Measuring Your
Mutual Funds
William Goetzmann, a finance
professor at Yale University's
School of Management, has studied
how investors perceive their mutual-
fund results.
"Investors take a rosy view,"
he says. "What I've found is
that even relatively
sophisticated investors not only
overestimate the returns of their
funds, but they also
overestimate the returns relative
to a benchmark," such as
Standard & Poor's 500-stock
index.
Mr. Goetzmann posits that
investors typically prize the
investments they already own
and tend to ignore information
that suggests they made a bad
choice.
"Make sure that you really look at the performance of your
funds on a regular basis," he advises. "If a fund's been under-
performing for two or three years, there's good reli son to get
rid of it."
Don't, however, compare all your stock funds to the S&P
500. That may be a good choice for funds that specialize in
larger U.S. stocks. But if you own small-stock or foreign-stock
funds, track their performance relative to similar funds or an
appropriate market index.
These days, that is easy to do. Many newspapers and
personal-finance magazines offer regular updates on fund per
fortunately, these "total return" results aren't readily available
for individual stocks. The Wall Street Journal publishes this
information for 1,000 stocks, but only once a year, in its
Shareholder Scoreboard special supplement in February.
How should you use the Scoreboard? While you might want
to dump a fund that regularly lags behind an appropriate
benchmark index, that is not the case with individual stocks.
Indeed, lackluster performance may be the prelude to brilliant
returns.
On the other hand, if most of your stocks lag behind the
market averages, it is a clear indication that your stock-picking
prowess leaves something to be desired. "It's time to try your
hand at mutual funds," suggests John Markese, presi
dent of Chicago's American Association of
Individual Investors.
vestors.
Roman Scott
a Measuring Your Market Bets
Some folks flit between stocks
and conservative investments in an
effort to catch bull markets and
sidestep stock-market declines.
If you are in this camp, make
a point of writing down the
current level of the Dow Jones
industrials or the S&P 500 every
time you make one of these
portfolio shifts.
Was the market higher or
lower when you got back into
stocks? If you turn out to be the
world's first market forecaster
with a working crystal ball, keep
at it. If not, do your finances a
favor and call it quits.
Tracking a Portfolio's Performance Many investors fixate on the performance of one or two investments and end up with a skewed impression of how their whole portfolio is really doing. Want a more accurate picture? Tote up your portfolio's value at the beginning and end of each year, Mr. Markese says. Next, adjust these two numbers for the amount you added or withdrew from the portfolio. If you made additional investments, add half of the amount involved to the beginning balance and subtract half from the ending balance. Conversely, if you withdrew money, subtract half the sum involved from the beginning balance and add half to the end. Finally, calculate the percentage gain or loss over the course of the year. "It's a pretty good approximation," Mr. Markese says. TTqp this fiLyure to Lyet a sense for whether you are earning
A study says Charles Dow's much-maligned theory was actually pretty good.
THOUGH JOE AND MARY INVESTOR may pay scant heed, the investment community is going to be buzzing about an article that will appear this fall in the nation's premiere academic finance journal. The article concludes-brace yourself-that the ancient Dow Theory actually works. Academic sneering notwithstanding, the theory has been successflilly timing the stock market for nearly 100 years, the authors claim. The article is "The Dow Theory: William Peter Hamilton's Track Record Reconsidered," by professors Stephen Brown (New York University) and William Goetzmann and Alok Kumar (Yale). It will appear in the Journal ofEinance, but copies of the article are already circulating. For those who came onto the investing scene in the past quarter of a century or so, the Dow Theory traces its roots to a series of Wall Street Journal editorials that were written between 1902 and 1929 by William Peter Hamilton. It is the oldest technically oriented market-timing system still in use today. A keystone of the theory is that if both the Dow Jones industrial and the Dow Jones transportation averages are in sustained uptrends, a market rise will continue. If the averages diverge, trouble lies ahead. Thus, if both averages had been declining and suddenly one of the two begins to rise, a bull market might lie ahead. Though the theory doesn't have the following it once had, true believers still exist-and the forthcoming article will give them new prestige. Take what happened m the market last fall. Even though the was rallying to record highs, the stubbornly failed to eclipse its previous high, set on Aug. 6, 1997. Noting the divergence, Dow theorist Richard Russell of Dow Theory Letters forecast market weakhess. Thus he was not surprised by the October crash. That was fairly clear-cut, but it is not always easy to know what constitutes a significant divergence. Hamilton never codified the theory into a set of unambiguous rules. This has precipitated endless debates about what Hamilton really meant. In their forthcoming article the professors demonstrate a way of resolving these debates. They used state-of-the-art artificial intelligence software to identily the precise technical trading patterns associated with the buy-and-sell signals Hamilton issued with his editorials. The software then applied those patterns to subsequent markets. The study found that there was real merit in Hamilton's theory. Over the nearly 70 years since Hamilton's death, a portfolio that followed the signals identified by the software, using an index flind with no transaction costs, would have outperformed a buy-and-hold strategy by about two percentage points per year. In addition, such a portfolio would have incurred one-third less volatility (the professors' proxy for risk). That's a winning combination. What does the profrssors' Dow Theory model say about the stock market right now? It recently issued a buy signal, following several months in cash in the wake of last fall's divergence. This illustrates how conservative the Dow Theory
is: Hamilton was willing to leave the party early in return for not getting caught at the exit. The professors found that their Dow Theory portfolio beat the market most handily during such bearish decades as the 1970s and the 1930s. It showed the least favorable results during strongly bullish decades such as the 1980s and the 1990s. A similar pattern emerges from Richard Russell's Dow Theory Letters. Since 1980, according to the Hulbert Financial Dzgest, a portfolio that switched in and out of the market on Russell's signals would have lagged a buy-and-hold by about 2.7 percentage points per year. Not surprisingly, many investors have grown disillusioned with this market-lagging performance. They forget that Russell's portfolio also was 35% less risky than the market as a whole. On a risk-adjusted basis Russell beat the market. Sooner or later, of course, the bull market will end. When it does, I suspect the Dow Theory will become popular again. In the meantime, the professors' Dow Theory model is on a buy signal.
An equally tall order was deciding which papers to focus on. So many papers, so little space. But after reflecting on what I heardùmuch of it destined to appear in leading academic and professional journalsùone theme resonated. Global asset allocation strategies look convincing on paper. But what about the real world?
Two papers in particular shed light on that subject. The first examines historical equity premiums in stock markets around the world, utilizing performance data going back to 1921. A key finding: Historical equity premiums (excess returns in stocks over so-called riskless securities, such as Treasury bonds) look far less attractive on a global basis compared to the more encouraging numbers derived by examining a U.S.-only sample.
The second paper should persuade international investors committed to a buy-and-hold strategy to at least take a second look at momentum investing active management. Based on 15 years of data from overseas stock markets, the report found that trading in foreign markets every six months on a top-down basis can add value. Overall, the paper suggests that gains from momentum investing are both significant and recurring.
According to data from Chicago-based Ibbotson Associates, of the 52 holding periods of 20-year duration during the aforementioned time period, thereÆs just one instance (1929 to 1948) when large company stock returns lagged those of long-term government bonds. Though bonds did edge out stocks a bit more often when the data was sliced into 10-year holding periods, stocks nonetheless remained the superior performer by far on both an absolute and a frequency basis over that span.
What does the data tell us? Stocks always bounce back, at least eventually. Yes, there will be losing periods, perhaps years at a stretch, but patience and a generous allocation to stocks pays off over time.
This conclusion jibes ever so nicely with modern portfolio theory, which advises that higher return comes via higher riskùunsystematic risk, to be precise. After plugging historical performance numbers of stocks and bonds into the quantitative framework of the Capital Asset Pricing Model (CAPM), the resulting asset allocation is likely to be one of heavy equity weighting and low bond exposure for a long-term investment horizon.
ThereÆs at least one conundrum, however. If stocks appear safer than bonds over timeùbased on the fact that equities outperform bonds over the long haulùwhy do investors require a risk premium for investing in stocks? ShouldnÆt it be the other way around? Puzzling!
WeÆre not the only ones who find it puzzling, either. Rajnish Mehra and Edward Prescott are puzzled, as well, or so they wrote more than a decade ago. In their paper, "The Equity Premium: A Puzzle" (The Journal of Monetary Economics, 1985), the pair noted the historical premium generated by stocks over bonds looked unjustified based on reasonable assumptions of investorsÆ risk aversion.
Solutions to the puzzle have since been offered, though no single explanation has become widely accepted. Some say flaws in CAPM are to blame. Others argue the puzzle is the logical consequence of a market dominated by investors fixated on short-term performance. Still others say what seems a large equity premium is justified by low-probability events with potentially large impacts, such as a stock market crash.
Two professors with a slightly different take on this subject presented their thoughts at the recent WFA gathering. In an as-yet unpublished paper ("A Century of Global Stock Markets"), Will Goetzmann of the Yale School of Management and Philippe Jorion of the University of California at Irvine, sound a cautionary note. Goetzmann and Jorion stress that what iinvestors expect in terms of a risk premium relies heavily on data from the U.S. equity market. ThatÆs a risky assumption to make, they add. Simply stated, the exceptionally positive history of U.S. capital markets isnÆt a random sample and, therefore, may cast an undeserved bullish aura on global equity markets.
