Sunday, August 28, 2016

We Are Not Always So Rational, Part 1

A personal note

I’m proud to say that I have recently been awarded the CFA charter.

Although I’m fortunate to have passed each of the 3 exam levels on the first try, it took me a long time to complete the program. I wrote level 1 in 2009, followed by level 2 in 2011. At that time, I was working as an engineer and didn’t see the value in finishing.

Also around that time, I first discovered the work of Meb Faber and Gary Antonacci. I continued to research markets on the side since then and Gary has really been instrumental in accelerating my learning curve. A little over a year ago, Gary nudged me to start this blog. And earlier this year when I met Gary in person for the first time, he encouraged me to finish the CFA program. It’s been a very interesting journey so far and I hope to share more announcements with you in the future.

Incidentally, both Meb and Gary are coming to my hometown Vancouver on Sept 6th to give presentations. Small world. If you live in the area, I highly recommend you attend. Register here.

The most interesting topic in finance

Of the 3 CFA levels, the third one taught material I enjoyed the most. It skips the humdrum accounting and statistics of other levels and instead focuses heavily on portfolio management. There were a couple chapters dedicated to Behavioral Finance (BF) – what I consider to be the most interesting topic in investing.

BF is the study of human nature and its impact on our investment decisions. It challenges the main assumption of traditional finance: that individuals are rational and that the markets they shape are efficient. It is where the world of investing intersects the disciplines of psychology, history and biology.

As we will see, investors suffer from numerous behavioral biases that lead them to wreck havoc on their portfolio. It is truly amazing how many distinct biases there are that they need to be categorized into two main categories:
  1. Cognitive – faulty decisions that arise from the lack of knowledge, information processing errors or memory errors
  2. Emotional – faulty decisions that stem from feelings, impulses or intuition

The remainder of this post will discuss some common cognitive biases. There is so much to discuss on the topic of BF, that we will follow up with 2 more posts:
  • Discussion of common emotional biases, plus a quiz!
  • Impact of our biases, how to minimize this impact as well as additional resources

Cognitive Biases

  • Anchoring – New info is not viewed objectively, but rather in relation to an initial view or thought.
Example: Studies show that when a group is asked to estimate the price of a car, the average estimate tends to be reasonable. However, if asked first what the last digit in their phone number is, people who had a higher digit tend to over-estimate the car's price.
  • Framing - When the same information is presented in different ways, it leads to different outcomes.
Example: Sally is loss averse. When her advisor presents a new fund in terms of historical return and volatility, Sally invests. However, when the advisor presents the same fund in terms of probability of a loss, Sally declines to invest.
  • Availability Bias - Giving undue emphasis on info that is readily available and fresh in our minds. This leads to giving higher importance to recent events rather than old events (the "recency effect"). 
Example: Bob chose to invest with XYZ fund because of a billboard ad he sees on his daily commute.
  • Confirmation Bias – looking for new info to support an existing view.
Example: Soon after buying stock XYZ, you selectively search for bullish articles while ignoring any bearish articles.
  • Hindsight Bias – Overestimating what could have been known. People often remember their correct views while forgetting their errors
Example: “I saw the 2008 crises coming all along” 
  • Conjunction Fallacy – before explaining this one, I want you to participate in this question:
Linda holds very strong views about the environment. Which is more likely?

a) Linda is a bank teller, or
b) Linda is a bank teller that donates to an environmental organization

If you said (b), that is incorrect. But don’t feel bad, 80% of people choose that answer.

The probability of Linda being a bank teller is already small. But for her to make a donation in addition to being a bank teller reduces the probability further. This example shows how we can be tricked into believing that two events have a higher chance of occurring together than either one occurring on their own. That’s the conjunction fallacy.

In part 2, we’ll look at some common emotional biases. Stay tuned

Wednesday, July 27, 2016

Momentum on Individual Stocks vs Asset Classes

I had the pleasure of finally meeting Gary Antonacci earlier this year.

Gary is the creator of the momentum strategy that I follow and have been discussing on this blog.  I first came across his work in 2011 on the blog Abnormal Returns (which should be a daily read for investors). Gary and I have been e-mailing each other ever since. After over 4 years, it was nice to finally see him in person.

Gary gave an excellent 2+ hour presentation on momentum in Seattle. There were over 100 people in attendance and it was the local AAII chapter’s largest turnout. The presentation covered everything: what momentum is, why it works, its history and correct use.

