A photo by Geoff Scott. unsplash.com/photos/8lUTnkZXZSA

How Fantasy Ruins Football (and Investing)

It’s that time of year again, where the heat of summer recedes, sweatshirts make a comeback and businesses lose billions in flagging productivity due to fantasy football. But it’s not just businesses losing out—fans and players come up short as well.

How, after all, can I truly dedicate myself to rooting fully for my beloved Baltimore Ravens if I took Le’Veon Bell—who, for those not acquainted with the best rivalry in football, plays running back for the Steelers—second in the fantasy draft? It can’t be done. It’s just wrong.

I’m kidding, right?

Partly. But there are more serious personal and financial implications to embracing fantasy (sports or otherwise). The danger in fantasy is its distance from reality. It’s “betting on a future that is not likely to happen,” according to Psychology Today.

Our fantasies tend to sensationalize what we’d prefer to imagine while ignoring what we’d prefer to not. Then, when our actual spouse, child, parent, friend or co-worker falls short of the impossibly high bar we’ve set for them, we—and often, they—are crushed.

“Emotional suffering is created in the moment we don’t accept what is,” says Eckhart Tolle, who, perhaps unintentionally, delivers a potent dose of truth that especially informs us in our personal dealings with money.

Here are a handful of financial fantasies, followed by their unvarnished truths:

Fantasy: The market has made 10% per year, so I should expect to make 10% per year.

Truth: The market almost never makes 10%. In fact, in the past 88 years, only thrice has the S&P 500 ended the year with a positive return between the numbers 9 and 11! The market’s only consistent trait is its inconsistency, and while the market has actually returned an approximate annual average of 12%, you should expect to be surprised. Every. Single. Year.

Fantasy: Gold is a good hedge against inflation. (Or a good hedge against currency risk, or a good investment. Just take your pick.)

Truth: Of the many traits often attributed to gold as an investment, the only one that really holds up is that the precious metal historically has risen in price when stocks are in deep decline. People tend to buy gold when they are scared (and sell it when they aren’t). But good luck shaving off some of your bullion for bread when the Hunger Games start (or when any dystopian tween books series becomes a reality).

Fantasy: “Wow, they have a big house. They must be rich!” (That’s an actual quote from my 10-year-old son. I know. We’re working on it.)

Truth: They might be “rich.” Or they may just have a very big mortgage. Regardless, The Millionaire Next Door taught us that appearances can—and often are—deceiving.

Fantasy: Money is power. Everything would be better if I had more of it.

Truth: Literally (since 1971) and figuratively (forever), money has no value other than that which we attribute to it. Most of us have a tendency to over-value money, and in so doing, diminishing what has true power in our lives—relationships. But when we see money as the neutral tool that it is, it can be used very effectively, especially when in the service of enhancing relationships.

Fantasy isn’t all bad. Expanding our imaginations often leads to the conception—and eventually, the accomplishment—of endeavors formerly relegated to the realm of impossibility. Perhaps the key, then, is to ensure our fantasy only enhances our reality.

Fantasy football provides a great example. It can be a great way to have fun with friends, to enhance your knowledge of the game and to learn more broadly about its players. But as clutch NFL kicker Justin Tucker reminds us, “If you’re going to take it so seriously, then you’re an idiot.”

This commentary originally appeared September 3 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

Discussing project

Research on Luck versus Skill in Mutual Fund Performance Highlights Active Management’s Shortcomings

In many walks of life, trying to discern the lucky from the skilled can be a difficult task. For example, it seems like every time a professional sports draft occurs, debate again flares up over whether the evaluation of college (or even high school) athletes is an exercise in skill or in luck.

Were the Portland Trail Blazers unskilled in the 1984 NBA draft when they selected Sam Bowie with the second overall pick, just ahead of Michael Jordan? Or were they just unlucky? (Bowie went on to an uneventful and injury-plagued career, while Jordan led the Chicago Bulls to six championships and is considered by many to be the greatest basketball player ever.)

