Industry trend analysis informs investment decisions

Biotechnology industry analysis

One of the advantages of incorporating charts into long-term investing analysis is the ability to visualize what has been going on with the stock, index, or ETF over time. Another advantage of using charts and technical analysis when researching long-term portfolio investing is to provide a faster method for finding and selecting stocks.

Using industry and sector index charts is one way of helping to identify where the next generation of growth stocks are likely to be found. The use of the Industry Index chart also helps with decisions regarding mutual funds and other stock investment derivatives such as ETFs. Many investors find that studying industries first by using the index chart can eliminate many of the difficulties in focusing on where to invest.

We use three Super Sector index charts (provided by TC2000, based primarily on Morningstar classifications): Cyclical, Sensitive, and Defensive. There are 11 sectors: Basic Materials, Industrials, Technology, Consumer Cyclical, Financial Services, Real Estate, Consumer Defensive, Health Care, Utilities, Communication Services, and Energy. Each sector is broken down further into specific industries. Some industries have less than 10 companies, while others have hundreds. Choosing an industry that has many companies is often a good place to start.

There are 146 industries within the 11 sectors. One example is Biotechnology, which falls under the Health Care sector and has 486 companies as component stocks. These are listed stocks on the U.S. exchanges. Biotechnology has strong potential for future growth, with newly emerging technologies in many areas of science, the environment, and medicine.

The Biotechnology Index chart provides a wealth of information on how this industry has been performing, and where it is in the industry business cycle. This is a line chart on a monthly scale (Figure 1).


Source: TC2000 chart courtesy of Worden Bros.


Line charts are best for technical analysis of the long-term trend. The chart contains the index value represented as a continuous line, month over month. In addition, it has monthly volume and the cycle indicator known as the detrended price oscillator, which removes the trend from the value chart to reveal the industry cycle.

This Biotechnology industry monthly chart has 28 years of data. Currently, the industry has been in an industry-cycle correction mode. It started in 2015 as the industry cycle peaked with an extreme deviated peak in its cycle. This was due to massive speculative investing and trading in Biotechnology stocks between 2010 and the beginning of 2015.

Stock prices went beyond what was warranted by fundamental values and financials of the companies. Technical analysis warned of the risk of a correction for many stocks in this industry. The correction is still underway, but there is improvement in the recent industry technical patterns. This is due to many bottoming formations that began in 2018 and are completing in 2019. Individual stocks within the industry appear to have quiet “accumulation bottoming,” which will show on individual stock charts first, and then later on the industry chart.

There was an extreme trough pattern followed by a failure to top, and then recently a failure to trough. This means the industry has some companies that are stronger than others. The volume for this industry has been on an upward angle of ascent, even while it has been in a sideways price correction mode. This is due to continued quiet accumulation, likely by buy-side institutions and developers for ETFs.

This chart provides ample information for investors, revealing that this industry should have many stocks that are in a recovery mode, with those bottoming formations developing at this time.

The opinions expressed in this article are those of the author and do not necessarily represent the views of Hilbert Financial Group. These opinions are presented for educational purposes only.

Source: Industry trend analysis informs investment decisions

The efficient frontier fails the test of time

Like so many simplistic approaches to the financial markets, the efficient frontier fails to reflect market reality.

To understand the investment efficient frontier, it helps to go back to its origin. In 1952, economist Harry Markowitz published an investment model that became known as modern portfolio theory. One elegant aspect of the model that transformed portfolio design was the development of an efficient frontier to balance risk and return. Markowitz looked at the effect of allocating percentages of a portfolio between bonds and equities. Graphed on a risk (standard deviation) and mean return basis, the result was a fishhook-shaped frontier that, based on historical data prior to 1952, showed a blend of 40% bonds to 60% equity allocation that produced a higher return at a roughly comparable risk level to a 100% bonds position.

The “hook” is the element that makes the efficient frontier so intriguing. It clearly illustrates that a blend of stocks and bonds can potentially improve the risk-return balance of a portfolio—achieving higher returns than a conservative all-bond portfolio without substantially increasing risk, as measured by standard deviation.


Figure 1 shows a portfolio composed of the Barclays Capital Aggregate Bond Index and S&P 500 Index allocated in 10% portfolio increments using mean/average standard deviations and returns over the 65-year period from 1950 to 2014. The circle indicates the point at which the portfolio is invested in 60% equity/40% bonds. Risk for the 60/40 portfolio is slightly more than a 100% bond portfolio, but annual return has increased from 6.47% for the 100% bond portfolio to 9.95% for the blended approach, indicating a considerably more efficient portfolio in terms of risk-return. In Figure 1, it appears that Markowitz’s efficient frontier still holds true 60 years later. Or does it?

The problem with the efficient frontier is that it is a moving target. If one looks at the frontier between bonds and equities over 10-year intervals, which is much more representative of the average investor’s time frame, the highest return for the lowest risk ranges from 100% bonds to 100% equity. That’s not very efficient.

Figure 2 was first published by Rydex Investments and has been re-created by the research team at Flexible Plan Investments to encompass the period from 1950 through 2014.


Seven time periods, seven different frontiers

Figure 2 depicts the efficient frontier of equity and bond portfolios illustrated in 10% increments. Equity returns are based on the S&P 500 Index, including the reinvestment of dividends. Bond returns include the reinvestment of dividends and are based on the Barclays Capital Aggregate Bond Index. Index returns do not reflect any management fees, transaction costs, or expenses. Standard deviation is used as a measure of risk. This is a statistical measure of the historical volatility of an investment, computed over each 10-year period. The higher the number, the more volatility is to be expected.

Financial markets rarely fit the assumptions of mean-variance models.

In decades that include a major bear market, bonds tend to outperform equities. In 1970-1979, the fishhook disappears as 100% bonds and 100% equity portfolios achieve roughly the same return but with equities at more than double the volatility. In 2000-2009, the fishhook is inverted and bonds dramatically outperform equities, moving the point of lowest risk/highest return to 70% bonds/30% equities.

These discrepancies illustrate the problem with trying to use simplistic 60/40 portfolio designs and expecting a predictable return. Financial markets rarely fit the assumptions of mean-variance models. Fifty-plus-year averages almost always fail to match actual results of shorter periods. If the optimal portfolio is defined as one that achieves the greatest return with the least risk, there isn’t a single 10-year period that matches the 60/40 allocation. Each decade has a different “efficient frontier,” with the lowest risk/highest return portfolio varying as shown in Figure 3.


Note: Lighter shade represents the fixed-income allocation; the darker shade is the equity allocation. In the 1970s, 100% bonds and 100% equity portfolios achieved roughly the same return, hence only one column is shown. 


Another way to utilize the efficient frontier portfolio approach is to develop an allocation offering the maximum expected return for a given level of risk. According to the efficient frontier’s traditional curve, using the 65 years of data from 1950–2014, the appropriate allocation is 70% bonds/30% equity at an 8% standard deviation risk level.

Once again, each decade produces a different value for a portfolio with an 8% standard deviation/risk level. The 2010 decade actually offers two options: An 80% bond/20% equity portfolio has a roughly equivalent risk level to a 30% bond/70% equity allocation, as seen in Figure 4.


Note: Lighter shade represents the fixed-income allocation; the darker shade is the equity allocation.

*The 1980s were a particularly volatile decade with the lowest average standard deviation at 12.25%. Thus, no allocation would have met an 8% standard deviation.


The lasting value of the efficient frontier concept is the fishhook curve. With the exception of the 1970s, when the curve flattens out, there is a point on each frontier where diversification reduced risk beyond that of the perceived lower-risk investment (i.e., bonds) and improved returns.

The brilliance of Markowitz was his recognition of the potential for diversification to reduce portfolio risk without unduly depressing returns. However, he created the efficient market theory before computers and the multitude of investment vehicles were developed that allow today’s investment managers to slice and dice the market into endless allocations and change those allocations quickly and cost-efficiently. The market was in many ways much simpler: a world without instantaneous transactions, global influences, data-driven computer models, and the ease of analyzing and investing in a great number of investment choices.


It is time to rethink the efficient frontier to accommodate new investment approaches to achieve reduced risk and improved returns. Today’s investment managers have the ability to go beyond simplistic formulas to create financial security for their clients by using investment approaches that take advantage of the enormous potential and flexibility of the financial markets.

By developing allocations based on market conditions and incorporating the use of strategic diversification, today’s active managers can manage risk while dynamically optimizing portfolio allocations. This is where a total portfolio approach to active management comes into play.


The opinions expressed in this article are those of the author and do not necessarily represent the views of Hilbert Financial Group. These opinions are presented for educational purposes only.


This article first published in Proactive Advisor Magazine on May 14, 2015, Volume 6, Issue 7.

Source: The efficient frontier fails the test of time

Are we looking for investment answers in all the wrong places?

One of the most seductive words in investing is “because.” If one understands the “because,” many investors believe, then the answer to “what happens next” is assumed to be within reach. Ideally, a logical pattern emerges that indicates future price direction, and the risk of investing can be managed.

