Visualising The Damage on The Stock Market

Bed goes up, bed goes down, bed goes up, bed goes down.

– Homer Simpson

Since the GFC stocks have been the perfect place to hide. In fact, there has been no safer bet with stock markets around the world trading at multiples of their GFC lows. Here’s how major stock markets around the world performed (total return) since the bottom of the GFC:

(orange line – Australia, purple line – Asia, green line – Europe, blue line – US, red – Emerging Markets)

Only when the tide goes out do you discover who’s been swimming naked.

– Warren Buffett

Financial markets however, have no regard for what you want or what you need, and will turn on you like the Melbourne weather leaving you perplexed as to which season it is.

The recent spasm of news coverage on the stock market correction prompted me to assess the damage done on stocks. For the last two months, these were the headlines investors have been reading – how exciting!

I’m not sure who defined a market correction being a decline of 10% or more, but it’s the widely accepted definition. What good is it for investors to know that the correction has begun based on some meaningless threshold someone fabricated? Why is the threshold not 12%, or 15%? Why should a manufactured definition trigger investors to revisit their investment strategy? To me, this threshold seems illogical, and to base investment decisions on these definitions seems foolish.

Let’s take a look at what all the fuss is about. Here’s a chart showing the total return of the above indices since 8 October (when the decline began) to Friday, 23 November 2018:

Within two months, the US stock market is down 10.69%, Europe is down 9.05%, Asia down 7.97%, Australia down 5.92%, and Emerging Markets down 5.25%. Having said this, if we were to look at peak to trough using 52 week highs, the chart above would look different again. In fact, Emerging Markets would look a lot worse if we pulled the start date back to earlier on in the year. It doesn’t matter where you were invested your money, there really was nowhere to hide.

If you think that’s bad, just spare a moment for the tech investors. Here are the FAANGs (Facebook, Apple, Amazon, Netflix, Google) against the S&P500 (orange line) and Nasdaq (grey line):

(purple line – Facebook, green line – Amazon, blue line – Apple, yellow line – Google)

Hey, what do you expect after a run up like this:

Netflix’s market cap is currently sitting at US$112 billion. To put that into perspective, Citigroup is currently valued at US$150 billion. Number of employees at each company: Citigroup – 209,000, Netflix – 5,400. Revenue (2018 est): Citigroup – US$216,000,000, Netflix – US$16 billion. Net income (2018 est): Citigroup – US$18 billion, Netflix US$671 million.

Markets can remain irrational for a lot longer than you and I can remain solvent.

– John Maynard Keynes

Most money managers will highlight and emphasize performance for a select period of time (I’ll let you decide why), so it’s very useful to me (and investors) to look at things through a wider lens. So here it goes – the recent market declines since the GFC for stock markets around the world:

It comes as no surprise that the asset class that has performed the best over the last 10 years is the one that has fallen the most when things are seem a little uncertain.

Even following a market “correction”, the US stock market is still up 265%, the Australian market up 144%, and Asia, Europe, and Emerging Markets up 123%, 80%, and 59% respectively.

There are several narratives that are making headlines justifying the recent market decline. The general theme goes something like this: This bull market has been running hot for almost 10 years. Interest rates are rising, and cost pressures are rising, which will cause inflation. Whatever narrative you decide makes most sense to you, the reality is that the news that is floating around is not new and is probably priced into current market valuations anyway.

At the end of the day, the more you pay for an asset, the less the future expected return. The less you pay for an asset, the greater the future expected return. In life, and in financial markets, things sometimes just don’t make any sense – although they eventually do. Don’t try and keep up with the Jones’ or get caught up in the market and media hype – it takes guts, discipline, patience and time to make money.

When you decide to embark on the journey of investing, remember the wise words of Homer Simpson – bed goes up, bed goes down.

Source:

  • Charts and headlines – Thomson Reuters
  • Returns are denominated in AUD for all charts except the FAANGs

The 6 Biggest Mistakes You Will Make as an Investor

Most of us want to achieve success, whether that may be at work, in our relationships, or our health. In the pursuit of success, we all experience moments of self-loathing and frustration that stems from nowhere other than from our own hands – we are, our own worst enemies. Success in personal finance is no exception.

Have you ever wondered, what is the biggest risk to achieving your financial goals? Is it geopolitics, inflation, the rise of crypto-currency, a property bubble? No. It’s your own mind.

You can invest is all the right things, minimise all your fees and taxes, and diversify most risks away, but if you fail to master your own psychology, it is still possible to fall victim of financial self-sabotage.

