|
About IndexInvestor.com |
Privacy Policy |
Transaction Policy |
Legal Disclaimers |
Contact Us |
My Account |
Home
|
|||||
|
|
|
|
|
|
|
Implementing Your Asset Allocation: An Active or Passive Approach?
Once you've determined the asset allocation that is best for you, you have to implement it via the investments you choose for your portfolio. At this point, the most important question you have to answer is whether you are going to take an active or a passive approach to investing. In a nutshell, the active investor believes that he or she can regularly earn (or choose fund managers who can earn) returns that are above the average return for the asset class as a whole. In contrast, the passive (or index) investor wants only to match the average return for the asset class in question at the lowest possible cost.
A good starting point for examining this issue is an overview of how financial markets function in practice. Armed with this information, it should be easier to decide how likely it is that a person will be able to consistently earn returns that are above the average for the asset class as a whole.
Individual Psychology and Investing
As Alan Greenspan has rather memorably put it, "there is one important caveat to the notion that we live in a new economy, and that is human psychology."
We have noted before that psychological researchers have found that human beings tend to behave in ways that are predictably irrational. In other words, most people's thinking is reliably biased in a consistent manner.
Why is this important to an index investor? Because, despite their understanding of the twin dangers of high expenses and high turnover (both of which generate costs, and make it impossible to 'beat the market'), we too are human and therefore occasionally tempted to trade more actively than is good for our financial health. As is the case with our physical health, we can benefit from the occasional "booster shot" that strengthens our resistance to these dangers.
With that in mind, we'd like to briefly review the results of two important academic research studies.
As a starting point for understanding why investors get surprised, it is helpful to ask why active investors believe they will be able to earn returns above the market average. Logically, these returns must come from some combination of three sources:
What types of irrationality give rise to both surprises (for individuals) and above market returns (for those who exploit them)? At this point, behavioral finance theorists are far from agreeing on a single answer. However, a number of themes are emerging from their studies.
Perhaps the most important finding is that, contrary to efficient markets theory, investors vary widely in how quickly they adjust their valuation of an investment after new information about it becomes available. Why does this happen? The key suspects are a number of biases (that is, departures from pure rationality) that characterize most people's thinking:
In addition to these biases in their approach to estimating the value of investments, investors also tend to be less than rational in the way they make decisions about buying and selling them.
Prospect theory suggests that when confronted with choices about gains (e.g., an investment whose current value is above the price paid for it), people will tend to be risk averse in their decisions, while confronting them with choices about losses causes them to become risk seekers. In short, academic studies have now proven what any fan of country music has known for years: "losing hurts twice as much as winning feels good." In investment terms, this has serious implications. A recent study by Professors Terrence Odean and Brad Barber examined this in more detail.
Entitled "The Courage of Misguided Convictions", the study analyzed the performance of 10,000 investor accounts between January, 1987 and December, 1993. It focused on the question of why investors tend to sell their winners too early, and hold their losers too long. There are two logical explanations for why people might do this.
On the one hand, they might believe that over time, the performance of most shares "revert to the mean." This means that a company with poor recent performance is more likely to improve than to get worse, while a company with above average recent performance is more likely to decline than to get better. Arguably, "mean revision" is the single most important belief held by true value investors (and its opposite, "mean aversion" is the single most important belief held by momentum investors, who expect price changes to continue in the same direction).
On the other hand, investors might sell their gains faster than they realize their losses because the latter causes them twice as much pain as the former causes them pleasure, as prospect theory predicts.
In the study they conducted, Odean and Barber started out with the reasonable hypothesis that if investors were motivated by mean revision, then the losing stocks they held on to would tend to outperform the winning stocks they sold in the months following their sale. Unfortunately, the data they studied did not support this. Over the year following their sale, investors' winning stocks outperformed their losers by 3.4% per year (relative to a market index). In other words, "investors who sell winners and hold onto losers because they think the latter will outperform the former are, on average, mistaken."
