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Don’t Invest With Your Convictions. They’re Wrong.

Summary Investors overestimate their knowledge of financial markets. Realized returns of individual investors substantially lag benchmark results. There is no clear evidence of persistence in mutual fund returns. Most investors have some kind of view on today’s stock and bond markets. It’s only natural. Financial media is everywhere. Investment news and opinions are delivered to our smartphones as soon as they are written. While the bandwidth of financial information has expanded dramatically, its noise to signal ratio remains stubbornly high. Buy Gold! Metals are dead! The Stock Market is too high! The Market has room to run up! The reality is that almost no one knows. And it’s virtually impossible for John Q Public to identify those few who do know. This newsletter talks about investor convictions and their impact on financial outcomes. The Big Picture One way to evaluate the success of individual investor sentiment is to take a look at aggregated performance. How is everybody doing? As a group … very poorly. DALBAR is an independent consultancy that reports annually on the success that individual investors enjoy relative to various financial benchmarks. In effect, they measure the ability of the public to time movements into and out of mutual funds over long periods of time. There is a lag between expectations and performance. For the 30 years ending 2014, average equity and bond fund investors massively underperformed their respective benchmarks – the S&P 500 and Aggregate Bond Index. Why is the Investor so Wrong? There are two basic explanations for the lag. Investors repeatedly demonstrate tendencies injurious to financial health. Collectively, they lurch from euphoria to panic – based on recent market performance. In fact, investor performance lags are largest during periods of heightened market volatility. These general conclusions deserve some anecdotes. Gallup and Wells Fargo conduct a quarterly survey on investor sentiment by interviewing over 1000 individuals with stock market exposure. They distill the responses into an index of overall market optimism. It reached its apex in January 2000 – 2 months before the dotcom bust. The sentiment index reached its nadir in February 2009 – one month before what has become the 3rd longest bull market in American history. So much for investor convictions. It has been my experience that investors overestimate their own ability to maintain rationality in the face of market turbulence. The aggregated date supports this view. According to a Wells Fargo/Gallup survey conducted in early February, 76% said they were either very or somewhat likely to take no action during market volatility. Yet investors exited the equity markets en masse in late 2008. The second problem with investment outcomes are the products themselves. The mutual funds that investors choose to implement their beleaguered strategies also fall short of the mark. Fund companies spend fortunes to convince the public that their portfolio managers can beat the market through astute security selection or tactical asset allocation. These superstars get paid well. Data compiled by Morningstar indicates that the cost structure of mutual funds has remained high in the new century. The average US equity mutual fund still charges 1.25% annually. Given the secular decline in bond yields, this resilience of high fees is especially surprising in the fixed income space. Fees in the average bond fund now exceed 25% of the yield to maturity of the ten year Treasury bond – up from 13% a decade ago. Have the expert fund managers delivered? The aggregate data tells us no. In fact, actively managed mutual funds lag the performance of a corresponding index by an amount that is not significantly different than the expenses they charge. A reasonable response to this result might be that mutual funds cannot beat the average because they are ultimately competing against themselves. It’s up to individual investors or their investment consultants to identify the “best of breed” managers in each asset class. A foundational approach in this effort is the evaluation of past performance. Again the data throws cold water on this theory. Past performance demonstrates virtually no persistence across a wide range of equity mutual fund asset classes. Top quartile performers depart the top quartile at the rate faster than predicted by random chance. If returns were completely random from year to year, there would be a 25% likelihood that a dart throwing manager could return to the top quartile. Doesn’t work that way as selected data from S&P Dow Jones indicate in the table below. Is There a Better Way? There is a corollary to the rather pessimistic findings of the previous section. If moving assets around is a destructive behavior, then keeping them in place is a better option. Long term performance of the major classes has been sufficient over the last ten or even hundred years to deliver comfortable retirement outcomes to most serious investors. Sure, it’s no guarantee that the public financial markets will continue to serve as stores of value. But stocks and bonds are about the best option the investing public has. A qualified investment advisor can play a constructive role here. Besides the technical ability to craft and implement an investment plan, a key advantage is the discipline that investors gain to stick to the plan amidst the financial noise that is sure to follow. Vanguard estimates that behavioral coaching is worth about 1.5% to investors each year. Based on a Vanguard study of actual client behavior, we found that investors who deviated from their initial retirement fund investment trailed the target-date fund benchmark by 1.5%. This suggests that the discipline and guidance that an advisor might provide through behavioral coaching could be the largest potential value-add of the tools available to advisors. Although the financial markets have suffered few reverses over the past six years, rest assured that market panics will follow at some point. Consider the wisdom of Meir Statman, Professor of Finance at Santa Clara, who wrote the following in the Wall Street Journal near the nadir of the recent financial crisis when investor sentiment was stacked against the stock market. Don’t chase last year’s investment winners. Your ability to predict next year’s investment winner is no better than your ability to predict next week’s lottery winner. A diversified portfolio of many investments might make you a loser during a year or even a decade, but a concentrated portfolio of few investments might ruin you forever. Consistency will get you there. Have the courage NOT to act on your own beliefs. It will be worth it. 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Myths Of Discounted Cash Flow