"We find striking evidence in support of the survival explanation for the [U.S.] equity risk premium," Goetzmann and Jorion write. Reflecting on their study of foreign markets in the 20th century, they report the "United States had by far the highest uninterrupted real rate of appreciation, at about 5% annually. For most other countries, the median real appreciation rate was around 1.5%. This strongly suggests that estimates of equity premia obtained solely from the U.S. market are either biased upward by survivorship or reflect fundamentally different investor expectations about risk across markets."
Overall, the pair advises that the higher real rate of return in U.S. stocks relative to the other markets studied is "the exception rather than the rule."
The biggest challenge was reconstructing performance histories from markets that closed, if not collapsed. The authors wrote that overall, the process is akin to "financial archaeology." It was well worth the effort, they state, because their findings provide "the first comprehensive long-run estimates of return on equity capital across a broad range of markets."
The paper expands on an earlier study co-written by Goetzmann, Stephen Brown of New York University, and Stephen Ross of the Yale School of Management. That paper, "Survival," was published in the July 1995 issue of The Journal of Finance. In it, the three professors suggest the true equity premium may be closer to zero when correcting for survival bias. A marketÆs survival, as in the case of the United States, they explain, "will induce a substantial spurious equity premium."
WhatÆs beyond doubt is that the equity premium for stocks on an international basis is far below the comparable U.S. level, based on data published in "A Century of Global Stock Markets." The annualized, compound real (inflation-adjusted) return for the United States is 7.37% between January 1921 and the end of 1996, the paper reports. ThatÆs far above the negative 0.28% mean, annualized return for the comparable period for all 39 countries analyzed (including the U.S.), and the 1.51% for the 14 countries with continuous histories from the 1920s onward (see Table 1).
Goetzmann and Jorion warn in "Century" that "if we fail to account for the ælosersÆ as well as the æwinnersÆ in global equity markets, we are providing a biased view of history which ignores important information about actual investment risk."
If so, then thereÆs a lot of bias going on in the real world, at least from GoetzmannÆs point of view. During a recent phone interview for this article, he stressed that he knows of no asset manager who takes into account the survival bias in U.S. data when making asset allocation decisions.
Rornan Scott
for stocks and bonds. The
bonds have performed each year put 40% of their money into stocks. But employees who were shown 30-year returns plunked 90% into stocks.
So all you have to do is overcome your myopic loss ~version and reap the reward of the extraordinary equity premium? Not quite. It's a good idea to buy stocks and invest for the long haul. But that doesn't mean you will outpace bonds by the hefty margin that history suggests.
"Today, there's a lot of talk that myopic loss av~rsion is disappearing," notes Jeremy Siegel, a finance professor at the University of Pennsylvania's Wharton School. "If people are recognizing the long-term benefits of stock investing and have bid them up as a consequence, this will narrow the spread in performance between stocks and bonds in the future."
Q.What evidence do you have that shows investors believe their mutual funds
performed better than they actually did?
Q. Did the more sophisticated investors have less tolerance for poor performance?
Q. You found evidence of the endowment effect people are more likely to believe
something they own is better than something they do not and the cognitive-dissonance
effect people revise their beliefs to match their actions. Which has the greater impact
on investor behavior?
Q. But even when the evidence is incontrovertible, your research shows that investors
are reluctant to abandon poorly performing funds. Are switching costs a factor or is it
simply inertia?
Q. You observe that while investors appear overly optimistic about their past
investment choices, cognitive dissonance is not a major problem in the mutual-fund
industry as a whole. For example, there are not large pools of wealth invested in
obviously underperforming funds. Why should there be a discrepancy between the
behavior of individuals and the industry?
Q. What are you working on now?
Need some money in the interim? You just borrow against stocks. Hang in for at least 30 years and you can't lose money. How do we know this? From the statistics. In every 30-year period since 1871, stocks have handily beaten every other financial asset, including cash. Since 1926, stocks, with dividends included, have made money in every 20-year period. The gospel is preached these days by just about every financial planner, financial columnist and stockbroker you run into. The problem with it is that it may be based on a faulty interpretation of history. Listen to Paul Samuelson, the distinguished Nobel-winning economist and also an astute investor: "Most people have been encouraged to become long-term stock investors by a line of reasoning that is incorrect," he says. "That doesn't mean I can tell someone not to be a long-term investor in equities, only that the current bull market is being fed by a misunderstanding of the law of large numbers." The misunderstanding he is referring to has to do with survivorship bias. When the pundits say stocks always win, they turn for proof not just to any nation with a history of stock returns but to a particular one: the U.S. The record is long and wonderfully positive. If you had held U.S. stocks since 1816, you would have averaged a terrific 6.7% compound return, above and beyond inflation. Considering that money doubles every 12 years at 6%, you'd need a lot of zeroes to show how much you would have if you had invested $100 in stocks in 1816. You'd need a computer to tell you. But is this country typical? In the early 19th century the U.S. was just beginning a two-century-long expansion into a resource-rich continent, unpunctuated by a revolution or invasion. Not coincidentally, long continuous records are lacking for countries that have had periods of acute discomfort for owners of equity capital—countries like Germany, Russia, Poland and Japan. Probably there weren't any stocks in Russia in the very early 19th century, but if there had been, we're not at all sure they would have been a great investment. Maybe stocks are not the sure winners they are cracked up to be.
The New York Stock Exchange has maintained continuous trading since its inception in 1792. Tack on the London exchange, and the unbroken ticker tape stretches all the way back to 1773. More importantly, the two big Anglo-Saxon exchanges kept going through the 1930s and 1940s, when their less fortunate cousins either suffered big breaks in trading or simply winked out. Financial historians depend on Anglo-Saxon data because they need long data series to draw conclusions about long-term risk. The trouble is they have picked two big winners. Great Britain was the preeminent economic power in the 19th century and into the 20th; the U.S. has been for most of the 20th. How good, though, is triumphalist history, written from the winner's point of view?
"Economists commonly take historical data from the winning countries and extrapolate that into the future," warns William Goetzmann, a professor of finance at the Yale School of Management. "If you take data from the losing countries, you get a different picture." Since 1993 Goetzmann and Philippe Jorion, of the University of California at Irvine, have been doing just that, collecting data from countries where economists have lacked stock market data because of breaks in trading.
What happens when stock trading stops? You could suffer a temporary inconvenience, as Swiss shareholders did when their exchange closed during a general mobilization in 1940 against a feared German invasion. Or you could lose everything, as did those who invested in the St. Petersburg exchange before the Russian Revolution of 1917. The chart, Survivors rule, gives the benefit of the doubt to markets like Tokyo's where there was a prolonged disruption: It simply ignores missing years. But Goetzmann speculates that half of equity value vanishes in such years. So what are some of the really bad things that might happen to our stock market? Take a look at another seemingly secure country: Britain in the 1970s. "In the early 1970s the U.K. went through an incredible period of turmoil," says Goetzmann. "When we looked at the pages of The Economist, we found articles questioning whether capitalism would survive in Britain at all. "In a slightly different world the U.S. exchanges might have met their end in the 1930s," he goes on. "Had the Senate investigation into the stock market crash discovered one more scandal, it might have tipped the balance in favor of those who wanted to end equities trading for good. It seems hard to imagine, but then, no one who comes off a long period of stable finance is likely to see that kind of disaster looming until it's too late. "After the Russian Revolution, the British press was really skeptical that the mining shares on the St. Petersburg exchange would be really worthless," says Goetzmann. "They figured they [the mines] were too productive for the Bolsheviks to be so foolish as to kick out management. So the Bolsheviks took over the mines, and then they said, 'Okay, but they'll still need foreign capital.' Then the foreign capital was expropriated. There was denial all down the way, until the shares were really worthless." Goetzmann doesn't disagree that most stock markets have done well most of the time. He simply finds enough disturbing exceptions to the rule to give him pause. Looking only at price returns, since dividend data is extremely scanty in most of the world, he and Jorion plotted average annual inflation-adjusted returns for 39 countries. A sampling is shown in the chart on page 206. For a number of countries, including Belgium, Spain, New Zealand and Italy, the number is negative. In this context the U.S. stock market is a bit of a freak, combining a long uninterrupted data series with a very positive return.
What would you get with dividends added back in? No one knows for a lot of these countries, but dividends would probably be high enough to put just about all of the 39 into the positive column for real total return. In Spain, though, the return would be pretty meager—in the vicinity of 1% or 2% over stretches covering at least half a century.
Japan is an interesting case. During the period 1921-44, the professors calculate, stock prices in Tokyo did not keep up with inflation. During 1949-95 they raced ahead. What happened to stockholders between 1944 and 1949?
Good question. We know that some controlling owners of companies—for example, Kononsuke Matsushita of Matsushita Electric Industrial Co.—were able to retain their property after the war. But just what happened to public holders of shares traded on the Tokyo exchange remains a mystery.
Those who bought Japanese equities in late 1989, when the Nikkei was at 39,000, have lost nearly half their money after eight years. It's impossible to lose money in stocks if you hold them for 30 years? Maybe, maybe not. Remember this: From 1966 to 1982, the U.S. stock market, as measured by the Dow industrials, went nowhere. It has since more than made up for that, but this didn't help someone who bought in 1966 and died in 1976. It has long been a mystery among academics why stocks have done so much better than bonds throughout U.S. history. Goetzmann and Jorion think they have part of the answer: It's a rational response on investors' part to the risk that something catastrophic will happen someday to the New York Stock Exchange. Not everyone agrees with them. Jeremy Siegel, a professor at Wharton and an authority on financial history, thinks that stocks have done well because savers have been too foolish to want them. Had people been rational, that is, they would have accepted smaller returns on stocks and insisted on better returns on bonds, pushing the two asset classes closer to equality (see chart, Stocks beat bonds).