A multi-billion-dollar industry is focused on supplying the “because” of financial markets’ behavior. Prices were up today because … Prices were down because … There are a host of reasons for every market action and for the direction of the next market move.

Well-known market technician Ralph Acampora maintained in early November that the stock market was in bad shape—worse than many Wall Street investors appreciate. “Honestly, I don’t see the low being put in yet and I think we’re going to go into a bear market,” he said.

Tom McClellan, another high-profile chart technician and publisher of the McClellan Market Report, told MarketWatch at roughly the same time that the recent action was more a function of seasonal volatility associated with October, and not a more significant upending of a 10-year bull market.

Two highly respected market technicians, two opposing viewpoints. Is one right and the other wrong, or is a coin toss just as reliable a forecast?

The principles of modern finance are very much a result of the human need to understand the “because” of market behavior and to define future behavior through a series of “rules.” The efficient market hypothesis, modern portfolio theory, the efficient frontier, the capital asset pricing model, and a multitude of market theorems seek to impose order on financial markets. Unfortunately, these theories fail when they are needed most: when market trend changes direction. Among their greatest fallacies is trying to fit financial market behavior into a statistical bell curve.

Markets are ‘wilder and milder’ than expected

On Oct. 19, 1987, the Dow Jones Industrial Index fell 29.2%. Based on a “normal” distribution—the logic that underlies beta and the calculation of risk—the probability of that happening was less than one in 1050 (10 to the 50th power). Oct. 19 was by no means an isolated anomaly. Market moves are much more volatile and extreme than predicted by a normal distribution. The use of algorithms and computerized trading promise to accentuate and compress volatility even more going forward.


Source: Bob Maynard, chief investment officer at the Public Retirement System of Idaho,
“Managing Risk in a Complex World.” October 2014.

According to probability statistics, a loss greater than 3.9% should have occurred seven times during the 82 years from 1928 to 2010. In reality, there were more than 151 single-day declines in excess of 3.9%. The probability of the Oct. 19, 1987, Dow decline of 29.2% in one day was, statistically speaking, virtually impossible. The probability that the Dow would record single-day drops of 3.5%, 4.4%, and 6.8% in one month was 1 in 20 million. Bob Maynard, chief investment officer for the Public Retirement System of Idaho put his view of market behavior succinctly and memorably in an article in 2014: Markets are “wilder and milder” than expected.

Does chaos theory present a more realistic model for the markets?

The one theory that has proven to create the most accurate simulation of market behavior so far is chaos theory—and that theory changes the entire investment game.

Chaos theory says that in the real world, causes are usually obscure. Critical information is often unknown or unknowable, making it impossible to predict the fate of a complex system.

Chaotic systems are predictable for a while and then “appear” to become random. In “The Black Swan,” Nassim Taleb uses the term regime change to describe transitions in chaotic systems. “Black swan” events occur, he says, because rules developed from the observation of events never contain the full range of possibilities. Within that apparent randomness, however, are underlying patterns, constant feedback loops, repetition, self-similarity, fractals, self-organization, and dependence on initial conditions. Chaos is not simply disorder, but the transition between one condition and the next.

Price changes are not independent of each other but rather have a “memory,” according to mathematician Benoit H. Mandelbrot (1924–2010). Contrary to the disclaimer that past performance is not indicative of future returns, chaos theory says today does, in fact, influence tomorrow.

An excellent book for rethinking the financial markets in the framework of chaos theory is “The (mis)Behavior of Markets: A Fractal View of Risk, Ruin, and Reward,” published in 2004 by Mandelbrot and his co-author Richard Hudson. Mandelbrot makes it impossible to listen to a financial news program or read the market analysis of the day without thinking, “What a humbug.”

Reframing financial markets in the context of complexity gives greater insight into why investment theories and strategies can appear to work, only to fall into disarray when market conditions change. “The (mis)Behavior of Markets” shakes one out of habitual ways of viewing the markets to understand why active investment management is so essential. What has been true is not guaranteed to remain so. Is reversion to the mean a lasting phenomenon or one subject to change? Is there a way to measure value, or is it all relative to the current market? If changes too small to be commented on at the time are creating large differences in a later period, does the cause cited in the evening news have any validity? If directional change results not from factors that we are aware of but those not considered, does anything matter other than the present?

What matters in chaos theory is not the “because” but rather the present action of the market. Given that all of the initial conditions of a complex system are not fully knowable, it is impossible to predict the fate of a complex system.

It is, however, possible on a short-term basis to detect trends and patterns in the market and, most importantly, to accept the possibility and reality of a change in direction.

Unlike most books on the financial markets, “The (mis)Behavior of Markets” does not provide any investment answers or secrets of success, but rather focuses the reader on the realities of the market from a mathematician’s view, placing no value in averages or theories.

‘10 Heresies of Finance’

Toward the end, Mandelbrot sets forth “10 Heresies of Finance.” Below, his rules are listed and brief statements are derived from his explanations to give a flavor of his arguments. A full reading of the “10 Heresies” is warranted for a better understanding.

1. “Markets are turbulent.”

A turbulent process is one that proceeds in bursts and pauses and whose parts scale fractally, all interrelated from the start to the end of the journey.

A fractal is a pattern or shape whose parts echo the whole, as seen in Figure 2.


2. “Markets are very, very risky—more risky than the standard theories imagine.”

Turbulence is hard to predict, harder to protect against, hardest of all to engineer and profit from. Conventional finance ignores this.

3. “Market ‘timing’ matters greatly. Big gains and losses concentrate into small packages of time.”

What matters is the particular, not the average. Some of the most successful investors are those who did, in fact, get the timing right.

4. “Prices often leap, not glide. That adds to the risk.”

The mathematics of Louis Bachelier, Harry Markowitz, William Sharpe, Fisher Black, and Myron Scholes all assume continuous change from one price to the next. Given that equity prices do not change incrementally from one price to the next, but rather leap over gaps to the next price, their formulae simply do not work, especially in today’s fast-paced markets.

5. “In markets, time is flexible.”

The genius of fractal analysis is that the same risk factors, the same formulae, apply to a day as to a year, an hour as to a month. Only the magnitude differs.

6. “Markets in all places and ages work alike.”

One of the surprising conclusions of fractal market analysis is the similarity of certain variables from one type of market to another.

7. “Markets are inherently uncertain, and bubbles are inevitable.”

This one you should really read for yourself. It is a fascinating mind-bender, as it explores the consequences for financial markets of “scaling.”

8. “Markets are deceptive.”

People want to see patterns in the world. It is how we evolved. It is a bold investor, however, who would try to forecast a specific price level based solely on a pattern in the charts.

9. “Forecasting prices may be perilous, but you can estimate the odds of future volatility.”

It may well be that you cannot forecast prices, but evaluating risk is another matter entirely.

10. “In financial markets, the idea of ‘value’ has limited value.”

Value is a slippery concept and one whose usefulness is vastly overrated. The prime mover in a financial market is not value or price, but price differences; not averaging, but arbitraging.


In the end, there is only one number that really matters: the price provided by the market—not theories, hopes, or speculation. And that perhaps informs some of the most important tools of active investment management.

“Knowing the limits of our ability to predict is much more important than the predictions themselves. …”

— Tom Konrad, author and financial analyst

The opinions expressed in this article are those of the author and do not necessarily represent the views of Hilbert Financial Group. These opinions are presented for educational purposes only.

Source: Are we looking for investment answers in all the wrong places?

The Case for Active Over Passive Investing is Really About Investor Behavior

Most investors do not behave in ways that are consistent with the theoretical benefits of long-term passive investing. They will likely be better served by an actively managed approach.

The fact that we are still debating the merits of active versus passive investing more than 40 years after John Bogle launched the first index investment trust is a testament to how central that debate is to the very essence of investment management—and how rooted the underlying issues are in deep-seated investor behavior.

It also reflects that a simple comparison between an index fund and a group of actively managed mutual funds is an oversimplified representation of the issue. It happens to be a handy comparison because the data is widely available in the public domain, but it doesn’t necessarily reflect the realities involved. A behaviorist would note that most people don’t actually behave in ways that map to a totally passive strategy and that independent investment managers do not behave in a manner that is similar to the managers of public mutual funds. From this perspective, the whole debate is built on comparisons that do not accurately represent real behavior on either side, thus putting investor behavior itself at the core of the debate.

Nobel laureate and behavioral science pioneer Daniel Kahneman said, “Economists think about what people ought to do. Psychologists watch what they actually do.” This statement may have more relevance to active and passive investment management than people realize. Using an index fund to illustrate the returns from a passive strategy represents the economist’s approach—a representation of what people should do to achieve a long-term return equal to that of the broad market. The economist’s numbers may be valid, but the basis in behavioral reality is not. A psychologist would point out that buying and holding an index fund for a very long time is simply not how most people behave, even though the opportunity has been there for decades.

Both sides of the data comparison ignore behavioral reality

A single index fund fails to reflect behavioral reality since few investors or managers toss all of their assets into a single broad index fund and let it sit there for a decade or two. The pull of emotions, biases, and the need to exert control are simply too strong for most investors to ignore. As a result, even investors with the right intentions stray from a strict adherence to an index fund, thereby negating its hypothetical long-term benefit. And because there are so many index funds for different groups and sectors, a more common approach involves the construction of portfolios of different index funds, leading to periodic reallocations and rebalances, thereby injecting an active management component back into the equation.

