Smart Investing: Seeking Reward While Reducing Risk

Transcription

1 Smart Investing: Seeking Reward While Reducing Risk Charles Rotblut, CFA Vice President & AAII Journal Editor American Association of Individual Investors As in driving, the secret to success is not making big mistakes. Source: Charles Ellis, My Investment Letter: Words of Advice for My Grandchildren, AAII Journal, October

2 The optimal strategy is not one that maximizes return, but rather one that helps you stick to your long-term investing plan and achieve your goals. A Lesson From My First Job OIL BOOM: Build Cash Reserve OIL REBOUND: Profit! OIL BUST: Buy Assets on the Cheap 2

3 Economic and financial theory assumes humans act in rational ways. Behavioral scientists have evidence suggesting otherwise. Was This Rational? Source: Kickstarter, July 12, 2014; $55,492 pledged in total 3

4 We Do Not Consider Expected Outcomes Source: Illinois Lottery, February 8, 2015; Overall odds of winning are 1:32 (3%) We Are Risk-Averse Source: Thinking, Fast and Slow, Daniel Kahneman (Farrar, Straus and Giroux, 2011) 4

5 Biology Makes Us Risk-Adverse Source: Cortisol Shifts Financial Risk Preferences, Narayanan Kandasamy et al., Proceedings of the National Academy of Sciences of the United States of America, March 4, What Scares People Source: Fear of Financial Planning Consumer Study, Nationwide Financial, July

6 How Our Brains Rationalize Overconfidence We humans are likely to believe our decisions are correct How Our Brains Rationalize Confirmation Bias We look for information confirming our beliefs 6

7 How Our Brains Rationalize Recency Bias We assume present conditions will continue into the future The Impact of Behavioral Errors Source: 2014 Dalbar QAIB Highlights Futility of Investor Education, Dalbar, data from 1994 to

8 What If You Are Nervous? Admit you are scared by the markets, take a deep breath and wait a day before making changes to your portfolio Sell investments that keep you up at night But realize that if you want to beat inflation, you have to accept some volatility and down markets Cognitive Decline The ability to make sophisticated decisions peaks at age 53 Approximately 1 in 7 Americans age 71 or older have dementia according to the Alzheimer s Association 8

9 Cognitive Impairment Affects Financial Skills Source: Finances in the Older Patient With Cognitive Impairment, Eric Widera, Veronika Steenpass, Daniel Marson, and Rebecca Sudore, JAMA, February 16, Many Manage Their Finances While Cognitively Impaired Source: Dementia Risk and Financial Decision Making by Older Households: The Impact of Information, Joanne W. Hsu and Robert J. Willis, Federal Reserve Board Working Paper,

10 Simplify your strategy and be cautious about making big changes as you age Use the Power of the Written Word to Your Advantage 10

11 Write and maintain emergency instructions on how to manage your portfolio. Need another reason for writing down instructions for managing your portfolio? Psychologists say people make more rational decisions when they are not in a crisis situation. 11

12 All AAII Portfolios Have Written Buy and Sell Rules Model Shadow Stock rules located at My Favorite Investing Tool (It s a spiral notebook) 12

13 AAII Dividend Investing Log What I Write Down The reasons why I bought an investment The reasons why I would sell an investment Updated news and fundamental data about the investments I own and monitor Research notes about what I ve looked at 13

14 Write down everything that matters to your portfolio, rather than keeping it in your head. It s more important to remember birthdays and anniversaries than the details of your portfolio. Among the things to write down is your long-term allocation strategy 14

15 AAII Allocation Models AAII Asset Allocation Models located at If you don t know what is going to happen, don t structure your portfolio as though you do! Source: The Purgatory of Low Returns, James Montier, GMO Quarterly Newsletter, July

16 Key Points About Diversification The mix of stocks, bonds and cash will have the biggest impact on your returns Nobody knows how much inflation or interest rates will rise in the future Diversify, Then Rebalance Rebalancing prevents allocation drift, maintaining diversification benefits Gives you a strategy for volatile markets Forces you to buy low and sell high Vanguard suggests annual or semiannual rebalancing when allocations are off target by 5% or more* Source: Best Practices for Portfolio Rebalancing, AAII Journal, May

17 Rebalancing and Returns A $100K portfolio based on AAII s moderate allocation model No retirement withdrawals taken 5% threshold used for rebalancing Performance calculated from Vanguard index funds used to avoid impact of active management Results From 27 Years of Data Source: The Danger of Getting Out of Stocks During Bear Markets, by Charles Rotblut, AAII Journal, May 2014; Updated February 1,