"People have an irrational fear of short-term risk," Siegel says. If he's right, and if you have no such fears, you can improve your lot by dumping your Treasurys and buying stocks. He denies that investor jitters reflect a rational fear that what happened to foreign exchanges might one day happen to ours. Reason: Bonds are equally vulnerable to political disaster. Paul Samuelson is not a bear, but he agrees with Professor Goetzmann that people who are not 100% in stocks are not necessarily stupid.
"There is a survival bias," Samuelson says. "My hunch is that if you were able to eradicate all of that bias, you would remove part of the demonstrated superiority of equities in the last 150 years over alternative investments, such as bonds, money market funds and bank accounts. "It is in terms of that rational calculation that you should determine whether you are a 10% equities investor, or 50% or 100%," says Samuelson.
He adds, a bit sadly: "I have students of mine—Ph.D.s—going around the country telling people it's a sure thing to be 100% invested in equities, if only you will sit out the temporary declines. It makes me cringe."
ROGER IBBOTSON, Yale economist and vendor of financial databases, has almost all of his liquid investments in common stocks. He thinks stocks always have been, and always will be, much better than bonds in long-term performance. He has a lot of company (see story).
What sets Ibbotson apart is the passion with which he preaches the equities gospel. His view: You ain't seen nothing yet. By year-end 2001 the Dow Jones industrial average will hit the magic 10,000. By 2015 it will clear 34,000. In 2020 look for the average to hit 53,000.
Let's see. I put $100,000 in stocks today, I'll have $757,000 in 23 years without even counting dividends.
Ibbotson will turn 77 that year. If he's right, he's going to be one rich professor. He's already doing quite well, as principal owner of Chicago-based Ibbotson Associates, which sells software and data that money managers use for statistical analysis.
What makes him so confident? Not fundamentals. Stocks, after all, are trading at historically steep multiples of their earnings, dividends and book value. No, his market calls are predicated on just one thing: past performance. What was, will be.
Along the way, there are corrections, of course, but intrepid investors just ride them out. With one exception, market dips have never lasted more than two years. That exception was a doozy, a 90% decline in stock prices between 1929 and 1932. So the professor doesn't say that prolonged crashes can't happen, only that they are unusual. The corrections of 1987 and 1990 were much shorter and are mere blips in a long-term chart. "Over the past 71 years, stock prices have moved up in two of every three years," says Ibbotson.
He goes on: "There's been no 20-year period where you lost money in the stock market, and only two periods of ten years, 1929-38 and 1930-39, when stocks lost ground." He is putting stocks in their best light: including dividends but not adjusting for inflation.
What if you look at price changes only and adjust for inflation (as in the international scatter chart, Survivors rule)? Then you see more bearish stretches, including, in the U.S., the decade of 1965-74.
Given that recent performance has been well ahead of the long-run average, don't stocks have to take a bit of a breather?
Nonsense, says Ibbotson: "There's no evidence to support the idea that after a period of high returns we get a period of low returns. We don't have to offset the high returns. It's possible we'll mark time. It's possible, but not likely."
So why isn't everyone 100% invested in stocks? "There's a one-in-three chance that stocks will go down in any year. Most people aren't willing to take that risk. Risk causes prices to be lower and makes the returns higher," he maintains. Ibbotson makes it sound too easy.
The venerable Dow Theory currently is on a buy signal. Should you be paying any
attention to the Dow Theory, this 100-year-old market-timing model? I think so. It has
an impressive track record that--believe it or not--even a few pioneering finance
professors are beginning to recognize.
The Dow Theory began with a series of William Peter Hamilton editorials in the Wall
Street Journal between 1902 and 1929. Many of those editorials focused on how to
distinguish the beginning of a bear market from a mere correction. That's the question on
everyone's mind today.
Here's the theory: If the market comes back strongly after a correction and both the
Dow industrial and Dow transport averages surpass their precorrection highs, then it's not
a bear market. But if the postcorrection rally fails to take either one or both the Dow
averages back to their previous highs and if both averages then proceed to fall below their
correction lows, a Dow Theory sell signal will be generated.
The Dow Theory has some very impressive calls to its credit. Several were from
Richard Russell, who has been editing his Dow Theory Letter since l158--longer than
any other advisory letter editor publishing today. Russell used the Dow Theory to
generate a buy signal in January 1975, within a few weeks of the bottom of the great
1973-74 bear market--in which he had been predominantly bearish. He used it again in
August 1987 to get out of stocks two months prior to the 1987 crash.
Academics have traditionally dismissed the Dow Theory, starting with a seminal 1934
study that appeared in a prestigious academic journal. The study found that followers of
the Dow Theory lagged a buy-and-hold between 1902 and 1929. It was a watershed
article, which in many ways became the father of the Efficient Market Hypothesis.
The study turns out to have been fatally flawed, however. According to William
Goetzmann, a professor at Yale's School of Management, the Dow Theory substantially
reduces the risks involved in buying and holding. Once this risk reduction is taken into
account, Hamilton's application of the Dow Theory beat the market by an impressive
margin.
Now to the burning question: Is the Dow Theory calling for a bear market now? After
one of the biggest market retreats since 1990, it is not surprising that people are worried.
What does the Dow Theory say? The Dow transportation index has already surpassed
its precorrection high, so let's turn to the Dow Industrial index. Will it eclipse its
precorrection high of 7085? If it does, the bull market will be deemed intact. If it
doesn't, and if both Dow averages then drop below their correction lows of 6477 and
2350, respectively, look out below!
What should you do while waiting for the market to resolve the matter? You could
jump the gun and build up cash now in anticipation of an eventual bearish resolution.
This is Russell's recommended course of action.
Not all Dow theorists agree with Russell, however. Their response is to stay invested
until and unless a definite sell signal is generated. This is the approach that is being
recommended by Dow Theory Forecasts, another long-lived letter whose market-timing
(though not its stock selection) is based on the Dow Theory.
Dow Theory Forecasts recommends that investors "remain invested and use price
pull-backs to add to portfolios." Here are the service's top picks for one- to three-year
gains: Abbot Laboratories (recent price: 61), Air Products & Chemicals (71), American
Business Products (24), Callaway Golf (30), ECI Telecom (22), Harcourt General
(45),
Hewlett-Packard (52), Merck (92), Pittston Brink's (32), Southwest Airlines (28),
VeriFone (50), Vishay Intertechnology (23), (ECI Telecom trades o-t-c.)
The two Dow Theory letters agree the market is at a crucial point. They disagree as to
where it will go from here.
Risk-Adjusted Investment for the Meek: Making a New Case for the Dow
Theory
We were right. Sort of.
At issue are the writings of The Wall Street Journal's William Peter Hamilton. Born
in Scotland, Mr. Hamilton joined the newspaper in New York in 1899, after a stint as a
reporter in London and Johannesburg. He went on to edit the Journal's editorial page
from 1908 until his death on Dec. 9, 1929.
Colleagues admired Will Hamilton for his concise writing and remarkable calm. But
our man Hamilton had an unfortunate quirk: He thought he could predict the stock
market. Anybody tempted to guess the direction of today's jittery market would be well
advised to consider his record.
In his editorials, Mr. Hamilton popularized and elaborated on the Dow Theory, which
attempts to forecast the market by analyzing the Dow Jones Industrial Average and Dow
Jones Transportation Average.
The Dow Theory posits that, if the industrials and transports are together hitting new
highs or new lows, that's the signal that stocks have entered a prolonged bull or bear
market.
Mr. Hamilton turned cautious in the years running up to the 1929 stock-market crash.
He reiterated his bearishness in a famous Journal editorial headlined "A Turn in the
Tide." The editorial, which was first published in Barron's and reprinted four days later
in the Journal, appeared just ahead of the Oct. 28-29 market crash, which saw stocks
tumble 23% in two trading sessions.
"The twenty railroad stocks on Wednesday, October 23, confirmed a bearish
indication given by the industrials two days before," noted the Journal, in reprinting the
earlier Barron's editorial. "Together the averages gave the signal for a bear market in
stocks."
But no good deed, it seems, goes unpunished. Soon after Mr. Hamilton's death,
gentleman scholar Alfred Cowles analyzed his market calls, by looking back through the
editorials he wrote between 1933 and 1929. Result? Mr. Hamilton's market predictions
would have generated a return of just 12% a year, far less than the market's 15.5% annual
gain.
At the time, many on Wall Street still believed it was possible to forecast the market
and thereby earn superior returns. The Cowles study, which appeared in 1934, spurred
the development of the efficient-market theory, the idea that prices of stocks and other
securities reflect all prevailing public information and hence it's very difficult to earn
long-run market-bearing results.
The Cowles study also, no doubt, encouraged the Journal's editorial page to spend less
time predicting the stock market, thus freeing up space that could be devoted to the
foibles of Washington. But the shift from bulls and bears to donkeys and elephants was
maybe a tad premature.
Or so suggest finance professors William Goetzmann of Yale University's School of
Management and Stephen Brown of New York University's Stern School of Business.
Recently, they went back and re-examined Mr. Hamilton's track record. Yes, the
professors concede, Mr. Hamilton did indeed lag behind the market averages. But in
doing so, he took remarkably little risk.
The two professors calculate that, if investors had followed Mr. Hamilton's advice,
they would have spent 38% of their time in cash investments, 46% of the period invested
in stocks, and 16% of their time short the market, meaning that investors sold borrowed
stock in a bet that share prices would fall.