Performance numbers on actively managed mutual funds may likewise misrepresent the behavioral reality of independent portfolio managers. Heavily constrained by the Investment Company Act of 1940, public fund managers are required to hold cash for redemptions, are restricted in leveraging or shorting, and are prohibited from using derivatives to hedge their holdings. As such, painting independent managers who are not bound by the 1940 Act with the same performance brush can be highly misleading.

Active mutual fund managers are also locked into their stated objectives and generally manage with the intention not to veer far from their benchmarks. So, comparing the performance of a single index fund to a group of actively managed mutual funds is almost like comparing you to a picture of you and declaring the real you to be better looking.

The allure of control and engagement

Choosing an index fund over active investment management removes the sense of control over one’s investment. While this is a plus for many people who don’t want control, or feel ill-equipped to handle it effectively, it does not fit everyone’s needs.

Risk tolerance and the desire for control are not constants among the investing populace, and behavioral studies also show that they vary with age, wealth, and life circumstances, not to mention the market environment. Many investors need tailored, flexible strategies that can dial the risk level up or down according to the variables mentioned above, getting more defensive or aggressive as conditions warrant. In most cases, active managers can supply these strategies better than the individuals themselves.

A final observation regarding engagement is that a lot of people with 401(k) programs or self-directed IRAs have control over those assets, but they are truly ill-equipped to manage them properly. Plan administrators provide only minimal education and are prohibited from making recommendations. I remember one example of a woman who spread her money equally over the 20 funds available in her 401(k) plan, thinking she was maximizing her diversification that way. Other plan participants select the index-fund option out of a paralysis about choosing from the other available options—they would like active help, but either it simply isn’t available to them or they are unaware that a growing number of plan administrators now provide that opportunity. Active portfolio management in these plans could undoubtedly benefit many of these employees, helping them to manage risk and feel more secure about their retirement fund.

The passive return argument and “hindsight bias”

Looking back over a 20- to 30-year horizon or longer, it is very easy to show how the markets recovered from sell-offs as large as those in 1987, 2000, and 2008. But that’s because there is now absolute certainty surrounding those rebounds. The problem with looking back at past events is that we experience “hindsight bias”—a distortion of the probabilities of a past event by the fact that we know the outcome with certainty. In other words, we forget how uncertain (and in some cases downright scary) those prior events were when they occurred.

As the markets were tumbling out of control in 2008 and prominent financial firms were going under, people might have been well-justified to have pulled their money out or reduce their exposure. Today’s 10-year or 20-year returns for passive investing assume that one remained completely invested during that entire period. For many people, that doesn’t jibe with the realities of the time and thus reaches a conclusion that might be theoretically correct but behaviorally invalid.

The illusion of the long-term average

Behavioral studies show that the human mind has systematic quirks about the way it deals with probabilities and statistics. Kahneman and psychologist Amos Tversky addressed some of these in their landmark paper on prospect theory, and they are as much a part of behavioral finance as the more well-known cognitive and emotional biases we exhibit. Among other things, prospect theory notes that people tend to distort actual probabilities, using instead a subjective version of those probabilities referred to as “decision weights.”

We also tend to confuse averages with means, and we tend to underestimate variance from the mean. You might be tempted to move to a city like Lakeport, California, once you see that the average temperature all year is 56 degrees and the average high temp is a balmy 72. But when you get there, prepare for summers in the 90s and 100s and winters as low as the teens and 20s. Similar surprises play out on the stock market. The long-term average return over the last century for the S&P 500 is just under 10%, yet the annual returns are rarely within one or two percentage points of 10% and have often been 20-30 percentage points above and below the average.

An analysis of rolling 10-year returns from passive funds in a recent article from Vanguard showed that “contrary to expectations, the average index-fund investor hasn’t exactly tracked the broad market. In fact, the excess returns versus those of a total market fund have fluctuated greatly, outperforming or underperforming the market by nearly 14% and 8%, respectively, at various intervals. … This suggests index-fund investors have been building active portfolios.”

So, while Nobel Prize-winning academics tell us that the market is such an efficient pricing mechanism that beating it through active management does not produce excess returns after transaction costs and management fees, they are correct. But they speak of averages, not variance. To be sure, there will be plenty of exceptions to the average—the laws of chance assure that, even before skill is considered at all. And while few exceptions will persist over a significant time period on a consistent basis, the human mind is a sucker for the laws of chance, as any casino will happily attest. The same mental aberrations that keep people flocking to lottery tickets and blackjack tables will also drive them to managers who they believe can help them beat the stock market. Right or wrong, average returns spell mediocrity for many people, and they would rather take the extra risk than settle for it.

Context bias: What a difference a half-century makes!

When John Bogle introduced the first index fund in 1975, mutual funds were enjoying so much success that the idea of a nonactive one was viewed not just with a yawn, but with disdain. The notion of an actively managed mutual fund was so ingrained across the population as a tribute to U.S. capitalism that some competitors tried to position Bogle’s index fund as “un-American.”

For the average retail investor, mutual funds offered a way to achieve both diversification and professional management in a single instrument. The alternative was to manage your own assets, or to rely on a broker’s recommendations, which generally fell into the category of the hot stock of the week. In addition, America was going through a post-WWII business boom that fueled powerful industry giants such as IBM, General Electric, and General Motors—companies that did have something of a patriotic appeal to them. With this backdrop for context, passive index investing drew little fanfare.

Fast-forwarding to today, the amount of money flowing into passive funds is growing so rapidly, they are not only pulling in more money than actively managed funds, they are pulling money out of active funds. There are no consistent figures to indicate how much money is coming out of actively managed accounts with registered advisors to go into passive funds, or how many advisors themselves have now shifted to passive funds for their clients, but there is enough anecdotal evidence to know that both are significant. In the 401(k) world, where assets are substantial, investors don’t always have the option of a privately managed account, or they are unaware that they do have that option and therefore believe they are faced with only a choice of mutual funds. Passive index funds serve the need for a “no-brainer” investment uniquely well, and, in many cases, an index fund is the default fund of choice by plan administrators, who see it as the fund of least risk to themselves as fiduciaries.

What’s more, there is also evidence that the millennial generation has more of a predisposition toward passive investing than preceding generations. This may be because of a heightened sensitivity to fees, mixed with a touch of anti-Wall Street sentiment.

The performance numbers have long favored the passive fund in a side-by-side comparison, particularly when commissions and transactions costs were sky high. But investor behavioral biases and perceptions kept the active management allure alive. Though active mutual funds are steadily losing assets to passive index funds, active management is hardly circling the drain. There is plenty of evidence that active managers use passive funds or ETFs in sophisticated rules-based strategies that focus more on allocation among multiple asset classes (and geographies) and sector timing than pure stock picking. These strategies also can have the ability to ratchet up or down their market exposure depending on current trends, as well as further risk management through hedges or inverse positions.

Additionally, investor behavior is not solely geared to financial performance. People also use their money to express their views: to make statements on social issues, support causes they like, reward ingenuity or innovation, bolster their local economy, and even to approve or disapprove of a CEO’s behavior. Active managers are in a much better position to help investors express their views than any broad index fund.

Behavior isn’t binary, and neither is management

Lastly, the comparison of an index fund to an actively managed mutual fund (let alone a portfolio of active strategies) assumes a binary set of options that simply do not meld with investor behavior, which lies in different places along an ever-widening spectrum defined by the risk posture of the client, the investing environment, the client’s time horizon, and their need for expression, among other variables. Active managers today can offer investors a multiple-asset-class investment strategy that may well use passive components, but which can be centrally driven by where the client needs to be on this spectrum.


From this perspective, the active versus passive debate may not even be a debate anymore. Instead, the question for investors and their financial advisors is to determine where they best fit on the active management spectrum and what degree of active management is optimal to their needs.

The opinions expressed in this article are those of the author and do not necessarily represent the views of Hilbert Financial Group. These opinions are presented for educational purposes only.

Source: The case for active over passive investing is really about investor behavior

Advisors Prefer Active Management

Several studies assess advisor attitudes around portfolio management and risk mitigation for clients—showing a continued preference for actively managed strategies.

Editor’s note: This article first published in our magazine in October 2015, but it is perhaps even more relevant today. The S&P 500 finished 2017 with a ninth consecutive year of positive total returns (though volatility has returned in 2018), leaving advisors and investors wondering if and when the next bear market will appear. With the Trump administration’s policies generating hope that the economy will continue to improve—and also creating an unprecedented level of uncertainty—it is no time for advisors to decrease their emphasis on risk management for client portfolios.

“Index funds clearly have won the hearts and minds of many investors. Are there any reasons to even consider actively managed funds these days?” So said The Wall Street Journal in an article published on February 8, 2015.

They partially answered this question with the observation that, “Little surprise, then, that last year, people yanked $98.6 billion out of actively managed U.S.-stock mutual funds while putting $71.3 billion more into ‘passive’ ones that merely track an index.”

