Saturday, December 18, 2010

Flawed Investor Behavior; A Random Walk Down Today's Financial Newspaper

After reading the newspaper this morning, I decided to write this reflective piece about private investors (and maybe for that sake: also those professional investors who do not qualify as 'Best-of-Breed'). It felt like a Random Walk Down the Newspaper (slightly modifying the title of a famous investment book) which explained quite a bit about a lot of problems investors are facing today. The interesting part of it is that different components of what we write below are not  from one big, major article in that newspaper but they are linked to different articles. Some that were investments-related and others that aren't.

It was already known and documented in tons of articles including scientific books like Prof Burton Malkiel's A Random Walk Down Wall Street that it is very difficult (even for professional investors) to beat the market index structurally and consistently. But it is also true that around this average there is some sub-categorization in groups going on. The US Defined Contribution market that allows individuals to take care of their own pensions is a fantastic pool of information about the investment style and performance of private investors. More information about that style will follow below. What is important now, as a basic premise, is that studies seem to conclude that (whereas private investors always - at parties, on their websites or in their well-known discussions with friends, family and neighbors - proudly present their own investment successes) the group as a whole underperformed. This implies that - so as to reach the average net return for the market as a whole - there are others who outperform. And I am not talking about those with non-diversified, 'lucky' one-shot portfolios then. No, I mean outperformance over a couple of years, with stable risk profile and realistic returns. There are best-of-breed grandmaster investors who create well-structured portfolios of outperforming products so as to  achieve this result.
Burton Malkiel: Wall Street's Randomness Makes the Investment Game Complicated.

LMG: But that doesn't imply non-existence of a sub-group of grandmasters and a sub-group of under performers.
Early Adopter Bias 
One of the problems is that different asset classes and products outperform at different times. So long-term investment success is about getting the averages right. Not about going all the way with one or the other temporary success. And that was exactly one of the main problems. Today, Hollands financial newspaper quoted a scientific study by scientists from the universities of Groningen and Maastricht who surveyed a representative group of Dutch investors. Compared to investors in most countries on this planet, Dutch investors are reasonably educated, reasonably cosmopolitan in their orientation, reasonably exposed to (international) investment news, acting in a market with reasonable cost levels, quite well regulated etc. We do therefore not believe that the bias is typically Dutch. Result of the study: private investors - even relatively experienced ones - had a tendency to be so-called early adopters . Normally it is good to be not too late in a cycle, but being an early adopter with a new product is not the same as riding the tide and being an early adopter in a new cycle for an existing security within a well-known traditional asset class.

EarlyAdopter: Testing the waters before the others dare to do so.

Receiving awe for it: but was the water safe?
There is a kind of early adopter premium which brings them awe and admiration from other investors. However, very often these new products are structured products created by financial institutions in an effort to transfer risks from the bank or insurer's balance sheet to the buying investor. Or products especially created to fulfill the needs / new demand for a 'hot' niche in which case performance and quality are of lesser importance than having something to sell. 'Turbos', 'Teak wood funds', 'Trackers', 'Guarantee Products', 'Shipping Ventures with positive tax treatment', 'Green Funds' you name it. There is so much. Most of the time the early adopter investors do not even completely understand what they are buying. And almost always these innovative products are added to portfolios that from the start weren't even neatly structured or diversified as far as standard, traditional asset classes are concerned. And in almost all cases these products are offered by parties that did not establish themselves a reputation as 'Best-of-Breed' in this new asset category, but simply offered it being the  bank or insurance firm with which the investor had a relationship already. You could even say that to some extent they were misusing their fiduciary relationship. But then again: looking at the early adopter premium one could also say that these investors wanted to be fooled because they derived non-monetary gains from buying these products. 

Is it therefore surprising that both these products and the buying investors were underperforming? Not really.

Fiduciary Problems
But why did these investors buy those products? Partly because of the non-monetary utility derived from being able to receive awe from other private investors. 'Waw, you are so good at this stuff. I didn't even know that this product existed!' or 'It is such a complicated product. Amazing that you already understand it!' and similar lines are a kind of bonus to the admired early adopter. And in an industry in which performance analysis and keeping track of performance over time are already underdeveloped when it comes to most professional product providers and their institutional clients, it is not a surprise that the admired early adopters get away with things the moment those products do not deliver. Solution: you simply stop talking about it, and instead spread the gospel about some other product that you were successful with and/or think to be successful with in the future. The trend followers will do what they always do: follow.

But, OK, what about the early adopters themselves? They are not crazy, are they? Why did they and do they continue to buy these products? In another article in the same newspaper we got our answer. Stefanie Tzioti of the Erasmus University Rotterdam received her Ph.D for a very interesting piece of research. What she did in her experiments was the following: she provided the participants in her experiments with choices between i) types of wine; ii) investments in stocks or bonds; iii) this or that mobile phone offer. In the first part of the research participants could make the choice themselves, based on a concise information package about the choices. In the next stage of the research they were offered additional help by advisers. They did not only receive the additional information, but were also shown pictures of the advisers and some information about them.