As a result, investors earned slightly less than the market averages while suffering only
about a third of the stock-market gyrations. "Adjustment for systematic risk appears to
vindicate Hamilton as a market timer," the professors conclude.
That's gratifying, to be sure. But should we care? Earning healthy risk-adjusted
returns might be attractive to the faint of heart, who would otherwise avoid stocks. But as
Wall Street wags will tell you, you can't eat risk-adjusted returns. Unless investors were
willing to make leveraged bets when following Mr. Hamilton's advice, they would have
ended up with more money by simply buying and holding stocks.
I have no doubt that you can reduce the price swings in a portfolio by market timing.
After all, if you jump in and out of stocks, you will spend at least part of the time sitting
in sedate cash investments, like money-market funds and Treasury bills. But for long-
term investors, the biggest worry shouldn't be short-term market fluctuations. Instead,
the key concern is the long-term damage done by inflation and taxes.
If that's the danger you're worried about, you shouldn't flit in and out of stocks. All
you will do is crimp your returns, enrich your broker and realize your capital gains
quickly, thereby fattening your tax bill. Instead, if you want to garner top-notch returns
over time while beating back the threat from inflation and taxes, your best bet is to buy
stocks-and stick with them.
"Over the 26 years, you would have made more money by holding stocks," Mr.
Goetzmann agrees. "While you should care about risk adjustment, a lot depends on how
sensitive you are to risk. If you are insensitive to risk, you shouldn't worry. But if you
are sensitive, the Hamilton theory may be for you."
Jorion and a colleague conducted what he termed "financial archaelogy," sifting through stock market data from earlier periods collected by the International Monetary Fund, the United Nations and even its precursor, the League of Nations. They sought "the data that no one wants anymore," he said at a conference sponsored by the Federal Reserve Bank of Atlanta.
Looking at stock markets before they "emerged" or even cases where markets emerged then submerged and re-emerged later, Jorion and
The average returns on markets that have emerged are temporarily high," he said. Looking only at the later data "provides an overly optimistic picture of future investment performance. Therefore, basing investment decisions on the past performance of emerging markets is likely to lead to disappointing results."
Markets are classified as emerging typically when economic growth and some measure of political stability push stock market capitalizations over $100 million, Jorion said. Wars, coups or economic chaos can push emerging markets underwater and out of view of global investors.
For example, Portugal's stock market has been around since 1901 but has been interrupted by political upheaval. The IFC has only tracked Portugal since 1986, reporting an average annual return of almost 30% since then.
But, when the market initially dropped in the 1970's and was disrupted for three years, prices dropped 80%, Jorion found.
"When these markets are interrupted, typically there is a big drop," he said. That means that looking only at "emerged" markets ignores the returns of those same countries' stock markets when times were bad, he said. Emerging stock markets seem to do best just after they are classified as "emerging" and then taper off, he warned.
Looking at 25 countries in the IFC data, Jorion found countries posted an average return of almost 31% in the first five years after emerging, dropping to 16% in the following five years. The results were even more dramatic looking at just the first three years, with a return of 37%, compared to a return of 13% for the second three years.
Back in 1900, Baring Brothers and Co.'s non-government-bond investment portfolio -- a mix of corporate stocks and bonds -- was only 37% invested in the U.K. The U.S. accounted for 27%, Chile for 12% and Argentina for 6%. The rest was spead among Austro-Hungary, France, Mexico, Australia, Russia, India, China, Roumanina and South Africa...
U.S. Investors did venture abroad from time to time, but they often lost their shirts -- especially in the Latin American and Weimar Republic bond defaults in the 1930's. World War II didn't help. "Borders were slammed shut and you couldn't get your money out," says IntersSec's Mr. McCain. "In many cases assets were literally destroyed."
It wasn't much easier after the war, when U.S. laws restricted Americans' investment abroad. Moreover, "the U.S. is so huge that people felt they could diversify sufficiently within the U.S. economy," Says Prof. Goetzmann of Yale.
There's a saying in the investment community that when the Dow sneezes, the rest of the world catches cold...'Just because a market is more integrated with the world capital market, it does not mean that it is more correlated with other equity markets says Prof. Harvey...Will Goetzmann, associate professor of finance at Yale University's School of Management, concurs. Reactions to moves in the Dow "can fool the market for a few weeks," he says, "but not for much longer than that."
Most people probably have met someone who, at first impression, displayed a certain type of
personality - only to discover later that person was quite different. Mutual funds can be like that;
some appear to be one thing when, in fact, they're something else, or their personality changes
over time.
Unlike people, however, mutual funds do not have good or bad personalities. What is
important for investors is to select the funds whose "personalities" match their individual goals,
objectives, tax situation, and tolerance for investment risk. For instance, if you're young and
investing for retirement well down the road, you may prefer the dynamic personality of an
aggressive growth fund that primarily seeks to increase its share price by buying fast-rising new
companies. If you're a more conservative investor or a retiree seeking primarily current income,
you may want the button-down personality of a growth-and-income fund or a government bond
fund.
The challenge today is that independent studies, and a few headlines, have shown that many
mutual finds are not always what investors perceive them to be. One example that made news
recently involved a well-known institutional government income fund. To its shareholders,
"government income" implied a conservative, safe fund owning primarily U.S. Treasury
securities. In reality, the fund was invested heavily in a more speculative class of
mortgage-backed securities. When interest rates rose during 1994, the fund lost more than 20%
of its net-asset value within a few months. Two major components define the personalities of
mutual funds. First, what objective does the fund's prospectus say the fund is trying to achieve for
its investors? Generally, this means one of three things: current income from interest or
dividends, growth through long-term gains in share price, or a combination of income and
growth. Second, how does the fund intend to achieve its stated objective? If seeking income,
does it invest primarily in bonds and, if so, what type of bonds? Or will it invest mostly in the
stock of companies that pay out high dividends? If looking for growth, does the fund emphasize
the stock of small, medium-sized, or large companies? Will it invest mostly overseas, in real
estate, in gold and silver? Will the fund try closely to track a broad index such as the Standard &
Poor's 500 or focus on a specific sector of the economy such as technology or financial services?
Or does the fund have a wide latitude to invest in whatever it sees fit as long as this achieves the
stated objective?
Based on its objective and policies for reaching that objective, each fund is placed into one of
about 20 categories - such as aggressive growth, growth-and-income, international, index,
fixed-income, and money market. A fund's name also may suggest what type it is. This is
where things may get sticky for investors. A rose may be a rose by any other name, but a mutual
fund by a different name or classification can be misleading. A study by a Harvard University
student, Erick Witkowski, now with Northfield Information Services, found that 56% of the
mutual funds he analyzed were miscategorized. Economists Stephen Brown of New York
University and William Goetzmann of Yale University found that just 35% of 282 funds listed
as growth funds by a mutual fund rating service actually should have been listed in that category.
They argued that 17% of those funds belonged in a higher-risk category of small-company funds.
Having a "misleading" personality doesn't necessarily mean a fund will perform poorly. One
top-performing fund characterized as a growth-and-income fund - Oppenheimer Main Street
Income and Growth Fund - returned 24.3% annually the past five years. However, the fund
appeared to have achieved that success by emphasizing growth, not income. Its income was a
mere 2.1% - low for conservative investors who bought the fund primarily for steady income.
So how can you identify the real personality of a mutual fund, or whether its personality has
changed since you bought it? * Never invest in a fund based solely on its last year's performance.
* Never pick a fund based only on its name or categorization. * Read the prospectus carefully. It
may state the minimum and maximum percentages of a particular type of asset the fund will
invest in, or the guidelines may allow a lot of leeway. The wider the latitude, the greater the
potential that returns and risk may deviate from your expectations and needs. * Pay particular
attention to the actual investment holdings listed in the annual and semi-annual fund reports.
Two funds investing in 60% stocks and 40% bonds might be classified as "balanced" funds. Yet,
while one focuses on conservative blue chips and high-quality bonds, the other may bet on more
speculative small companies and higher-risk junk bonds. * If returns are unusually higher or
lower than the average returns for its peer group, that may be a sign the fund belongs in another
category. Experts caution that some funds intentionally misstate their category in order to stand
out among their more conservative peers. * Follow a fund carefully if it changes managers. The
new regime may bring a different style of implementing policies and achieving objectives,
especially if the fund gives the manager enough latitude. * Watch the fund size. For instance,
new investment money may pour into a particularly successful fund that focuses on small,
high-growth companies. The flood of money may force the fund to invest in larger companies or
hold larger amounts of cash, thereby changing its original personality.
Inconsistent? Undisciplined? That's hardly a description befitting the world's most famous investment machine. Fidelity's considerable stock picking prowess has produced the most remarkable growth streak in the annals of finance...How Fidelity manages its spectacular growth will have major consequences for the company's customers -- and the $3 trillion mutual fund industry as well. "Fidelity and Magellan are in a special position of representing the mutual-fund industry," says William Goetzmann, at Yale University's School of Organization and Management.
Yale School of Management economist William Goetzmann has spent a decade crunching 280 years' worth of auction prices. Sitting in his bare-walled (sic) office, he says "You can double or half your money with an art market portfolio" He does think a diversified portfolio of good art can beat the stock market with an average annual return of 17%.
William D. Grampp, a retired Univer
MARKET TIMERS get no respect. Almost every time you read a money manager
interview, there's a quote like this: "We pick stocks. Only fools try to
predict
the market." Cynical investors even use a composite of market-timer
sentiment as a counterindicator--doing the opposite of whatever the sages
recommend.
