This article is part of a regular series of thought leadership pieces from some of the more influential ETF asset managers in the money management industry. Today's article is written by Michael McClary, chief investment officer of Akron, Ohio-based ValMark Advisers, which markets the “TOPS” brand of asset allocation models.
While we believe that markets are generally efficient, it would be shortsighted not to acknowledge the irrational behavior markets sometimes exhibit in the short term.
We are often amazed at how events that might have a less than 0.1 percent impact on global GDP can sometimes wipe out 5 percent of global market cap in a short period of time.
Recent events in Greece would be an example. While Greece’s economy is only about half the size of Massachusetts, this debt-laden country helped to impact a pullback in world stocks of about 5 percent in just a week’s time.
Many times behavioral finance plays a key role in short-term market movements. Behavioral finance, according to author Michael Pompian in “Behavioral Finance and Wealth Management,” attempts to understand and explain observed investor and market behaviors. As portfolio managers, we recognize that behavioral bias is a frequent distraction for markets and investors, so we have to deal with it and build investment processes that allow for them.
To study the behavior of markets at a macro level, it may be helpful to start with the micro level. In this piece, we will review factors of behavioral finance and theories on how emotions may be exhibited in markets and investment decisions.
There is a vast body of work that has been completed in the area of behavioral finance. Accomplished researchers, such as Meir Statman from Santa Clara University, have been working for decades to outline and help explain why investors make the decisions they make.
In his book, “What Investors Really Want,” Statman outlines several key ideas, including:
- We want to be No. 1 and beat the market
- We want to nurture hope for riches and banish fear of poverty
- We want to feel the pride of profits and avoid the regret of losses
- We want the sophistication of hedge funds and the virtue of socially responsible funds
- Cognitive errors mislead us into thinking that investments with profits higher than risks are easy to find
Statman’s work is remarkable and has helped to outline why investors continue to make bad decisions and pay handsomely for their mistakes. After all, investors are all humans. Even program trading involves an algorithm that is developed, reviewed and approved by a human at some point. Nobody’s Bloomberg terminal wakes up on Monday morning and all of a sudden decides to start making trades on its own.
Markets Are Ultimately Human
Abraham Maslow's famous hierarchy of needs, first introduced in "A Theory of Human Motivation" published in 1943, outlines a popular belief of what drives human psychology. In simple form, humans strive to have their basic needs (physiological) met first, then they move on toward other needs, eventually striving for self-actualization (essentially what the U.S. Army would later describe in its slogan, "Be all that you can be").
Most investors’ physiological needs (air, food and water) are easily met. By definition, they have money to invest, so they have presumably already bought their groceries before buying 50 shares of the next hot Internet stock. Therefore, they move quickly on to safety, Maslow's next need.
Since financial safety is included in this stage, investors sometimes resort to making decisions based on safety, especially in times of crisis. The next stages, before self-actualization, are love/belonging and esteem. At this point in the year, we believe investors are floating between safety and self-actualization.
Vol Of Vol
One example of this behavior is a recent spike in a technical measure called Vol of Vol. Vol of Vol measures the volatility of volatility. If there is a high Vol of Vol, that typically means markets are exhibiting spastic behavior. Represented by the CBOE VIX Volatility Index (VVIX), the VVIX measure of VIX options’ implied volatility (Vol-of-Vol) saw its second-largest daily gain ever on June 29.
There are some market events, like Greece, China and the Fed rate cycle, that touch on an investor’s basic need for safety. On the other hand, low unemployment in the U.S., relatively strong economic numbers across much of the global market capitalization, and attractive valuations for non-U.S. stocks leave investors searching for self-actualization and asking, "Where is my return?". This psychological barbell may be leading to some of the spikes in VVIX.
While there are typically thousands of factors that impact market movements, events in Greece seemed to be a key driver of the pullback. Like Greece, we feel there are countless examples of factors that investors worry too much about, affecting their results over time.
3 Questions Investors Worry Too Much About
While there are many potential examples, we have chosen three relevant areas where investor behavior may currently be playing too big of a role:
- Should I be trying to beat the “market”?
- Should I take a big bet on interest rates?
- Should I be worried about the length of the current stock market rally?
Should I Be Trying to Beat The ‘Market’?