Two main ideas on the correct use of momentum were discussed:
  1. Momentum applied on asset classes works much better than on individual stocks
  2. The role of absolute and relative momentum and the synergistic effect of combining the two
In this post, I will focus on point #1. When momentum is applied on individual stocks, there are 3 main drawbacks:
  1. Low scalability
  2. High volatility
  3. High transaction costs
Let’s discuss each of these in detail.


When applying momentum on individual stocks, trade execution can suffer for large trade sizes or thinly traded stocks. The very act of buying and selling changes the market price, hence reducing the alpha that can be achieved.

Contrast this with momentum applied at the asset-class level. You can enter/exit large positions in an ETF such as SPY (SPDR S&P 500 ETF) and the vast liquidity of this ETF would absorb the buying/selling pressure.

The chart below shows that momentum on individual stocks is theoretically best when both the number of stocks and holding period is small. However, a small number of stocks means low scalability and high volatility while a small holding period means high transaction costs.


The second drawback to trading individual stocks is that they are also more volatile. This is due to company-specific risk such as earnings reports or regulatory changes. It can also be due to stocks being thinly traded or belonging to a volatile industry such as mining.  

The table below shows a momentum strategy using individual stocks compared to the S&P 500. While the returns are higher for the momentum strategy, the volatility is also a lot higher. The Sharpe Ratio does not improve much (after trading costs, it may actually be lower for the momentum strategy).


In an individual-stock momentum strategy, you typically will hold a much larger number of stocks than you would ETFs in an asset-class momentum strategy. This results in a higher volume of trades and hence, transaction costs.

The table below shows that after transaction costs, momentum applied on individual stocks (whether large cap or small cap) actually performs worse than a buy-and-hold strategy.

We can alleviate the drawbacks of scalability, volatility and transaction costs by instead applying momentum at the asset-class level. But which asset classes should we use? 

The book “Stocks for the Long Run” by Jeremy Siegel shows that equities (especially US equities) have had the highest risk premium among all asset classes, so they should be the focus of any momentum model. Bonds should also be included since they tend to outperform equities during recessions. 

The GEM strategy I follow uses 3 asset classes: US stocks, non-US stocks and bonds. You can refer to this page to see how the strategy has fared over the past 40+ years compared to each of the 3 assets on their own. 

Despite all the evidence supporting asset-class momentum over individual-stock momentum, it is astonishing to see so many commercial momentum funds doing the opposite: AQR Mutual Funds (AMOMX, ASMOX, etc), PowerShares ETFs (PDP, PIZ, PIE, etc), iShares ETF (MTUM), Alpha Architect ETFs (QMOM, IMOM). 

Results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Additional information regarding the construction of these results is available upon request. Past performance is no assurance of future success. Please see our disclaimer page for more information.

Thursday, June 16, 2016

Be Thankful

I apologize that I haven’t posted on this blog for the past several months - I was studying for the CFA Level 3 exam, which I wrote earlier this month. It is a great feeling to be back into my regular routine again and have some spare time. So here is a simple post that I hope you can apply not only in your investing but life in general. Enjoy

Being grateful

I was talking recently with my friend Deep who I’ve known since about age 4. He told me how he just started wearing eyeglasses again. This seems like a minor lifestyle change until you learn the history of my friend’s eye condition.

When Deep was 5, he got his first pair of eyeglasses. But his vision kept deteriorating that he needed a stronger prescription lens every year. By age 11, he was on the strongest lens available. The optometrist told Deep that if his vision didn’t stabilize soon, he would be legally blind.

At that time (over 20 years ago), we did not have proven, mainstream eye surgery techniques like Lasik or PRK. Of the limited procedures that were available, there was no internet to do research, evaluate risks and learn from testimonials of other patients. Instead, Deep did the only thing he really could do. He prayed. Every day.

At age 12, Deep underwent a procedure called Radial Keratotomy. “Weren’t you scared?” I asked. “Of course, it’s your eyes after all. But I really didn’t have much of a choice. There wasn’t much to lose” he replied.

I can’t help but think how grateful Deep must be that the surgery was successful. How he went from barely being able to see to not needing glasses until recently (something the optometrist said was inevitable later in life). His life dramatically improved. Deep is currently a Senior IT Manager and one of the most passionate people I know about computer technology, motorcycles, and life in general.