Result: the power dressing guy with the big car (or better phrased 'right car'; there was also something going on like specific brands of cars, watches being more expensive but 'wrong'!) was more often believed than his more casual 'guy-next-door' colleague. This is something banks and other financial firms know quite well. No matter how lousy their back office situation (compare
news yesterday about insurer Aegon who some 10 years ago acquired Scottish Equitable in the UK and continued to be sluggish about a known back office problem to such an extent that there are now more than 200,000 (!) clients that cannot be traced due to problems with addresses) or the actual quality of a financial product, in the end they still seem to be capable to impress their clients with their size, wealthy looking front and branch offices and power dressed sales staff (with or without long legs; male or female). In other words: fiduciary relationships  were often more about 'form' than about 'content'.

 There were however other factors at stake as well. 'Age' was also a positive factor, and so was 'content'. So, genuine, non-power dressed people of a certain age with great content were able to compensate their non-power dressing disadvantage. But still: it was clear but sad that 'content' seemed to be everything but the most important of these factors.

Power Dressing instead of Power Results: Form matters at least as much as Content
The Definition of Risk 
Risk is a far more complex and less-understood concept than Return. But both are of equal importance when it comes to creating a good investment portfolio. Risk is a derivative concept of a return distribution. But there are types of risk: we can use 'volatility' which is basically the standard deviation of the return distribution. We can also look at 'beta' or market risk which analyzes how much - on average - a security will go up or down when the market index goes up or down one percent. We can also look at 'Value-at-Risk', 'Downside Risk' et cetera. There are a lot of indicators. And even if you incorporate them in a structural manner in your decision making process, so that you can analyze risk and return in some integrated fashion you are not there yet.

There is a difference between Risk at the security level and Risk at the portfolio level. It was Dr Harry Markowitz (Nobel Prize Laureate 1990) who taught us about this difference when he developed his work on Modern Portfolio Theory in the 1950s (followed by equally important work by another Nobel prize Laureate Bill Sharpe in the early 1960s). When going from the individual security level to the overall portfolio level  things change because of a new dimension that is now added to the investment problem: 'correlation'. 'What is the relationship between the various components within your portfolio?' Over the last 10 years I have worked with Dr Markowitz on a new asset allocation framework based on i) a more efficient integration of bottom-up, security and asset class level information and top-down market information (including correlation analysis); and ii) some of the basic principles laid down in his earlier work. Prof Kritzman of MIT performed a series of tests that confirmed the value of this new approach. The approach was not really rocket science, just a careful integration of all factors involved when taking investment decisions and its results are therefore more indicative of the problems others have with the treatment of risk.
Harry Markowitz, often misunderstood or misinterpreted: No Power Dressing, but Enormous Content when it comes to Risk.

But back to the difficult relationship between private investors and the concept of risk.

 Investors are not just relatively bad in getting their partial or individual security risk calculus right, they are even worse when it comes to getting the correlations and portfolio structuring right. To some extent this is understandable. In an earlier piece that we wrote for the first issue of UK asset allocation journal Portfolio Institutional, we explained that regime shifts imply shifts in correlations and not just that: in different regimes return patterns seem to change as well. That complicates things tremendously.

 We had to think about these aspects when reading yet another article in today's financial newspaper, again totally coincidental that it ended up in the same issue. But it illustrates the intensity of the problem and its many different faces. It was a piece about private investors and their visions about markets in 2011 and beyond. It was based on a survey by a prestigious Dutch, independent market bureau. The pool of participants was a representative group of private investors with portfolios in excess of Euro 50,000 each. That 50,000 cut-off rate is important, because it is the hurdle rate applied by the Dutch regulator to distinguish between those private investors that are small (and who therefore need to be protected) and those that are big enough to assume that they can shop around and know what they are doing. An important distinction of course for providers of investment solutions, because for minimum investments below 50k you need a hard-to-get private investor market license and above 50k you don't.