The point is that sometimes it’s not easy to distinguish luck from skill. This difficulty extends to the evaluation of active mutual fund managers. With that in mind, we’ll review the academic literature on the subject of luck versus skill in mutual fund performance. We will examine the results of five studies. The first is by Bradford Cornell.

Skill Vs. Serendipity

Cornell, who contributed to the literature with his study “Luck, Skill, and Investment Performance,” which was published in the Winter 2009 issue of The Journal of Portfolio Management, noted: “Successful investing, like most activities in life, is based on a combination of skill and serendipity. Distinguishing between the two is critical for forward-looking decision-making because skill is relatively permanent while serendipity, or luck, by definition is not. An investment manager who is skillful this year presumably will be skillful next year. An investment manager who was lucky this year is no more likely to be lucky next year than any other manager.” The problem is that skill and luck are not independently observable.

Because this is the case, we are left with observing performance. However, we can apply standard statistical analysis to help differentiate the two, which is precisely what Cornell did. He used Morningstar’s 2004 database of mutual fund performance to analyze a homogenous sample of 1,034 funds that invest in large-cap value stocks.

Cornell’s findings are consistent with the previous research. The great majority (about 92%) of the cross-sectional variation in fund performance is due to random noise. This result demonstrates that “most of the annual variation in performance is due to luck, not skill.” Cornell concluded: “The analysis also provides further support for the view that annual rankings of fund performance provide almost no information regarding management skill.”

French & Fama Weigh In

Our second study is by Eugene Fama and Kenneth French, who contributed to the literature with their study, “Luck versus Skill in the Cross-Section of Mutual Fund Returns,” which was published in the October 2010 issue of The Journal of Finance. They found fewer active managers (about 2%) were able to outperform their three-factor (beta, size and value)-model benchmark than would be expected by chance.

Stated differently, the very-best-performing traditional active managers have delivered returns in excess of the Fama-French three-factor model. However, their returns have not been high enough to conclude they have enough skill to cover their costs, or that their good returns were due to skill rather than luck.

Fama and French concluded: “For (active) fund investors the simulation results are disheartening.” They did concede their results appear better when looking at gross returns (the returns without the expense ratio included). But gross returns are irrelevant to investors unless they can find an active manager willing to work for free.

Increasing Difficulty

Our third study is “Conviction in Equity Investing” by Mike Sebastian and Sudhakar Attaluri, which appears in the Summer 2014 issue of The Journal of Portfolio Management. Their study is of interest because it showed a declining ability to generate alpha. The authors found:

  • Since 1989, the percentage of managers who evidenced enough skill to basically match their costs (showed no net alpha) has ranged from about 70% to as high as about 90%, and by 2011, was at about 82%.
  • The percentage of unskilled managers has ranged from about 10% to about 20%, and by 2011, was at about 16%.
  • The percentage of skilled managers, those showing net alphas (demonstrating enough skill to more than cover their costs), began the period at about 10%, rose to as high as about 20% in 1993, and by 2011 had fallen to just 1.6%, virtually matching the results of the aforementioned paper by Fama and French.

Our fourth study is “Scale and Skill in Active Management,” which appeared in the April 2015 issue of the Journal of Financial Economics. The authors, Lubos Pastor, Robert Stambaugh and Lucian Taylor, provided further insight into why the hurdles to generating alpha have been growing. Their study covered the period 1979 to 2011 and more than 3,000 mutual funds. They concluded that fund managers have become more skillful over time.

They write: “We find that the average fund’s skill has increased substantially over time, from -5 basis points (bp) per month in 1979 to +13 bp per month in 2011.” However, they also found that the higher skill level has not been translated into better performance.

They reconcile the upward trend in skill with no trend in performance by noting: “Growing industry size makes it harder for fund managers to outperform despite their improving skill. The active management industry today is bigger and more competitive than it was 30 years ago, so it takes more skill just to keep up with the rest of the pack.”

