In a Financial Planning article titled “Investing Should Be Painful,” founder of research firm Wealth Logic, LLC Alan Roth writes, “I suggest telling clients to embrace the pain and take it as a good sign.” This approach reflects insights from psychology and behavioral finance. The “pain” Roth is referring to comes from going against the cognitive biases of the human brain. Borrowing from Nobel Laureate Daniel Kahneman and others, Roth describes the more automatic and emotional “system 1” thinking (in contrast to the slower, more effortful and logical “system 2” thinking) as the source of the pain investors feel when buying as prices plummet or selling as they near their summit. Roth admits he is not immune: “financial theorist William Berstein described my feelings perfectly when he told me the best financial moves he has made typically occurred when he wanted to throw up.”
Roth highlights concepts such as “recency bias” (expecting the recent past to continue) and the “herding effect” (“we all like to believe we are contrarians . . . we are herd animals”) and notes that the emotion-laden “system 1” often fools us into believing we are being logical. He tells investment advisors that to apply these insights for clients in late 2008 and early 2009, “I asked if they thought it was more logical to buy or sell stocks after a half-price sale.”
Roth reminds us that “System 1 typically prevails in investing . . . we buy more stock funds near the top price and sell more near the bottom.” Bucking this tendency, Roth writes, requires “working through the pain.” He suggests: “if we can get our clients to embrace the pain and then apply System 2 thinking, we’d provide sound service to them.”
Sandy Rufenacht, of Aquila Three Peaks, takes an intensive look at companies before investing, looking especially at their free cash flow over the next 12 months and their relationship with debt. The approach seems to be paying off. The Aquilla Three Peaks Opportunity Growth Fund he manages beat 97% of competitors over the past three years, and the Aquilla Three Peaks High Income bond fund has beaten two-thirds of its peers over that period.
Looking at probable free cash flow over the coming year allows Rufenacht to assess how the cash may lift debt covenants and what will be left for equity investors. This does not mean Rufenacht shies away from indebted companies. Instead, he sees leverage as a possible way to increase the company’s potential. Still, he prefers companies with more predictable cash flow and business models, tending to avoid cyclical industries.
Asked what he is optimistic about, Warren Buffett reflects on some key points of progress over his lifetime and suggests some things we might all be thankful for. “If I’d been born 200 years ago my life would have been just a tiny, tiny, tiny fraction of what it is now,” he noted, continuing: “I tell the students [they] are actually living better than John D. Rockefeller Senior lived when I was born.””
Buffett’s optimism persists even where he sees challenges, such as in education: “I think students are generally throughout the world getting a better education, certainly than they did when I was getting my education,” while acknowledging that “we like to say we have equality of opportunity in this country but unless everybody has a shot at a similar education there is no equality of opportunity. We’ve got a long way to go on that.” Asked about deficits, Buffet commented: “Our output per capita goes up year after year. How it gets divided is another matter. But if you look at real GDP per capita it’s six times what it was when I was born.”
Going forward, Buffett suggested, “even at 2% GDP [growth annually] that’s over 1% per capita and in one generation that means the next generation is going to live 25% better than we live per capita in the United States .” Although he acknowledged distributional issues, he also maintained that progress is made on such issues over time in the United States.
Financial Advisor magazine offers up brief predictions by some top fund managers. Ruchir Sharma, of Morgan Stanely, says “We are now just one big shock away from a global downturn, and the next one seems most likely to originate in China.” Yang Zhao, chief economist with Nomura Holdings, seems to disagree: “Is there going to be a hard landing in China? I don’t think so. . . . Should any systemically important financial institutions have any problems, we believe that the government will step up to rescue them.”
Rebecca Patterson, CIO of the Bessemer Trust, discusses the situation in Europe, describing the refugee crisis as “the biggest challenge to the European Union yet” and questioning whether the crisis “could result in political and/or policy shift[s], or simply lead consumers to change their spending patterns.” Jim Vero, of JP Morgan Stanley Latin American Private Bank, discusses Latin America. He sees “a ray of sunshine from Argentina,” and suggests “there will be some very interesting entry points in Latin American assets between now and the end of next year.” Barbara Byrne of Barclays Capitaol, sees “recovery in the prices of natural resources for largely – and critically important—political reasons,” noting the significance of energy resources for Norway and Saudi Arabia.