Our brain’s natural instincts, to avoid pain and seek pleasure, may be very useful to Fred Flintstone, but can be very harmful when making financial decisions. So how do investors overcome these biases? The concept is simple, yet will test even the most seasoned of investors.

Our ideas are so simple that people keep asking us for mysteries when all we have are the most elementary ideas. – Charlie Munger

Put in place a system, rules, and a set of procedures that will protect you from yourself.

Mistake #1 – Seeking confirmation of your own beliefs

Our brains are wired to seek and believe information that validates our own existing beliefs. We love proving to ourselves how smart and right we are.

The solution

Ask questions and actively seek the opinions of well respected people that disagree with your own.

The power of thoughtful disagreement is a great thing – Ray Dalio

Mistake #2 – Extrapolating recent events

One of the most common and most dangerous, recency bias – to believe the current market trend will continue into the future. Investors end up buying more of something that has recently increased in price, ultimately paying more for the investment.

The solution

The best way to avoid this impulse of buying high (aka FOMO), rebalance your portfolio. You effectively sell assets at higher prices and buying assets at lower prices – when one investment performs well, you sell some of it, and top up the investment that hasn’t done so well.

Mistake #3 – Overconfidence

Ask a room full of people to raise their hands if they are a better than average driver, and you’ll have 93% of the room raise their hand. As human beings we overestimate our own knowledge and abilities, which can lead to disastrous financial outcomes.

The solution

By admitting you don’t have an edge, you’ll end up with an edge..

If you can’t predict the future, the most important thing is to admit it. It its true that you can’t make forecasts and yet you try anyway, then that’s really suicide. – Howard Marks

Mistake #4 – Swinging for the fences

As tempting as it is to go for the big winners to fast track your financial wealth, the more likely you are to be bowled out, which also means it’s going to take you even longer to get back on track.

The solution

The best way to win the game of investing, is to achieve sustainable long-term returns that compound over time. Short-term noise is simply a distraction from Wall Street.

The stock market is a device for transferring money from the impatient to to the patient. – Warren Buffett

Mistake #5 – Home bias

We have a tendency to invest in markets we are most familiar with creating a ‘home bias’. For example, we invest in the stock market of the country we live in, we invest in the stock of our employer, or we invest in the industry we work in. This bias leaves us overweight in “what we know”, which can destroy our hard earned wealth in some circumstances.

The solution

Diversify across asset classes, regions, and industries. From January 2010 to October 2018, Australian shares returned 7.50% pa. International shares returned 12% pa, and US shares returned 16% pa.

Mistake #6 – Negativity

Our brains are wired to bombard us with memories of negative experiences. The amygdala – the fight of flight system in our brain, floods our bodies with fear signals when we are losing money. Think GFC – markets were plunging, investors panicked, selling down their investments to cash. The US market has tripled n value since the GFC, making up all the losses plus more.

The solution

1) Be clear on why you made a certain investment.

2) Invest today for the long-term but assume the market will collapse tomorrow.

3) Partner with the right financial adviser to act as your sounding board.

By failing to prepare, you prepare for fail. – Benjamin Franklin

These aren’t guarantees that you will be successful during your investing journey, but it will damn sure put the odds in your favor.

Godspeed.

Source: Visual Capitalist, Wikipedia, Vanguard

You’re Being Fooled Into Overpaying For Underperformance – Here’s How

When people ask me what I do, I tell them I’m in the business of helping people make money. The business we’re really in though, is helping improve the lives of our clients. It comes from the belief that life is about more than money. I believe money is an enabler – it provides us with options, choice, and flexibility. So if we can help our clients preserve and build their financial wealth, we can help them live a more meaningful and fulfilled life – a life that is truly rich.

Sadly, most people never achieve a life that is truly meaningful and fulfilling – true wealth. Why? Because they’re focused on the scoreboard, and not the process. They’re focused on chasing the money.

Enter the world of investments, stock brokers, financial advisers, fund managers, and high flying financial institutions. If you’re not careful, you might be sailing toward financial freedom with a hole in the bottom of your boat. That hole, is in fact lining the pockets of those purporting to be helping you sail toward the sunset.

When was the last time you looked at your superannuation or investment portfolio statement? Your portfolio has probably grown, especially over the last ten years, so you haven’t taken too much notice. The real question is, how much have you left on the table?

Australians have around $2 trillion sitting in superannuation, which has attracted fund managers like bees around a honey pot. And Australian are paying some of the highest fees for the management and oversight of this money. In fact, last year, Australian’s paid $31 billion in superannuation fees – totaling around $230 billion in the last decade.