Pastor, Stambaugh and Taylor came to another interesting conclusion: The rising skill level they observed was not due to increasing skill within firms. Instead, they found that “the new funds entering the industry are more skilled on average than the existing funds. Consistent with this interpretation, we find that younger funds outperform older funds in a typical month.” For example, the authors found that “funds aged up to three years outperform those aged more than 10 years by a statistically significant 0.9% per year.”

They hypothesized this is the result of newer funds having managers who are better educated or better acquainted with new technology, though they provide no evidence to support that thesis. They also found all fund performance deteriorates with age, as industry growth creates decreasing returns to scale, and newer, and more skilled, funds create more competition.

A Factor-Based Analysis

Our fifth and final study is “Mutual Fund Performance through a Five-Factor Lens,” an August 2016 research paper by Philipp Meyer-Brauns of Dimensional Fund Advisors. His sample contained 3,870 active funds over the 32-year period 1984 to 2015.

Benchmarking their returns against the newer Fama-French five-factor model (which adds profitability and investment to beta, size and value), he found an average negative monthly alpha of -0.06% (with a t-stat of 2.3). He also found that about 2.4% of the funds had alpha t-stats of 2 or greater, which is slightly fewer than what we would expect by chance (2.9%).

Meyer-Brauns also found that the distribution of actual alpha t-stats had shifted to the left of what would be expected from chance if all managers were able to produce excess returns over the five-factor model sufficient to cover their costs.

He concluded: “There is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.” He added that “funds do about as well as would be expected from extremely lucky funds in a zero-alpha world. This means that ex-ante, investors could not have expected any outperformance from these top performers.”


In 1998, at a time when about 20% of actively managed mutual funds were outperforming their risk-adjusted benchmarks, Charles Ellis called active management a loser’s game. What he meant was that, while it certainly was possible to win the game by selecting funds that would outperform, the odds of doing so were so poor that it wasn’t prudent to try.

Today the combination of academics having converted what once was alpha into beta (a common factor explaining returns)—thus eliminating potential sources of alpha—and that increasingly skilled competition has raised the hurdles, now only about 2% of actively managed mutual funds are generating statistically significant alpha. And that’s even before the impact of taxes on taxable investors.

The choice is yours. You could try to beat overwhelming odds and attempt to find one of the few active mutual funds that will deliver future alpha. Or you could accept market returns by investing passively in the factors to which you desire exposure. The academic research shows that investing in passively managed funds is playing the winner’s game.

This commentary originally appeared August 22 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

Lauterbach Financial Advisors - Fee Only Financial Advisors in El Paso

When should TIPS be used in a client’s portfolio?

The short answer to this common fixed income question: It depends on the client. If the client’s lifestyle could be greatly affected by an unexpected spike in inflation, or if the client is generally fearful of inflation, then a higher allocation to TIPS would be warranted regardless of how “inexpensive/expensive” they appear in the market. But let’s examine this question from the wider perspective of a client who is neutral in regards to inflation protection.

First, let’s look at the market’s expectation for inflation going forward. The easiest and most effective way to determine this is to look at the break-even inflation rate, which is calculated by subtracting the yield on a TIPS bond from its nominal Treasury counterpart. For example, if a five-year TIPS bond is trading at 1.00 percent and a five-year Treasury is trading at 4.00, then the 3.00 percent difference between the two yields is roughly the market’s expectation for inflation over the next five years. The advantage of using the break-even inflation rate is it is easily observable and uses real-time, forward-looking market data. Now that we know the market’s five-year inflation expectation, we have our baseline measurement.

Traditionally, BAM’s Fixed Income Desk has not purchased nominal Treasury bonds for our client portfolios because there are better-yielding options with similar credit risk, such as U.S. agency bonds or FDIC-insured brokered CDs, and a similar break-even inflation number can be computed for these other options. For example, if evaluating the purchase of a five-year brokered CD at 5.00 percent, subtract the 1.00 percent real yield on the TIPS bond from our previous example for a break-even inflation number of 4.00 percent. Compare that number to market break-even inflation in order to make a judgment about the best product to purchase. In the example above, the break-even inflation rate on the brokered CD is
4.00 percent while the market break-even inflation rate is only 3.00 percent. Inflation would have to be 100 basis points, or 1.00 percent, higher than what the markets are currently expecting for the TIPS bond to provide the same nominal yield as the brokered CD. This same math can be applied to other fixed income securities such as U.S. agencies and taxable and tax-exempt municipal bonds. Given that large difference of 100 basis points, BAM would recommend purchasing the brokered CD as opposed to the TIPS bond.