Moreover, if investors' decisions were actually motivated by a belief in mean revision, when adding to their portfolios they would tend to buy stocks that had previously performed poorly. Unfortunately, Odean and Barber found that this wasn't true for the investors they studied, who bought stocks that, on average, had outperformed the market index by 25 percent over the previous two years.
In another study entitled "Are Investors Reluctant to Realize Their Losses?", Professor Odean analyzed a data set consisting of the trading records of 60,000 households that maintained an account at a large discount brokerage firm between February, 1991 and December, 1996. Odean found that over this period, the average investor in his study earned a compound annual return on his or her account of 15.3%. However, the 20% of households that traded most frequently realized a compound annual return of only 10.0%. In other words, frequent trading (a sign perhaps, of overconfidence) reduced rather than increased portfolio returns. In summary, these studies seem to support some of the key conjectures put forth by specialists in behavioral finance.
Information Flows and Group Investing Behavior
In the last section, we looked at the psychology of individual investors. In this one, we will look at the way information passes between investors, and how this gives rise to group behavior. In the next section, we will look at how the structure and institutions of the markets themselves affect behavior and returns.
Individual investors don't operate in a vacuum. Rather, they interact everyday with other investors, either directly by trading with them or indirectly by observing the consequences of their actions (for example, changes in the price of a stock, its trading volume, etc.).
At the same time, investors are dealing with information about the stocks they own and the ones they would like to buy or sell short. Some of this information costs them very little to obtain (e.g., yesterday's prices and volumes, or prices relative to an index or moving average), while the cost (in time or money) to obtain other information can be quite high (e.g., buying a research report from Multex, or interviewing customers to check on the relative performance of a company's products). On top of this, not all information available to an investor is an equally reliable guide to a company's future stock price Ð either because it may not be accurate, or because the way other investors will interpret it may not be clear. Finally, investors differ in terms of their perceptions of their own abilities relative to others to accurately interpret the information they have. For example, while Venus Williams certainly wouldn't defer to Morgan Stanley's internet analyst when it comes to choosing a tennis racquet, she probably would when it came to buying a technology stock.
These starting points give rise to a number of interesting phenomena in financial markets. Let's look at the most interesting of these: bubbles and crashes, which are both examples of the phenomena known as "herding". We'll use an example to show how these play out.
Let's start with ten people, one of whom is a well known analyst at a famous Wall Street Investment Bank, one of whom is your cousin Al who regularly drones on at family parties about his great record "in the market", and one of whom is your friend Lisa who has a PhD. in software engineering. Further assume that the other seven people (including you) are regular Janes and Joes. On Monday morning, following the release of strong quarterly results by the company, Well Known Analyst announces a strong buy recommendation on XYZ.com, a firm you've never heard about before. All of the regular folks hear about this (it is public information), and so take an interest in XYZ. A couple of them buy solely on the strength of the analyst's recommendation, but everyone else holds back because they are cynical about sell side analysts. On Tuesday, Lisa tells you that she has bought some XYZ, and its price went up ten percent. At the same time, you are sitting at Starbucks and overhear two skateboarders with multiple tattoos and body piercings strongly criticizing XYZ's website.
That night, you mull over your decision. The analyst recommended it. And Lisa (who at the very least knows more about software than you do, and is therefore better able to make sense of the public information about XYZ, even if she doesn't have any private information about the company) bought it, and earned a quick ten percent profit (assuming minimal trading costs). On the other hand, you also have private information (from Starbucks), that isn't positive. On balance, you decide that the weight of the public information (the analyst recommendation and the financial information disclosed by the company), and what you infer from the actions of others about the information they have (Lisa's and the others' purchases, and the rise in the stock price), together with the results of those actions (the stock is up ten percent) more than offsets the weight of your private information, and you decide to buy.