18 Other Allocation Approaches Allocate solely to one asset class Set allocation and (mostly) do nothing Rebalance to a glide path Segment portfolio (bucket, by goal, core and satellite, etc.) Tactical strategies Source: Choosing the Right Portfolio Allocation Approach for You, by Charles Rotblut, AAII Journal, October 2014 Don t Buy High and Sell Low Source: 2014 Investment Company Fact Book, Investment Company Institute 18

19 Panicking Is Very Costly *Allocation shifted to all bonds in 2003 and 2009 and back to target allocation in 2004 and 2010; Source: AAII Journal, May 2014; Updated February 1, 2015 What If Your Timing Is Bad? *Allocation shifted to all bonds in 2003 and 2009 and back to target allocation in 2004 and 2010; Source: AAII Journal, May 2014; Updated February 1,

20 Good investment practices only work if you select good securities and funds The first decision in security selection is not determining what to buy, but choosing whether to use a passive or an active strategy. 20

21 Passive vs. Active Passive Gives you the index s returns, easy diversification, lower tax and transaction costs, requires less time and effort Active More control, can beat the market or reduce volatility, requires more time and effort How Do You Choose? Do you have the time to research individual securities and funds? How good have your previous stock and bond picks been relative to the broad market? 21

22 Choose Both Passive and Active Choosing both allows you to take advantage of each strategy s strengths Active management gives you the opportunity to beat the market Passive management ensures that, no matter what, part of your portfolio will always track the market s performance Index funds (passive investments) should be your default option when you can t find an attractive stock, bond or fund to buy. Source: Dishonesty, Choices and Investing, Dan Ariely, AAII Journal, June

23 Watch Out for Bad Management Source: Social Science Research Network (SSRN), June 17, 2014 Lululemon s Declining Margins Source: Stock Investor Pro, February 6,

24 Be Wary of the Latest Fad Source: MarketWatch, July 7, 2014 Ridiculous Valuations Source: CNN Money, October 4, 2013; 2015 P/E is 56.8 as of February 20,

25 Cash Flow Matters Source: New York Times, February 5, 2015 J.C. Penney s Cash Flow Source: Stock Investor Pro, February 6,

26 Stocks: Key Traits to Look For Strong Business Model products fulfill needs, barriers to entry exist and the company is profitable Good Financials positive cash flow, adequate cash, low debt, rising sales and profits Attractive Valuation both price-to-book (P/B) and price-earnings (P/E) ratios are reasonable Dividends Boost Returns Source: Ned Davis Research, data for period of February 1972 through May

27 Momentum Helps Too Stocks with 26-week relative strength rankings of 60% or higher tend to outperform Combine momentum with valuation measures such as the price-earnings ratio Momentum strategies have more turnover, and therefore are more costly Source: What Works on Wall Street, Fourth Edition, James O Shaughnessy (McGraw- Hill, 2011); Quantitative Strategies for Achieving Alpha, Richard Tortoriello (McGraw- Hill, 2008) Liquidity: An Overlooked Style Source: The Liquidity Style: Finding Bargains by Seeking Less Popular Stocks, Roger Ibbotson, AAII Journal, April

28 My Stock Screening Criteria Price to Book < 3 Current Ratio > 1.0 Price to Earnings < 20 Debt to Equity < 0.50 Dividend Growth = 1+ Years Times Interest Earned > 2 Earnings Estimates Revised Up Sales Growth = 3+ Years 26-Week RSI Rank > 60% EPS Growth = 3+ Years Market Cap < $1 Bil Better Free Cash Flow = 3+ Years Operating Margin Rank > 60% EPS Up Year-over-Year Return on Equity Rank > 60% EPS Up Quarter-over-Quarter Intangibles < 50% of Equity Six Reward Criteria Price-to-Book Price-to-Earnings Dividend Growth Market Cap Positive Estimate Revisions Momentum (Relative Strength) 28

29 Seven Risk Criteria Balance Sheet Liquidity (Current Ratio) Level of Debt Intangibles as a Percentage of Book Value Sales and Earnings Growth Free Cash Flow Return on Equity Operating Margin My Stock Screening Criteria Source: AAII s Stock Investor Pro, data as of February 20,

30 I Use Custom Fields Source: AAII s Stock Investor Pro Momentum Score Source: AAII s Stock Investor Pro 30

31 Stocks Passing My Screen Source: AAII s Stock Investor Pro, data as of February 20, 2015 Passing Stocks-Relaxed Screen Source: AAII s Stock Investor Pro, data as of February 20, 2015; No five-year average P/E requirement used 31