The next logical question: What is the cutoff for when TIPS would be recommended as opposed to another nominal bond option? BAM’s rule of thumb is roughly 25 to 30 basis points. So if the difference between the break-even inflation rates is less than 25 to 30 basis points, TIPS bonds are recommended because the small yield give-up is worthwhile because of the inflation risk that is taken off the table.

When evaluating the use of TIPS, the break-even inflation rate for the nominal security and the market break-even inflation are critical. If the difference is greater than 25 to 30 basis points, then the nominal option will likely be the better solution. If the difference is less, then TIPS are the preferred solution. Remember, though, that this evaluation can vary client to client depending on sensitivity to inflation. ___________________________________________________________________________________________

Copyright © 2016, The BAM ALLIANCE. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm.
Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.

Wall Street

What are the differences between fixed income and stock trades?

The bond market is less transparent in pricing and trades less frequently than equity markets. Blerina Hysi explains how a trusted advisor can help navigate these market inefficiencies and prevent you from suffering excessive mark-ups.

Featured photo by Rick Tap.


Brexit – Our Perspective (Q&A)

Britain’s decision to exit the European Union has brought with it all the expected trappings of a significant news event – projections of crazy market volatility, wild headlines and a fair dose of uncertainty about the long-term impact on the global economy and our individual financial lives here at home. Many questions immediately arise as we pay close attention to how the event will play out in the weeks and months to come. But our perspective is the same as it has always been in times like these. Your financial plan is built with diversification and your personal risk tolerance in mind – it’s designed to weather the ups and downs that inevitably follow significant world happenings. Jared Kizer, Chief Investment Officer for the BAM ALLIANCE, reminds us of this below:


What did British voters decide?
To the surprise of many – including stock and bond markets – Britain voted to leave the European Union (EU) by a margin of 52 percent in favor of leaving (i.e., “Brexit”) and 48 percent in favor of remaining. The general belief from the economic community is that this decision will weaken the British and European economies since Britain both imported and exported a significant amount of its economic consumption and production, respectively, to continental Europe.


How have markets reacted?
At the time of this writing, stock markets have fallen precipitously and bond interest rates have dropped as well. With the exception of precious metals, commodity markets are also generally down, and the British pound has dropped by about 8 percent against the U.S. dollar.


Why have markets reacted so violently?
Without question, the primary reason is that markets had incorporated a belief that Britain would remain in the EU. Stock markets had been up significantly over the last couple of weeks, and interest rates had started to move back up after being lower earlier in the month. These movements were generally believed to be an indication that the market expected Britain would remain in the EU.


Because the vote did not go as most expected, stock markets are giving back those gains and more, and interest rates are now falling instead of increasing. We emphasize, though, that while these market moves have been swift, this is normal market behavior when a significant event (like Britain leaving the EU) turns out differently than what the market had anticipated.


Why has the U.S. market reacted so strongly to Britain’s decision?
We truly live in an interconnected, global economy at this point. Any decision by an economy that is the size of Britain’s (fifth largest in the world) will impact markets elsewhere, including the U.S. market. The European market is a significant trading partner for many U.S. firms, so it’s not surprising to see U.S. stocks decline since Britain’s decision is thought to be a net negative for Europe from an economic perspective.


Will Britain’s decision precipitate a global recession?
It’s impossible to say whether we are headed toward a recession, but Britain’s decision likely increased the likelihood of a recession. However, the strong caveat here is that markets are forward looking and have already started to incorporate this likelihood, meaning you can’t use this information to your advantage. This increased likelihood of recession is no doubt one of the reasons that stock markets have moved down sharply while bond prices have moved up sharply.


