or financial service. Investor behavior examines the cognitive factors (mental processes) and affective (emotional) issues that individuals, financial experts, and traders reveal during the financial planning and investment management process. In practice, individuals make judgments and decisions that are based on past events, personal beliefs, and preferences." - This is an excerpt from a great book I highly recommend by Victor Ricciardi. Click below for the free 24-page PDF summary. Investor Behavior: The Psychology of Financial Planning and Investing or click here to order the complete 640-page book directly from Amazon
True Story: My client was charged this by her former advisor last year and needless to say, once I exposed what she was being charged and how a Fee-Only firm operates, it didn’t take long for her to become my client. To add insult to injury, this former “advisor” provided no financial planning, tax or estate planning, or other advisory services to my client outside of just managing her retirement portfolio. While on the surface, this former advisors fees seemed somewhat reasonable, however as we all know, the devil was in the details. Like most people I talk with, my client had no idea of all the other fees that she was being charged, in her particular case it included 12b-1 fees and front-loaded sales charges which actually made up the bulk of the $22,000 she paid. I have such strong feelings about this being wrong on so many levels...I’ll name just a few of them. 1. The amount charged is way out of line, in fact it’s multiples of what she should have been charged and what my firm charges. 2. The client wasn’t aware of this amount. Sure it was “legally” disclosed in the fine print, but wasn’t explicitly explained to her - a big difference. If you are using an advisor make sure you get a complete analysis of all the fees being charged, and how your advisor is compensated - of course get this all in writing. 3. The conflict-of-interest in placing clients in investments that pay the advisor is a huge concern, which all the big firms never like to discuss. 4. Obviously my clients former advisor isn’t required to place their clients’ interests ahead of their own – another major problem when working with the vast majority of banks and brokerage firms. As this year closes out and we begin a new year, it's a great time to review your own investments, financial plan and ensure you aren't paying unnecessary fees.
I would like to know what you think.
Differences in individual investor behavior stem from genetic predispositions and environmental factors. Several determinants play a critical role in why some individuals become value-oriented investors and others become growth-oriented investors. Click here to read the entire abstract. - Abstract author Paul R. Rossi, CFA
The research introduces a five-factor asset pricing model that outperforms the well-known Fama–French three-factor asset pricing model in explaining stock returns. Surprisingly, when the two additional factors of profitability and investment are added to the original three-factor model, the value factor becomes superfluous. Although the five-factor model is not without its challenges, it is useful in describing the cross-sectional variance of the factors’ expected return. Click here to read the entire abstract. - Abstract author Paul R. Rossi, CFA
If you are not familiar with Charlie Munger, he is the Vice-Chairman of Berkshire Hathaway, the Chairman of course is none other than Warren Buffett. Together they have built one of the most successful business partnerships the world has ever known. In addition to his incredible investing success, Charlie is known for extreme rational behavior and deep-insight, which he contributes to his success in life. His attitude toward life and his desire to continually seek self-improvement is inspiring.
"Another thing, of course, is that life will have terrible blows in it, horrible blows, unfair blows. It doesn't matter. And some people recover and others don’t. And there I think the attitude of Epictetus is the best. He thought that every missed chance in life was an opportunity to behave well, every missed chance in life was an opportunity to learn something, and that your duty was not to be submerged in self-pity, but to utilize the terrible blow in constructive fashion. That is a very good idea."
"Generally speaking, envy, resentment, revenge and self-pity are disastrous modes of thoughts. Self-pity gets fairly close to paranoia, and paranoia is one of the very hardest things to reverse. You do not want to drift into self-pity. ... Self-pity will not improve the situation."
“A lot of people with high IQs are terrible investors because they’ve got terrible temperaments. And that is why we say that having a certain kind of temperament is more important than brains. You need to keep raw irrational emotion under control. You need patience and discipline and an ability to take losses and adversity without going crazy. You need an ability to not be driven crazy by extreme success.”
The S&P 500 rose 1,100-fold over the last 70 years, including dividends. But look what happened during that period:
Below is what the stock market has returned on average over the following time periods. The picture shows what the stock market (and bond market) has returned in any given year-as represented by each dot. Investors need to understand how the market whipsaws back and forth, however by staying the course and being patient investors can earn a respectable return.
Annual stock returns:
100 years: 10.13%
75 years: 10.95%
50 years: 9.8%
25 years: 9.47%
-Deutsche Bank, returns effective Aug. 31, 2014.
Investors’ appetites for risk have been waning as a result of changing demographics and increasing market volatility. The authors provide a framework to construct an income-focused portfolio as the demand for reliable current income increases. Income-oriented portfolios are somewhat less diversified than traditional total-return portfolios, but they can expect to generate higher levels of income than total-return portfolios. Click here to read the entire abstract. - Abstract author Paul R. Rossi, CFA
Quick Summary: The hedge fund industry claims that actively managed funds can offer uncorrelated alpha compared with traditional investments. Attempting to gain insight into the value added from actively managed long–short equity hedge funds, the author finds that as a group, they tend to produce negative alpha during periods of market instability—the opposite of what they claim. Click here to read the entire abstract. Abstract author - Paul R. Rossi, CFA
Paul R. Rossi, CFA