There’s an important message here. Too often we’re constantly listing all the things we’re missing in life. “If only I had ____, life would be better.” This leads us to being unhappy and even depressed.

One of the simplest and most effective ways of increasing our happiness is to stop focusing on what’s missing and instead be thankful for the things we already have: A home. Modern medicine & good health. Wide selection of fresh food at your local grocery store that even the wealthiest didn’t have in past civilizations. It is a great feeling once you believe we are not owed anything in life and that everything we have is a bonus.

As applied to investing, it is easy to be unsatisfied with your portfolio size, returns or both. In addition, it is easy to get sucked in by the media and dwell on the constant barrage of negative news. These factors often lead us to make sub-optimal decisions with our portfolio, which in turn further add to our stress and misery.

Instead, focus on all the positives of being an investor:
  • It is easier now more than ever to follow the research of professional investors. I am especially grateful for having a simple & proven strategy and evolved philosophy thanks to the generosity of Gary Antonacci, Meb Faber, Tadas Viskanta, Ben Carlson, and many others
  • Be grateful that you have savings to invest (no matter how small). A large % of the population unfortunately does not have this benefit
  • Perhaps you have developed a sound investing plan at a young age. Be grateful for that, as many go their whole lives not having figured out their finances
  • ETFs have given us diversification at low cost. Online brokerages have made it cheap & easy to execute trades 

Evaluating thyself

Related to the problem of overly focusing on our negatives is the problem of comparing ourselves with those that are more successful than us.

Often, as investors it is tempting to compare our performance with other investors. Did I beat XYZ
manager? This is one of the worst things you can do. There will always be someone out there better than you. You can never always be the best, nor should you care to be.

Seth Godin has an excellent blog about general business & marketing philosophy. But so much of what he writes applies to investing. He recently wrote a post titled “It’s not a race.” Seth writes: 
A race is a competition in which the point is to win. You're not supposed to enjoy the ride, learn anything or make your community better. You're supposed to win. Once you see it that clearly, so many things are clearly not races. And when we treat life that way, we cheat our customers, the people we seek to serve, as well as ourselves.

Instead of trying to compete with other investors, I recommend you compare your present self with you one year ago. And I’m not talking about portfolio returns. I’m talking about:
  • Was I more disciplined this year?
  •  Did I have less stress?
  • Was I able to ignore the noise?
  •  How many people did I help with their finances?
  • What did I learn?

Please feel free to share you own thoughts in the comments below. Thanks for reading

Saturday, March 5, 2016

Buffett's Advice to Young People

Dear readers, I will be away for the next 3 months studying for an exam. I see some of you have left comments – I will respond to you in June.

In the meantime, I’d like to leave you with a speech given by Warren Buffet to a young audience. The video is almost 20 years old but the advice is timeless. Some of the key takeaways:
  • Qualities of great employees: integrity, intelligence, and energy. You must have integrity in order for the others to matter. 
  • The importance of forming good habits at a young age in order to develop into the kind of person you most admire. 
  • Do what you love, not what makes you the most money
  • Stay out of debt and live frugally. Compare two people: one with net credit card debt of $10K paying 18% while another has net savings of $10K growing at say 8% over the long-term. You want strive to become the latter at an early age. 


Thursday, February 4, 2016

You Gotta Be Here

Source: Kenn Leonhardt

In 2010, Vancouver BC hosted the Winter Olympics and the city ran catchy marketing slogans including “The Best Place on Earth” and “You Gotta be Here.”

Vancouver has supernatural scenery with the ocean and mountains in the backdrop. We have world-class ski resorts just 30 mins away from the city core and enjoy a very moderate climate.

We also have some of the most expensive real estate on earth. In fact, last month the average detached house in Greater Vancouver has surpassed $1.8 million!

Source: REBGV

As you can see from this graph, prices of detached homes have gone parabolic in the past year. The locals here are dangerously in love with real estate and it seems it’s the only market they ever talk about. You got to be here to witness it.

According to the annual Demographia housing study, Vancouver real estate is regarded as the 3rd most expensive in the world (based on average housing prices divided by average local incomes).

Source: Demographia

Our housing valuations (Price/Income and Price/Rent ratios) are now over 3 standard deviations from their historical norms. Yes, I know. Something that’s expensive can become even more expensive and that’s why I’m a trend follower instead of a value investor.

