If investors were asked, “Who do you think is the greatest investor of our generation?” I’d bet an overwhelming majority would answer, “Warren Buffett.” If they were then asked, “Do you think you should follow his advice?” you might think that they would say, “Yes!”
The sad truth is that while Buffett is widely admired, a majority of investors not only fail to consider his advice, but tend to do exactly the opposite of what he recommends.
Buffett has said that “investing is simple, but not easy.” He has also said that “the most important quality for an investor is temperament, not intellect.” By that he meant the ability to stay disciplined, ignore recent events and returns, and adhere to your well-thought-out plan. He explained: “Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”
While financial economists consider 10 years of data as nothing more than “noise,” my more than 20 years of work as an investment advisor have taught me that, when contemplating investment returns, the typical investor considers three years a long time, five years a very long time and 10 years an eternity. (What inspired me to write this piece was a new record set when an investor expressed concern over the fact that a fund had underperformed in the 11 weeks he owned it.)
10 Years Is Not A Long Time
For investors to be successful, they must understand that, in the market, even 10 years is a relatively brief period. No more proof is required than the -1.0% per year return to the S&P 500 Index over the first decade of this century.
That’s an underperformance of 3.8% a year relative to riskless one-month Treasury bills and a total return underperformance in excess of 40%. Investors in stocks shouldn’t have lost faith in their belief that stocks should no longer be expected to outperform safe Treasury bills due to the experience of that decade.
The following table shows the annual premium, Sharpe ratio (a measure of risk-adjusted returns) and the odds of outperformance for the six equity factors (beta, size, value, momentum, profitability and quality) that have provided persistent premiums, not only in the U.S. but around the globe.
Note that these six factors also explain almost all of the variation in returns between diversified equity portfolios. With a single exception, what the table shows is that, no matter the investment horizon, there is always some probability that the factor will deliver a negative return. The sole exception was the momentum premium, which was positive during each of the 20-year periods. Of course, even this is not a guarantee that it will be positive over all future 20-year periods. See Table 1.
There are two other important takeaways. The first is that, no matter what the investment horizon may be, you are putting the odds into your favor by gaining exposure to these different factors. The second takeaway is that, as demonstrated in Table 2, the factors all have low-to-negative correlations to each other, resulting in a diversification benefit.
Benefits Of Diversification
The diversification benefits can be seen in Table 3. This table shows the mean premium for each of the factors, the volatility of the factor and its Sharpe ratio. It also provides the same information for three portfolios.
Portfolio 1 (P1) is allocated 25% to each of four factors (beta, size, value and momentum). Portfolio 2 (P2) is allocated 20% to each of the same four factors and adds an allocation to the profitability factor. Portfolio 3 (P3) is allocated the same way, substituting the quality factor for the profitability factor.
The low correlations among the factors resulted in each of the three portfolios producing higher Sharpe ratios than any of the individual factors. Furthermore, we can see the benefits of diversifying across factors in the table below, which shows the odds of underperformance over various time horizons. See Table 4.
As you can observe, no matter the horizon, the odds of underperformance are lower for each of the three portfolios than for any of the individual factors.
Playing The Odds
There is one other important takeaway that relates to an issue I am often asked to address. Some investors will see this data and say: “But I don’t have 20 years to wait for a premium to be realized.” The best way to think about this, however, is relatively simple.
Unfortunately, there are no clear crystal balls in investing. Thus, the best we can do is to put the odds of success in our favor as much as possible. As the above tables show, regardless of your investment horizon, be it one year or 20, you are always putting the odds in your favor by gaining exposure to any of these factors. It’s just that the odds grow increasingly in your favor the longer the horizon.
Because any factor can deliver a negative premium over even long horizons, the prudent strategy is obvious: Diversify across factors and don’t put too many of your investment eggs in any one of them. But, as Buffett said, while investing really can be that simple, it’s not easy to ignore what feels like long periods of underperformance. And that leads to impatience and the loss of discipline.
The bottom line is that an investor’s worst enemy is staring right back at him when he looks in the mirror. One of my favorite expressions is that knowledge is the armor that can protect you from making bad decisions. You have the knowledge. Now all you need is the discipline.
This commentary originally appeared June 10 on ETF.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2016, The BAM ALLIANCE
Money destroys relationships because people can’t compete with money. Money, after all, doesn’t disappoint you, or express disappointment with you.
It’s not that money is inherently bad or evil, but it’s not inherently good or righteous either. Money is simply a neutral tool that can be used well or poorly. It only has the value—the personality and the relational standing—that we give it.
One of the few criticisms I have of the movement to explore the psychology of money is its use of the phrase “your relationship with money.” Unintentionally, this gives money entirely too much credit by implying personhood. Indeed, if you have a “relationship” with money, you’re likely elevating it unnecessarily, and maybe even subconsciously devaluing those in your life who actually have a heartbeat.