However, this opening salvo was quite misleading. The Journal article later acknowledged that the support for active management among professional investors and financial advisors was often much stronger than the massive funds flow statistics might suggest.

In addition, it must also be noted that there is a great deal of confusion in the business press when discussing “the active management debate.” The Journal article, and many others, frequently equate “actively managed mutual funds” with the entire universe of “active management.” This is simply not the case, as those mutual funds are usually restricted in their techniques/charter, stock universe, and tracking requirements, while holistic active portfolio management is not. The latter is usually primarily concerned with employing strong risk-management techniques in portfolio strategies while seeking favorable opportunities among a wide range of diversified asset classes.

That distinction noted, the Journal did cite many instances where actively managed funds could have an advantage versus passive funds:

“Many advisors still believe that at certain times, and for certain strategies, actively managed funds are superior to index funds. That is particularly true, they say, if the active fund has a good long-term track record. The lesson here? Historically, active managers have lagged behind benchmarks during long, strong bull markets. But they tend to make up lost ground when markets level off or suffer corrections. 

“‘Active managers have more ways to play defense,’ says Tim Clift, chief investment strategist for Chicago-based Envestnet Inc., a firm that guides advisers on using active and passive funds. ‘They (active managers) don’t have the pedal to the metal when the markets are going up, and they put the brakes on more quickly when markets are going down.’”

In fact, several recent independent research studies have shown that more advisors are (1) moving a greater percentage of their book of business to fee-based services; (2) increasingly utilizing the services of third-party money managers; and (3) supportive of active investment strategies and risk management, despite the lengthy bull market.


Source: PriceMetrix, “The State of Retail Wealth Management 2017,” May 2018.

Why is this so?

Undoubtedly, a major reason is that financial advisors wish to deliver on the investment objectives, suitability parameters, and risk appetites of their clients—with a significant percentage of clients approaching or already in retirement. These clients, many burned twice in the 2000s by market meltdowns, are valuing capital preservation and slow and steady portfolio growth over “market-beating” outperformance (and all of its related risk).

Advisors are moving more of their books of business to fee-based services and increasingly utilizing the services of third-party money managers.

Vanguard Investments wished to take a look at a range of investor attitudes, segmented by net worth, during the very bullish equity market in 2013. While they saw that investors had “slowly become less risk-averse with the passing of time from the financial crisis, they remain tilted to the conservative side. Almost half agreed with the strong statement that they will not invest in anything that will result in a loss of principal.”

And, directly related to this, a Natixis “2015 Global Survey of Individual Investors” shows 70% of affluent investors are “looking for new portfolio solutions”—not wanting a repeat of steep portfolio drawdowns.


Natixis presented updated research in 2017 in the study, “2017 Individual Investor Survey Trust.”

Among the study’s many findings, two statements stand out related to risk management and the “active versus passive debate”:

  1. “Understanding risk is the #1 area where most investors want the help of a financial professional. Risk is also the #1 item on the agenda of many financial professionals.”
  2. “In comparing the strengths and weaknesses of active and passive management, investment professionals see clear advantages for active managers in terms of generating risk-adjusted returns (66%). They also give the nod to active for taking advantage of short-term market movements (73%), as well as providing exposure to both non-correlated asset classes (73%) and emerging market opportunities (75%).”

The independent research firm that conducted the Vanguard research, Spectrem Group, updates its “Affluent/Millionaire Investor Confidence Index” monthly. Their tracking finds that while investor confidence among the affluent has improved during the 2009-2018 period, it is still consistently well below levels seen in 2006-2007 and is relatively unstable—prone to shift rapidly based on current market conditions, the political climate, and economic/geopolitical news. The “mood swings” seen among affluent investors are indicative of what many behavioral economists see as the “hangover effect” of the Great Recession.

Given this backdrop of conservative attitudes by many clients toward risk and capital preservation, financial advisors continue to find investment solutions in actively managed portfolio approaches.

Clients are valuing capital preservation and slow and steady portfolio growth over ‘market-beating’ outperformance.

CoreData Research, an independent third-party research provider, conducted another commissioned study of more than 1,000 financial advisors, institutional investors, and professional buyers in the first half of 2015. The survey finds that active management is the preferred broad investment approach for professionals—despite those significant investor flows into passive mutual funds in recent years.

According to the survey, close to 60% of U.S. professional investors surveyed say that actively managed strategies will play a significant role in their portfolios in the future. Fifty-two percent of the sample say they are “highly confident” in active strategies; the combination of “highly confident/confident” attributes average better than 90% for those surveyed. In comparison, only 39% are “highly confident” in passive strategies.

The survey also identifies the major criteria investment professionals are looking for in selecting active managers, with risk-management-related reasons identified as the top-ranking attributes.


However, based on this and other data, there clearly is no “one size fits all” approach either for investment professionals or their investor clients. Many find that a combination of active and passive strategies, or a “core and satellite” approach, is a very viable alternative for modern-day portfolio management.

In May 2015, ThinkAdvisor reported on the findings of, yes, yet another study on the topic of active versus passive investment management approaches. The report was based on data from 600 wire-house, regional, independent, and registered investment advisors, plus data from 525 advisors focusing on just liquid alternatives. Howard Schneider, president of Practical Perspectives and co-author of the report, “Major Trends Driving Change in Portfolio Construction,” says, “Most advisors still tilt toward being primarily active or a blend between active and passive.”

The study release notes, “Indeed, more than 80% of the advisors surveyed indicated significant or moderate use of active management strategies. … While many financial advisors are increasingly gravitating to passively managed solutions (for some asset classes and sectors), active management remains a core pillar to how advisors build portfolios.”

What is the bottom line here?

The investor clients of financial advisors and wealth managers have shown an increased risk appetite during the lengthy bull market of 2009-2018. But most investors, as the 2015 Natixis study put it, have remained, “cautious, conflicted, and in need of guidance.”

The 2017 Natixis study adds, “Managing clients and their emotions is no easy task.”

They found that investors continue to be skeptical of the long-running bull market and “confidence may only run skin deep.”

They noted the following in their conclusions:

“In broader sentiment, we see what may be the lingering effects of the turmoil experienced by investors over the past ten years manifested in mixed emotions in how investors view risk, return, and their portfolios:

  • “Despite a record run of low numbers for the VIX, investors are still concerned about the threat of volatility, with most believing it undermines their ability to achieve savings and retirement goals.
  • “Despite an extended bull market globally, investors define risk as losing assets rather than losing out on investment opportunity.
  • “Despite high hopes for investment returns, most say they will take safety over investment performance.”

The good news is that financial advisors have an increasingly complex array of portfolio alternatives, strategic tools, and third-party investment solutions at their disposal. Active management remains a vitally important component of meeting client objectives for a majority of advisors, particularly in addressing the core client concerns of managing risk and preserving capital over the long term.

The opinions expressed in this article are those of the author and do not necessarily represent the views of Hilbert Financial Group. These opinions are presented for educational purposes only.

Source: Advisors prefer active management

Clients understand volatility – except when it happens

For financial advisors, understanding core financial concepts such as variance, portfolio volatility, and systematic risk are one thing. Reckoning with their psychological effects on clients is another.

Investment professionals are, of course, well-acquainted with the concept of risk. They know that they can diversify away most of the idiosyncratic risk from individual securities but that client portfolios must still bear the risk of the overall market as it gets pummeled by the forces of economic cycles, geopolitical events, and interest-rate policy. Clients, however (including those with advanced financial acumen), are likely to get anxious almost every time the market takes even the slightest dip or volatility ramps higher.

That’s because human brains are riddled with pesky emotional and cognitive biases that can overpower even the most well-considered plans. (This isn’t only true of people who have their investments managed professionally. Those managing their own money will second-guess themselves as well.)

The market doesn’t even have to sell off to stir up such anxieties—the mere suggestion by a well-known firm or guru that stocks are vulnerable is enough to give many people the jitters. The reasons are rooted in psychology and are as inevitable as the closing bell at the end of each trading day. But if financial advisors understand the source of the anxiety better, they may not be as surprised when it happens and might even be able to prevent many clients from experiencing it in the first place.

As much as a financial advisor would like to believe they can identify the best possible stocks or indexes to own throughout all environments and predict the timing of the economy’s next move with clockwork precision, they fully appreciate that stock investing is a probabilistic exercise rooted in uncertainty and that performance perfection is unattainable.

To take advantage of the long-term benefits of owning equities, one must be able to view investing as an imprecise activity, virtually assured to be wrong some of the time—not for the lack of professional skill, but for the simple realities of chance and volatility. Fortunately, financial advisors and investment managers can access the collective wisdom of numerous Nobel laureates who have provided elegant mathematical techniques for dealing with market uncertainty. Unfortunately, none of these techniques work on client emotions.

Client reactions to volatility, news, and underperformance are natural human reactions to uncertainty. Such reactions are visceral and are tied very closely to chemical and physiological reactions in the body. They may vary in degree among different people, but they cannot be entirely shut off. Humans are simply hardwired to be uncomfortable with uncertainty, and most people will try to avoid it if they can. And while we realize that it is something we must accept with investing, that does not prevent our automatic self-protection systems from kicking in.