How did markets get this wrong?
While outguessing markets is difficult, in hindsight markets will always appear to have been overly optimistic or pessimistic, which means it’s easy to critique them while looking in the rearview mirror. This particular vote was expected to be close, so markets weren’t certain but were tending toward a “remain” vote.


What will markets do from here?
While it’s very difficult to predict markets, it is highly likely markets will be volatile for some time to come. Stock market volatility has been relatively low over the last few years, but it can change quickly. The VIX, which is a measure of annualized stock market volatility, has gone from about 17 percent to 25 percent in reaction to the news, which is higher than the long-term average of about 20 percent per year.


It is important to remember, however, that higher volatility can work in both directions. While we could certainly see more days when stocks fall significantly, it’s also possible we will have days when they rise significantly.


What should I do with my own portfolio?
Our guidance is the same that it has always been. If you have built a well-thought-out investment plan that incorporates your ability, willingness and need to take risk, you should not change your plan in reaction to market events. Doing so rarely leads to productive results.


Your plan incorporates the certainty that we will go through periods of negative market returns, and market reactions like this are also the primary reason we emphasize high quality bond funds and bond portfolios, which help buffer the risk of stocks. The early read on this bond approach is that it’s doing exactly what we expect it to since high quality bonds have appreciated significantly in reaction to the Brexit vote.


How will this impact Federal Reserve interest rate policy?
As we have previously noted, interest rates have dropped dramatically in reaction to the vote. In early trading, the 10-year yield is at about 1.5 percent after having been at about 1.75 percent one day earlier. These early movements in interest rates indicate the market does not expect the Fed to increase interest rates at any point during the rest of the year. The primary ways this would likely change are either an unexpected increase in the rate of inflation or unexpectedly positive developments in the U.S. and global economy.


Do international and emerging markets stocks still deserve a place in a well-diversified portfolio?
International and emerging markets stocks comprise about half of the world’s equity market value, so we continue to believe that a well-diversified stock portfolio should include a significant allocation to international and emerging markets stocks. While both have underperformed U.S. equities over the last five and 10 years, that does not mean they will continue to do so. We have seen periods in the past when international stocks have outperformed U.S. stocks for a long period of time only for that to reverse in the future. Further, international stocks are trading at significantly lower prices than U.S. stocks, indicating expected returns are higher for international stocks compared to U.S. stocks.


What role do currencies play in this situation and in my portfolio?
Initially, we are seeing the U.S. dollar and Japanese yen appreciate against most other currencies, while the British pound is falling precipitously. The international funds we use do not hedge foreign currency, so when the U.S. dollar appreciates relative to other currencies, this negatively impacts their returns. The long-run academic evidence, however, shows that hedging currency risk has minimal impact on an overall portfolio and that it can be beneficial to have exposure to currencies other than the U.S. dollar for a portion of an overall portfolio.

The Influence of Recent Market Returns on the Risk Tolerance of Individual Investors (Part 2)

Last week, we examined a study that found investors’ risk tolerance fluctuates positively with recent market returns. This behavior is in direct conflict with rational economic theory, which dictates that when market returns become negative, wealth contracts and risk aversion should therefore decrease (while risk tolerance should increase).

Instead, the authors found that investment losses, combined with loss aversion, contribute to an increase in risk aversion during bear market declines. On the other hand, gains during a bull market lead to the well-documented “house money” effect and a decrease in risk aversion.

The findings from this study— Do Market Returns Influence Risk Tolerance? Evidence from Panel Data by Rui Yao and Angela Curl—suggest that individuals invest greater amounts after periods when market returns are high and withdraw partially or even completely from the market after periods when returns have been poor.

Today, we’ll examine some additional support for Yao and Curl’s conclusions, as well as explore the relationship between loss aversion and investor overconfidence.

Investor Risk Tolerance

To begin with, Yao and Curl’s findings are consistent with those of Michael Guillemette and Michael Finke, authors of the June 2014 paper, Do Large Swings in Equity Values Change Risk Tolerance?

