Investing should be all about the long-term. Yet almost everyone who grabs our attention when it comes to investing – media pundits, asset managers, brokers – have an incentive to keep us guessing about the state of the market, and the performance of individual shares and funds.

• Magazines and websites want us to tune in and ideally pay up to hear the latest news and views.

• Fund managers want us to recognise their apparent skill and then switch to their funds.

• Brokers want us to trade our holdings. And then to trade them again.

• Even non-financial companies may benefit from a febrile atmosphere if they need to tap the markets through rights issues, IPOs, or spin-offs.

Heck, even the tax man would probably prefer we churn our portfolios. In the UK most share purchases are liable for stamp duty tax, and most investments sold for a gain outside of ISA or pension face capital gains tax, too.

Whatever you do, don’t do it

There are big problems with being too concerned about the meanderings of the stock market when you’re a private investor.

Active investors who are overly obsessed with day-to-day market noise and commentary are more likely to feel the need to do something – which usually means trading shares or swapping funds their around.

Too much of trading increases expenses and will likely reduce your returns. And most of the time, when people swap funds they are chasing performance, which can have a damaging impact over the long-term, as they repeatedly sell low and buy high.

Yet even passive investors can suffer if they’re partial to weather reports and horoscopes stock market updates and analysts’ commentary.

A well-balanced asset allocation can be derailed if you react to some super-smooth pundit opining about asset classes, touting that “only a fool would own government bonds right now” or claiming that “This is surely a once in a lifetime chance to invest in the Democratic Republic of Congo!”

Then there’s the worst fate of all – being scared out of your positions at the bottom of a bear market, and missing out on the rebound.

Stick to the plan, Stan

Sticking to your long-term plan is vital for success, as this video from Sensible Investing TV explains:

As Vanguard founder Jack Bogle says:

“Why in the name of peace do we pay any attention to the stock market? The stock market is a derivative.

The stock market is a derivative of what? It’s a derivative of the earning power and dividend yields on, in the case of this nation, US corporations.

The dividend yield, plus the earnings growth that follows, is what creates the fundamental return on stocks.

The speculative return on stocks, compared to that investment return, is how much people are willing to pay for a dollar of earnings.

That carries the market up and down, and in the long run, in the last 100 years, the contribution of speculative return to total market return is zero.

The contribution of investment return, if you happen to have 4.5% dividend yield and 4.5% earnings growth, that’s the 9% you read about in the past for the US market.

Bogle’s conclusion? The stock market is a giant distraction to the business of investing.

Most people are best off ignoring it like you’d ignore the tantrums of a greedy and tired child, and letting long-term compound interest work its magic.

Check out the rest of the videos in this series.

The low volatility phenomenon is described as an anomaly; like ball lightning or a dog that says “sausages” or sexy popes, it shouldn’t work but it seemingly does.

The promise of low volatility equities is three-fold:

• Returns that match or exceed the market over time…

• …while inflicting around 20% less price fluctuation pain upon investors, and…

• …during a bear market nightmare, total losses that are less severe than the market as a whole.

It sounds too good to be true. The same or better returns for less risk? Yes please, I’ll have some of that.

Most investors will be aware that financial theory warns that you don’t get something for nothing. There’s no reward without risk they say, and so more volatile investments should offer greater expected returns than safer options. Except they don’t.

Low volatility equities have been shown to outperform their high vol peers, offering superior risk-adjusted returns over the course of the last 40 years.

And that’s as weird as a catfish playing with yarn. What are we doing stocking our portfolios full of shares that are about as stable as dynamite when we could get the same results for much less trouble?

The low down

Low volatility is another of the return premiums that concentrate on certain company traits to produce something like a genetically modified super-crop of equities – with the potential to increase the return of your portfolio.

In this case, the low volatility bracket is filled with companies that are relatively less affected by the movements of the broader stock market.

These are known as low beta companies. When the stock market takes a tumble, their prices won’t necessarily fall so far in tandem.

An example of a low beta equity is a power company. Customers still need to keep the lights on even during a recession, so the firm and its share price may be less badly hit than say a car manufacturer when the wider economy heads south.

Equally, if there’s a raging bull market, the utility firm will benefit from the general upswing in demand. But it’s unlikely to get as big a bounce as the car company with its new line of robot-chauffeured roadsters.

The upshot is that low volatility strategies tend to underperform during the good times and outperform during the bad.

Humans don’t learn

None of this explains why sluggish shares should out-perform high beta (that is, high volatility) shares that experience more ups and downs than an elevator operator.

For that it seems we must once again turn to our dumb human brains.

There are a number of theories from behavioural finance that might explain why we accept higher prices and lower returns when buying high volatility equities:

• We love a lottery. We’d sooner gamble on an overpriced tech company that’s never made a bean in the hope that it might become the next Google than we would invest in some boring dog food cannery that will keep making profits as long as people don’t want to starve their dogs.

• Overconfidence means we’re convinced we can pick the next Google out of the crowd, even though we know most investors don’t have this skill and most ‘next Googles’ turn into the last GeoCities.

• Optimistic analyst forecasts for fast-growing equities serve to push up prices and consequently lower future returns.