So what can you do about it? Here are three things to consider:

1. Fund Fees

When it comes to truly understanding the cost of your investments, it’s hard enough for the professionals to do, let alone the general public. There are many hidden costs that lie beneath the surface – here they are (average):

1. Expense ratio – 0.90% pa

This covers marketing and distribution cost, as well as the management of the portfolio. Typically, this is the only fee investors are aware of.

2. Transaction costs – 1.44% pa

Typically investment managers buy and sell frequently. And with these transactions comes transaction fees. There are three types of transaction costs: 1) brokerage, 2) market impact, and 3) spread.

3. Cash drag – 0.83% pa

This is the portion of your portfolio that is invested in cash. It hurts your return over the long-term because of the missed opportunities in the market.

5. Taxes – 1.00% pa

When you by into a fund, sometimes you’re being taxed for other investors’ gains.

The total of these fees can be as high as 4.17% pa. Although on face value these fees don’t seem high at all, when you compound these costs over long periods of time, it will blow your mind. The above list didn’t even include performance fees!

Here’s what happens when you invest $100,000 into the market with a 7% pa return. The compounding value over 50 years is almost $3,000,000! Let’s start deducting some fees from this return – here’s what you’re left with when you take 1% and 2% in fees:

Even a small number like 2%, compounded over a long period of time, can lead to financial ruin. Jack Bogle, the founder of Vanguard once said:

You put up 100% of the capital, you took 100% of the risk, and you got 33% of the return!

2. Chasing Performance

Forget fees. Just invest in the top performing funds, or sell before the market falls and buy before the market rises (market timing). Easier said that done.

A) Chasing the top performers

Over the last 15 years, almost 80% of all Australian fund managers have failed to beat the broad Australian share index. And after 15 years, only 56% of Australian find managers survived.

Over the last 15 years, almost 90% of all international fund managers failed to beat the broad international share index. And after 15 years, only 46% of international fund managers survived.

B) Timing the market

Researchers Richard Bauer and Julie Dahlquist examined more than a million market-timing sequences from 1926 to 1999. Their research concluded that by just holding the broad market index outperformed more than 80% of market-timing strategies.

Clearly, neither of these strategies put the odds firmly in your favour. In fact, they’re akin to gambling more than anything. Making money in the markets is tough. So if you can’t beat the market by hiring the best, what to the the real experts recommend you do?

3. The Advice

Making money in the markets is tough. The brilliant trader and investor Bernard Baruch put it well when he said:

If you are ready to give up everything else and study the whole industry and background of the market and all principal companies whose stocks are on the board as carefully as a medical student studies anatomy – if you can do all that and in addition you have the cool nerves of a gambler, the sixth sense of a clairvoyant and the courage of a lion, you have a ghost of a chance.

Jack Bogle says understand that what appears to be success in financial markets could just be dumb luck:

If you pack 1,024 gorillas in a gymnasium and teach them each to flip a coin, one of them will flip heads ten times in a row. Most would call that luck, but when it happens in the fund business, we call him a genius!

Warren Buffett wrote this in his 2013 letter to Berkshire Hathaway shareholders:

My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers

He even made a bet in 2008 and put his money where his mouth was. You can read my note about it here.

It’s super important to know that not all costs are bad. The right financial adviser can help you make better decisions over the long-term to save you money. Vanguard recently published a study to help quantify the value of a good adviser.

1. Suitable asset allocation – 0.75% pa

2. Cost effective implementation – 0.70% pa

3. Rebalancing portfolio – 0.37% pa

4. Behavioural coaching – 1.50% pa

Total – 3.32% pa of value added

This does not include any other benefits or value of a good financial adviser, such as strategic and structural advice. Compound that and see what your portfolio looks like.

Next time you pick up your investment portfolio statement, think twice about what you’re doing. Are you 100% sure the financial odds are firmly in your favour? Fees are the silent killer in your portfolio, and only a handful of funds beat the market consistently and over the long-term, and much of this can be attributed to randomness.

Being in the market, while minimising costs, can empower you to getting the real financial freedom you deserve.

Source: Forbes – The real cost of owning a mutual fund 2011, Visual Capitalist, Vanguard, SPIVA, Berkshire Hathaway Shareholder Letter 2013

A Text From a Real Estate Agent – Here’s What it Said

Each Saturday afternoon between 2:30 and 3:30 pm, I receive a text message from a real estate agent who provides his distribution list with an update of how the day went. Last Saturday, his tune completely changed, which intrigued me. Here’s the text:

I commend him for his honesty – well done. And it’s true. Clearance rates have been falling sharply since mid 2017 (see below chart).

Source: AMP

Clearance rates have dropped from a solid 80% to about ~46% (final) in Sydney, and ~49% (final) in Melbourne. The last time we saw these levels were back during the GFC and 2012 (when interest rates were first cut).