Discounted cash flow (DCF) is the adjustable wrench of modern financial mechanics. Essentially, the analyst forecasts the revenue and costs for several years out and applies an appropriate discount, or interest rate, to calculate what those future dollars are worth today. The process is supposed to provide a hard number for the current worth of the company. But as many of us recognized in college, there is a lot of room for wiggle in the process. Forecasting revenues and costs is tricky and always based on assumptions. An optimistic analyst might generate a rosy forecast while a pessimist may predict gloom and doom. Usually, analysts just assume the future will look like the past, which is always a dangerous assumption. How many oil analysts saw the recent collapse in oil prices as a result of projecting the past into the future? Next, analysts have to choose a discount rate, which means they have to forecast interest rates. That is more difficult than predicting revenues and small errors have enormous leverage to ruin analyses. In my book Financial Bull Riding I quoted former American Finance Association president John Cochrane who said in a speech that investor discount rates can change radically: Discount rates vary a lot more than we thought. Most of the puzzles and anomalies that we face amount to discount-rate variation we do not understand. Our theoretical controversies are about how discount rates are formed.” [1] Also, few analysts pay attention to the business cycle that drives the largest changes in revenues, costs and interest rates, and fewer know anything about the ABCT. Not only do profits rise and fall with the amplitude of the cycle, so does risk tolerance on the part of investors that translates to discount rates. The wizards of finance in academia created DCF in order to make the field more like the hard, math-based science of physics. But all they accomplished was to trowel body putty over the ugly subjectivity and apply a coat of paint. However, one professor has peeled back the cracking paint and putty. Aswath Damodaran is Professor of Finance at the Stern School of Business at New York University who teaches classes in corporate finance and valuation, primarily to MBAs. He recently wrote on his blog that: Most people don’t trust DCF valuations, and with good reason. Analysts find ways to hide their bias in their inputs and use complexity to intimidate those who are not as well versed in the valuation game. This may surprise you, but I understand and share that mistrust, especially since I know how easy it is to manipulate numbers to yield almost any value that you want, and to delude yourself, in the process. It is for this reason that I have argued that the test of a valuation is not in the inputs or in the modeling, but in the story underlying the numbers and how well that story holds up to scrutiny. Damodaran uses Amazon (NASDAQ: AMZN ) as an example. He arrived at a value of $175/share, but he demonstrates that optimists have arrived at $468 while pessimists went as low as $32. The current stock price is the average of all investors’ expectations about the company. The author concludes that “…the conventional view that intrinsic value, if done right, is timeless is nonsense.” Austrian investors have known this all along and have insisted on a radical application of subjectivism to stock analysis. Of course, the goal of DCF is to help the investor find undervalued stocks and earn more in returns than just investing in a stock index such as the S&P 500. Another way to look at the market is to consider that investors undervalue almost all stocks in the depths of a recession. Profits are low, but so is risk tolerance and the discount rate that investors apply to earnings. Then as profits rise and risk tolerance enlarges during the expansion, most stocks become overvalued just before the next crash. Investors are waking up to the fact that stocks have been overvalued for a while and the economic omens point to a looming recession. So the smart move would be to abandon the stock market for the bond market or cash and wait for the crash, after which investors will be pessimistic and profits will be low, so stocks will become undervalued. Most of the stock market is a great value play in the depths of a recession. Investors don’t even have to be choosy. Just throw money at it. All stocks will rise. But if you want a big boost, choose stocks in the NASDAQ. Companies listed on that exchange tend to be capital goods industries, and as we know from the ABCT, those companies take the hardest hits in the economic collapse but rebound the most in the recovery. [1] John H.Cochrane, “Presidential Address: Discount Rates,” The Journal of Finance, Vol. LXVI, No. 4, (2011): 1092.

The 3 Key Factors In Biotech ETF Investing

Although stocks are having a rough year, investors still remain captivated by certain sectors of the market. Undoubtedly, one that remains at the top of the list is the biotech space, as this corner of the market has been a strong performer despite the volatility. However, thanks to recent market conditions, biotech has become a choppier investment, while concerns over regulation aren’t helping matters either. Still, the space is intriguing for many reasons – and especially those in it for the long term – so having at least some exposure probably makes sense for most investors. Biotech ETFs? But due to the risks, a single stock investment might be inappropriate for most investors. This space, more than most, is subject to booms and busts, where one right – or wrong – stock pick will make or break an investment idea. That is why biotech ETF investing has become so popular, as it gets rid of the company-specific risks, while still allowing exposure to the overall story. Many investors still don’t know the basics here, or the key differences between the many funds that populate that space. That is why I have distilled the market into 3 key factors that every investor needs to know before jumping into this hot corner of the market: Not All Created Equal No fund here in the unleveraged space tracks the same index, and while some, such as the iShares Nasdaq Biotechnology ETF (NASDAQ: IBB ) and the Market Vectors Biotech ETF (NYSEARCA: BBH ), follow large cap-focused indexes, others use an equal-weight benchmark such as the SPDR Biotech ETF (NYSEARCA: XBI ) or a modified equal-weight benchmark like the First Trust NYSE Arca Biotechnology Index ETF (NYSEARCA: FBT ). This can have a huge impact on risk and return, so investors definitely need to keep this in mind. XBI has actually doubled IBB in the past year, largely thanks to its small cap focus. Study the Index Other funds have more stringent criteria for inclusion and do not follow the same rules as the major ETFs listed above. Funds here include the BioShares Biotechnology Clinical Trials ETF (NASDAQ: BBC ), which only holds companies that have drugs in clinical trials, or the BioShares Biotechnology Products ETF (NASDAQ: BBP ), which zeroes in stocks that have already received FDA approval for a drug. Knowing the index applies to the leveraged space too, as these can drastically alter the risk profile. For example, although the ProShares UltraPro NASDAQ Biotechnology ETF (NASDAQ: UBIO ) and the Direxion Daily S&P Biotech Bull 3x Shares ETF (NYSEARCA: LABU ) both over 3x leverage, LABU follows an equal-weight benchmark, and is thus likely to be more volatile than UBIO. Expenses! Investors often overlook expenses in this corner of the market, as most are just hoping for big gains. However, expenses can vary pretty widely in this space, and this is definitely something to consider, as they can add up for a long-term hold. In fact, the range goes from 0.35-0.85%, so your total cost can change by a big amount, thanks to this factor. Original Post