Thursday, April 7, 2011

An understanding of your brain functioning could improve your investment performance.

From Your Money and Your Brain, by Jason Zweig, writer for the Wall Street Journal.

In the book, Jason introduces the reader to the field of Neuroeconomics -the combination of imaging technology and psychological studies that have lead scientists to better understand humans reactions to risk. It explains why our investing brains often drive us to do things that do not make logical sense but make perfect emotional sense. Our brains were developed to survive - to react to risk. Our logical brain is no match for our reactive, risk protecting brain.

Scientists have found:

* Monetary gain or loss has a profound physical effect on the brain and body.
* The neural activity of someone making money is indistinguishable from that of someone high on cocaine.
* Financial losses are processed in the same areas of the brain that responds to mortal danger.
* Once people believe that an investment return is "predictable" their brains respond with alarm if the pattern is broken.

The key for investors and investment professionals is to understand the above psychological effects and better manage them. Many recent supporting studies indicate that the average investor severely under performs market benchmarks because of these effects.

Sunday, March 13, 2011

Think you can invest without help? Think again.

The 2010 DALBAR report: the Quantitative Analysis of Investor Behavior (QAIB) has recently been issued.

DALBAR is a third party analyzer of the financial services industry. They have been analyzing investor behavior for almost 2 decades.

This years report indicates that the average equity investor outperformed the S&P 500 in 2009, and the average bond investor did better than the Barclays Aggregate Bond Index in 2009.

That is the good news. The bad news is that over the 20 year period ending 12/31/2009 the average equity investor's return of 3.17% was well below the S&P 500 20 yr return of 8.20%. As well, the average bond investor returned 1.02% over 20 yrs compared to the index return of 7.01%

The numbers are dramatic and many, including DALBAR, conclude that investors do not buy and hold. They become irrational and buy and sell at the wrong times.

The same conclusion was reached in a study, highlighted in a recent NY Times story, by Philip Maymim , a professor of finance and risk engineering at Polytechnic Institute of New York University. Professor Maymim found that the value of an investment advisor is not in the stocks or mutual funds they recommend but in their ability to prevent an investor from impulsively trading at the wrong time.

I would also add that a good advisor starts by placing the investor in the appropriate portfolio for their risk tolerance and time horizon, then hold their hand and keep them on course.


It most cases it will pay for investors to find an advisor they can trust. I recommend an independent fee-only advisor who has no conflicts of interest from commissions and who has a good understanding of market history and investor behavior.



Sunday, March 6, 2011

AWM analysis of weighting of US/International Stocks

I recently had my University of Buffalo graduate student of financial engineering, Shwetha Narayan Iyengar complete an analysis on the diversification effect of adding international stock to a stock portfolio.

The study summarized below is not a recommendation , rather it shows how adding international stocks can reduce overall risk and improve return.

There is debate on how much non-us stock should be in stock portfolio. The results do seem to support those that argue that investors should hold stocks in proportion to their weighting in the mix of all stocks issued by all nations. The US currently makes up about 45% of the global capital market.

Keep in mind that this analysis does not include emerging markets or factor in value or small cap effects. It does support a diversification into international stocks when building your stock portfolio.

The summary:

Analysis of total US market vis-à-vis the other developed markets in a portfolio.

The CRSP 1-10 Index represents the total US cap weighted equity market. It measures the performance of all stocks aggregated across NYSE, AMEX and NASDAQ markets, spilt in deciles from large cap to small cap. MSCI EAFE index measures the equity market performance of developed markets outside of the U.S. & Canada and includes Europe, Australia, New Zealand (Australasia) and Middle East

Annualized returns and Standard deviation (measure of risk/volatility) for CRSP and EAFE for a period from 1970- 2010 are as provided below,

Annualized

Returns

STD deviation

CRSP1-10

9.88%

16.13%

EAFE

9.94%

17.25%

Portfolio with 45/55 ratio of CRSP 1-10/EAFE gives the highest return for risk ratio (Sharpe ratio) and to further validate, a Monte -Carlo simulation value averaged over 3 independent simulations provides a higher value at 90 percentile or 10% probability of going above the value. (Monte Carlo is a statistical tool that will estimate probable outcomes for a particular set of risk and return inputs)

Weights

CRSP1-10

55%

60%

65%

70%

75%

80%

85%

EAFE

45%

40%

35%

30%

25%

20%

15%

Return Portfolio

10.196%

10.185%

10.168%

10.145%

10.116%

10.081%

10.040%

Std deviation Portfolio

14.910%

14.899%

14.926%

14.989%

15.089%

15.226%

15.400%

Sharpe ratio

0.311938

0.311430

0.309728

0.306892

0.302936

0.297911

0.291883

Wealth at retirement (90-percentile) from Monte Carlo simulation

Scenario 1

$4,893,889

$4,590,990

$4,450,640

$4,763,008

$4,428,423

$4,755,993

$4,338,645

Scenario 2

$4,593,936

$4,237,107

$4,514,705

$4,570,777

$ 4,709,112

$4,748,913

$ 4,483,666

Scenario 3

$4,610,162

$4,517,348

$ 4,627,469

$4,369,035

$ 4,385,526

$ 4308,407

$ 4,631,853

Average, Wealth at retirement (90-percentile) MonteCarlo simulation

$4,699,329

$4,448,482

$4,530,938

$ 4,567,607

$ 4,507,687

$4,604,438

$ 4,484,721

The most optimum scenario is 55/45 portfolio. A higher weighting of CRSP 1-10 reduces the Sharpe ratio, the return and the final value of the portfolio. If the analysis is expanded using higher weights for the MSCI EAFE and lower weight for CRSP 1-10 , the result does not vary much and the most optimum portfolio still remains as 55/45 .