How did we get here, to the point where we’ve personified—and in some cases deified—the “almighty” dollar? Yes, I’m sure it’s due to our culture of consumerism, the perpetual marketing machine, but I primarily blame institutions of which I am a part: the financial industry and the business that has grown up around consumer personal finance experts. In these realms, money has been made the goal or end, when in reality it is only the vehicle or means. What, then, can we do to relegate money to its rightful place?
First, we can better understand how we deal with money by better understanding ourselves.
What is your first memory of dealing with money? Typically, it doesn’t take more than a few seconds for us to recall our first allowance or cash gift, our first theft or childhood extortion. The incredible impact these experiences had on us is apparent. Events decades past immediately spring to mind. Would you rate your first money memory as a positive or negative experience?
Now take a few moments and jot down your prominent memories—both good and bad—of dealing with money, especially early in life. Include anything particularly impactful later in life as well: The job loss that forced an unwanted move away from childhood friends; the windfall that came just in time; the formative investment experience that burned or elated you.
Behavioral science suggests that our money-related hardwiring occurs largely in the first 10 years of life and that our proclivities—for better and worse—are formed by our experiences. Don’t be shocked to discover that the negative experiences seem to have an even bigger impact, as studies show we suffer more (about twice as much) from the pain of loss than we benefit from the joy of gains.
Consider creating a list of your most prominent money memories. Catalogue your estimated age, the event and the impact it had on you, positively or negatively:
“5 – Received an allowance – Felt great; my first taste of independence.”
“8 – Parents divorced – Horrible; insufficient income to manage two households.”
Keep going. See if you can come up with a Top 10 list of momentous money memories. Then review your personal money story and bask in the glow of self-awareness. It explains a lot, right?
Second, we can share our story with those we’re going through life with and learn more about their story. The number-one reason cited for the divorces that split more than half of American families is financial disagreement. This is because we have the capacity (and for some, the tendency) to demonize our spouses for their apparently wayward ways. “You’re a spendthrift!” “No, you’re a miser!”
Completing this exercise will help you see your spouse for who they are—a collection of their experiences. But don’t stop there. Share your money memories with your kids and ask them about their prominent memories (if you dare).
Lastly, it’s helpful to understand an economic term that could help improve your relational money dealings: sunk cost. Sunk cost is water that’s already gone under the proverbial bridge. The rational economist doesn’t weigh what has already been spent and can never be retrieved when making present financial decisions or future plans. The best plan forward is simply the best plan forward, regardless of the past. (That stock or mutual fund, by the way, doesn’t know the price at which you purchased it, and it doesn’t care where you want it to go.)
How helpful might this be in navigating your future? To acknowledge that what’s done is done, opening the door to forgiving your parents, your significant other, your children and, most importantly, yourself?
The good news is that people who see money as it is—a lifeless but effective tool—typically end up managing it better and often accumulate more of it in the long run. The great news is that people who don’t develop a relationship with money tend to have better, richer relationships with the living, breathing humans in their lives.
This commentary originally appeared June 13 on Forbes.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2016, The BAM ALLIANCE
As I’ve written about before, the goal of sustainable, or socially responsible, investing (SRI) can be characterized as “doing well by doing good.” The implication of such double-bottom-line investing is that you are seeking not only profitable investments, but also investments that meet your personal standards.
SRI has gained a lot of traction in portfolio management in recent years. Total assets managed by agents that included environmental, social, and governance (ESG) criteria in their decision-making processes were estimated at $3.7 trillion by 2013, out of a total $33.3 trillion invested in the US marketplace.
Meir Statman and Denys Glushkov contribute to the literature on SRI with their study, “Classifying and Measuring the Performance of Socially Responsible Mutual Funds”, which was published in the Winter 2016 issue of the Journal of Portfolio Management. Their contribution adds two social responsibility factors to the commonly used four-factor model (beta, size, value and momentum).
The first social responsibility factor they propose is the top-minus-bottom factor (TMB), consisting of relations, environmental protection, diversity, and products. The second factor is the accepted-minus-shunned factor (AMS), consisting of the difference between the returns of stocks of companies commonly accepted by socially responsible investors, and the returns of stocks of companies they commonly shun. Shunned stocks include those of companies in the alcohol, tobacco, gambling, firearms, military, and nuclear industries.
Statman and Glushkov built their social responsibility factors with data from the MSCI ESG KLDSTATS database and note: “The two social responsibility factor betas capture well the social responsibility features of indices and mutual funds. For example, TMB and AMS betas are higher in the socially responsible KLD400 Index than in the conventional S&P 500 Index.”
The authors’ study covered the period from January 1992 (when data first becomes available) through June 2012. To construct their two social responsibility factors, they calculated each company’s TMB-related score (total strengths minus total concerns) at the end of each year based on their set of five social responsibility criteria (employee relations, community relations, environmental protection, diversity, and products) and its AMS-related score, based on whether it is shunned or accepted. They then matched the year-end scores with returns in the subsequent twelve months.