Their study investigated whether the measured risk tolerance of U.S. and Canadian individuals correlated with market movements. Using a dataset provided by FinaMetrica, which creates and distributes a risk tolerance questionnaire widely employed by financial planners, the authors examined average monthly risk tolerance scores (MRTS) during the period from January 2007 through May 2012, a period that spans the financial crisis. A total of 341,782 people were surveyed over the time period. Their objective was to test whether fluctuations in equity returns influence average risk tolerance scores over time. The following is a summary of their findings:

  • There was a strong positive correlation (0.70) between the S&P 500 and the MRTS.
  • Risk tolerance scores are consistently lower immediately following a market decline. The correlation between the S&P 500 and the MRTS climbed to 0.90 for the period from January 2007 through March 2009, when the market bottomed out. However, the correlation during the recovery was 0. A rising market is seen by some as a buying opportunity, while others remain more risk averse after recent losses.
  • The correlation between the MRTS and consumer sentiment was 0.67.
  • When consumer sentiment was most negative, investors were the most risk-averse.
  • When consumer sentiment was the most positive, respondents were far more risk-tolerant.

Unfortunately for investors, their average monthly risk tolerance was also highly correlated with equity market valuations as measured by price-earnings (P/E) ratios. In fact, Guillemette and Finke found that risk tolerance increases when equity valuations are high (and expected returns are low), and that individuals are most risk-averse when equity valuations are low (and expected returns are high). This change in risk tolerance can lead to a buy high and sell low pattern of trading. As you would expect, this perverse behavior negatively impacts investor returns.

For example, Geoffrey Friesen and Travis Sapp, authors of the 2007 study Mutual Fund Flows and Investor Returns: An Empirical Examination of Fund Investor Timing Ability, found that individual investors lose, on average, 1.56% a year in dollar-weighted returns because they tend to pull money out of equity mutual funds following a significant market decline (when equity valuations are more favorable). Conversely, investors increase equity allocation following recent price increases (when valuations are less favorable).

As yet another example of recency’s impact, one that spanned the period of the financial crisis, the June/July 2011 issue of Morningstar Advisor looked at the behavior gap, the difference between the dollar-weighted returns earned by investors and the time-weighted returns earned by the mutual funds in which they invest, for the one-year and three-year periods ending December 2010. For domestic equity funds, the gap was 2% and 1.3% per year, respectively. For international equity funds, the gap was 0.6% and 0.8% per year, respectively.

Loss Aversion and Overconfidence

Shan Lei and Rui Yao, authors of the 2015 study Factors Related to Making Investment Mistakes in a Down Market, contribute to our understanding of investor behavior. They explored the following hypotheses:

  1. Loss aversion positively affects the likelihood of making investment mistakes.
  2. Overconfidence positively affects the likelihood of making investment mistakes.

To test their hypotheses, they used data from the 2008 FPA-Ameriprise Financial Value of Financial Planning Research Study. The data was collected online by an independent market research firm between June 27, 2008, and July 18, 2008, in the midst of the financial crisis. The total sample size was 2,792 respondents. The survey asked participants for their reaction to the market changes during the past year. One question asked: “Since the market has changed over the past year, what actions, if any, have you taken?” One possible answer was: “Moving assets into more of a cash position.”

Lei and Yao considered it a mistake if investors moved assets into cash in a down market while having an adequate amount in an emergency fund. Because more loss-averse investors are more likely to react in a down market, those who chose these items as answers were considered to be more loss-averse investors. The following is a summary of the authors’ findings, all of which are consistent with findings already discussed:

  • Consistent with the first hypothesis, respondents who were more loss-averse were also more likely to make investment mistakes.
  • Consistent with the second hypothesis, respondents who expressed more confidence were 1.4 times as likely to make investment mistakes.
  • After controlling for other variables in the model, women were found to be less likely than men to make the mistake of moving to cash during the bear market (with an odds ratio of 0.726). This is consistent with prior research that demonstrates men are more likely to be overconfident, and thus more likely to make mistakes.
  • The percentage of respondents making mistakes was generally greater for higher investable asset groups. This is consistent with the idea that investors who are more confident will be less risk-averse and hold riskier assets.