Here’s what the auction market looked like last week:

Source: Core Logic

Allow me to give you insight as to the implications (at least historically) of falling clearance rates. They’re a leading indicator for house prices by about 5 months (see chart below). As auction clearance rates fall, we see property prices fall in the following months.

Source: JP Morgan

Not only are clearance rates a leading indicator, so too are housing finance commitments (loans). These have also been falling (see chart below). Loan commitments are a leading indicator by about the same time as clearance rates – 6 months.

Source: JP Morgan

As the regulators and banks tighten lending standards, as we continue to see a rise in the supply of dwellings, as affordability is still an issue given low wage growth, and with the constant drumming of political and policy uncertainty (negative gearing and CGT discount), we can expect further weakness ahead.

As I began to write this note, I found out that 60 Minutes was airing ‘Bricks and Slaughter’ at 8:30 pm (click here for the ‘Part One’ episode).

The episode was basically calling for a housing crash. Martin North of Digital Finance Analytics predicts a housing crash of 40%-45% within the next 12 months, and we hear Louis Christopher of SQM Research echoing Mr North’s call.

Follow these gentlemen on Twitter and you will see a slightly different point of view:


Well done 60 Minutes in fear-mongering the Australian public.

To this day, we continue to hear comparisons being made to the US property bubble. What most people don’t understand is that the “housing market” is made up many other smaller ‘markets’. To illustrate this point, take a look at the table below. It shows the top 10 US cities’ boom from 1996-2006, crash from 2006-2011, and so on.

Take a look at New York, up 173% during the boom, and down 24.45% during the bust. Dallas was down 7.53%, and Boston down 16.38%. The interesting thing about all of this is that the city with this largest gain (LA) was not the city with the largest fall – it was Phoenix, down almost 55%! On average, the US housing market fell 33%.

One fact that I don’t believe gets enough showtime is the oversupply of dwellings in the US pre GFC. Leading up to the GFC, the US had overbuild close to 6,000,000 units of housing. As of the beginning of 2018, the US is sitting close to 2,000,000 units short (see below chart).

In Australia, we have a very different story (see below chart). For many years, we have never truly caught up to the demand for dwellings. Having said this though, we are getting to a point where we are now seeing good supply hit the market.

Source: NAB

The Australian, specifically Melbourne and Sydney property market has been running hot for a number of years now. We will see a collapse in prices – timing and magnitude, no one truly knows. However all indicators are pointing to a slow down and natural correction.

The fundamentals for property in this country remain strong, yet the sentiment remains weak. The market will present buying opportunities for those that are patient, disciplined, have a game plan and are cashed up. As foolish as one may feel for holding funds in low returning cash and term deposits, the tide will turn, and you too will have your opportunity.

A Bear Market is Just Around The Corner (or is it?)

You’d be totally forgiven for thinking no more of what a bad economy and market looks and feels like. I mean, how could you not?

Consumer confidence is the highest it’s been for a number of years, and well ahead of GFC lows:

Australia Consumer Confidence

We’re spending more:

Australia Consumer Spending

We’re saving less:

Australia Household Saving Ratio

We’re earning more money since the GFC:

Australia Average Weekly Wages

And of course, the stock market…say no more:

World stock markets continue to make all time highs. The current bull market (as defined as a 20%+ increase in the market) has lasted 3,255 days, which in fact is the second longest on record behind the 4,494 day bull market that ran from late 1987 through to the early 2000. The market climbed 13 years without a single decline of 20% or more.

If this bull market was going to topple the record of the 1987 bull market, we’d see our stock market continue to climb until the 19th of June 2021. Hard to imagine right? It’s not as if it hasn’t happened before!

Here’s a chart of both bull and bear markets since 1926. It shows the number of days both bull and bear markets have lasted. A couple of things to note: 1) Bull markets last longer than bear markets (I mean, a lot longer!) – the average bull market has lasted 981 days, and the average bear market has lasted 296 days, and 2) Bull/bear market cycles have been lasting longer since WW2.

Source: BIG

Let’s dig a little deeper into the post WW2 period. The chart below shows all the bull (in green) and bear (in red) markets, when they started, ended, the percentage change, and number of days they lasted. The average bull market was up 152.4% and lasted 1,651 days, with the average bear market falling 31.8% and lasting 362 days.