The long side of the TMB factor is a value-weighted portfolio of stocks from firms that rank in the top third of companies by industry-adjusted net scores in at least two of the five social responsibility criteria and not in the bottom third by any criterion. The short side of the factor is a value-weighted portfolio of stocks from firms ranked in the bottom third of companies sorted by industry-adjusted net scores in at least two of five social responsibility criteria and not in the top third by any criterion.
Similarly, the long side of the AMS factor is a value-weighted portfolio of the accepted companies’ stocks, and its short side is a value-weighted portfolio of shunned companies’ stocks. The authors constructed theTMB and AMS portfolios as of the end of each year. The following is a summary of their findings:
Statman and Glushkov concluded: “A lack of statistically significant differences between the performances of socially responsible and conventional mutual funds is likely the outcome of socially responsible investors’ preference for stocks of companies with high TMB and high AMS. The first preference adds to their performance, whereas the second detracts from it, such that the sum of the two is small. A proper analysis of socially responsible mutual funds’ performance requires separate accounting for the effects ofTMB and AMS on performance.”
Their finding that the AMS factor produces negative alpha is consistent with both theory and prior research: if a large enough proportion of investors choose to avoid “sin” businesses, the share prices will be depressed. They will have a higher cost of capital because they will trade at a lower P/E ratio, thus providing investors with higher returns (which some investors may view as compensation for the emotional “cost” of exposure to offensive companies).
For example, Harrison Hong and Marcin Kacperczyk, authors of the study, “The Price of Sin: The Effects of Social Norms on Markets,” published in the July 2009 issue of The Journal of Financial Economics, found that for the period from 1965 through 2006, a US portfolio long sin stocks and short their comparables had a return of 0.29% per month after adjusting for the same four-factor model. As out of sample support, sin stocks in seven large European markets and Canada outperformed similar stocks by about 2.5% a year.
As further evidence that avoiding sin stocks comes at a price, Elroy Dimson, Paul Marsh, and Mike Staunton also studied returns to sin stocks. Using their own industry indices that covered a 115-year period (1900-2014), they found that tobacco companies beat the overall equity market by an annualized 4.5% in the United States and by 2.6% in the UK (over the slightly shorter 85-year period from 1920 through 2014). Their study was published in the 2015 Credit Suisse Global Investment Handbook.
They also examined the impact of screening out countries based on their degree of corruption. Countries were evaluated using the Worldwide Governance Indicators from a 2010 study by Daniel Kaufmann, Aart Kraay and Massimo Mastruzzi, “The Worldwide Governance Indicators: Methodology and Analytical Issues” (World Bank Policy Research Working Paper No. 5430). The indicators comprise annual scores on six broad dimensions of governance.
Dimson, Marsh, and Staunton found fourteen countries that posted a poor score, twelve that were acceptable, twelve that were good, and eleven with excellent scores. Post-2000 returns for the last three groups were between 5.3% and 7.7%. In contrast, the markets with poor control of corruption had an average return of 11.0%.
Realized returns were higher for equity investments in jurisdictions that were more likely to be characterized by corrupt behaviors. As the authors note, the time period is short and might just be a lucky outcome. On the other hand, it’s also logical to consider that investors will price for corruption risk and demand a premium for taking it. But it may also be a result of the same exclusionary factors found with sin stocks (investors boycott countries with high corruption scores, driving prices down, raising expected returns).
However, the finding of positive alpha for the TMB factor is a puzzle for the same reason that the negative alpha for AMS should be expected: if enough SRI investors shun stocks with low TMB scores, the cost of capital of such companies will rise, and so will their expected returns. Hence the apparent anomaly. A possible explanation is that perhaps the alpha could be explained by exposure to another factor (such as quality or low beta) not included in the four-factor model (beta, size, value, and momentum).
Other explanations can be found in the behavioral finance literature. For example, the 2011 study from Alex Edmans, “Does the Stock Market Fully Value Intangibles? Employee Satisfaction and Equity Prices,” found that stocks of companies with highly satisfied employees earned higher returns than other stocks. The 2005 study, “The Eco-Efficiency Premium Puzzle,” by Jeroen Derwall, Nadja Guenster, Rob Bauer, and Kees Koedijk found that stocks of companies with good environmental records earned higher returns than other stocks. And the 2007 study by Alexander Kempf and Peer Osthoff, “The Effect of Socially Responsible Investing on Portfolio Performance,” found that stocks of companies that ranked high overall on community, diversity, employee relations, environment, human rights, and products did better than stocks that ranked low on those measures. In each case, higher returns could result from investor myopia — they tend to focus on possible negative short-term costs (such as higher wages) and underestimate long-term benefits.
The Bottom Line
One final comment: investors may be aware that there are tradeoffs between wants, and some are willing to trade the utilitarian benefit of higher expected returns for the expressive and emotional benefits of avoiding the stocks of shunned companies.
This commentary originally appeared June 1 on MutualFunds.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2016, The BAM ALLIANCE