Evidence From the U.K.

Since misery loves company, it’s nice to know that U.S. investors are not alone in their bad behavior. Thanks to Andrew Clare and Nick Motson—authors of the study Do U.K. Retail Investors Buy at the Top and Sell at the Bottom? have evidence demonstrating that investors in the U.K are equally guilty of bad or irrational behavior.

Clare and Motson examined the impact of timing decisions of both retail and institutional U.K. investors. The authors’ study covered the almost 18-year period from January 1992 through November 2009. The following is a summary of their findings:

  • Just like U.S. investors (both individual and institutional), U.K. retail investors (though not institutional investors) are performance chasers as fund flows correlate with prior 12-month returns to the equity market.
  • When they examined the prior six-month returns, the correlation between market returns and fund flows increased. Unfortunately, so did the negative correlation between fund flows and future returns, and it was now statistically significant at the 99% level of confidence.
  • For retail investors, these correlations were also found to be significant between the 15- and 24-month horizons.
  • The performance gap (the difference between a buy-and-hold strategy of a fund and investor returns in that fund) for retail investors was -1.17% per year. For institutional investors there was also a performance gap, but it was smaller at -0.20%.

The bottom line is that, over the 18-year period, the performance-chasing behavior of U.K. retail investors cost them a total return loss of 20%.

The Bottom Line

Warren Buffett has warned investors that their greatest enemy is looking at them in the mirror. Three of the most common and, unfortunately, most expensive mistakes that individual investors make are: overconfidence in their ability to withstand the stress of bear markets (which may lead to panicked selling), recency, and thinking that they are playing with the “house’s” money. These three are among the 77 mistakes covered in my book, “Investment Mistakes Even Smart Investors Make and How to Avoid Them.”

But individual investors aren’t the only ones impacted by these problems. In his book, “Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing,” Hersh Shefrin reported that the risk-tolerance levels of both institutional investors and financial advisors were positively correlated with stock market returns.

Having a sound understanding of risk tolerance is not only important for individual investors, but also for their financial advisors. The research shows that while advisors may treat investor risk tolerance as a stable characteristic, it’s clearly important to periodically revisit their clients’ risk tolerance, as risk tolerance changes not only as investors age but with movement in the markets as well. If an investor’s risk tolerance does change in response to market returns, it’s likely that either the investor (or the advisor) overestimated their ability to understand risk and properly assess their individual risk tolerance. And thus a change in the overall financial plan may be required.

This commentary originally appeared May 3 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


The Influence of Recent Market Returns on the Risk Tolerance of Individual Investors


The recency effect—that the most recent observations have the largest impact on an individual’s memory and, consequently, on perception—is a well-documented cognitive bias. This bias could impact investment behavior if individuals focus only on the most recent returns and project them into the future. Such behavior may lead investors to experience a reduction in their risk tolerance (which, in turn, can lead to selling) after a bear market, when valuations are lower and expected returns are higher. Conversely, recency may lead investors to experience an increase in their risk tolerance (which, in turn, can lead to buying) after a bull market, when valuations are now higher and expected returns are lower.

The Recency Effect

The recency effect nudges investor behavior in a direction contradictory to economic theory, which states that relative risk aversion is a function of increasing wealth (the marginal utility of wealth declines as wealth increases). Strong market returns would increase investor wealth, and thus we should see a reduction in investor risk tolerance.

Rui Yao and Angela Curl—authors of a 2011 study, Do Market Returns Influence Risk Tolerance? Evidence from Panel Data, which appeared in the Journal of Family and Economic Issues—hypothesized that the recency effect would dominate rational economic behavior. They posited that risk aversion is negatively related to recent market returns (or, in other words, that risk tolerance is positively related to recent market returns).