Why do people often have a difficult time dealing emotionally with something they reasoned out thoroughly beforehand with their financial advisor?

Kahneman’s two-system framework

Behavioral legend Daniel Kahneman provides a framework for understanding why this happens in his book “Thinking Fast and Slow.”

Kahneman distills the complex way humans think into two systems, labeled for simplicity as “System 1” and “System 2.” System 1 (or fast thinking) is instinctive, emotional, gut-driven thought that involves little if any conscious analysis. System 2 (or slow thinking) is where all higher-level reasoning, logic, and complex thought originate. System 1 decides what you want for lunch, while System 2 must be brought in to create that project analysis you need to present to your boss.

System 2 thinking requires much more effort from our brains, so it is available to us when we invoke it, but System 1 serves as the default system we use most of the time. People are often surprised to learn how much of a simple conversation, or even driving a car, is handled predominantly by our subconscious faculties.

System 1 also handles virtually all of our automatic control mechanisms, such as the environmental monitors that let us know when we are too warm, hungry, or tired. It also watches out for our safety and warns us when it senses fear or danger. That alarm system is so effective that it automatically generates responses for us. In the same way our bodies sweat without us thinking about it, they react hormonally to perceived danger, and our brains consider losing money to be one of those dangers.

So, when the market is selling off, our subliminal reaction comes from a System 1 signal that emits fight-or-flight messages to various parts of our bodies. That signal, being more primal than logical, sets off reactions that cause worry and anxiety, stirring us to action. Instead of preparing to run or fight, that action might take the form of a frustrated call or an email to our advisor. For those who self-invest, it often results in a “sell first, ask questions later” event.

Financial professionals are not immune to these feelings, but they develop a reaction tempered by their knowledge and experience and focus on the bigger picture. The advisor’s or manager’s reaction is thus typically handled more by the logic side of the brain, which is not terribly surprised or disturbed by an adverse market action. The client’s mental focus, however, is generally on their own careers and life priorities, so their reactions are more visceral and handled subliminally by System 1. As a result, the same news item generates a very different response in the client than it does in their advisor.

To make matters worse, emotions tend to overshadow logic, so financial professionals will find it challenging to impose logic on an emotionally charged client to resolve an issue. Our brains are insistent, even when they are not right.

Recency bias and anchoring to the high-water mark

Another reason clients overreact is because they often have a different reference point. A financial advisor or investment manager will tend to focus on a reference point related to the last milestone from which their performance was measured. If that is annually, then the previous year-end is their typical reference point. (Hopefully, performance is measured over much longer time frames.)

For clients, however, it is very different. The tendency is to watch one’s portfolio closely—recency bias combined with availability bias keeps clients anchored to the most recent high-water mark. If there was a high in May, for example, that will likely become the current anchor. The media makes this more pronounced by feeding us headlines on recent events and particularly on recent highs. When the new high-water mark becomes the reference point, even a small decline becomes a source of anxiety. And as Kahneman’s prospect theory tells us, losses carry twice the emotional impact of equivalent gains.

What’s the answer?

The answer may be simple, though its execution is challenging. Faced with a client in System 1 mode who is fearful, anxious, or upset, the way to reach a constructive solution is to get them out of that mode and into System 2 mode where the problem can be thoughtfully reasoned through.

Logic and emotion don’t mix, and trying to apply logic when a client is reacting emotionally is an uphill battle. The advisor certainly doesn’t want to drop into System 1 mode to argue with a client on an emotional level, as that is a prelude to a heated discussion that will likely have negative consequences.

The key is for the advisor to remain in System 2 mode and to get the client in that mode as well. Then, both parties will at least be able to communicate with one another from the same logical state of mind. This can be challenging, but well worth the effort.

Remember that System 1 is the default mode and that a person needs to intentionally invoke System 2 to enter that state. Invoking System 2 is seamless to the individual, but they will do so only when they have to, and that is generally when a question is posed to them that requires them to do so.

When you sit down to take a test, you subconsciously enter System 2. You subtly move into a higher-level thinking mode. In so doing, you simultaneously squeeze out the emotionally charged thoughts that came from System 1. (The emotions can creep back in, but at least they are subdued in favor of reasoned thought.) The mere act of engaging your cerebral cortex causes you to focus and use more logic. The more you focus, the less likely you are to let emotions rule your thoughts.

The advisor needs to get the client out of System 1 mode, and asking questions is a great way to do that. Listening to a client rant about performance or question a holding won’t put them in System 2 mode. It just lets them vent their emotions. They need to be induced to move into System 2 mode by entering a thoughtful discussion.

Here are some approaches that I believe have merit to move clients into System 2 mode:

  1. First, ask the client to very specifically outline their current concerns. Is it an isolated aspect of their portfolio that is troubling them, overall portfolio performance, or an undefined anxiety about the market based on something they read or heard? How long has this been going on and what time frame are they referring to? Many times, their concern will be something that, when examined deeply and in context, is not as threatening as it might have originally appeared.
  2. Review again with the client their financial plan objectives and how they relate to their overall life goals. Ask them the critical question point-blank: “Are you still on track to meeting your long-term financial and investment objectives?” With a well-constructed financial and investment plan that was developed with the client’s risk tolerance at the forefront, the answer should undoubtedly be a calming “yes.”
  3. Ask the client to examine with you the rationale and assumptions that led to their original risk-tolerance assessment. If they, for example, said they could tolerate up to a 15% drawdown, why are they upset now with a 10% drawdown? Examine in concert with them whether their risk profile should be adjusted, leading to an overall different portfolio construction framework for the future.
  4. Have a frank discussion about the trade-offs of different types of portfolio allocations, the depth of exposure to equity markets, and the use of buy-and-hold passive strategies versus more active, risk-managed strategies. Would this client be more comfortable with a less-volatile portfolio construction, understanding that the consequence might be some “underperformance” versus the major market benchmarks in times of roaring bull markets? However, they must understand this is importantly counterbalanced through the use of strategies meant to mitigate the worst effects of bear markets.

Once you can engage your nervous client in a System 2 conversation, issues can be resolved in different ways, and a constructive resolution is much more likely to occur. Advisors may find additional benefit from this process by getting more clarity on a client’s risk tolerance or an additional perspective on the way the client is viewing the financial markets that they didn’t recognize before.

No matter what investment strategy is used, there will inevitably come a time when it isn’t performing 100% as expected and clients will voice what are usually emotion-based concerns. Understanding Kahneman’s two simple states of mind (illustrated in Figure 1) may not only help to deal with nervous clients, it may help reduce the number of times such anxieties even surface.


The opinions expressed in this article are those of the author and do not necessarily represent the views of Hilbert Financial Group. These opinions are presented for educational purposes only.