Thomas Lee of Fundstrat Gobal Advisors predicts “equities are going to do really well in 2016, especially banks and blue chip businesses.” Joseph LaVorgna, chief U.S. economist at Deutche Bank, sees “growth accelerating a bit because it seems like there are reasons that the economy should get better,” but he notes that overall, “the message is ‘more of the same.’”
Several other trends are noted. Mark Haefele of UBD Wealth Management sees investors becoming increasingly interested in “align[ing] their portfolios with their social values.” He points to investment in early-stage cancer research as “an opportunity to earn an attractive long-term return and benefit society.” Alan Patricof of Greycoft Partners warns of “overexuberance in financing of startups,” while Katie Kock of Goldman Sachs Asset Management predicts that “the rise of the millennials will have long-term investment implications.”
Yale’s endowment fund has performed exceptionally well under David Swensen, returning an average of 10% per year since 2005, beating all major stock indexes and all but 2 of Morningstar’s mutual fund categories. Morningstar’s John Rekenthaler suggests that this outperformance comes from Swensen’s unconventional choices, but quickly quickly parrots Swensen’s advice to individual investors: “don’t try this at home.” So what can we learn from Yale’s success?
Rekenthaler identifies a few possible lessons from Yale’s success:
- Illiquid assets can be more profitable;
- Reduce or eliminate bond holdings, if possible;
- Invest with funds run by successful active managers.
Each of these possible lessons, however, comes with a set of caveats that may be the equivalent of “don’t try this at home.” Illiquid assets are hard to identify and invest in as an individual, and funds have not had much success attempting to emulate Swensen’s approach on this point. Fixed-income is a maintstay of a balanced portfolio and finding an alternative is risky. Although Swensen has profited from active managers, he has much better information and access than the individual investor. As Renkenthaler puts it, integrating these ideas is “most appropriate for portfolios with long time horizons, owned by investors who have a relatively high risk tolerance.” He also notes that current market trends may make this a particularly bad time for attempting to apply ideas gleaned from Yale’s success.
A recent article by Cliff Asness and colleagues from AQR Capital Management challenges the academic finance recommendation to avoid attempts to time the market. “Sinning a little,” Asness and colleagues suggest, can boost returns. Among other things, they suggested trimming exposure to stocks in October 2015, as the article went to print, by holding more cash.
The article uses two core factors – valuation, measured by the cyclically adjusted PE (CAPE) factor made known by Rober Shiller, and momentum. Drawing on 115-year data, they found meaningful advantages to timing the market in moderation. The article cautions against extremes, but moderately applying the value-plus-momentum strategy to an equity strategy yielded a “1.2 percentage point increase annually over a buy-and-hold portfolio” over a 115-year period and an annualized 0.8% return for a portfolio of 50/50 in stocks in bonds over that same time frame. In both tests, the strategy also materially reduced risk by lowering the max drawdown results.
Bonnie Baha, head of global developed credit at DoubleLine Capital LP, said “I think there is a high probability of an accident” if the Fed raises rates in 2015. She said that a rate hike would be “like putting your foot on the brake when there’s no gas in the car to begin with,” suggesting it could trigger a “tightening cycle” and the Fed might then have to backtrack.
DoubleLine has a strong record, with its flagship fund beating 97% of peers over one, three, and five years.
Baha said she expects “more of the same but worse” for corporate bond investors in 2016. She said companies are borrowing too much and pointed to energy as particularly problematic. “Right now, to step into this, you’d be catching a falling knife,” she opined. “With oil at $40 a barrel, these people can’t make it . . . At some point there are going to be some bargains out there, but we’re not stepping into that now.” She pointed to closed-end bond funds as a good alternative.