Saturday, February 19, 2011

Start saving and planning before its too late: WSJ 2/19/2011

In my financial planning practice, I am constantly working with clients who are not prepared for retirement. This WSJ article paints a good picture of the average American approaching retirement:

http://online.wsj.com/article/SB10001424052748703959604576152792748707356.html?mod=ITP_pageone_0


Monday, February 14, 2011

Monte Carlo and Your Probabilty of Success

Are You saving enough for retirement?

How much can you withdraw from your retirement portfolio?

Does your retirement plan give you a probability of success?

A retirement savings/investment plan should take into account how much you are saving, how that money is invested, and what your spending will be in retirement.

Planners often use the above mentioned factors along with a probability simulator (known as a Monte Carlo Simulator) to determine your chance of success in retirement. When the probability is low, adjustments need to be made.

Monte Carlo simulators have been around since World War II, and with the power of personal computers, it is available to financial planners. Monte Carlo will use the historical risk and return characteristics of your investment portfolio , combined with your anticipated withdrawals, and simulate 10,000 different possibilities in order to give probabilities of success.

Monte Carlo will produce outcomes much different than assuming your money will grow at a constant return. Constant returns do not occur in the real world. Investors do not receive a constant 7% or 8% on their investment portfolio. One year they may be up 12%, the next down 3% etc. Over time, the average may be 7% but the ups and downs result in very different outcomes, especially when one is withdrawing money every year from the portfolio.

Years of study by academics and financial planners using monte carlo analysis has shown that withdrawing more than 4% per year out of a 50% stock/50% bond portfolio could result in a retiree running out of money before he/she dies.

This topic is an important area of study for planners for obvious reasons. telling a client that they can spend more per year than they can afford is disastrous. A simple rule is offered by William Bernstein in his book “The Investor’s Manifesto”

“At a 2 percent withdrawal rate, your nest egg will survive all but catastrophic institutional and military collapse; at 3 percent, you are probably safe; at 4 percent you are taking real chances; and at 5 percent and beyond you should consider annuitizing most, if not all, of your nest egg,”

What Bernstein means by annuitizing at 5% and beyond is that if you need to withdraw more than 5% from your retirement portfolio you may want to purchase an immediate fixed annuity. This is an insurance product, where you turn over your portfolio to an insurance company and they guarantee you a fixed monthly payment for life. Even in today’s low rate environment, one can purchase annuities at 6% returns.The trade off is that you lose access to your nest egg. If you die 2 months after you purchase the annuity, the insurance company keeps your money.

Canadian planner and author of “Unveiling the Retirement Myth,” Jim C. Otar, who uses historical returns to generate his data, specifies 3.8% as the max withdrawal rate from a diversified stock/bond portfolio.

Finally, an October 2007 Journal of Financial Planning article by three professors from the State University of New York at Brockport confirms the above discussion. They use Monte Carlo to create safe withdrawal rates for different stock/bond allocations. Once again, withdrawal rates exceeding 4% in a 50% stock/50%bond portfolio show increasing fail rates.

The important point in all the analysis is that there is no investment magic that will allow a retiree to withdraw more than 4% per year and not risk running out of money in retirement. That is why it is important to develop a savings plan before retirement in order to build enough savings so that you can live the lifestyle you want in retirement.

Wednesday, February 2, 2011

Two Short Practical Books

I have recently read two wonderful books that are extremely valuable for anyone concerned about saving and retirement.

The first: : "The Investment Answer" is only 56 pages yet filled with decades of investing wisdom. In the book, the authors clearly explain investment theory for the layman. This book is a labor of love. It was co-author, Gordon Murray's, dying message to investors after working on Wall St for 25 years. He wanted to give the world the benefit of his insight before dying from brain cancer. Below is a link to a NYT article profiling the authors: Daniel C. Goldie, and Gordon S. Murray.


The second book, "Can I Retire" by Mike Piper runs exactly 100 pages and deals with the nuts and bolts concerning how much one may need to have saved in order to retire, social security, IRAs, investing, and taxes during retirement. Mike Piper has written a practical guide that will benefit anyone who is concerned about effectively managing their retirement.

Both books are written for the average person with little or no financial background. They will educate and possibly help one make decisions that could benefit them in real dollars exceeding thousands per year.

Monday, January 31, 2011

Money Magazine interview with Jack Bogle

In the link below, the Vanguard founder expands on his 2 simple rules:
1.Ignore Fads
2. Stop trying to beat the market


Bogle is one of the most respected men in the investment and mutual fund industry. His books and interviews have taught me a great deal. I recommend his books and articles. He is an advocate for the average investor and he writes so that the average investor can understand and learn.