Their study used data from the 1992, 1998, 2000, 2002 and 2006 interview waves of the Health and Retirement Study (HRS), an ongoing biannual study conducted by the University of Michigan and funded through the National Institute of Aging. The target population for the HRS is noninstitutionalized men and women, born from 1931 to 1941, living in the contiguous United States. Based on responses to a set of income gamble questions, researchers assigned participants to a risk tolerance level for each wave: most risk tolerant, second-most risk tolerant, third-most risk tolerant and least risk tolerant. Stock market performance was measured as a continuous variable using the S&P 500 Index’s trailing 12-month returns prior to each interview. The following is a summary of the authors’ findings:

  • Consistent with the recency theory and their hypothesis, there was a significant positive linear relationship between S&P 500 returns and respondent risk tolerance.
  • Controlling for time and other independent variables, a one percentage point increase in market returns increased the probability of taking substantial or high risk by 1%. A one-standard-deviation increase in S&P 500 returns increased the likelihood of taking substantial or high risk by 15.7%.
  • When the stock market is falling, average monthly investor risk tolerance scores are strongly correlated with changes in the S&P 500. However, when stock prices start to rise, changes in average risk tolerance seem to be largely uncorrelated with the market.

Yao and Curl also found that:

  • Each additional year of age above the sample mean decreased the likelihood of taking some risks by 2%—consistent with theory and prior research showing that the likelihood of being in the high-risk or some-risk groups decreases as people age.
  • Higher educational attainment was consistently predictive of higher levels of risk tolerance.
  • Investors with greater financial assets reported lower levels of risk tolerance. This is consistent with the theory of declining marginal utility of wealth.

The key finding is in direct conflict with rational economic theory. When market return becomes negative, wealth decreases. Therefore, risk aversion should decrease (and risk tolerance should increase). But Yao and Curl’s analysis found that risk tolerance fluctuated positively with market returns. While the loss of money, combined with loss aversion, contributes to an increase in risk aversion during a bear market decline, gains during a bull market lead to the well-documented “house money” effect and a decrease in risk aversion.

The authors concluded that investors don’t behave according to rational economic model assumptions, and that “such changes in risk tolerance in response to market returns may be an indication that investors, and possibly their financial advisors, overestimate their ability to understand risk and assess individual risk tolerance.”

These findings suggest that individuals invest more after periods when market returns are high and withdraw partially or even completely from the market after periods when returns have been poor. Yao and Curl reached the conclusion that their findings support “the projection bias hypothesis and confirms the recency effect.” What’s more, their findings on investor behavior are consistent with those from the field of behavioral finance.

Behavioral Finance

For example, Richard Thaler and Eric Johnson, authors of the 1990 study Gambling with House Money and Trying to Break Even: The Effect of Prior Outcomes on Risky Choice, found that individuals experience less dissatisfaction from losses after a prior gain and greater dissatisfaction after a prior loss. Thus, risk aversion is time-varying and dependent on prior outcomes.

Yao and Curl’s findings are also consistent with those of Robin Greenwood and Andrei Shleifer, authors of a 2014 study, Expectations of Returns and Expected Returns. They were able to document a strong negative correlation between investor expectations of stock returns and recent returns for the S&P 500—investors change their expectations of the reward from taking risk based on recent changes in stock market returns.

The financial crisis of 2008 provided a good example of how recency impacts investor risk tolerance. During the crisis, individual investors pulled out hundreds of billions of dollars from the equity market. The result was that, by 2010, portfolio allocations to risky assets had declined to their lowest level for people under the age of 35 in the history of the Survey of Consumer Finances.

A more recent example can be found by examining the returns from emerging markets and investor flows. From September 2014 through September 2015, the MSCI Emerging Market Index lost more than 23%.Investment Company Institute data shows that beginning in July 2015, emerging-market funds experienced net withdrawals in every single month. For the period from July 2015 through January 2016, total net withdrawals exceeded $13 billion.

Next week, we’ll examine some additional support in the research for Yao and Curl’s findings, as well as explore the relationship between the recency effect and loss aversion and investor overconfidence.


This commentary originally appeared April 26 on MutualFunds.com

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