Whenever there's a strong consensus that something is hogwash, it's
probably worth a second look. So this month I'm going to let you in on a
startling discovery. Dow Theory, the market's oldest, most regularly derided
timing strategy, really does work-at least according to a study soon to be
published
in a leading academic journal. In what follows,
I'll explain this research and offer a Dow
Theory primer. I'll also provide the current
stock picks of a 52-year-old newsletter
(edited by a thirtysomething University of
Chicago M.B.A.) that still treats Dow Theory
as gospel.
First, some history. In 1896, several years
after he co-founded The Wall Street journal,
Charles Dow created two stockprice averages,
one for industrials and one for railroad
companies. Until then, investors had to make
do with one average that included both types
of companies. By studying his averages, Dow
realized that the market's broader trend had a
major influence on prices. Dow and his
successor, William Hamilton, saw patterns in
the early averages and used them as the basis
for editorials that predicted market moves.
The most famous urged caution just days
before the 1929 crash.
The core assumption of classic Dow
Theory is that a primary trend dominates the
market and can last for years. It's possible to
predict these bull and bear trends based on
close study of the two Dow averages. Two
key observations show what
missed Dow Theory and its offshoots as
bunk. But one day, in Will Goetzmann's
investment-management class at Yale, a
student asked a troubling question. Had
anyone ever used modern statistical
techniques to evaluate Hamilton's old
recommendations? Goetzmann saw an
opportunity-and soon realized that under
sophisticated scrutiny, Dow Theory stands
up remarkably well.
to look for: An extende
sideways movement
precedes major trend
reversals, and a trend won't
continue without everhigher
highs (or lower lows) in both
averages. That's why Dow
theorists are troubled that as
of late May the
Transportations (as the
railroad average is now
known) haven't "confirmed"
the recent records posted by
the Industrials.
If this sounds like
mumbo jumbo, don't worry. In 1934, a few
years after Hamilton died, a skeptical
economist named Alfred Cowles wondered if
the famous 1929 call was just luck. So he took
a close look at the predictions in 255
editorials Hamilton had written be
d
tween 1902 and 1929. Cowles calculated that
a Dow Theory investor would have earned an
average return of 12 percent for the period,
while a buy-and-hold investor would have
earned 15.5 percent.
From that point on, most scholars dis-
Dow's market-
timing strategy
has beaten
the indexes for
100 years. Now
it's signalling
sell. Should you?
The math is off-putting,
but Goetzmann's conclusion
is inescapable. On a call-by-
call basis, Hamilton was right
twice as often as he was
wrong. And following his
advice produced better-than-
expected profits from
portfolios that were
remarkably stable. Sure,
Cowles's buy-andhold
numbers were winners over
the full 27 years. But along
the way, Dow Theory was
more often ahead than behind-
and these superior risk-
adjusted returns are what
many investors want.
The professor was hooked. He recruited
two colleagues (Stephen Brown from New
York University and Alok Kumar from Yale)
and started a high-tech detective project. Since
Dow Theory has always been a matter of
interpretation, the three academics tried their
own version-based on artificial intelligence.
First, they wrote a computer program to
recognize the patterns that led to Hamilton's
original calls. Then they let their machine train
itself and turned it loose on more recent data.
You probably know what's coming.
"The Dow Theory Still Lives"
Forbes, April 6, 1998
Mark Hulbert
"The 7 Deadly Sins of Investing"
Robert Frick
You know that greed and sloth can do you in. But pride? Lust? Envy? Anger?
Gluttony? They, too, can ruin your portfolio.
If you want to irk a financial planner, try this: Don't take money out of
your fat savings account to pay off credit card bills. It drives planners nuts.
Of course, you're making only 4% on your bank account and paying perhaps 18% on
your credit cards. So paying off those credit cards is like earning an instant
18% on your money.
Wasting that kind of money is, well, a sin. But planners report that not
taking that simple step is a common problem with clients, and one that's not
easy to fix. "You can run charts, show the numbers, spin around in your chair
and stand on your head," says New York City financial planner Gary Schatsky.
"But some people won't budge."
No doubt about it: We have all sinned and fallen short of financial
perfection. And, as Schatsky points out, rationality often isn't enough to make
us break bad investment habits. What may help is understanding some solid
(though subliminal) psychological and emotional reasons we perpetuate the credit
card paradox and other seemingly irrational--even ridiculous--ways we handle
money.
For example, consider the following scenarios that help explain the credit
card conundrum: You travel to the theater with a $40 ticket in your pocket. At
the box office, you discover the ticket is missing and that to buy a new one
will cost another $40. Do you do it? Or this: You were planning to buy a ticket
once you got to the theater, but when you open your wallet at the box office,
you discover you are missing $40. Do you still buy the ticket? If you decide to
see the play, the result is the same in either case--at the end of the evening
your wealth will have been reduced by $80. But while almost 90% of people say
they would buy a ticket after having lost $40, fewer than half as many would
replace a lost ticket by spending another $40.
The reason for the discrepancy is that we separate money into "mental
accounts," according to the late Amos Tversky, one of the fathers of "behavioral
finance," which studies how our quirks and predilections affect our investing.
So in the case of the lost ticket, the $40 it cost represented a debit to the
"theater account," and an extra $40 for a new ticket would have meant spending
$80 in total on the play. However, losing $40 cash is for most of us a debit
from another mental account, so the cost of the play would still be just $40. In
the same way, we may separate our "credit card" from our "savings" mental
accounts.
Hoarding money in a savings account can be a deadly financial sin, akin to
gluttony, because it represents an unrestrained desire for an asset that isn't
being put to its best use. For Schatsky, the first step toward repentance is to
acknowledge that your hoarding is actually costing you money. "Only when someone
will say to me, 'I know that costs me $1,000 a year,' will I rest," he says.
Gluttony is but one of the Seven Deadly Sins passed down to us from the
Catholic Church of the Middle Ages. We've also found financial parallels to the
other six. Avoid all of them and you just might be able to keep your portfolio
out of purgatory.
GREED
As this sentence is being written, some colleagues sit at the corner
Starbucks checking $130 worth of lottery tickets bought in a pool in the hope of
hitting a $48-million pot. Now if anyone should know better, it's a pack of
personal-finance journalists. But sometimes the lure of a big score just cannot
be resisted.
The reason is that it's human nature to overweight low probabilities that
offer high returns. In one study, subjects were given a choice between a
1-in-1,000 chance to win $5,000 or a sure thing to win $5; or a 1-in-1,000
chance of losing $5,000 versus a sure loss of $5. In the first case, the
expected value (mathematically speaking) is making $5. In the second case, it's
losing $5. Yet in the first situation, which mimics a lottery, more than 70% of
people asked chose to go for the $5,000. In the second situation, more than 80%
would take the $5 hit.
If like many people you can resist anything but temptation, the answer may be
to limit your "mad money" by setting up a small, separate account for such
things as trading speculative stocks. To limit completely irrational risks, such
as lottery tickets, try speculating only with money you would otherwise use for
simple pleasures, such as your morning coffee. If you buy it at Starbucks, that
can add up to a hefty sum--but you won't bounce the mortgage check.
PRIDE
In hindsight, it's easy to see that no matter how lovingly you waxed your
first car or upholstered the dashboard, it was, in fact, a heap. Yet at the time
you truly cherished that pile of corrosion. In the same way, we tend to let
pride of ownership inflate the value of our investments.
For example, researchers gave a group of volunteers a coffee mug and asked
them to write down their lowest selling price for it. Other volunteers were
asked to write down the highest price they'd pay for the mug. Because both
groups were chosen at random, you'd expect some commerce. But very little took
place because sellers priced the mugs at $5.75 on average, and buyers at
$2.25.
In investing, this so-called endowment effect leads us to value our own
investments more highly than the market does. Some who fall prey to it hold on
to securities too long and don't sell when the market is telling them to bail or
to seek new and better opportunities. One solution is to set limits when you
first purchase a security--such as a stop-loss order, which will sell a security
automatically when its price falls to a certain level.
Dovetailing with this pride of ownership is the tendency to fall in love with
companies you may feel particularly proud of or are familiar with. A study done
by Gur Huberman, a finance professor at Columbia University, looked at
investment patterns of the regional Bell holding companies, commonly called the
Baby Bells. In all but one state, his study found, people tend to hold many more
shares of the closest Baby Bell than any of the others--an average of $14,400
worth of the local, versus $8,200 for the others. Every parent thinks his or her
baby is the prettiest, but not all of them are correct. Likewise, not every Baby
Bell investor who believes his or her stock to be the best can be correct.
Huberman says that while Baby Bells nicely make the point, a more depressing
example is lopsided 401(k) portfolios. According to the Profit Sharing/401(k)
Council of America, the average investor's defined-contribution plan has about
24% of its assets in company stock; for employees of the largest public
companies, the amount is about 40%. Huberman says that while the risk "may not
be huge" in choosing to invest in one phone company versus another,
concentrating so much of your net worth in one stock is unwise.
We're not suggesting that the hundreds of Microsoft and Intel employees who
became millionaires by owning an inordinate number of shares of their companies
were stupid. But if you feel your company is rocketing along a similar
trajectory, just remember that fate is fickle when dealing with pride. Could you
get by--could you achieve your goals--if the stock you own in overabundance were
to lose three-fourths of its value?