So what's the point I'm trying to make?

I want to show you (especially if you’re a local) something that may surprise you. I want to show you that as hot and exciting as Vancouver real estate might look, boring old bonds would have made a better investment over the past 40 years.

Going back to the price graph above, a single detached home went from about $80K to $1.8M in 39 years. That’s an annual price growth of 8.3%. If you count rental income, then the total return would be closer to about 10%.

Over the same period, an Aggregate Bond Index such as AGG (which mostly contains AAA-rated government bonds with an average 5-year maturity) grew at a total return of 8%. OK, not quite as high but consider these important things:

  • Bonds are low-cost. They don’t have the enormous costs of property tax, insurance, maintenance and repairs. Just property tax alone in Vancouver would be $34K/year on the average $1.8M house.
  • Bonds are more liquid. To sell a home in Vancouver, realtor fees alone would be $60K on the average $1.8M average house. To sell a bond ETF, it would cost you $10 and it would be instant and painless.
  • Bonds are less volatile
  • Bond indices are more diversified

When you factor in the high costs of owning a home, we can say that the total return for a detached home is closer to 9% annually. I’d much rather take the 8% that bonds gave and have the benefit of lower volatility, better diversification and better liquidity. (Actually, I’d much rather take the 18% that GEM has produced over that same period but I’m making another point here).

Despite all these points, no one ever talks about bonds. That would just be a buzz kill at cocktail parties and nobody wants that!

I’d like to end with a quick discussion on interest rates. Here’s a chart for the 10-year US Treasury Yield going back over 100 years:


The stellar growth in both bonds and Vancouver real estate for the past 30 years was on the back of falling interest rates. In fact, if you look at pre-1982 and post, you can see how rising and falling interest rate environments have affected bonds: 

Going forward, we no longer have that tailwind of falling rates. Instead, over the next 20 years we may see something more like the 50s and 60s. This would mean a low-return environment for bonds and real estate.

And when you also factor the current stretched valuation of Vancouver real estate, I wouldn’t be surprised to see a couple lost decades in this market.

But I promise not to mention any of this at a party.

Related posts:

Sunday, January 17, 2016

Get Rich Slow

With the recent declines in the stock market, I was reminded of this article I read in the WSJ journal written on May 14, 2015: Chinese Investors Are Staying on the Risky Margins

The article explained how “China’s rocking stock market has encouraged typically conservative investors to embrace leverage. They are borrowing money to buy stocks and ride a rally that has seen the Shanghai Composite Index more than double in a year.

The article was written just 3 weeks before the Shanghai index peaked. The chart below shows how the index doubled in less than a year before erasing the majority of those gains in just 7 months. You can also see how margin debt went up over 5-fold before the market peaked. 

Source: WSJ,

The most striking part of the article was the story of one Chinese trader:
“Kevin Zhang, formerly a senior manager at a state-owned company in Shenzhen, started with a five million yuan ($800,000) stock portfolio last year. He borrowed an additional 10 million yuan from his broker, and the value of his initial investment doubled in a year.
But he isn’t satisfied. At a dinner for big investors arranged by his broker, Mr. Zhang found that several of them made 10 or 20 times their initial investment last year. These people had borrowed money from other channels, such as umbrella trusts, now banned, that allowed people to borrow up to 10 times their investment money. 
This year, Mr. Zhang gave up his stable job, with an annual salary of a million yuan, to be a full-time investor. Work wasn’t that busy at the state company, but it got in the way of trading. He says he came out of a meeting one day and found he had lost a year’s salary in an hour, so he decided he should focus on investments. 
Mr. Zhang knows the market looks bubbly. The price-to-earnings ratio of stocks on Shenzhen’s growth enterprise board is close to 100 times. But he believes the government is keen for the bull market to continue. “I’m going to leave the market after I double my money again,” he said. “That will be enough for me to live the life I want to live.”

Again, this was just 3 weeks before the Chinese stock market peaked.

This is a classic example of how our emotions kill us in the markets. Too many people get lured by the prospect of rapid gains that they take absurd levels of risk, often at precisely the wrong times. Only a disciplined, systematic approach with a long-term mindset wins in the markets. Warren Buffet has a great quote: “The stock market is a device for transferring wealth from the impatient to the patient.” I couldn’t have said it better. 

