IN THIS ISSUE: When Oliver Stone’s ‘Wall Street’ debuted in 1987, it was considered a scathing commentary on the greed and excess of the 80’s. With a sequel on the horizon and the economy treading unsteady waters, how are greed and fear affecting today’s investors? How can one take a stand against the market’s volatile ups and downs? Where is the safe investment? In this issue of Tactics, NWM President David Sung revisits the topic of investor behaviour and how, as it turns out, most investors end up being their own worst enemy.
This September, 23 years after the original, Oliver Stone will be releasing his follow up to the 1987 hit film, Wall Street. Wall Street spoke directly to the topic of greed and making wrong choices due to blinding temptation. After moving through another market cycle, greed was once again on the tip of everyone’s tongue when it came to the state of our world economy leading up to 2008. Today, after the crash, greed has been replaced by fear.
In many ways, it can be summed up in a famous farmer’s proverb: “the chickens have come home to roost.” That phrase was once just a cautionary tale that parents and grandparents would use to warn children about the dire consequences of any impulsive actions. We have lived through the metaphor – the chickens have roosted all around us. From bad debt and lower consumer spending to falling home prices and high unemployment in the US, Europe and Japan, we are paying the price for our greed. This has resulted in a state of fear today and, more importantly, poor investor behaviour.
Sub-prime mortgages and inconceivably ridiculous negative amortizing debts led to a bubble that burst in 2008 and caused the worst market crash since the Great Depression. A good number of Wall Street pillars have simply vanished, including Lehman Brothers and Bear Stearns. Many banks failed, including the seemingly too-large-to-fail Washington Mutual. The biggest government bailout of any financial firm in history (AIG) was done primarily to prevent a host of Wall Street investment banks from going under.
How could this have happened? What went wrong?
Granted, Wall Street and investors didn’t all participate in this equally. There were some who were certainly guiltier than others. However, what’s probably most important at this point is not laying blame, but instead learning how human nature can cause us to make short-term choices that are in direct opposition to our long-term best interests. This is especially true when it comes to money, which has the inexplicable power to blind us with short-term greed or fear. We can delude ourselves into ignoring the consequences of allowing these emotions to cloud our better judgment.
It’s fair to say there were some extremely bright minds involved in the destruction of trillions of dollars of wealth. (It’s also arguable that the wealth was illusory in the first place, as greed created it and fear destroyed it.) However, rational thought seems to suffer in the face of “group think.” It’s hard to be contrarian and go against the crowd, especially when the crowd is saying “we’re all going to get rich.” It’s equally hard to go against the crowd when everyone is paralyzed by fear. Ayn Rand put it eloquently when she wrote: “The hardest thing to explain is the glaringly evident which everybody has decided not to see.”
It’s hard to choose the rational choice when it’s not the popular choice. It’s not just AIG, Lehman Brothers and Bear Stern (aka Wall Street) who are susceptible to making bad short-term choices – it’s any investor. There’s no better proof of this than the annual Dalbar Study, a report that we have referenced in past issues and that we feel is worth revisiting.
This study is seen by many as an up-to-date analysis of behavioral finance. Contrary to what Gordon Gekko may have thought, the study shows that greed is a thief that robs investors of potential gains.
On the flip side, the Dalbar study also shows that fear is no better. When markets are hot, investors lose sight of balance and pile into high risk investments. When markets correct, the pendulum swings and investors jump ship to money market instruments or bonds.
For the past 16 years, Dalbar, a Boston-based financial services market research firm, has released its annual Quantitative Analysis of Investor Behavior (QAIB) report. Consistent with previous reports, the 2010 Dalbar study shows that the average investor may have underperformed equity markets by as much as 5.03% annually, suggesting greed and fear continue to wreak havoc on investor performance.
This is where the best financial advisors earn their keep. From an advisor’s point of view, educating investors and managing emotions suddenly becomes more important than all the work that was done structuring the portfolio. In October of 2008, when the bottom fell out of the market, we were quick to send out a series of communications to our clients explaining the status of their investments and our plan of action during such a tumultuous time.