Source: BIG

Meanwhile, pundits have been calling for the mark top since 2012. I want you to read these comments, seriously, read them. And next time you hear or see another attention grabbing headline about the market, I want you to recall this post. Here’s a summary of the commentary since (click for larger image):

Market All Time Highs (ATH) doesn’t necessarily mean the market will crash. Here are the number of ATHs each year since 1929. The year 1995 set the record with 77 ATHs, 1964 recording 65, and 2017 notching up 62. The year 2017 is sitting in third place with the number of ATHs in any given year. Presently, the year 2018 is in 27th place, with four months to go in the year – anything could happen.

No one knows how long this market will continue to run hot. No one knows when the market will collapse either.

What you can and should do however, is design your portfolio as if the market will collapse tomorrow. Because someday, maybe sooner rather than later, the market will collapse tomorrow. And you will exhibit precisely the same behaviour as you did in 2008. You will have forgotten how you behaved, however you will remember exactly how it felt. Your human mind will switch to ‘fight-or-flight’ mode, and you will either destroy a lifetime of savings, or you could create a lifetime of savings – the choice is yours.

As long as the music keeps playing, we’ll all continue to dance, until it stops.

Property Prices Doubling Every 10 Years is a Myth, Here’s Why

There’s an old saying in Australia, property prices double every 10 years.

How true is this old saying? I was recently presenting financial analysis we had undertaken for a property portfolio. As we presented our findings, our assumed rates of return were questioned – why would you use such a low rate of return – historically property prices have double every 10 years?

Let’s jump down this rabbit hole.

We Aussie’s have an obsession over property. I get it, I love my property too and have also been lucky enough to be a beneficiary of this market. I will however be the first person to admit that it was through no skill whatsoever, nor did I anticipate to what extent this market would rise when I initially invested in property. My decisions are driven with specific objectives – a roof over my family’s head, investment properties in specific locations for income and future development potential to help my kids in the future, a beach house to get away from the hustle and bustle and spend time with my family. What I do with any of my properties are unlikely to be be influenced by what the market is doing, nor by what the market believes my property is worth. In fact I couldn’t care less.

Yet so many people have the equation so wrong – speculating on the price of land on the basis that property doubles every 10 years. Allow me to let you in on a little secret – the concept of property values doubling every 10 years is completely misleading. Don’t believe me? I’ve crunched the numbers, and here’s what I think.

I’ve summarised the return of the Melbourne property market for every decade beginning 1980 in the table below (median price). For example, for ten years ending 1990, the growth in the median price of Melbourne property was 237.93% – ridiculous, right!?

Table 1: Nominal 10 Year Return

Source: REIA, Core Logic

Based on the above table, I can understand why you may have been told (and believed) that property prices double every ten years – both the average and median percentage return for price rises have been over 100% since 1980.

Let’s take a look at what happens when you take into account inflation. The table below is the same as above, and I have calculated the Real Rate of Return in the third column. Take a look at the example we looked at earlier. The nominal (before inflation) return from 1980 to 1990 was 237%. When you take into account inflation, or the real return for the same period, was 55.06%. Although this is still a solid return, its certainly a far cry from 237%.

Table 2: Nominal & Real 10 Year Return

Source: REIA, Core Logic

Once you take inflation into account, the average and median ten year real return is 50.24% and 44.14% respectively.

Even though in Table 1 the average and median price rises are in excess of 100%, prices only increased more than 100%, 55% of the time – 45% of the time, prices did not double. Once you take inflation into account, since 1980, Melbourne median property prices have not double. Ever. During the decade ending 2005 they came close, returning 92.58%.

Now that we have established that real property prices don’t double every ten years (although my guess is that there will still be those who don’t believe me, and if this is you, reach out to me – we can chat further), I decided to analyse Melbourne’s rolling ten year real returns per annum. In other words, what was the real rate of return each year for every decade since 1940. For example, let’s say you purchased a Melbourne property in 1940 and held it for ten years, your actual real rate of return was about 9% pa. If you held property for ten years ending 1960, your annual return was a bit over 10% pa. If you held property for ten years ending 1987, your annual real return was 0% – yes, property can not grow in real terms.

The average annual real (after inflation) return for those holding property for ten years was about 4% pa since 1940 (ending 1950).

Here’s the chart. The blue line represents the return, the green dotted line is that average annual return, and the red dotted lines represent +/-1 and +/-2 standard deviation from the average.

Table 3 – Real Melbourne 10 year Rolling Growth (pa)

Source: Stapledon, ABS

What we can also see from the above chart, is that property goes through cycles – who would have thought!? Periods of high growth are followed by periods of low growth, and periods of low growth are followed by periods of high growth.

Where does this leave housing as an investment?

This is probably one of my favourite charts. It’s put together by Shane Oliver of AMP Capital and compares the long-term return of Australian residential property, Australian shares, Australian bonds, and Australian cash.