Source: Clients understand volatility – except when it happens

Investing is about managing stress—as well as performance

While there is no way to eliminate all market risk, an actively managed portfolio with an emphasis on risk management may produce less stress than a passive portfolio for both advisors and their clients.
In my 35-year career in and around Wall Street, I have seen the markets exact a personal toll on many investors, both retail and professional. Driven by subliminal inner forces, many people have allowed the markets to push them to extremes and, unfortunately, have done harm not only to their portfolios but also to their health and well-being as a consequence. A focus on investment strategies that avoid, minimize, or mitigate these extremes can provide more advantages—both in realized long-term performance and behavioral benefits—than a completely passive portfolio. It does so in part by eliminating the negative actions people (including advisors) often take under stress.
An extreme example of stress
The following is a true story, and one I doubt I will ever see again. Early in my career, I was an options coordinator for a major wire house in New York. The CBOE had recently opened its doors, and options trading was exploding. Since stocks had languished for months, the idea of writing naked strangles on the OEX (selling both uncovered calls above the market and puts below) was all the rage at this firm. A large options trader in the retail system (let’s call him Joe) was writing naked OEX options for many of his clients. The strategy performed rather well for months. Then came a stock explosion to the upside, and with it a return of volatility. Losses piled up quickly, and the stress of managing portfolios with naked options skyrocketed. One afternoon, I received a call from Joe’s office manager. Joe had just been carried out of the office by paramedics with an apparent heart attack. As they put him on a stretcher, he was unable to speak but motioned for a pen and paper. The manager read his note to me. Even as they were trying to save his life, Joe was trying to put in an order to cover OEX call options! Joe may have been an exception due to the extreme risk of his option positions, but even a plain vanilla portfolio of stocks will cause people stress. Financial advisors often believe that their job is to take the stress of investing off the client’s shoulders, but that can turn into an unhealthy premise for many advisors. For one thing, advisors can’t remove all of the market risk from stock portfolios, no matter what their strategy or how closely they monitor it. This is especially true for advisors who primarily rely on passive portfolio allocations since the premise behind such strategies is to hold on through the storm, no matter what level of market risk they are facing. For another, they cannot simply absorb the stress that a client might be feeling. Clients can still generally feel the effects of portfolio stress even when they believe the advisor’s tools for risk management are somehow going to keep them out of trouble or when the advisor is counseling them to just keep calm through any turmoil.
The nature of stress
We know stress mostly by its physical manifestations: headaches, nausea, insomnia, elevated blood pressure, and sometimes even chest pains. We also know that while it is part of a highly useful alarm system that is key to human survival, it is unhealthy for us to carry too much of it around with us for too long. Stress is not just behavioral, it is chemical. The American Psychological Association defines stressas the “automatic response developed in our ancient ancestors as a way to protect them from predators and other threats. Faced with danger, the body kicks into gear, flooding the body with hormones that elevate your heart rate, increase your blood pressure, boost your energy and prepare you to deal with the problem.” So, when subliminal sensory perceptions decide that we are in danger, they automatically invoke a protective protocol that unleashes a chain reaction of chemical and neurological events geared to stir us to action and making us more capable of doing so—hence the urge to panic and sell when things look vulnerable in the stock market. It is a visceral human reaction. It has been firmly established by researchers that the chemical reactions in the human brain to basic instincts such as sex, food, and survival are also stimulated by money. Dopamine, for example, the chemical neurotransmitter that passes on messages to neurons about rewards and pleasure, can be associated with the idea of making or winning money. So it should be no surprise that the idea of losing money also sets off basic chemical reactions within humans through neurotransmitters such as adrenaline and cortisol. The stimulus that sets off these chemical reactions is stress. The problem is that our biological sensors do not distinguish between a physical attack, a dress-down from one’s boss, or a stock market tumble. With stocks, they kick in not just when we actually see the market decline but can also show up when others even suggest that it might. This chemically induced urge to action is responsible not only for unhealthy levels of stress but for the pervasive underperformance of self-managed stock portfolios.
Headwinds-tailwinds asymmetry
Classic financial theory offers diversification of our holdings to reduce the idiosyncratic risk of individual securities, but that is no antidote for market risk, without also removing your opportunity for gain. Consequently, many advisors and wealth managers, along with their clients, are forced to accept the ups and downs of the market and to take a long-term perspective on investing. This, however, flies in the face of human nature when the market declines, and even in climbing markets. Long-term optimism is simply no match for short-term loss aversion and fear of uncertainty. Exacerbating the problem is a psychological effect called “headwinds-tailwinds asymmetry.” We tend to relax when the wind is at our backs and things are going well. (Running and cycling enthusiasts know this well, hence its name.) But when we face problems of any kind (a headwind), it is natural to become anxious. The reaction is asymmetrical in that the anxiety occurs with every headwind, no matter how infrequent, while there is no offsetting joy during tailwinds since we tend to expect that. For investors, this lopsided effect causes anxiety almost every time the market goes down, despite the long-term trend moving up. It is pervasive, even if only slight in magnitude, but it can also be cumulative over time and increase along with the size of the portfolio and other factors. If you are invested in stocks, it is almost impossible to be totally immune to headwinds-tailwinds asymmetry. The anxiety of declining days subtly builds up in us. Abnormally large sell-offs cause a proportionately greater reaction, and the effect can remain with us well beyond the point when the market has recovered the loss. It is the slow buildup of anxiety that leads to stress.
Coping with the unavoidable
To address the problem of stress, we can counter the body’s reaction to it, or we can reduce or eliminate the cause. Today’s emphasis on good health offers a bevy of stress-management techniques that generally include relaxation activities such as yoga, meditation, tai chi, or almost any type of exercise. So that type of advice is readily available. But how can an advisor reduce the cause of stress to clients in the first place? Part of the fear that accompanies ownership of a stock portfolio is the fear that an investor has little or no control over what happens next. For a passively managed portfolio, this fear creates a continuous dilemma about when, if ever, to sell, creating a subsequent stress about when to repurchase. This gets more complicated through loss aversion, regret, hindsight bias, and a host of other stress-producing biases. Investors with personal financial advisors certainly have an advantage in this regard versus self-directed investors. Yet, as seen in a 2017 study from Wells Fargo and Gallup, even those investors with advisors still stress out over the market—only 39% “strongly agree that they are prepared for a market correction.”
Source: Wells Fargo/Gallup Investor and Retirement Optimism Index, July 28–Aug. 6, 2017.

This is where active management can add value beyond performance. Active management reduces the fear of lack of control. Active managers tend to shine in down markets because they know how to manage a portfolio or strategy throughout the process rather than try to time a wholesale liquidation and re-entry, which almost everyone will get wrong. Thus, by its very nature, active management provides a solution less prone to stress than passive. In addition, just knowing that someone is managing their portfolio during periods of declines and elevated market risk can assuage the fears of many clients and reduce their stress. Next, advisors need to recognize the natural focus of clients on the negatives and do their part to redirect that. Part of headwinds-tailwinds asymmetry holds that if clients are examining the performance of their portfolio, they will tend to focus more on the declining stocks or sectors than advancers. Unfortunately, the media will also, so advisors need to be prepared with the offsetting positives when talking with clients, focusing on the big picture of performance over several years, not what happened yesterday, last week, or last month. A market sell-off of 5% will induce much more fear from the perspective of the most recent high than it will from the perspective of the past 12-months’ performance.
Lastly, don’t underestimate the power of communication with your clients in reducing stress. In many cases, clients just want to know what you are thinking or planning in order to feel less fear. You will likely find your own stress reduced through such conversations as well. Stress is a silent and sinister enemy. It can wreak havoc on your health, your performance, and your clients. It certainly might be worth taking that morning yoga class several times a week, but it is probably a more effective plan to help reduce stress through sound portfolio-management practices and strong client relationships. Active investment management and active communication with clients will go a long way toward this goal.

Black swans & the ‘10 best days’ myth: Can investors prepare for market outliers?

Black swans & the ‘10 best days’ myth: Can investors prepare for market outliers?

by | Jan 4, 2017 | UpClose |

How much effect do market outliers have on long-term performance? Can the investor prepare for these anomalies, or are they truly ‘black swans’ that cannot be managed?

Editor’s note: Many thanks to Meb Faber and his associate, Prabhat Dalmia, for permission to publish an abbreviated version of this paper, “Where the Black Swans Hide & The 10 Best Days Myth,” which was first published in August 2011. Thanks also to the Market Technician’s Association (MTA), which published this paper in July 2016. A full version of the paper can be downloaded here.

Mr. Faber’s analysis addresses several assumptions behind the “missing the 10-best-days” argument, which, as he says, is “often proffered by advocates of buy-and-hold investing.” He also examines the issues of how market “outliers tend to cluster and the majority of both good and bad outliers occur once markets have already been declining.” Mr. Faber advocates “that investors attempt to avoid declining markets where most of the volatility lies” and concludes that “market timing and risk management is indeed possible, and beneficial, to the investor.”

Nassim Taleb, author of “Fooled by Randomness” and “The Black Swan,” popularized the concept of the black swan theory—namely, the occurrence of utterly unforeseeable events that are thought of as not being possible based on previous experiences.Taleb defines a black swan as an outlier outside the realm of regular expectations because nothing in the past can convincingly point to its occurrence. The event carries an extreme impact and is often “explained” after the fact, giving the impression that it is explainable and could have been predicted.

Many market commentators have latched on to this term to describe all financial market events. However, the existence of large outlier events known as “fat-tailed distributions” in financial market returns has been well-documented for more than 40 years (see Benoit Mandelbrot’s “The Variation of Certain Speculative Prices” and Eugene Fama’s “The Behavior of Stock-Market Prices”). While the financial media have only recently revisited the fat-tail concept (due largely to the occurrence of the Internet bust in 2000–2003, as well as the global financial meltdown in 2008 and 2009), it has been a thoroughly studied field in finance over the past several decades.

Investors should realize that normal market returns are extreme. Individuals that continue to believe in the Gaussian (bell-shaped) distribution, or ignore empirical results, will continue to be surprised by future events. Roughly 40% of all yearly returns in U.S. stocks are greater than 10% or less than -10%. Bear markets are common, and markets can and do decline from 50% to 100%.

Financial market return distributions are similar to fractal systems that follow a power-law distribution (which is useful in describing events such as earthquakes and volcanic eruptions). Below is a chart from the book “The Failure of Risk Management” by Douglas Hubbard, which illustrates the inability of the Gaussian models to account for large outlier moves in financial markets. In a normal-distribution world, a 5% decline in the Dow in a single trading day should not have happened in the past 100 years. In reality, it has happened nearly 100 times.


Unfortunately, many investors have come to the conclusion that rare events are impossible to predict, and therefore, there is nothing to do other than buy and hold their investments and wait out any negative outliers. However, this explanation simply rids the investor (advisor) of any responsibility. The fatalistic attitude becomes “it was a black swan; it’s not my fault!”

In this article, we examine market outliers, their effects, and, more importantly, when they occur and if the investor can do anything to protect against them.

Market outliers: The ‘10 best days’ myth

We begin our examination by taking a look at market outliers in the U.S. stock market back to 1928.