Penance, in this case, is doing a thorough job of comparing companies close
to home with their peers in other parts of the country. And in the case of your
401(k) account, unless you have strong, logical reasons for holding a large
percentage in your company's stock, don't let it dominate your assets.
LUST
Temptation leers at us from so many sources today: the Internet, new TV
channels, new magazines, to name a few. We're not talking about smut, but
financial information. "I think we're bombarded with news," says Needham, Mass.,
financial planner Constance Barber, a former psychologist who thinks this
overload of stock prices, economic reports and flashy business programs gives
investors itchy trigger fingers when buying and selling investments.
Compounding this overload is a tendency by many investors to lust after even
more tidbits of undigested information. Thus, they jump into or out of a stock
when the latest blip doesn't have anything to do with the long-term health of
the company. Terrance Odean--an assistant professor of finance at the Graduate
School of Management at the University of California at Davis who has studied
the trading patterns of individual investors--suggests two strategies to combat
snap decisions: One is buy and hold, while remembering the reasons you bought.
The other is, "Don't open the paper." Personally, Odean says, he hasn't checked
the price of a stock mutual fund he has in an IRA in about a year.
That may be extreme, but weaning yourself from reacting to too much news may
save not only time, but dollars and angst as well.
Envy
The tendency to want what other investors have can lead you to chase stocks
or mutual funds with the biggest recent returns, but that can be a losing
strategy.
Consider Lexington Troika Dialog fund, up an impressive 68% in 1997. Yet many
of its investors actually sent their portfolios to the gulag by chasing the
fund's returns, which at one point in 1997 were around 130%. Those investing at
the top--before Russia caught a case of the Asian flu--lost almost 50% of their
investment. Considering that the fund started late in 1996 and by mid 1997 had
assets of more than $200 million, a legion of investors apparently succumbed to
its charms.
In the case of stocks, a study by three finance professors found that
"glamour" stocks, those with the most robust sales growth and highest ratio of
price to cash flow during the previous five years, were miserable performers
during the subsequent five years, compared with stocks at the opposite extreme.
So to buy stocks with the highest past rates of growth and hold them
indefinitely may be perilous to your wealth. You'd be better off buying and
holding stocks whose past earnings growth was least impressive. The
psychological phenomenon here is called "representativeness," or the tendency
for us to believe even short-term trends will continue into the future.
Overcoming the follow-the-leader mentality is particularly tough because the
stocks that brokers promote tend to be the glamour issues, says University of
Illinois finance professor Josef Lakonishok, an author of the study. What's
worse, even analysts who should know better tend to "extrapolate past
performance way too far," he says.
If you're blinded by glamour, you might consider tempering your portfolio
with a dose of unadulterated value. One mutual fund that fits the bill is
Vanguard Index Value fund (minimum initial investment, $3,000; no sales fee; for
a prospectus, call 800-662-7447), which is based on the S&P 500/BARRA Value
index. That index contains the 250 cheapest stocks in Standard & Poor's
500-stock index based on their ratio of price to book value. Its five-year
annualized return to January 5 is 21%. Also, consider Oakmark fund ($1,000; no
sales fee; 800-625-6275), which manager Robert Sanborn packs with big-company
stocks he figures trade at 60% or less of what they would fetch were the company
to be sold in its entirety. Oakmark's five-year annualized return is 23%.
ANGER
For investors, anger takes a couple of forms, the most damaging of which may
be anger with yourself for making poor investment decisions. In psych terms,
this is called "aversion to regret" and comes from our irrational tendency to
beat ourselves up for making bad decisions.
Say you began last year invested in the tried-and-true Fidelity Magellan
fund. You'd heard Russia was where the investment action was going to be, so you
thought about switching your Magellan money to Lexington Troika Dialog, then
decided to pass. Your friend, on the other hand, began the year in the Russia
fund, but figured President Yeltsin's health was too iffy and played it safe by
switching to Magellan. In 1997 you both would have earned Magellan's respectable
27% and lost out on the Lexington fund's 68%, but your friend would be kicking
himself more than you because we regret taking action more than inaction. This
often leads to poor investment choices, especially not selling a losing
investment. That's because to sell is to admit to a loss--and feel regret.
If aversion to regret has you frozen, focus on your portfolio's goals, not on
individual investments or what returns others may be earning.
SLOTH
Perhaps the most amazing thing about the Steadman Technology & Growth fund
isn't its truly appalling performance--an average annualized loss of 27% over
the past five years. The most amazing thing is that $300,000 is still invested
in the fund, which points to one of the great mysteries in the mutual fund
industry: how consistently bad funds manage to keep any investors at all.
Researchers have come up with a number of reasons for such investor
inertia--read sloth--ranging from irrational behavior to fear of high
transaction costs. But a recent study has shown that mutual fund investors may
keep their money in laggards because they can't come to grips with how poorly
these funds are performing. A survey of presumably well-informed
investors--members of the American Association of Individual Investors--showed
that they overestimated the annual total returns of laggard mutual funds by an
average of 3.4 percentage points.
The reason, speculates the author of the study, Professor William Goetzmann
of Yale University, is something you may remember from your Psych 101 class:
cognitive dissonance. Basically, this means we change our beliefs to support
past decisions. So in the same way nobody admits the car they bought turned into
a financial sinkhole, some people can't come to grips with the fact that the
fund they own is a dog, so the dog is never put to sleep.
Another reason for inertia is the emotional attachment we may form with a
particular stock. Financial planner and psychologist Maury Elvekrog, based in a
Detroit suburb, often finds himself in the sticky situation of parting a client
from inherited General Motors shares. "They do take it personally," says
Elvekrog, even after he tells them that GM's earnings today are "about the same
as they were 15 years ago."
His advice is a worthy exercise in contrition for all financial sins: "Always
look at investments as if you were looking at them from scratch. It's not
whether you like something. It's a matter of intellectual evaluation."
For Hedge Funds, Performance Doesn't Count
Howard R. Gold
In the bull market of the 1990s, money managers have become celebrities. And
few are more celebrated than the elite group who run hedge funds.
George Soros, Julian Robertson and Leon Cooperman generate the kind of awe
in some circles that Michael Jordan, Ken Griffey, Jr. and Barry Sanders get
in sports arenas. To some people, hedge-fund managers are demigods with guts
of steel, making huge bets and winning even bigger for their select group of
well-heeled investors.
But a recent study by three eminent academics suggests that at least when it
comes to performance, hedge fund managers don't outshine your garden-variety
mutual fund.
In a paper published in 1997 -- and revised for publication again later this
year -- Professors Stephen J. Brown, William N. Goetzmann and Roger G.
Ibbotson throw cold water on the idea that most hedge fund managers bring
something extra to the party.
"We find that the average annual return to offshore hedge funds was 13.26%
from 1989 through 1995, compared to the S&P 500 return of 16.47% over the
same time period," the paper says. "In contrast to the mounting evidence of
differential manager skill in the mutual fund industry, the hedge fund arena
provides no evidence that past performance forecasts future performance…It
is striking to find absolutely no evidence of differential skill among
offshore hedge fund managers."
The study tracked the performance -- after management fees -- of hedge funds
listed in The U.S. Offshore Funds Directory since that guide began
publication in 1990. By the end of 1995 that comprised 399 funds with some
$40 billion in total capitalization. The database included defunct funds as
well as existing ones to eliminate what the academics call "survivorship
bias" -- i.e., winning funds stay in business while losers tend to fold
their tents. (To see the paper, go to www.stern.nyu.edu/~sbrown/hedges.htm.)
Hedge funds are so elusive that many people can't agree on a definition --
let alone their performance or the actual number out there (estimates range
from 400 to 5,000). So, here's our crack at it: Hedge funds are specialized
investment vehicles, generally for high-net-worth individuals or
institutions, that get certain tax and regulatory treatment and are often
headquartered offshore. They typically charge investors 1-2% annual
management fees plus incentive fees of 20% of the fund's total return over a
certain benchmark, like three-month Treasury bills.
According to MAR/Hedge, a New York-based company that follows the hedge fund
universe, hedge funds have a wide variety of investing styles, from
so-called "global macro managers" (like Soros and Robertson) to those that
use conservative hedging techniques to funds that go long and make leveraged
bets on stocks and markets. But the definition has been stretched to the
breaking point as hundreds of money managers have left "mainstream" firms
like Fidelity to start or join hedge funds in the current bull market.
How are they doing? By the benchmarks most of us use, not so hot. "They did
OK, but they didn't do outstandingly well," says Brown, the David Loeb
Professor of Finance at NYU's Stern School of Business, in an interview with
Barron's Online. His explanation: hedge funds are becoming increasingly
correlated with the markets; most managers don't bring any special knowledge
or skill to the table; attrition is high, and, as with most active managers
of all kinds, superior performance doesn't persist over long time periods.
"Buying any one specific fund is a highly risky venture," he adds.
Not surprisingly, some people in the business didn't think much of the
professors' findings. "Hedge funds are not supposed to outperform raging
bull markets," says Martin J. Gross, who operates a 'fund of funds' out of
Livingston, NJ. "Hedge funds are for the absolute-return investor who may
not want a lot of risk."
"There are 'hedged' funds and there are hedge funds," says Patrick J.
Moriarty, partner and senior vice-president for Evaluation Associates
Capital Markets, a Norwalk, CT firm that invests over $1 billion in hedge
funds. The firm's own index of hedge fund performance, the EACM 100, just
about matched the S&P 500's compound annual return from 1990 to 1997, with
much lower standard deviation -- a traditional measurement of risk.