Source: AMP Capital

Since 1926 residential property has provided investors with a similar return to Australian shares – 11.1% pa to 11.5% pa.

As you can see from the above chart is that although Australian shares have performed slightly better, they have come with higher volatility. They are more liquid and easier to diversify, whereas property has been less volatile (partly because it’s not valued every single second of the day – unlike the share market), it is less liquid and harder to diversify.

Both shares and property have rewarded long term investors. In fact, shares and property tend to have low correlations with each other, meaning they typically don’t go up and down at the same time and at the same magnitude. Therefore, from a diversification point of view, there is a very strong case to hold both in your portfolio for the long-term.

I guess anyone can fudge the numbers to support whatever narrative they’re peddling. At the end of the day, the facts are the facts. You deserve to know the truth, it helps you manage your own expectations and make better investment decisions. Just because property prices haven’t doubled every ten years, doesn’t mean they won’t.

Godspeed.

The Most Expensive Game of Golf You’ve Ever Played

Last week I wrote an article on investing following a speeding infringement. I received quite a number of positive responses to this note – thank you. I also received a number of questions on the concept I talked about in my blog, that is, compound interest and market timing. I touched on this topic a little while back, but let me give it another go.

Have you ever played golf and placed a bet on each hole? You know, everyone places a small amount of money on each hole, and the winner on each hole takes the lot? Pretty simple, and a bit of fun. Have you ever played this game whilst doubling the amount of money you bet on each hole? Not a big deal…start with 10 cents a hole, and double this amount for 18 holes. Any idea what the number is on the 18th hole? Before reading any further, just take a guess, quickly, don’t take too long!

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.

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.

.

.

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$13,107.20! Ridiculous, right!?

How on earth does this happen I hear you ask? Here’s the above table in a chart.

Notice how nothing happens for a long time, the all of a sudden, BOOM, the amount explodes. This my friends is compound investing – the eighth wonder of the world.

If you think that all you need to know is which way the stock market is going in order to make money, think again. Talk to any successful business owner or investor, it’s more about being disciplined, having a game plan, and taking the long view.

Meet John – he’s the world’s greatest stock picker. He only buys when the stock market index is trading at 52-week lows, and assuming they are 17% below his last purchase. Meet Jane – she’s the world’s worst stock picker. She invests $2,000 only at market peaks beginning in 1970, when she’s 22 years of age. She increases her investment by $2,000 per decade – $4,000 per year during the 80’s, $6,000 a year during the 90’s etc. She retires at age 65.

The results? Hands down winner is John, right? The results of this experiment (thanks to Ben Carlson) may surprise you. John does quite well, as you would expect. But the results are very similar. You’d think John’s portfolio would be multiples of Jane’s as he was buying at market lows, and Jane at market highs, however this is not the case. Why? Compound interest.

Jump on any online calculator and calculate the capitalised interest on a 30 year loan. It’s okay, I’ve done for you. A $500,000 loan, with an interest rate of 5%, accumulates interest of $966,279.60. Think about that for a second – that’s only the interest. Imagine compounding capital and interest on your stock investment! The reason John misses out on the benefit of compounding, is because he’s out of the market for long periods of time. Carlson clearly states in his analysis, “Short-term moves in and out of the market don’t matter nearly as much if you have a long-time horizon. Thinking long-term increases your probability for success in the stock market while the day-to-day noise gets drowned out by discipline and compound interest.”

The strategy is so simple, requires no insight into the future, yet it is so powerful, and actually exists – unlike the perfect market timer. The catch? It takes a long time, and it’s b-o-r-i-n-g! The irony is however, that the group of people who have the greatest capacity to absorb the market’s volatility, are the same group of people who seem to be the least interested in it.

Here’s What Vikings And Investing Have in Common

On Saturday afternoon I visited the Vikings exhibition at Melbourne Museum. Over 450 artefacts were on display, making it the largest collection of it’s kind in Melbourne, and boy was it packed! Two things I learned from the exhibition:

1) Vikings’ swords weren’t that heavy, and

2) The importance of silver during trade.

This precious metal became such an important component of trade during the Viking period. Silver coins and ingots were used to balance transactions. Vikings would carry around their own set of small scales to ensure each transaction they entered into was measured accurately and precisely, and the transaction was completed fairly and that they weren’t being cheated.

When I look through the funds that have been used to construct a portfolio for individuals, families, and/or superannuation funds, I am always stumped by the high fees that are being paid by investors.