One of the most common rhetorical bulwarks in the defense of buy-and-hold investing is to demonstrate the effects of missing the best 10 days in the market and how that would affect the compounded return to investors. This is perhaps one of the most misleading statistics in our profession (another being the Brinson asset-allocation study misquote). A number of academic papers have examined the effects of missing both the 10 best and the 10 worst days (two good ones are Paul Gire’s “Missing the Ten Best,” published in the Journal of Financial Planning, and Richard Ahrens’ “Missing the 10 Best Days”).

In Table 1, we examine the S&P 500 (and the broad market predecessor) from 1928 to 2010. We use price history only, as dividends will not have a meaningful impact on the daily return data.


What about the outlier returns? Table 2 shows the best and worst 1% of all days, which equates to only about two or three days per year.


One can expect these days to occur a handful of times every year since 1928. Much to the displeasure of the fear-mongering media, -4% and +4% days are fairly regular.

To help us really examine the blackest of swans, Table 3 shows the best and worst 0.1% of all days. They occur, on average, only once every few years.


Days of -8% and +8% are fairly rare, as are the -20% and +16% days. Exactly how big of an impact do these outliers have on performance? Massive. Table 4 shows the annualized returns if the investor missed some of the best and worst days. If you missed the best 1% of all days, your return gets crushed from 4.86% down to -7.08% per annum. However, the converse is also true: if you miss the worst 1% of returns, your returns explode to 19.09% a year. And take special note that if you miss both the best and worst 1% of days, your return is higher than buy and hold.


Most analysts, unfortunately, stop here and throw up their hands. They proclaim buy-and-hold investing to be the only way to ensure being in the market for these best days. Because these events are so rare, and because they have such as massive impact, there is an infinitesimally small chance of predicting when they will occur, and therefore the effort is useless. They take the ball all the way down to the five-yard line but stop there.

What are they missing?

The human element

Markets are a collection of humans, and, therefore, a collection of human emotions. Greed, fear, jealousy, pride, and envy all manifest themselves to the fullest in capital markets.

When you are making money, you are thinking about the new car you are going to buy, how smart you are (and how much smarter you are than your neighbor), the vacation you are going to take, and the (second, third, fourth) house you are going to buy. The part of the brain that is firing nonstop here is the same region that gets stimulated by cocaine or morphine.

However, when you are losing money, you are probably not opening your account statements. Instead, you are thinking about how dumb you are (and how stupid you were to listen to your neighbor) and how you are going to pay for that second house. Even thinking about investing is likely to elicit feelings of revulsion. The brain processes portfolio losses in the same region that is stimulated by the flight response. (For more in-depth discussions on behavioral biases, please consult some of the work of the great MIT professor, Andrew Lo.)

Table 5 examines the returns (and, more importantly, the volatility) when the market is appreciating versus declining (defined as above or below the 200-day simple moving average, or SMA). Based on this data, and that of Table 6, it is little wonder that the volatility found in declining markets can have such a profound impact on investors’ emotional responses.


(To be read: 69.59% of 1% “worst days” occur in a declining market, 78.34% of 1% “best days” also occur in declining markets.)

What about the outliers—where do they occur? As Table 5 shows, the vast majority (roughly 60%–80%) of the best and worst days occur after the market has already started declining. The simple reason is that markets are more volatile when they are declining, and when the really volatile events and days occur, they tend to cluster together.

Our central argument is that returns improve and volatility is reduced when an investor is invested in uptrending markets, thus avoiding the volatility and clustering of best and worst days inherent in declining markets. As you can see in Table 6, in declining markets, returns are much lower and volatility is much higher.


Benoit Mandelbrot provides an insightful passage on volatility clustering and timing in his book “The Misbehavior of Markets”:

“What matters is the particular, not the average. Some of the most successful investors are those who did, in fact, get the timing right.”

This effect also plays out on the monthly time frame as well. For a look at other markets, including real estate, bonds, and foreign stocks, on the monthly time frame back to 1972, you can view a blog post here titled “Your Irrational Brain.”


For those investors pondering how they can attempt to avoid these highly volatile periods in markets, we invite you to download a few of our other white papers : “A Quantitative Approach To Tactical Asset Allocation” and “Relative Strength Strategies for Investing.”

Astute market analysts must also realize the drawbacks and downsides of any indicator or investment approach. In the case of a trend-following approach, there are two main drawbacks. First, in trendless markets, whipsaws can occur that have negative effects on the portfolio. Second, and perhaps more important, a trend-following approach does not guarantee the investor will miss a black swan event in an uptrend. A very sharp move against the trend will not allow the investor or model time to react and protect against such a move. Investors looking for protection against this sort of event can use derivatives such as options to protect the portfolio when fully invested (so-called tail-risk insurance), or consequently, to gain long exposure when mostly in cash and bonds (risk of missing out). This process could be a net cost (insurance) to the portfolio.

That is the point of risk management: understanding and trying to account for as many risks as you can.

Our broad summary points from this analysis?

  1. The stock market historically has gone up about two-thirds of the time.
  2. All of the stock market return occurs when the market is already uptrending.
  3. The volatility is much higher when the market is declining.
  4. Most of the best and worst days occur when the market is already declining. Reason: see #3. Markets are much riskier than models that assume normal distributions can be used to predict.
  5. The reason markets are more volatile when declining is because investors use a different part of their brain when making money than when losing money.

The opinions expressed in this article are those of the author and do not necessarily represent the views of Hilbert Financial Group. These opinions are presented for educational purposes only.

Source: Black swan events and the ‘10 best days’ myth

Buy and Fold

Buy and fold

by | Mar 10, 2016 | UpClose |

The only investment approach investors should consider is one they will actually follow.

Millions of Americans follow what has become traditional advice to “buy and hold.” This approach might be best summarized by John Bogle, founder of The Vanguard Group: “Get out of the casino, own corporate America, and hold it forever.”The basic idea of buy and hold is that you can’t time the market. Investing is a zero-sum game, so if you try to time the market, the only party that wins is the one collecting the commissions (the casino dealer/croupier in Bogle’s analogy).The most commonly cited evidence about investor inability to time the market is the DALBAR Quantitative Study of Investor Behavior (QSIB). The key statistic from the 2014 QSIB was quite remarkable, though not a surprise to advisors who have witnessed investor behavior firsthand:

The 20-year annualized S&P return was 9.85%, while the 20-year annualized return for the average equity mutual fund investor was only 5.19%—a gap of 4.66 percentage points.

Put more plainly, the average equity mutual fund investor underperformed the broad equity index by 4.66 percentage points annually over the last 20 years. 4.66! Over that lengthy period of time, and especially when compounding is factored in, that represents a tremendous difference in the ending value of a portfolio. These investors are giving up (compared to the “market return”) close to $380,000 in gains for each $100,000 of principal (see chart).

The buy-and-holders cite this as evidence that misguided attempts at timing the market (buying those funds high and selling them low) is the main explanation for poor returns. In theory, it is difficult, maybe even impossible, to argue with buy and hold. The problem comes when we all wake up and realize investors/clients do not live in a theoretical world and they do not retire on theoretical money.

To summarize, the buy-and-holders believe that large-scale underperformance comes from investors not using buy and hold. I have a slightly different hypothesis: Investors “buy in” to buy and hold when the case looks the best—market tops—and they “fold” (give up) on buy and hold when it looks worst—market bottoms.

How low would you go?

What if a client found out that their current portfolio was 300% riskier than he or she was prepared to tolerate? At our firm, we see it every day when analyzing the holdings of a new client or prospect. Besides questions of knowledge, experience, time horizon, liquidity needs, and so on, the most important risk-tolerance question we ask is this: “You are investing $XXX dollars with us today. What is the lowest balance you could handle before you would fire us or go to cash?”Clients often answer that a 15% decline in portfolio value would be a tipping point, but the answers can fall anywhere from 0% to 50%. This is not unexpected, given our relatively large sample of clients with unique goals, experience, sophistication, and life situations.

When we show an equity investor with a theoretical maximum loss tolerance of 15% that the maximum drawdown of the S&P 500 is well over 50%, and can exceed 20% on a fairly regular cyclical basis, they’re often shocked. No wonder they have difficulty being disciplined investors—they were never mentally prepared to withstand a 50% loss. They aren’t trying to “time” the markets, per se, when they sell at the bottom—they’re panicking! They’re throwing in the towel on the entire idea of buy and hold.

If you know ahead of time that you will panic when the market enters bear territory, why would you commit to a strategy that historically has lost twice your tolerance (or more) every five to seven years?

Don’t blame Bogle

Mr. Bogle is, of course, 100% aware of the past. In a recent CNBC interview, he said an investor should be prepared for two 50% drawdowns in the next ten years. Many people mistook this for a “call” or prediction. It wasn’t. It was Mr. Bogle stating historic fact, that markets go up and markets go down, and if you are going to buy and hold, you should fully expect the future to at least resemble the past.To reiterate, I believe when investors buy at the top, they are “buying” buy and hold as a concept or strategy. Conversely, when investors sell at the bottom, they are throwing in the towel on an idea they were never emotionally prepared to follow in the first place.