• Active fund managers dare not tilt towards low volatility equities for fear that they’ll get fired when they deviate from their benchmark for a prolonged period.

• We’re not all Sages of Omaha. One way to exploit the low volatility anomaly is to load up on less risky equities and then pump your returns with leverage. ++ Alert ++ Alert ++ Compulsory Warren Buffet reference: Warren Buffet apparently does this with his insurance company float. ++ End Alert ++ But many investors are prone to leverage aversion. They’re either not allowed (pension funds) or too afraid (me!) to take on the risks, costs, and hassle of borrowing to invest. So instead they lean on high beta assets for extra snap, crackle, and pop but that dependency raises prices and reduces future returns.

A low ebb

Human behaviour being what it is (i.e. mentally frozen in the Paleolithic), there’s good reason to believe that low volatility may survive the ravages of arbitrage as has momentum.

For instance despite the anomaly’s discovery in 1972, low volatility beat the US market by 2% per year between 1963 and 2009, while exhibiting 15% less risk.

However, like all the return premiums, low volatility is not an escalator to dreamland. There’s no guarantee it will outperform in the future and there’s a near certainty that it will underperform for years at some point – testing your will and sanity when it does so.

Indeed, the irony of low volatility’s recent popularity (and the proliferation of supporting tracker products) is that low vol equities may have become significantly overvalued.

As always, when an investing strategy becomes a fad, then there’s a heightened danger that it’s due a strong dose of underperformance. That plus a few other controversies surrounding low volatility are worthy of further consideration.

Take it steady,

The Accumulator

Good reads from around the Web.

Finally, a bit of volatility in the markets after all that tedious upward marching, and we are reminded why equities are about risk as well reward.

As blogger Josh Brown put it in the midst of the volatility:

At least the 10%-ish correction has given pundits a chance to dust down their brace position mantras. I’ve selected a few below.

Most are aimed at active investors. There are rarely enough passive articles for me to squander any here – but you can find some relevant links in the Passive sections as usual.

That said, much of this stuff is behavioural, and it applies to everyone.

My advice to true passive investors would be to stick to your allocations, and ignore the movements until you come to your next scheduled rebalance.

(Oh, and remember when people were asking The Accumulator why he held around 40% in government bonds in his model portfolio, and how could he be satisfied with that supposedly dreary 6% annualized gain? This is a reminder.)

Some thoughts on the falling market

The market falls mean UK shares look pretty cheap by the CAPE measure, reports ThisIsMoney:

The current UK market CAPE ratio stands at 14 for what is broadly the equivalent of the FTSE All-Share using the data from Thomson Datastream.

That compares favourably to a long-run average of 19.6, although it stands someway above the 11.4 it hit at the bottom of the market slump in 2009.

..and UK Value Investor uses the same yardstick to question how much further the FTSE 100 could credibly drop:

At 5,000 the FTSE 100’s CAPE would be 10.

If it fell to 4,000 then its CAPE would be 8 and at 3,500 its CAPE would be 7.

To give you something to compare those numbers to, in 2009, when the FTSE 100 stood at 3,500 and everybody thought the financial world was about to end, the market’s CAPE was 9.5.

So assuming the CAPE approach is correct, for the FTSE 100 to reach 5,000 investors would need to be as pessimistic as they were when we were days, or even hours, from a global financial collapse.

Currently that seems a little unlikely.

Remember that that the “E” in CAPE can fall as well as the “P” – i.e. earnings would probably fall in a big global slowdown – although CAPE does smooth this out to some extent.

But for now the world is hardly ending, reports Alan Roth at AARP:

Stick to an asset allocation you can live with. Decide what proportion of your portfolio should be in stocks and stick to it, irrespective of the headlines.

The implications are simple: You have to buy stocks when they plunge and sell when they surge.

Simple? Yes. Easy? No.

The Eight at Eight blog has some less pithy and more poetic advice that might be worth reading if you’re young and not used to volatility:

Surviving isn’t a frozen moment in time, but is in fact a continuous effort to maintain equilibrium in your mindset and in your investment approach no matter what the market conditions are. A constant reminding to yourself of the end goal as an investor. A retaining of beliefs in yourself, your methods and investment decisions.

While the similarly colourful Wexboy begins his wide-ranging recap by pointing out how trivially we shout “Fire!” nowadays:

Traditionally, a 10% market reversal was defined as a correction, while a bear market was at least a 20% decline.

But now the business media’s upped the ante, unilaterally adopting something like 3% & 10% as the new thresholds

Perhaps that’s why Patrick O’Shaughnessy at Millenial Invest is already having flashbacks from the last war:

Markets are, at their core, about emotions and how you handle them.

It is so easy to be brave from a safe distance, to say that you will be cool when the tough times come.

During 2008-09, I learned that that is naïve bullsh*t.

Those were terrifying times. I was worried to my core about my family’s future, the business, and all of our clients who had trusted us with their money.  I convinced some to stay the course, but failed more often than I succeeded.

But the truth is we’re a long way from 2008 today. We’re not even in 2012 territory.

I enjoyed these articles, but I do think the sheer volume of words – of which the articles above are just a smidgeon – in response to what’s been a modest if swift correction so far tells us more about how gentle things have been than anything much about the future.

[continue reading…]