In the coming weeks, Standard & Poor’s will issue the next iteration of its popular S&P Index vs. Active (SPIVA) report. Past reports can be found at us.spindices.com. In the report, S&P analyzes actively managed mutual funds versus benchmark indexes. In a nutshell, the results have strongly supported index management over time. Morningstar, historically a purveyor of data on actively managed funds, has now begun producing a report that appears to be similar.
While data continue to largely support choosing indexes, the lure of active management (or trying to beat the “market”) is as American as apple pie. Note the bullet points above from Meir Statman. His list of behavioral traits would lead any logical advisor to recommend active management, as it is unquestionably what clients are looking for.
However, we believe in managing portfolios to optimize risk-adjusted return and giving investors their best chance for success. Like a lot of things in life, that might involve giving them what they need, not what their carnal instincts tell them they want.
This goes for us as well, and we execute the same discipline for our own investments, resisting the urge daily to take the governor off and really open up our stock-picking abilities to see what they can do.
I have received numerous comments over the years about active versus index management, both positive and negative. Many longtime purveyors of active management are understandably disturbed by the idea of index investing. Several times I have heard from different sources that "you should be embarrassed to accept average by investing in indexes."
A problem with active management has been that the average is subpar. If investing were golf, investing in the index historically would be like being a scratch golfer and active management would be the local hacker, not the other way around. What many assume is that indexes were average—a frequent mistake. Secondly, many assume that active management would do better than both indexes and the "average."
We believe in using index-based ETFs for exposure to select asset classes. We then focus our energy on asset allocation, ETF selection and monitoring. According to the statistics, we are not alone. ETFs and indexing continue to make large gains in assets compared with classic active management.
Should I Bet Big On Interest Rates?
Since the beginning, the Federal Reserve has functioned as a lubricant for the economy. However, at some point, the Fed arguably became the fuel. This shift for the Fed has helped to create the difficult interest-rate scenario currently plaguing the U.S. Likewise, this has many investors very concerned about the impact of interest-rates changes on bond prices.
It has been nearly seven years since the last Fed rate hike. With the Fed funds rate target still hovering at 0-0.25 percent and the 10-year U.S. Treasury ending June at 2.36 percent, the path back to “normal” interest rates is still in front of us.
The 10-year U.S. Treasury yield finished June 2007 at 5.06 percent, just eight years ago. However, we have not seen rates north of 4 percent since the end of 2007.
We are in a very unique interest-rate environment in the U.S. and there is a tricky path ahead.
We have seen some analysts place the probability of a rise in rates in September at less than 25 percent. The probabilities generally look higher as you approach December. Ultimately, no one knows for sure yet, as we don’t believe the decision has been made. Likewise, many things may change between now and then.
With the one- to three-year target investment horizon at which the TOPS team approaches strategic decisions, we feel comfortable that rates are expected to rise in our path, which we are prepared for. We would discourage investors from making big bets on interest-rate moves. Recognize the rate path may not be as they expected.
Should I Worry About The Stock Rally Ending?
The current stock market rally in the U.S. is nearly 6 ½ years long, making it longer than the average bull market (going back to 1950). We frequently hear investors say things like, "This market is getting long in the tooth.”
It is human to accept that "all good things must come to an end." Each day that the current bull market trudges on, we get one day closer to the next bear market. A problem with this logic is that we don't know the total life span of a bull market until it dies.
The average life expectancy of a male in the Middle Ages was somewhere between 30 and 45 years, despite their genetic makeup being similar to ours today. If someone were able to dodge disease and take relatively good care of themselves, then they could live quite a bit longer.
So, would a 40-year-old in the Middle Ages be long in the tooth? Yes. Was the marginal rate of death much higher for those from 45 to 50 versus 40 to 45? Not necessarily. They weren't dying of old age at 45, they were dying from other factors.
This bull market will not die of old age. It might die of a world crisis in some capacity, but bull markets don't die of old age.
What Should Investors Worry About
We feel investors should be focused on their asset allocation and investment process. Trying to pick active managers that may outperform an index, time interest-rate movements or the end to the bull market are all activities with low likelihood of success. We encourage investors to stick to the impactful aspects of portfolio management with higher likelihood of improving success.
ValMark Advisers Inc. is the manager of the TOPS Portfolios of ETFs. ValMark started managing "TOPS" separately managed accounts of ETFs in 2002. The firm manages more than $5.1 billion in ETFs for retail and institutional clients in multiple investment products. Email: [email protected]; Phone: 800-765-5201. For a complete list of relevant disclosures, please click here.