In business, there’s an old saying, you need to spend money to make money. When it comes to investing however, the more money you pay, history tells us that it has an adverse effect on what you have left in your pocket. Don’t get me wrong, every investment has a cost, even though it may seem as though you’re not paying anything. I recall being told by one “wealth management” firm, their fee to trade international shares for their clients was nil…NIL!? (I wasn’t aware you were a charity). After we did some digging around, we uncovered the firm would take a large clip from the foreign currency exchange. Sure, the brokerage was nil, but unless you understand how these things work, on face value it may seem as though you’re not paying anything.

Most people don’t evaluate the expenses incurred in managing their investments within their portfolio. When you understand how investment fees can dramatically reduce your returns, and when you understand how fees are a strong predictor of future returns, investors should spend more time in evaluating their investment fee.

Why costs matter 1

Sure, 0.50% here, 0.25% there, it doesn’t sound like much over the course of a year, but when you compound this number over long periods of time, it could mean the difference between retiring at age 65 instead of 69.

The impact of fees is two fold. Not only do you lose the annual fees you pay each year, you also lose the growth that money may have had for future years into the future.

To illustrate the significance of fees on an investment, I plotted the below chart, which shows 4 portfolios. Each earning 6% pa, and each invested over a 30 year period. Each portfolio has an internal fee of 1%, 2%, 3%, and 4% respectively.

As you can see, over long periods of time, the net result to the investor is significant. And if for one second you think a 4% pa fee on an investment is unrealistic, just think hedge fund.

Why costs matter 2

You’d be forgiven for thinking that the higher the fee, the higher the quality of the manager. This could not be further from the truth. Research on managed investments has shown that higher costing funds generally under perform lower costing funds. The more one charges, the more difficult it becomes to add enough value to overcome the additional expense.

Research by Vanguard illustrates funds with lower costs have outperformed more expensive ones.:

 

Nobel Laureate William Sharpe once said:

 

 

“the smaller a fund’s expense ration (cost), the better the results obtained by it’s stock holders”

The Australian Securities and Investment Commission (ASIC) in 2017 made changes to Regulatory Guide 97 which forced funds to disclose more information about their fees. Now, disclosure documents issued by investment managers should provide greater transparency to investors in order to help them make a more informed decision.

In my personal and professional opinion, your portfolios’ investment fees should not exceed 0.50% pa, in fact, you could probably get it down to as low as 0.30% pa for a properly diversified portfolio.

There’s an old Chinese proverb that says, If the river is too clean, you will catch no fish.” Meaning, by being too transparent you will not win new business. There are many different kinds of costs when it comes to the world if investments, but they all have one thing in common: If the money is going somewhere else, it’s not going to you.

Like the Vikings, maybe investors should be carrying around their own set of scales.

We’re Headed For Another Recession & You Have No Idea What Will Happen

Daniel Kahneman once said,

“The idea that the future is unpredictable is undermined every day by the ease with which the past is explained.”

As investors, in fact as human beings, we’re constantly fighting the last war. In other words, we overweight recent events when we make judgment on the probability of an uncertain future event. We simply extrapolate the most recent event indefinitely into the future.

Think about the most recent economic decline, investors we’re running for the exits with the view that the ‘things we’re going to get worse’. The financial crisis of 2007/2008 was one of the most painful experiences in almost a century, yet it only lasted 18 months. I know plenty of investors who retreated at possibly the worst time, and were left hanging out to dry after the market bounced off the bottom, waiting for ‘the right time to get back in’.

Contrast this to how the market has been performing since the bottom of the GFC (March 2009), we have witnessed one of the longest recoveries in history, as illustrated in the chart below. This is probably one of my favourite charts – Bull markets since 1950 in measure in both duration and magnitude.

I know plenty of investors who have either bought back in after they had sold out at the worst time, or have been redeploying cash because they believe the market will continue it’s stellar performance.

Source: Yahoo Finance

Investor’s not only extrapolate the most recent events, but also try to plan ahead for the next GFC and how they’re going to deal with it, and it causes investors to shift their tolerance for risk at precisely the wrong time. If  you’re worried about a 10% correction in the stock market, stocks are not a place for you. Unfortunately for investors, no two market cycles are ever quite the same, so studying the last crisis is unlikely to prepare you for the next. Studying how you behaved during the last crisis on the other hand, may be quite beneficial.

Financial markets never follow the exact same route more than once, yet human behaviour follows precisely the same route, each and every time. Here’s a great, simple 30 minute animated video by Ray Dalio, on how the economy works. It’s probably one of the best videos on the economy I’ve seen.

The timing, the impact, and the duration of recessions are all different. Here is every US recession going back to the Great Depression along with the corresponding stock market performance.