 This is therefore the group of private investors who supposedly knows what they are talking about. Here are some of the most remarkable results of the survey:
  1. Private investors in the Netherlands are currently considering the US market as the most risky one. Only the African market was considered to be of 'similar or higher risk level'.
  2. The bulk of investors is not convinced that the crisis is over. Only 21 percent is willing to reduce the size of their savings account and invest more in equities. So even with today's relatively low interest rates, fear is still there. And market momentum of the last few weeks is the result of actions by a few (when it comes to private investors) and institutional investors. But in the latter group pension plans were relatively quiet due to problems with coverage ratios.
  3. The so-called Home Bias is immense. Almost all investors over-invest first and foremost in their home country (in this case the Netherlands), and within the foreign component of their portfolio Europe is highly overrepresented. 
  4. Emerging Markets are popular when it comes to talking about them. But when looking at portfolio allocations, either current or planned, private investors are far less enthusiastic than the big banks who advise them. Only 13 percent indicates that they want to invest more in China during the next 6 months versus 24 percent who want to expand their Dutch holdings when interest rates remain low. And when replacing China by some lesser known or smaller, less spectacularly growing Emerging Market things are even worse.
A more than remarkable result. Whatever will happen in the world, if anything, the US market is not going to be the most risky one. And definitely not something comparable to Africa. And actually - with us being positive about the long-run prospects of Africa - don't forget to integrate return and risk at both the individual security and portfolio level when taking decisions. The Home Bias is an indication of cultural and news intensity related mistakes most investors seem to make all the time: 'if I know a market better, because I live in or close to it my risk is lower'. They forget that their investment outcome is a function of the quality of their information vis-a-vis other participants in the investment game. When there is far more information available about a specific market, this does not translate automatically into lower risk and/or higher returns. It is about differential information vis-a-vis the competitors in the market place. And then I even forget to what extent available data is really information. Most investors don't really understand that distinction, thereby mistakenly interpreting their excess data for the home market as priced information.

  Basically: what is very clear from this feedback is that investors extrapolate. The uncertainty about the US is nothing more or less but an extrapolation of Global Crisis related factors ('didn't it all start in the US with the sub-prime crisis and bank problems?') and fluctuations in the Dollar-Euro exchange rate. But if you want, you can hedge currency risks, and when looking beyond the financial sector the US economy is so much more. In market value it is still more than 30 percent of the world. And well-diversified in terms of industry distribution. No way that this market will be riskier than the not-so-well-diversified economies of Africa with all their political risk and corruption as a not-so-welcome add-on. OK, less risk will translate into lower return, but that is another story.

 The relationship between private investors and the concept of 'risk' remains a troubled one.

 Extrapolation/Trend followers Bias
 When analyzing studies about the behavior of private investors (and actually the not-so-good institutional investors as well), it becomes clear that they are trend followers while at the same time being early adopters (see above).

 When it comes to existing products, they want to buy after receiving confirmation that something is doing well. Some want more confirmation, others less. But all wait for confirmation signals. That explains why it is so much easier to sell Morningstar Five and Four Star Funds. It also explains why stocks with a good looking share price development over the last year experience continued 'momentum'. But sooner or later this trend following translates into 'buying expensive'. If you wait for confirmation, you actually skip the security in its cheapest phases. Nothing wrong with one or two confirmations, but when combining this with the risk analysis in the previous paragraph it becomes clear that the bulk of people wait for a lot more confirmation. They will start thinking about something  after that something had a fantastic ride already. And then obviously, with the chance of disappointments going up the more expensive you bought, sooner or later it translates into buying high, selling low.

The Private Investor Trendfollowing Cycle

 Is it therefore - when just browsing through today's newspaper - strange that tons of investors under perform? Not at all. Is it strange that what we wrote here for private investors does also apply to dozens of institutional advisers and / or large financial institutions offering products to private investors and/or not-so-well-informed institutions? Again: not at all. In the end the bulk of people - even professionals - is a private person as well. With all the flaws that come with it. And it is therefore not surprising that Behavioral Finance has gained so much in importance during the last 20 years.

 But the academics were wrong to translate this into the conclusion that there are no grandmasters in this game. You can conclude that they are hard to find, sure. But the same applies to any competitive sport, because that is what investing is. There are always far more lousy amateurs than excelling stars. Investment performance of investment managers has to be disentangled into several components
  • Skill
  • Market
  • Peer Group
  • Other Relevant Factors 
before you can distinguish between those that most likely did something 'special' and those that were just plain 'lucky'. That does not only apply to finding the best advisers. It also applies to your own portfolio performance. But as long as there is no structural, state-of-the-art performance analysis available investors and not-so-good advisers will often be trend followers with all the flaws written about above. And in the mean time the true investment grand masters will continue to struggle with ways how to distinguish themselves from the poor and mediocre. And even when they do show the value of their 'content', they still have to fight against the power dressed marketing managers of huge financial institutions with great front offices and branches all around the world.

 When looking at the possibilities of approaches like our 'Best-of-Breed' concept for manager selection and our cooperation with UK database provider Camradata (one of the largest institutional databases of performance of investment procucts vis-a-vis their peer group), we believe that increased transparency requirements, the role of the internet in general and the increased speed and depth of information dissemination will help things to improve. And that is good news for both private and institutional investors. But there is still a long way to go.

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