That's pretty much in line with the professors' findings that all types of
hedge funds, except for short sellers, outperformed the broader market on a
risk-adjusted basis from 1989 to 1995. "…Offshore hedge funds as a group
have done relatively well on a risk-adjusted basis," the paper says.
So, what does this all mean?
First, hedge funds aren't bad investments as a group -- just not as good as
most people think they are. Or, as Professor Brown puts it: "They do earn a
reasonable return after an appropriate adjustment for risk, but they don't
earn the spectacular returns you'd expect."
Second, if total return is your game, it's hard for anyone to beat an index
fund -- even the smart risk-takers who tend to run hedge funds. But if you
want a solid double-digit return at a lower risk than the market, the right
hedge fund or fund of funds may be a good idea.
Third, the field is getting crowded with hotshot money managers who chafed
at the constraints of established organizations and now are looking to swing
for the fences.
Even Marty Gross and Patrick Moriarty acknowledge that could be a problem.
"We've seen very little value in traditional equity managers becoming hedge
fund managers," the diplomatic Moriarty says. My translation: the bad money
is driving out the good.
With at least one notable exception -- George Soros. Even in the professors'
study, the legendary speculator stood out as the shining exception to
efficient-market mediocrity. Soros's funds boast compound annual returns of
30% for two decades, trouncing the S&P 500, the study reports. Like Peter
Lynch and Warren Buffett, Soros stands out as almost a force of nature, a
rare investment genius who consistently beats the odds. "George Soros is
virtually in a category by himself," the professors write, with obvious
amazement.
Now just try getting into one of his funds.
For more on hedge funds, see "Bucking the Trend," Barron's, February 9th.
Howard R. Gold is editor of Barron's Online. You can e-mail him at
hgold@online.barrons.com. "Fighting the Tape" appears monthly, usually on
Thursday.
Footprints in the Global Sands"
James Picerno
Where do you go if you want to rub elbows with the movers and shakers of modern finance? One place is the annual Western Finance Association (WFA) meeting. This year, it was held at the LoweÆs Coronado Bay Resort in San Diego. A great spot! But with more than 100 papers on finance and economics on tap, finding time to enjoy the locale was a tall order.
Table 1
Global equity Market Performance
Annual Compound Returns
Country
Period
Real
ReturnDollar
ReturnNorth America
U.S. Jan. Æ21 - Dec. Æ95 4.73% 7.37%
Canada Jan. Æ21 - Dec. Æ95 2.77 5.07
Europe
Austria Jan. Æ25 - Dec Æ95 1.52 5.04
Belgium Jan. Æ21 - Dec. Æ95 -0.54 3.30
Denmark Jan. Æ26 - Dec. Æ95 1.49 4.94
Finland Jan. Æ31 - Dec. Æ95 1.94 6.21
France Jan. Æ21 - Dec. Æ95 0.33 3.81
Germany + 1924-1995 4.46 8.49
Germany Jan. Æ24 - Jul. Æ44 1.65 3.40
Germany Jan. Æ50 - Dec. Æ95 5.74 10.84
Ireland Jan. Æ34 - Dec. Æ95 1.13 4.81
Italy Jan. Æ28 - Dec. Æ95 -0.01 3.01
Netherlands Jan. Æ21 - Dec. Æ95 1.98 5.44
Norway Jan. Æ28 - Dec. Æ95 2.60 6.02
Portugal + 1930-1995 2.25 6.55
Portugal Dec. Æ30 - Apr. Æ74 1.16 4.96
Portugal Jan. Æ82 - Dec. Æ95 5.72 11.65
Spain Jan. Æ21 - Dec. Æ95 -2.23 1.56
Sweden Jan. Æ21 - Dec. Æ95 3.71 6.56
Switzerland Jan. Æ26 - Dec. Æ95 3.03 6.95
UK Jan. Æ21 - Dec. Æ95 2.28 1.97
Eastern Europe
Czechoslovakia Jan. Æ21 - Jun. Æ43 4.39 N/A
Greece Jul. Æ29 - Sept. Æ40 -5.50 -8.08
Hungary Jan. Æ25 - Jun. Æ44 2.80 N/A
Poland Jan. Æ21 - Jun. Æ39 -2.97 -3.77
Romania Dec. Æ37 - Jun. Æ41 -28.06 -14.64
Asia/Pacific
Australia Jan. Æ31 - Dec. Æ95 1.50 6.38
New Zealand Jan. Æ25 - Dec. Æ95 -0.47 3.63
Japan + 1921-1995 3.69 6.88
Japan Jan. Æ21 -May Æ44 -0.34 -1.83
Japan Apr. Æ49 - Dec. Æ95 5.79 11.57
India Jan. Æ40 - Dec. Æ95 -2.01 1.09
Pakistan Jul. Æ60 - Dec. Æ95 -1.62 1.97
Philippines Jul. Æ54 - Dec. Æ95 0.96 -0.72
South America
Argentina + 1947-1995 -5.36 -2.03
Argentina Sept. Æ47 - Jul. Æ65 -25.09 -23.64
Argentina Dec. Æ75 - Dec. Æ95 16.81 22.61
Brazil Feb. Æ61 - Dec. Æ95 -0.90 4.02
Mexico Dec. Æ34 - Dec. Æ95 2.40 5.96
Chile + 1927-1995 -2.13 0.64
Chile Jan. Æ27 -Mar. Æ71 -5.37 -4.23
Chile Dec. Æ73 - Dec. Æ95 4.61 11.01
Colombia Dec. Æ36 - Dec. Æ95 -4.32 -1.05
Peru + 1941-1995 -3.71 5.06
Peru Mar. Æ41 - Jan. Æ53 -11.69 2.19
Peru Jan. Æ57 - Dec. Æ77 -9.71 -7.24
Peru Dec. Æ88 - Dec. Æ95 35.50 60.06
Uruguay Dec. Æ36 - Nov. Æ44 2.41 N/A
Venezuela Dec. Æ37 - Dec. Æ95 -2.60 -0.13
Middle East and Africa
Egypt Jul. Æ50 - Sept. Æ62 -2.82 -1.62
Israel Jan. Æ57 - Dec. Æ95 3.46 7.59
South Africa Jan. Æ47 - Dec. Æ95 -1.62 2.02
All 39 countries
Mean -0.28 2.79
Median 1.49 3.63
14 countries with continuous histories into the 1920s.
Mean 1.51 4.62
Median 2.13 5.06
Note: + indicates a discontinuity in the series.
Perhaps the most pressing challenge in asset allocation is determining the relevance, if any, of historical performance when projecting future returns. The stakes are high. The case for buying stocks at the expense of bonds is easily justified, of course, if investors expect a continuation of the 7.3% equity premium (U.S. large-cap stock returns minus long-term T-bond returns) posted during 1926 to 1996.
During his presentation to a standing-room-only crowd at the WFA meeting, Goetzmann recalled the many challenges associated with reassembling long-term performance data for 39 markets based on monthly data going back, in some instances, to 1921. The findings cited in "A Century of Global Stock Markets" were "painstakingly" collected from an array of international sources, many with erratic reporting histories, Goetzmann said.
Stocks Have Drubbed Bonds Historically, But Not All Investors Have Caught On
Getting Going, by Jonathan Clements
So why has the stock market done so well?
Forget about the dazzling performance over the past year or even the past 15 years. For many academics, the real curiosity is why stocks have done so much better than bonds in the 20th century
"Given the differences in volatility, stocks shouldn't beat bonds by more than a couple of percentage points a year," notes William Reichenstein, an investments professor at Baylor University.
Yet the gap has been far bigger. Since year-end 1925, for instance, Standard & Poor's 500-stock index has soared 10.7% a year, while intermediate-term government bonds have shuffled along at 5.2% and annual inflation has run at 3.1%, according to Ibbotson Associates, the Chicago research firm.
So what explains the so-called equity-premium puzzle? Two intriguing answers have been offered recently.
One answer suggests the data are flawed. When Wall Street touts the wonderful returns
from stock-market investing, it usually cites the performance of U.S. stocks and
neglects to mention foreign markets. University of California at
Irvine's Philippe Jorion and Yale School of Management's William Goetzmann address that oversight in an unpublished paper titled "A Century of Global Stock Markets." The two finance pro~ fessors tracked the performance of 39 markets, including 21 with histories going back to the 1920s.
Their findings? Of these initial 21 markets, eight had temporarily suspended trading during the 76 years analyzed and seven others had suffered a long-term closing. Much of the disruption occurred during World War II, when markets like Germany and Japan lost most of their value.
Clearly, stock-market investing is a dicey business. But does this mean that stocks have done far worse than the returns for the U.S. market indicate? Some
commentators certainly
think so, dismissing the "gospel" of stock-market investing as "history, as written by the winners."
But the Jorion-Goetzmann study doesn't justify such scorn. Yes, if you ignore dividends, you find that 18 of the 39 markets failed tc generate an inflation-beating rate of return. But most of these laggards turn out to be small, speculative emerging markets.
Indeed, after weighting each market by the size of its national economy, the two professors found that their index of all stock markets lagged behind the U.S. market by just 0.28% a year- a modest number, given the huge margin by which stocks have outpaced not only bonds, but also inflation.
"There is some evidence that there's a survival effect that explains part of the equity premium," Mr. Goetzmann
says. "We don't think we've explained all of it."
In fact, Mr. Goetzmann says he finds his study "somewhat comforting." He notes that most of the markets closed at times of political turmoil. "You can usually see political turmoil coming. If you see war coming, you will have a chance to change your allocation."
