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The Stock Market Is Getting More Expensive

One of the most underrated but among the most valuable skills required to succeed in stock market investing is resilience i.e., the ability to properly adapt to stress and adversity – either in the market, or in the businesses one is owning. How easily can you bounce back from a market crash? What would be your reaction to a sharp decline in your stocks’ prices? How many ‘surprises’ can you withstand in quick succession? How safe are your overall finances in light of extreme stress on the equity component of your portfolio? These are extremely important questions you must ask yourself every time you are looking at your portfolio, or looking to spend cash to buy more stocks. Surprisingly, despite its importance, resilience is least talked about by stock market investors and experts alike, and rarely considered an important mental model in investment decision making. Most of the time, we build our lives, our jobs or businesses around today, assuming that tomorrow will be a lot like now. Resilience, which is the ability to shift and respond to change, comes way down the list of the things we often consider. And yet, a crazy world is certain to get crazier. Jobs aren’t steady anymore. The financial market has gotten more volatile. The Earth is warming, ever faster. And the rate and commercial impact of natural disasters around the world is on growing exponentially. Hence the need for resilience, for the ability to survive and thrive in the face of change. Stock Market is Getting More Expensive Certainly I am not talking about stock valuations here. Because, if that were to be the case, the BSE-Sensex’s valuation – if you go by P/E – is now cheaper at 18x trailing 12-months earnings as compared to 23x just six months ago. Noted financial writer George J.W. Goodman – who used the pen name of Adam Smith – wrote this in his wonderful book, The Money Game – If you don’t know who you are, this is an expensive place to find out. By “this”, Smith meant the stock market. The people who bought commodity, infrastructure, or real estate stocks in 2006 and 2007 because they thought they had a high tolerance for risk – and then lost 95% over the next one year (some such stocks are down 95% even after eight years) – know just how expensive the stock market can be. While speculating on such stocks, they seemingly failed to answer the questions around their levels of resilience. And thus many ended up betting their houses and other people’s money on stocks that were destined to go down the drain. Something similar has happened to the guys who were utterly charmed by “moats” and forgot the subtle difference between paying up and overpaying over the last two years. A lot of such moated darlings are down between 30% and 50% over the past six months. Those who would have borrowed money to invest in such stocks are sitting on even bigger losses and much bigger dents to their egos. You see, knowing more about who you are as an investor can make you a fortune – or save you one. Knowing how resilient you and your portfolio are to severe market downturns also solves that purpose. Can You Handle Mr. Market Well? If you have been glued to financial media or online portfolio trackers, fixated on the sight of falling stock prices over the past few days and weeks, then this should tell you something about yourself that has enormous long-term importance – you probably have too much in stocks even as you don’t have the resilience to see your portfolio value declining (and that’s why you are checking stock prices so frequently). If you feel distressed by a decline of a few hundred points on the BSE-Sensex, then you are kidding yourself if you think you can withstand a drop of a few thousand points when it comes. Benjamin Graham, the father of value investing, divided investors into two types in his book The Intelligent Investor – defensive and enterprising. The defensive investor, Graham wrote, wants to avoid “serious mistakes or losses” and seeks “freedom from effort, annoyance and the need for making frequent decisions.” On the other hand, the enterprising investor, as per Graham, is willing “to devote time and care to the selection of securities that are both sound and more attractive than the average.” So, if you are an enterprising investor, then you should observe the stock market carefully in the hope that a substantial fall will present bargains. But if you are a defensive investor, you should observe yourself carefully. If you are not nearing retirement and have many years to invest and thus ability to see through a few big downturns; If you are not investing on borrowed money; If you are investing your own money, not other people’s money; If you do not owe a lot of money by way of loans, and have sufficient disposable income that prevents you from selling your stocks to meet your needs; and If you have seen through past market crises without much psychological upheavals… …you have adequate resilience to manage any major stress that the stock market may present you now. However, if you do not meet any or most of the above criteria, then beware. Reconsider your decision to be in stocks directly. Else, maybe, trim back on your stocks to create the much needed financial cushion so that any big decline does not become an even more expensive way for you to find out who you are. Remember what Keynes said – Markets can remain irrational longer than you can remain solvent.

Long/Short Equity Funds: The Best And Worst Of December

Long/short equity mutual funds and ETFs posted average returns of -1.23% in December, making it the third time in four months that the average fund in the category failed to post positive returns. This compares to a return of -1.58% for the S&P 500 Index and -5.02% for the Russell 2000 Index. The three top-performing long/short equity funds had monthly gains ranging from 1.74% to 2.01%, while the worst performers suffered losses of at least 5.65%. Top Long/Short Performers in December The three best-performing long/short equity funds in December were: KZSIX led all long/short equity funds in December with one-month gains of 2.01%. The $160 million fund launched on August 3, 2015, and thus did not have one- or three-year returns available, but its three-month returns through December 31 stood at +3.40%, ranking in the top 26% of the category. GURAX, with $106 million in assets and an inception date of March 2014, was December’s second-best long/short equity fund, in terms of returns, as it gained 1.88% for the month. The fund’s 3.59% gains in 2015 ranked in the top 12% of the Morningstar long/short category. Finally, SSPLX’s 1.74% gains in December ranked third among long/short equity mutual funds. The $22 million fund, which launched in October 2014, returned +0.47% in 2015, ranking in the top 31% of Morningstar’s Long/Short Equity category. Click to enlarge Worst Long/Short Performers in December The three worst-performing long/short equity mutual funds in December were: CIAXX, which returned -7.33% in December, was the category’s worst performer for the month. The $5 million fund launched on October 28, 2010, and through the end of 2015, its three-year returns stood at an annualized -4.70%, giving it a 1.43 beta (relative to the S&P 500) and -23.87% alpha for the three-year period. Its three-year Sharpe ratio stood at -0.15, with a standard deviation of 19.28, compared to respective category averages of 0.68 and 7.92. SLSAX lost 6.01% in December, making it the month’s second-worst-performing long/short equity mutual fund. The $63 million fund launched in December 2013 and returned -14.24% in 2015, ranking in the bottom 5% of the category. And the $644 million FMLSX, which lost 5.65% in December, rounded out the category’s bottom-three performers for the month. It launched way back in 2003 and generated 10-year annualized returns of +3.85% through the end of 2015. Over the past three years, however, FMLSX has lost an annualized 0.89%, ranking in the bottom 8% of its category for that time, with a beta of 0.79 and -12.03% alpha. Its three-year Sharpe ratio and standard deviation stood at -0.04 and 10.41, respectively. Past performance does not necessarily predict future results. Jason Seagraves contributed to this article.