When investors buy and hold, they often don’t consider things like drawdown, or they don’t anticipate how they may respond during a bear market and premeditate their actions. Most important, their expectations do not match historical results.How do you reduce that drawdown to something in line with a level of risk they can actually handle? In my experience there are only two ways to do it:

  1. True diversification.
  2. Dynamic management.

For the sake of brevity, we define true diversification across three levels:

  1. Multiple assets. (For example, don’t hold just one company, hold many. This is what many people think of when discussing “traditional” diversification.)
  2. Multiple asset classes. (For example, equities, fixed income, commodities, currencies, private equity, and real estate.)
  3. Multiple strategies. (Ideally, managers or strategies with varying approaches/strategies.)

Question what you read about “active managers”

I can just hear the media’s generalization now, “Managers?! 80% of managers fail to outperform the market!” (Before we get too far, if anyone ever tells you they know how to buy at the exact bottom and sell at the exact top, politely excuse yourself, grab your wallet, and run.) But, back to the “80% of managers” adage—I have several responses to that notion.First, I’ve never found a reputable study that proves that point the way it is commonly understood.

Second, I have found studies that say 80% of active mutual funds underperform their benchmarks, but here’s the problem: Mutual funds are not active (by our definition). Many have an investment mandate that requires them to stay fully invested and not deviate from their stated asset classes and allocations. (How active is a manager when they have to stay invested in one asset class or sector, and stay fully invested, regardless of conditions? When you are required to stay invested in a single asset class, can only diversify within that single class, but yet charge a higher fee than a passive benchmark that does the exact same thing, underperformance is the only logical outcome.)

The final piece to the response is the most important. Our clients are not looking to outperform the market. Rather, they are seeking to outperform on a risk-adjusted basis.

For example, consider two portfolios: Portfolio A has a compound annual return of 8% over the past 10 years, with a maximum loss of 15%. Portfolio B has a compound annual return of 10%, with a maximum loss of 55%. Which one is “better?” (“Better” is a very subjective term, as each person’s situation is unique, but for discussion purposes, I’ll use the word.)

Buy-and-holders would say the second. Annual performance that is 2% greater is enormous over ten years. “Brace yourself to deal with the 55% drawdown and stay patient,” they say.

Our clients would select the first. Getting an 8% return in a portfolio strategy you can handle long term is much more effective than “buying” portfolio B at the top and “folding” on portfolio B at the bottom (which, instead of those 10% returns, might lead to flat performance or even a loss).

If your clients are fine with sustaining a 50% loss every four to seven years to guarantee they never fall far short of long-term “market performance,” they should feel free to go for a buy-and-hold strategy. (This is not tongue in cheek at all.) If they are more focused on minimizing expenses and achieving raw returns rather than risk-adjusted returns, then it might be just fine for them over a very long period of time (assuming that the sequence of returns will not be an issue).

However, if they are anything like the hundreds of clients we’ve worked with over the years, the buy-and-hold strategy may include risk parameters far outside their tolerance. It remains my humble opinion that advisors should discourage clients from buying into a strategy they won’t be able to maintain for the long haul. Buy and hold, unfortunately, too often turns into buy and fold.

Tony Hellenbrand, RICP, is a partner at Fox River Capital, a registered investment advisor in the state of Wisconsin. For more information and full disclosures, please visit

Source: Buy and fold | Proactive Advisor Magazine

10 Reasons Investors Need Active Management in Retirement

Without employment earnings to offset portfolio losses, protecting portfolio value is essential for retirees. Do so with an active management portfolio!

by Linda Ferentchak | Jun 8, 2016


1. The traditional age-adjusted portfolio isn’t working

Traditional asset allocation maintains that as individuals age and approach retirement, their investment portfolios need to reduce exposure to high-risk assets and focus on capital preservation through investments such as more conservative bonds. A typical portfolio recommendation for an investor over the age of 55 might look like this:


Based on the Barclays U.S. Aggregate Bond Index, this pegs the majority of the portfolio at approximately a 2.1% annual yield, just below recent inflation estimates for the Consumer Price Index (CPI) around 2.2%. Add in taxes, and the equity and real estate portions of the portfolio have to provide substantial outperformance to offset both the loss in buying power of a bond-heavy portfolio and to provide real returns.


2. Bond risk is greatly underestimated

There can be no guarantee that a high bond allocation will preserve the value of the portfolio. Bonds face many of the same risks as equity investments, including the financial health of the issuer—default risk—and market risk. But they are particularly vulnerable to interest-rate and inflation risks. Since bonds typically offer a fixed interest rate (TIPs are one exception), increases in market interest rates lower the value of the bond, while increased inflation will whittle away the value of the return.


3. Traditional age-adjusted portfolios lack an inflation hedge

Inflation has been remarkably mild in recent years, but there is no guarantee it will continue at or below 2%. The U.S. money supply, as measured by M1, has increased since the credit crisis, generally outpacing domestic economic growth. Through the increased money supply, the Federal Reserve has deliberately sought increased inflation. At some point their wish will be more fully granted. The maturity value of a $20,000 bond investment 10 years in the future is still $20,000 regardless of whether or not it will buy an equivalent amount of goods or services.


4. Correlations break down in severe market declines

Traditional market theory maintains that bond values and stock prices are uncorrelated—they move in opposing directions. When stocks decline, bonds should increase in value, maintaining the overall value of a diversified portfolio. Studies have shown that in times of market uncertainty, relationships tend to break down with higher-risk bonds most vulnerable to losses. In the 2007–2009 market decline, asset classes became more correlated, moving down together.



5. Retirees need equities for higher returns, but may not have time to recover from a severe bear market

Buy-and-hold investment approaches rely on the market’s long-term upward bias to recover from a bear market. But the recovery is neither guaranteed nor predictable. It took close to five years for most major market indexes to recover from the 2000–2002 market decline and over three years to recover from 2008–2009’s worst levels. History shows that, on average, a new bear market begins every 5.5 years, with an average duration of 18.1 months. Omitting the distortion of the 1929 crash, the average time lost making up bear markets is 3.6 years. And that calculation merely measures the time spent for indexes to return to breakeven from the lowest point in a bear market—recapturing past market highs can often take even longer.


6. Active management offers more effective risk management than a bond-centric approach

The difficulty with using bonds for risk management is that investors forego the opportunity to participate in equity-market gains while remaining vulnerable to bond-market losses. 2013 was a good example of bond-market risk. The average core bond fund (at least 85% of assets in investment-grade bonds) fell 2% in 2013, including reinvested interest. The S&P 500 Index gained 31.9%, including reinvested dividends. The challenge is to capture equity performance for a retiree’s portfolio, but without the potential for losses such as the 37% loss that the S&P 500 experienced in 2008. Active management, with its focus on minimizing losses and participating in the majority of the market’s trend, is one approach to do so. Active management also has the potential to reduce the risk of bond investments, with the ability to utilize long/short bond funds and other tactics.


7. Active management doesn’t have to be perfect to work

The common criticism of active management is the statement that no one has ever been able to perfectly predict the market. But active management isn’t based on predictions, and doesn’t have to be perfect to work. The reason is the mathematics of gains and losses. It doesn’t take a 37% gain to recover from a 37% loss. It takes a 59% gain. Reduce the loss and an investor increases the leverage on the upside. With its goal of avoiding the majority of the market’s losses and capturing the majority of gains, active management can benefit from the leverage of having more capital to invest when the market cycle turns positive again.


8. There’s more than one way to actively manage a portfolio

Active management encompasses a wide spectrum of investment strategies and approaches. As the availability of data, computing power, investment alternatives, and market intelligence expands, so, too, do the active management capabilities. The right approach is the one that makes sense for the investor and the manager. Often that means a quite diverse blend of strategies and asset classes, all of which can benefit under the active management umbrella.


9. Active management accommodates behavioral finance biases

Faced with market declines or market gains, people tend to approach investing in predictable—although not necessarily logical—ways. These reactions tend to be counterproductive to long-term portfolio growth, and it is well-documented how individual investors have historically underperformed broad market indexes when left to their own emotion-driven decisions. Active management adds discipline, through professional money management, to the equation, resulting in the increased peace of mind so important to retirees. And this can benefit both advisors and their retired clients, with active management’s smoothing of returns over time facilitating the decision by clients to participate in the equity markets.


10. Market bubbles are inevitable

Exploiting their opportunity and limiting their damage requires active management. When it comes to pursuing exceptional portfolio gains, there’s nothing better than a good market bubble. But what goes up inevitably comes down. One of the best quotes on that topic comes from market analyst John Mauldin, credited to one of his mentors: “Mr. Market is a vicious sadist. He will do whatever it takes to create the greatest amount of pain for the largest number of investors.” Active management is a tool for participating in the “bubble” with eyes wide open, while always keeping one eye on the exit door.



It’s hard to calculate how long today’s retirees might live, but the one thing they want to know is that their money will not run out before they do. Answering in the affirmative requires combining capital preservation with the opportunity for capital appreciation. While no investor or investment management style can predict the future, everyone requires the flexibility to respond to opportunity. Active management can offer that opportunity.


Source: 10 reasons for an active management portfolio | Proactive Advisor Magazine