When a crisis is looming, your best bet is to get your money out of the country, r
ather than merely swap out of the troubled country's stocks and into its bonds. "When theres a big crisis, bond markets are no safe haven," Mr. Goetzmann says.
The Jorion-Goetzmann stody is fascinating. But it doesn't explain the equity-premium puzzle. So what does? If the fault doesn't lie with the data, then maybe it lies with investors. Why haven't folks been willing to buy stocks, given
the attractive returns available?
That question was tackled by Schiomo Benartzi of the University of California at Los
Angeles and Richard Thaler of the University of Chicago in a February 1995 article in the Quarterly Journal of Economics. Their answer relies on two insights into investor behavior.
First, they point out that investors are especially sensitive to investment losses, because they feel the pain of losses far greater than the pleasure of gains. Second, they note that investors usually evaluate their portfolio performance frequently, even when their investment goal is far away. The resulting "myopic loss aversion" causes investors to steer clear of stocks, despite the potential for handsome long-run returns.
"You can never prove that a theory is right," Mr. Thaler says. 'But we've done some experiments that lend support to the theory."
In one experiment, university employees were given charts displaying the returns
employees shown how stocks and
For Many Investors, to Deny That You Err Is Human
Aline Sullivan
Investors don rose-tinted glasses when reviewing the performance of their mutual
funds, according to William Goetzmann, a professor of finance at the Yale School of
Management. Instead of switching funds, he found, investors often adjust their beliefs to
support their decisions. In other words, they stay in poorly performing funds rather than
admit they were wrong.
Mr. Goetzmann discussed his research on investor psychology with Aline Sullivan.
A.We asked two groups of investors about the past performance of their mutual funds.
One study focused on a state chapter of the American Association of Individual Investors,
a group that we expected to be knowledgeable. The other was based on a group of
professional architects who have a profit-sharing plan and invest in mutual funds, who we
did not expect to follow year-to-year performance.
Both groups thought that their investments performed much better than they actually
did
A. They were more realistic in appraising their actual returns: They overestimated the
actual fund return by 3.40 percentage points, compared with 6.22 percentage points for
the architects. But they were not necessarily the ones who made the better choices.
It was interesting to note that the more control investors in both groups had in
selecting a fund manager, the better he or she perceived the fund's performance to be.
A. The dissonance factor has more impact. Investors receive tons of information
about mutual funds, investment managers and stock markets. They are bombarded with
information. But when they consider how that information impacts their choice of mutual
funds, they put on blinders. They want to focus on the positive.
A. It is very hard for people to admit that they made a mistake in an investment
choice. Instead they maintain a hope that the fund's management will turn around. Also,
if you have to admit that your first choice was ineffective, how do you make another?
It is a hassle to cash out of one fund and open another, but the psychological factor is
much greater.
A. We wanted to find out if the mutual-fund industry was taking advantage of people
based on this cognitive dissonance. If, for example, there was a large section of mutual
funds with high fees and regular poor performance and therefore a need for industry
regulation.
But we only found a small group of underperformers and these didn't have much
money. Instead, we found very clear evidence the poorly performing funds were shut
down or merged into better funds.
It became very obvious that the mutual-fund companies are disciplining themselves to
at least some extent.
A. We are looking at hedge funds because the absence of indexing should show
whether there is any real management skill in the fund industry. But we have not found
any evidence that hedge fund managers who have done well in the past continue to do well. This is
disappointing because some mutual fund managers maintain their performance.
History, as Written by the Winners
Phillip E. Ross
IT HAS COME to be taken as gospel: Stocks are a can't-lose investment. They have bad years, but they win out in the end. If you are young and can afford to sit through the inevitable corrections, you ought to have all your savings in stocks.
How now, Dow?
Mark Hulbert
Risk-Adjusted Investment for the Meek: Making a Case For the Dow Theory
Getting Going, by Jonathan Clements
GO ABROAD, WARILY
Chris Farrell
With the collapse of communism and the embrace of freer markets by much of
the developing world, a growing number of U.S. investors are looking to put
some money into the emerging markets of Latin America, Asia, and the former
East bloc. Stock exchanges are flourishing from Shanghai to Buenos Aeries,
and over the past decade emerging stock markets have expanded from a nearly
4% share of world market capitalization to more than 10%.
Of course, these are volatile investments. Over the past year or so, the
onetime stars of the emerging market world have languished, including
Singapore, South Korea and Thailand, while the Russian, Hungarian, Czech,
and other stock markets from the former Soviet empire have soared. Still,
investors going abroad into the world's frontier economies are seeking high
long-run rates of return, largely reflecting widespread expectations that
the long-term economic growth rates of the developing world will be at
least twice the growth rates of the industrial countries. What rate of
return, after adjusting for inflation, should investors anticipate?
Double-digit? Triple digit?
Chill. The recent extraordinary performance of many emerging markets may
not be sustainable, caution two National Bureau of Economic Research
papers, authored by William Goetzmann of Yale University and Philippe
Jorion of the University of California at Irvine. Many of today's emerging
markets were around a century or so ago=97and they were hot back then, too.
But war, hyperinflation, and expropriation shut down a few markets and sent
many into hibernation for long-periods of time. Instead of emerging markets
they became "submerged" markets. The economists collected data on 39
markets going back to the 1920s. The U.S. had the highest long-run rate of
return, after adjusting for inflation, should investors anticipate?
Double-digit? Triple digit?
Chill. The recent extraordinary performance of many emerging markets may
not be sustainable, caution two National Bureau of Economic Research
papers, authored by William Goetzmann of Yale University and Philippe
Jorion of the University of California at Irvine. Many of today's emerging
markets were around a century or so ago and they were hot back then, too.
But war, hyperinflation, and expropriation shut down a few markets and sent
many into hibernation for long-periods of time. Instead of emerging markets
they became "submerged" markets. The economists collected data on 39
markets going back to the 1920s. The U.S. had the highest long-run rate of
return of about 5% a year, after adjusting for inflation. For other
countries, the comparable figure was a median real rate of 1.5%.=20
Turns out returns sizzle when a submerged market re-emerges on to the
world capital market, perhaps because investment opportunities are
particularly good. Long-run performance lags, say the authors, after taking
into account severe economic and political disruptions. Take the Argentine
stock market. It dates back to 1872. It has been considered an emerging
market since 1975, and the market has surged by an average of 23% a year
since then, in dollar terms. Yet from 1947 to 1965, the era of Evita and a
time when the Argentine stock market was submerged, returns averaged a
minus -24%.
Investing overseas makes sense, both to branch out and to participate in
some the world's fastest growing regions. But investors are largely making
a bet on politics, not economics. Which countries will enjoy political
stability and the rule of law in the year 2010 and which ones will have
descended into chaos and banditry by then? China? Malaysia? Brazil?
Venezuela? Diversify for the long-haul, and keep investment expectations
reasonable.
Reuters 2/20/97 "Bad Data May Mislead Emerging Market Investors"
Aaron Pressman
Stock prices in the so-called emerging markets have sky-rocketed over the past decade, but those high returns may be a temporary phenomenon, according to an academic study released on Thursday... That data, ,from the International Finance Corporation, ignored the performance of such markets before they "emerged," warned Philippe Jorion, professor of Finance at the University of California.
The Christian Science Monitor 2/3/97 "Ivy League Graduates Manage Money Better"
David R. Francis
In 1994...William Goetzmann, now at Yale University, and Roger Ibbotson, president of Ibbotson Associates a Chicago firm providing various services to financial institutions, looked at the performance of 728 funds from 1976 through 1988. Their industry pleasing finding was that fund money manager winners on average remain winners. So past returns and relative rankings of funds are useful in predicting returns and rankings"
U.S. News and World Report, 2/3/97 "First, Pop the Hood: A fund's name may tell you nothing about how it acts"
Gregory Millman
"...an analysis of mutual fund styles by Stephen Brown of New york University's Stern School of Business and William N. Goetzmann of Yale did find some evidence of "moral hazard" in the industry. During the late '70's and early 80's, Brown [and Goetzmann] found numerous examples of funds that changed their names after performing poorly. Presto! Relative to their new benchmarks, the funds' track records "improved" by an average of 9.8%"
The Wall Street Journal 5/28/96(2), "Going Global"
Michael Sesit
...In many ways, today's mutual-fund investors and pension-fund managers are still playing catch-up with their globe-trotting British predecessors. "People now are crazy about international investing," says William Goetzmann, associate professor of finance at Yale University's School of Management in New Haven, Conn. "But U.S. investment in overseas equities is nothing compared to what British investors were doing."
The Wall Street Journal 5/28/96(1),
Different Drummers
Matthew Rose
USA Today (Magazine), January, 1996Has your mutual fund changed its personality?
Longstaff, John S.
Businessweek 5/6/96
Fixing Fidelity
By Geoffrey Smith and Jeffrey Laderman
It was a battle of money-management titans. In one corner stood the reigning champion, Fidelity Investments. In the other, five pesky rivals vying to break Fidelity's dominance of the fastest-growing segment of the financial services industry -- the $675 billion 401(k) market. The clash was over the management of the retirement assets for the employees of Toto, Inc., the Minneapolis-based manufacturers of lawn mowers...Fidelity lost out to the smaller Putnam funds because its funds were too erratic and unfocussed.
Forbes, 3/11/96
Absolutely No Guarantees
BY Doris Atheneos
Aside from its value in enriching your life and enhancing your prestige, is art a good investment?