 

Source: National Bureau of Economic Research, Ben Carlson

Even if you knew when the next recession was going to hit, the duration, and the impact it would have on the economy, it’s unlikely you would be able to profit from it. The stock market’s performance during each of these recessions would surprise most investors. This is one of the reasons why you can’t ‘wait for things to get better’ before investing – the stock market is a forward looking machine, not backward.

On average the stock market:

  • Has been up during a recession
  • Has been up 6 months prior to a recession
  • Has returned over 20%, 12 months after a recession has ended
  • Has returned over 52%, 3 years after a recession has ended
  • Has returned over 85%, 5 years after a recession has ended

By the way, we don’t need a crisis or a recession to see the stock market go down. Here’s 13 instances where the stock market has fallen 10% or more without a recession:

Source: Stocks for the Long Run, Ben Carlson

Paul Samuelson once said,

“The stock market has predicted nine out of the last five recessions.”

Next time you find yourself captivated by the alarming predictions made by the guy or gal on the television, in the paper or on Twitter, please remember this: More money is lost in trying to anticipate a collapse in the stock market than the collapse itself.

Probabilities Versus Predictions

Last week, South Korea stunned the football world by knocking out World Cup favourites Germany. In an astonishing finish, South Korea kicked two goals within minutes of the final whistle during extra time, in one of the biggest upsets in the sport’s history. Why? Because Germany were expected to take out the 2018 Fifa World Cup.

Here’s the 2 minute wrap up of the match courtesy of SBS:

It wasn’t only the football world who expected the German’s to take the cup home, it was also the expectation of UBS’ analytical team who ran complicated statistical models to place probabilities on all nations competing in the World Cup. Here’s the report if you’re curious.

Following Germany’s loss to South Korea, UBS have been copping criticism from journalists and social media trolls, about their inability to predict or forecast the future. Individuals’ and companies’ inability to forecast the future is well documented and certainly not news to anyone that studies the market, no matter how sophisticated they are or their technology is.

Let’s get one thing clear, UBS nor any of the other investment banks “predicted” Germany would win the World Cup. They simply applied a 24% probability of winning, in other words, a 76% probability of not winning – there is a huge difference.

“We are humble enough not to outright claim that Germany will win the tournament again, but our simulations indicate there is no other team with higher odds to lift the trophy than the defending champion.” – UBS (emphasis mine)

As nerdy and as absurd as this analysis may seem, what else do you have to rely on? Your gut feel? The tip your taxi driver gave you? Your “expert” football mate? I’ll take the odds thank you very much.

This is exactly how casino’s work. Their gaming systems are all designed to ensure the odds are firmly in their favour. Sure, you may win, and you may even win big, which is why you keep playing – but the odds are slim. And if you keep playing for long enough, you will eventually lose.

And when it comes to investing, investors seem to throw the odds out the window and prefer to play a very different game. One that is akin to the gambler at the roulette table. One where investment professionals try to outguess prices established by the collective wisdom of millions of different buyers and sellers each and every day.

Investors may be surprised by:

1) The number of investment funds that become obsolete over time, and

2) The low percentage of funds that are able to outperform their benchmark.

The chart below shows the sample number of funds that existed as at 31 December 2017, the number of funds that survived, and the number of funds that outperformed their benchmark. For example, 5 years ending 31 December 2017 (from 31 December 2012), there were 2,867 sample funds, of which 82% survived the 5 years, and only 26% were able to outperform their benchmark.

Source: Dimensional Fund Advisers (DFA)

Both survival and out-performance rates fall as the time horizon expands. For 15 years ending 31 December 2017, only 14% of funds survived and outperformed their benchmark. The odds of this game don’t seem very compelling if you ask me.

Let’s say you’ve found a manager who’s been able to outperform their benchmark for the last 3 years, and you’ve decided to hire them. Most investors and advisers use this method of manager selection, reasoning that a fund manager’s past success is likely to continue into the future – sack the poor performers, and hire the strong performers is how the narrative goes. The evidence suggests the contrary.

The chart below shows that among funds ranked in the top quartile (25%) based on previous three-year returns, most of them did not repeat their top-quartile ranking over the following. Over the periods studied, top-quartile persistence of three-year performers averaged 26%.

Source: DFA

The assumption that strong past performance will continue often proves faulty, leaving many investors disappointed. And despite all the evidence, investors continue to search for the winning investment – taking far greater risks than they ever expected.

Imagine for one second you could invest like the casinos. Putting the odds of success firmly in your favour the longer you play the game. As investors, we need to consider more than just a compelling story, and more than just good past performance. You may choose to ignore the evidence. You may choose to take on the odds. You may choose to ignore probabilities and make decisions based on predictions. Now that Paul the octopus is no longer with us, you may as well ask Achilles the cat for stock tips.