Why Invest In Chile?

I’ve heard it said that asset allocation means always having something to complain about. A brilliant asset allocation will have long periods when one or more component of the portfolio fails to appreciate. And for investment management a long period of time can be a decade or more. This past year the MSCI Chile Gross Index lost -16.58% as measured in US dollars. Chile is down -50.64% since it peaked at the end of April, 2011 with a 5-year annual return of -13.04%. The longer the downturn for a particular portfolio holding the greater the feeling that we should simply eliminate it from the portfolio. It is “doing nothing but going down” we say because our minds are apt to frame the movement in the present tense rather than the past tense. Our brains are very quick to find short term patterns and project them forward as long term trends. This cognitive ability is useful in many areas, but it is not particularly useful in investment management. Investments are inherently volatile. The rebalancing bonus which comes from having an asset allocation is dependent on two variables: volatility and correlation. The more volatile and less correlated your asset classes are the greater the rebalancing bonus you get from having those components in your portfolio. When you compare Chile to the S&P 500 Total Return since the beginning of 1988 when the Chile Index began, the S&P 500 had a 1,540.25% appreciation, growing $10,000 into $154,669. It averaged 10.28% annually. Even though the S&P 500 had phenomenal growth during the time period, it also experienced an entire decade where it dropped -29.48% and a 30 month period where it dropped -43.75%. Over the same time period, Chile had a 3,585.25% appreciation, growing $10,000 into $368,524. It averaged 13.75% annually. Click to enlarge Having twice as much growth as the S&P 500 over 28 years comes with the price of greater volatility. The standard deviation of annual returns for the S&P 500 was 14.39% while the standard deviation for Chile was 24.21%. This type of volatility is normal for the markets. While you might have had more money putting everything in Chile, we recommend a blended portfolio. Each individual component of a balanced portfolio is more volatile than the portfolio as a whole. Thus, adding a little bit of Chile to your portfolio can boost returns and reduce volatility on account of the rebalancing bonus. In fact, over this time period the mix which had the lowest volatility was 12% Chile and 88% S&P 500. This blended portfolio had an average return of 10.96% and a standard deviation of just 14.25%. This is a boost to annual returns of 0.68%. Over this time period, adding 12% Chile to your portfolio resulted in an extra $29,095 over the S&P 500 alone. Creating a mix of 19% Chile and 81% S&P 500 would have had no more volatility than a portfolio of 100% S&P 500. But this portfolio would have averaged 11.32%, and extra 1.05% annually and earned an additional $46,784. The return of these blended portfolios over long periods of time produce a risk return curve which can help investors find what asset allocation produced the greatest return for a given amount of risk. These blended portfolios are called the efficient frontier and produce curves between moving from 100% S&P 500 to 100% Chile. Click to enlarge Notice that with only these two choices, investing any less than 12% in Chile is not on the efficient frontier because there is a portfolio for which a greater return could have been achieved while experiencing an equal or lower volatility. In actual portfolio construction, there are dozens of components which are being fit together to craft a brilliant investment strategy for long term time horizons. Our current asset allocation model usually invests less than 2% of a portfolio’s value in Chile. Even if Chile were to lose half of its value the portfolio value would only go down 1%. Assuming that Chile doesn’t move in sync with other investments in the portfolio, this is a level of volatility which is acceptable for the potential additional return. As it turns out, the correlation between the monthly returns of Chile and the S&P 500 are low at 0.46. It is always disappointing when an investment category fails to perform as hoped. But after an investment has fallen in price it is often that much more attractive looking forward. Unlike individual stocks, a country index cannot go to zero. If the Chile index approached zero, you would be able to take your pocket change and buy every publicly traded company in Chile. Long before you could do that, people much wealthier than you would notice how low the price was and they would buy every company in Chile. Low prices for a country index is best thought of as the index going on sale. Stocks often move on very light trading as a few sellers push the stock price lower. Market makers who hold all the stocks in the index gradually move the price lower when there are more sellers than buyers. A market maker is forced to buy when there is no one else interested in buying. But at some point the price is low enough to wake up other potential buyers and the movement in price finds resistance. This can cause greater swings of volatility often over long periods of time. As a result, you should not be afraid of an major index. Assuming there were good reasons to be invested in it in the first place , a 3, 5 or even 10 year down turn is not a reason to abandon your brilliant investment strategy.