On Wednesday, the stock price is up another ten percent. That night Cousin Al sees that XYZ has been among the market's best performers for the past two days. As you've suspected all along, Al has neither the time nor the inclination to do any in-depth research on the company, so he has no private information about it. Instead, he looks at the analyst recommendation, the company's public financial information, and recent trading volume and price changes in the stock, infers that other people must have private information that is positive, and decides to invest.
On Thursday, three things happen. Two other people besides Al invest in XYZ, and its stock pops another twenty percent. Al calls you to brag about the latest hot stock he has found, and urges you to get in before it's too late (you change the subject). Later, while eating at your favorite restaurant, you overhear another diner tell his date that he is the head of sales at XYZ and is worried that they may lose a big new sale they had been counting on getting. As a result, earnings might be fifty percent less than expected. When you get home, you think about what is happening. On the one hand, a lot of relatively uninformed people seem to be piling into XYZ Ð you know for sure that Al can't have any private positive information about the company that would help him determine that it was undervalued. Nope, Al just bought because XYZ was heading up. You realize that the herd has begun to move, and a bubble may be developing (if the stock price is above the company's fundamental value, then it is a bubble; however, due to uncertainty about the fundamentals Ð that sale they may or may not lose, for example Ð you can't be sure yet). Moreover, you know that some other investors probably realize this too. You conclude that the risk of holding XYZ has probably increased. On the other hand, you don't want to be the first one to sell if the stock is still going up (you can just imagine what Al would say if he finds out you got out too soon). Trading off all these considerations, you decide to stay invested in XYZ only if its price gains get larger, to compensate you for what you perceive is the increased risk of holding a potential bubble stock.
On Friday, that is exactly what happens. XYZ finished the day up thirty percent, as two more people buy XYZ stock in a very thin market (nobody else wants to be the first one to leave either). On Saturday, however, you are back at your favorite restaurant, and see the XYZ sales manager sitting at the bar working on his resume, and overhear him telling the bartender that he's looking for a new job because things are falling apart at the (unnamed) company where he works. On Sunday, you realize that you now have a piece of private information (which, because of the way you obtained it, is legally not "inside" information) that provides a very clear signal about the worsening state of affairs at XYZ.
On Monday, you not only sell your shares in XYZ, but also sell more shares short (that is, borrow shares and sell them at a today's price for delivery later in the week, hoping that their price will fall by then and you will make a profit). The stock finishes the day fifteen percent up, as current investors (including, loudly, Cousin Al) add to their holdings.
On Tuesday, the short sale data for XYZ stock becomes publicly available, and the company announces that its vice president of sales has resigned. A few investors who were already nervous about a possible bubble begin to sell, and the stock price heads south. Under pressure from the investment bankers at his firm (who are trying to convince XYZ to acquire ABC in an all stock deal), Famous Analyst reiterates his buy, all the while feverishly making calls to his contacts at the company to try to figure out what is going on. At the end of the day, Famous Analyst checks with his trading desk and finds that the short sellers don't appear to have covered their position yet (that is, they have yet to buy the stock they have committed to deliver via their short sale), even though the stock is down fifteen percent on the day. That night, Soon-to-be-Infamous Analyst has that sinking feeling that somebody out there knows more than he does, and what they know isn't good. On Wednesday morning he downgrades XYZ.
At this point, the same phenomenon seen at baseball games and rock concerts kicks in. We're all familiar with it Ð nobody wants to be the first one to stand up, but once a few people do, everyone else soon follows. Wednesday becomes famous in the short history of XYZ as the day the stock lost sixty percent of its value and employees' options sunk under the waves.
Let's summarize what this example tells us about financial markets:
Table of Contents
Preface
Chapter 1: Getting Started
Chapter 2: Asset Allocation
Chapter 3: Implementation: Active Management Or Index Investing?
Chapter 4: A Closer Look at Indexes and Index Funds
Chapter 5: Toes in the Active Management Water
Chapter 6: Where to Go From Here