Related Posts:

Saturday, December 5, 2015

High Valuations and Low Yields

This is how your average buy-and-hold investor probably feels right now if they are looking to deploy new capital for the long run.

Today, bond yields are puny while stock valuations are rich. In fact, we currently have one of the worst yield and value combinations in history as seen in the charts below dating back to 1880:


Notice on these charts the years 1921 and 1982, when valuations were very low and yields were high. This launched the two largest bull markets in stocks ever, with the S&P 500 gaining over 4-fold in the Roaring Twenties and 15-fold from 1982-2000. And that's not even including dividends.

Now look at the years 1902, 1929, 1965 and 2000 when we had the opposite: high valuations and relatively low-to-medium yields. This led to all four secular bear markets in the past century, with each one lasting over a decade.

We can visualize this better by creating a scatter plot of the above data. We plot stock valuations (S&P 500 Shiller P/E Ratio) on the vertical axis and 10-year Bond Rates on the horizontal axis. The color of the dots will be used to indicate the future 10-year nominal, annualized, total return of a 60/40 portfolio containing the S&P 500 and 10-year treasury bond fund. This plot is shown below: 

Data for this plot from:

The dark red dots indicate the weakest future 10-year returns while the dark green dots indicate the strongest 10-year future returns. Black diamonds are for years after 2006 which we don’t have future 10-year returns for yet. One thing immediately jumps out: Dots in upper left hand of graph correspond to very weak future returns while dots in lower right correspond to strong returns. Everything else is a mix.

Currently, we are sitting in an area that would suggest a high likelihood that stocks will be weak (annual returns under 6%) for the next 10-years. Although admittedly, my chart only gives a very rough idea of future returns, a model with better predictive power has been produced by market analyst John Hussman. According to his chart below, we see that future 10-year returns on the S&P are likely to be near 0%.

Source: Hussman Funds

You might be saying “This is not fair. We just recently came out of a weak decade!”

Unfortunately, it’s what the data tells us. While the 2000’s were difficult, the current decade has been very good to us so far. It would be very healthy for the market to churn sideways, digest gains of recent years and set itself up for a great bull market further down the road.  

That doesn’t make me feel any better!” you might say. OK, I do have some good news for you.

The scatter plot above only gives a rough forecast for average annual 10-year returns. It doesn’t tell us a thing about the path that those returns will take. 

While in the long-run (5-10 years) markets are tied to valuation and mean-revert, they are dictated by momentum in the short-term (6-12 months). This is why valuation is not a good timing tool - it does not tell us when to enter and exit markets the way momentum does. These two points are really the key differences between value and momentum to understand. Please also refer to our post: The Philosophy of Momentum that tries to explain how momentum works in the market.  

So just because we are likely to face a challenging market environment doesn’t mean we can’t profit. If we look back to 2000, we also had high valuations and low yields. What happened next? Essentially, the stock market went nowhere over the next 12 years (as the valuation model correctly predicted), but in the process there were two times when stocks halved and two times when stocks doubled. In this highly choppy environment, the Global Equities Momentum (GEM) model continued churning out nice positive returns. 

The graph below shows how GEM performed against stocks and bonds in the first decade of this millennium. 

Over this decade, GEM gave a total annualized nominal return of 11.4% while a 60/40 portfolio returned just 2.8%. Furthermore, GEM only had one negative year during this whole period, and even that was a mere -7%. Now that is alpha! In terms of our scatter plot, GEM just turned a dark red dot into a nice green dot.

Side note: While GEM produced admirable returns during the 2000’s, they were quite a bit less than its past 40-year average return of 17.8%. This is not surprising given the challenging market environment.

In summary, today’s high stock valuations and low bond yields will likely mean a fixed 60/40 portfolio will not make much money over the next 10 years. However, the ups and downs during this period are likely to allow tactical GEM investors to achieve better risk-adjusted returns.

This is the real beauty of GEM. We don’t need to worry about valuations, yields, or whether the economy will accelerate or slow down. We don’t need to worry about lost decades. We are in a system that will dynamically change depending on the environment. It’s the buy-and-hold crowd that needs to be worried, arguably now as much as 15 years ago.

Happy holidays and see you in the new year!

Results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Additional information regarding the construction of these results is available upon request. Past performance is no assurance of future success. Please see our disclaimer page for more information.