32 Stocks: When to Sell The reason you bought the stock no longer applies (follow your sell rules) The valuation becomes excessive Business conditions, the fundamentals or the outlook deteriorates The dividend is cut or suspended You need to rebalance A Few Final Words of Investing Advice 32

33 Be a Proactive Investor No one cares more about your wealth than you do, so treat investing like a business Track your investments for any changes that make them less attractive Ensure that your asset allocations remain on track to meet your financial goals Read the annual reports and prospectuses 2 Rules for Investing Success Rule #1: Develop a consistent, well-defined approach to investing Rule #2: Stick to Rule #1 Source: James Cloonan, Adherence to Rules Helps Model Shadow Stock Portfolio's Performance, AAII Journal, October

34 AAII Resources AAII Updates ( 34

35 Stock Investor Pro ( $198 per year) AAII Dividend Investing ( $149 per year) 35

36 Smart Investing: Reducing Risk While Seeking Reward Charles Rotblut, CFA Vice President & AAII Journal Editor American Association of Individual Investors Bonus Content: A preview of a forthcoming webcast on how to follow the Model Shadow Stock Portfolio. 36

37 Guidance for Following the Model Shadow Stock Portfolio Charles Rotblut, CFA Vice President & AAII Journal Editor American Association of Individual Investors Model Shadow Stock Portfolio Looks in the shadows of Wall Street for mispriced, profitable companies Small company premium: Stocks with market capitalizations ranking in the bottom 10% of all NYSE-listed stocks Value premium: Stocks with price-to-book ratios ranking in the bottom 10% of all NYSE-listed stocks An actual, actively managed portfolio 37

38 Portfolio Management Changes, if any, are made quarterly Results we report include all transaction costs Requires a commitment to sticking with it Stocks are added once every three months: January, April, July and October Portfolio Notes Updated on the 15 th of Each Month ( 38

39 AAII Model Portfolios Update Newsletter (Subscribe at Shadow Stocks to Buy Look for stocks listed as being qualified These are held in the portfolio and meet the rules for purchase Qualified stocks have market capitalizations and valuations ranking in the bottom 10% of all NYSE stocks A stock can be held in the portfolio, but not qualify for purchase 39

40 Qualified Stocks Have the Most Attractive Valuations ( How Many Shadow Stocks to Buy Buy at least 10 Shadow Stocks Not necessary to buy more than 20 Shadow Stocks unless allocating more than $1 million to following the portfolio Allocate even amounts of dollars to each stock Don t put more than 10% of your portfolio into any single stock 40

41 If Not Enough Stocks Qualify Allocate 10% of the funds you were intending to devote to following the portfolio to each of the passing stocks Set aside remaining amount in cash or in a broad market index fund If allocating $50,000 to buy 10 stocks and just two stocks qualify, invest $5,000 in both and set aside remaining $40,000 Check the portfolio notes each month to see if additional stocks qualify Additional Candidates Shadow stock screen; built into Stock Investor Pro ( 41

42 Additional Candidates ( Passing Companies Companies currently meeting purchase rules May already be included in the portfolio May be excluded from the portfolio because of country (e.g. China), insufficient liquidity (less than $150,000 in volume per day) or there isn t not enough free cash to buy a new stock 42

43 Shadow Stock Sell Rules Earnings: Trailing 12-month earnings are negative (probation) and earnings are negative for subsequent quarter prior to 12-month earnings becoming positive Value Limit: Price-to-book-value ratio goes above 2.4 Size Limit: Market capitalization above $900 million Signs a Stock Could be Sold 43

44 Frequently Asked Questions How Often Are Changes Made? We only announce changes once per quarter unless an extraordinary event occurs with a specific company Due to the type of stocks this portfolio holds, a buy-and-hold approach is necessary to keep transaction costs low 44

45 How Much Should I Invest? You will need to allocate enough to offset the cost of commissions The more you can allocate, the less you will lose to commissions relative to the amount invested Investing a $1,000 per stock will cost you 2% in brokerage commissions; investing $2,000 will cost you 1% in brokerage commissions Is There a Shadow Stock Fund? There currently is not a fund that follows the Shadow Stock strategy We cannot invest money on members behalf; you will have to make the transactions yourself in your brokerage account 45

46 Additional Resources Shadow Stock Portfolio Rules ( 46

47 Model Portfolios User s Guide ( Jim Cloonan s Commentary ( 47

48 The Model Shadow Stock Portfolio is primarily an educational tool designed to provide a real-world example of how individuals can apply academic research regarding valuations and company size to their own portfolios. You have the option of following the guidelines presented here, or adjusting the rules to match your personal investment style and goals. 48