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Investment Philosophy
Arguably the most important step to helping clients is implementing and managing the investment process. Outlined below is a consolidated look at some of the primary factors that comprise our investment philosophy. Please keep in mind that this is simply an overview of our common themes, and clearly there is much more to consider when building an investment portfolio than what is included herein. Topics:
The Boston-based firm Dalbar has done several comprehensive studies on investor behavior. Their 2007 report, “Quantitative Analysis of Investor Behavior”, came to the stunning conclusion that over the past 20 years the average equity investor has realized a fraction of the annual total return of the S&P 500. This underperformance conundrum according to Dalbar can be traced primarily to “investor behavior.” “The investor’s chief problem – even his worst enemy – is likely to be himself.” Benjamin Graham Why do average investors perform so poorly? The most significant mistake made by investors is the tendency to buy the hottest / best performing asset category of the past four to five years. Historically, after approximately three and a half years of an investment performing at the top of the markets, the media and Wall Street begin a steady drumbeat of enthusiasm that the average investor finds hard to resist. The longer the investment category outperforms the more investors stampede to buy it. Unfortunately, history clearly shows that when an investment category outperforms for more than 4 years, the category will almost always suffer significant losses within the next 12 months. If we consider the tendency of the average investor to chase performance you won’t be surprised to discover that most investors end up heavily overweighed in the asset categories that have performed the best during the past several years. A recent example is the stunning collapse in the real estate and emerging market sectors in 2008. The underperformance conundrum is mostly caused by investors chasing performance, but it’s also caused by investors doing the opposite – avoiding, or bailing out of an investment category after a multi-year run of underperformance. The Dalbar study clearly showed that a four plus year run of a single asset category underperforming the rest of the market often leads to top performance within 12 months. What the Dalbar study illustrates is that the average investor underperforms because they get caught up in the extreme trends within the market. These extremes in performance at both the top and the bottom of the market are where the average investor is often guilty of doing the exact opposite of what they should be doing. Human nature and emotions are at the core of this underperformance conundrum, and going against human instinct takes extreme discipline. A study published in Cognitive Sciences, (2004) Vol. 8, by Eisenberger and Lieberman found that investors have a strong predisposition to follow a herd mentality. The study suggests that physical pain is experienced when an investor feels a sense of exclusion from the group. In effect, when an individual is not following the majority of investors in a hot market, that individual experiences a high enough level of anxiety and doubt to cause physical pain. This high anxiety is compounded by the influence of family, friends, the media, and the financial community. In the late 1990’s, if an investor recognized the obvious market extreme and did the opposite of the average investor, they would have avoided the large-cap growth category. An important consideration in following the strategy is that they would have ended up missing some of the upside in 1999. However, in our strong opinion, during market extremes it’s usually better to experience the pain of missing some upside rather than chasing performance. In fact, the large-growth category ended up losing almost 50% of its value and the tech, and telecom sectors lost over 70%. These are devastating life changing losses for any investor. A 50% loss means you need to make a 100% gain just to get back to where you started, and if you realized a 70% loss you’d need a 233% gain to get back to even. Even in a good investment climate it would take 8 to 17 years to recoup your losses. This clearly illustrates why Warren Buffet’s number one rule for investing is, don’t lose money. His number two rule: Don’t forget rule number one. At Leahy Wealth Management we believe that avoiding large losses is one of the primary objectives of any worthwhile investment strategy. Asset Allocation At Leahy Wealth Management we apply the concepts outlined above in our asset allocation models. The type of asset allocation that we practice is called “Tactical Asset Allocation,” and this approach is much different than the more widely used “Strategic Asset Allocation.” It’s very important to understand the difference between these two styles. With a strategic asset allocation model an investor’s risk tolerance is determined and then a fixed model of stocks, bonds and cash is assigned. The model is periodically adjusted so the asset weightings are very similar from one year to the next. Tactical asset models work on the same premise except the asset weightings are usually adjusted significantly from one year to the next, in other words, they are not blindly fixed. The Journal of Financial Planning, in August 2004 published a comprehensive study called “The Asset Allocation Hoax”. The conclusion of the study was: The strategic approach to asset allocation is underperforming assumed projections and therefore investors using the strategy are at risk of not meeting their long-term goals. The lessons outlined in the above “Market Extremes and Underperformance” illustrate why a blindly fixed asset allocation approach, such as strategic allocation, may be a less than ideal strategy for investors. Although, it is important to note that no strategy can promise a profit or a loss, and the market for all securities is subject to fluctuation and loss of principal. Market Trends / Timing The professionals at Leahy Wealth Management do not advocate short-term market timing. However, we feel it’s important to get a sense for where the market is in respect to the business / economic cycle, and we strive to asses what the underlying long-term trend of the market may be. Markets move in long-term trends called bull and bear markets. Pull-up a stock market chart going back 100 years and you’ll see the history of clearly defined bull and bear markets lasting on average 17 years. These long-term trends are based on economic fundamentals and more importantly human nature. Long-term bull markets, like 1982 to 2000, are marked by strong economic fundamentals and fairly consistent market performance. After a market has done well for ten to fifteen years people gradually become conditioned to good performance and optimism. That conditioning usually lulls investors into a sense of security which leads to large scale risk taking. Both individuals and businesses end up overextending which eventually causes the inevitable collapse of a speculative bubble - just like 2000. Long-term bear markets are the same as the bull market just in reverse. Long-term bear markets, like 1966 to 1982, are marked by weak economic fundamentals caused by the excesses of the previous bull market bubble, such as: high debt loads, high stock valuations, and shallow business cycles. Bear markets are often accompanied by volatile interest rates, rising energy prices, war, political turmoil, and a propensity for underlying pessimism. It’s important to realize that during these long-term trends there are short-term cycles that run contrary to the underlying trend. For example, during the 1982 to 2000 bull market the DOW went from 777 to 11,722, but there were four bear cycles (corrections) within the bull market that lasted on average 19 months, with losses on average of 27%. The mirror opposite occurs during bear markets like the1966 to 1982 period when the DOW went from 748 to 777 (that’s right - 16 years of sideways movement), but there were four bull cycles within the bear market that lasted anywhere from 18 to 44 months, with gains on average of 42%. History illustrates the importance for investors to try and accurately identify the long-term trend, and alter their investment strategy accordingly. In fact, investors that recognized the 1982 to 2000 period as a long-term bull trend, and used a simple buy and hold index strategy outperformed most investors by a wide margin. However, investors using the same strategy during a long-term bear trend have historically realized significant losses. History shows us that buy and hold works best in bull trends, and that more proactive tactical strategies work best in bear trends. In fact, from historical data, we know that value investors like Shelby Davis, Sir John Templeton, and Warren Buffet were extremely successful throughout the 1966 to 1982 bear trend. It’s important to note that using market history as your oracle can be very helpful, but every market period is unique in its own way. Different nuances will always exist, however, with that said, one of the most dangerous phrases in the world of investing is the old adage and familiar mantra from 1999 “It’s different this time.” Wall Street and Media Influence After all the post-bubble scandals involving Wall Street analysts you might assume that Wall Street would be doing a better job of stock selection and strategy, but unfortunately the facts don’t support that assumption. According to a 2005 study by Zacks Investment Research done for The Wall Street Journal, stocks with overall “sell” recommendations by Wall Street analysts have performed better than those with “buy” recommendations. The study tracked the data from 1991 through 2005, and only three times in fifteen years did “buy” rated stocks outperform the “sell” ratings, and there hasn’t been a single year since the scandals that “sell” rated stocks haven’t substantially outperformed the “buy” ratings. Unfortunately, the data shows that the average investor is heavily influenced by Wall Street and the media. Clearly, studies such as the one noted above illustrate why listening to Wall Street and the media machines may be less than ideal. Knowing who has above average long term (15+ years) performance, and even more importantly knowing who to ignore is extremely helpful in avoiding investment pitfalls. Investment Selection In order to better explain our investment selection process let’s consider a study from The Journal of Financial Planning dated February 2006, titled, “Difficulty of Selecting Superior Performance.” The study was designed to compare domestic large and mid-cap money managers with their respective index. The study concluded that the money mangers only beat their corresponding index (on average) a little more than 10% of the time during any ten-year period dating back to 1983. Furthermore, “predicting in advance which manager would outperform was difficult, if not impossible, and the cost of selecting the “wrong” manager was high.” At Leahy Wealth Management we take the above study to heart and believe that clients should avoid falling into the common problem outlined therein. In Closing Please keep in mind that this is a consolidated look at some of the primary factors that comprise our investment philosophy. There is much more to consider when building an investment portfolio than what is included herein. We do hope that you have enjoyed this overview and welcome your comments and questions. |
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