During that period, many of our clients stayed the course and saw our cash flow and asset allocation philosophy at work – where some equity markets fell in excess of 40% and even balanced portfolios dropped 20% on average, our average client only saw a 6.5% dip. With the rally in 2009, many of our clients were up from where they were before the crash, while many investors who owned a standard portfolio of stocks and bonds are still below levels of January 2008.
Dalbar’s annual QAIB report is a study on investor behavior between certain time periods. The 2010 report covers the 20- year period of 1989 to 2009 and it provides the same conclusion as previous years: investment return is far more dependent on investor behavior (often influenced by greed and fear) than on fund performance, as the average investor was unable to hold onto their mutual fund investments through periods of volatility. Reacting quickly to market changes, they bought funds when they were expensive and sold them when they went down in value. Commenting on a past Dalbar study, Heather Hopkins, director of marketing for Dalbar, said that “mutual fund investors who simply remained invested earned higher real investor returns than those who attempted to time the market”.
Are we preaching the “Buy, Hold and Prosper” mantra? Absolutely not.
We’re simply highlighting that indices, or even funds, have tended to outperform the average investor not because they are better investments than what the average investor might have chosen, but because reactive emotional decisions tend to overrule the detached analytical synthesis of information that would allow us to make rational investment decisions.
In many ways, one can look at the period leading up to the market peak in early 2008 as a cycle of greed. Returns were great and everything was on the rise. We had literally (and figuratively) reached a new high. However, once the markets started their tumble in the third quarter of 2008, the high of greed was replaced by fear. There was nowhere to hide and investors couldn’t get into cash fast enough. This marked what could reasonably be dubbed “The Year of Fear.” Investor emotions transformed quickly from manic to depressive.
Let’s use NWM’s results during the Crash of 2008 as an example. The chart below looks at cumulative returns starting from the second quarter of 2008 through to the end of 2009.
Click image to enlarge.
At a time when the market was in turmoil, our conservative cash flow philosophy and extensive diversification protected our clients’ investments and, more importantly, gave them peace of mind. During this fear period, of extreme volatility, our client portfolios offered what some in the industry affectionately refer to as a “thumb-sucking component,” a consistent cash flow that gives investors a sense of security. This cash flow helped to reduce volatility and, coupled with our advisor team’s communication, helped prevent our clients from selling out of fear. If anything, we saw this is as an unprecedented buying opportunity and, with careful due diligence, took the opportunity to be greedy while others were fearful.
Now let’s go back to the Dalbar Study, whose research points out that the average investor underperforms the market by about 5.03% annually. If we assume that Canadian investors are no more savvy than their American counterparts and apply this statistic to these returns, the average investor would have seen losses of almost -7.9% by the end of 2009.
That is a 12.6% lower return than the average NWM client.
On a $100,000 investment made in Q2 2008, that presents almost $8,000 lost and over $12,500 less than what one could have earned using an advisor-led, diversified cash flow approach.
As advisors, it is our role to stand between an investor and their emotions, safeguarding them from the potentially devastating effects of fearbased trading. I would argue that no other factor has a greater impact on long-term returns.
Perhaps the element of cash flow income is what has always made a real estate investor a less fickle, more assured and, ultimately, more successful investor than most equity fund investors. Of course, it’s not that real estate is a better asset, but the value is perceived to be greater due to the income generation of the property and not necessarily the market value. In many cultures, wealth is not measured so much by net worth, but by income. In fact, this makes sense since our lifestyle and standard of living is a function of our income (or cash flow).
Mind you, we are not intimating that investment grade real estate is an inherently superior asset class all the time. It benefits from being a relatively illiquid asset. High transaction costs and lower liquidity lend to real estate being more rationally bought and sold, even when prices are low – this, in turn, induces better investor behaviour.
Unlike the stock market or mutual fund investor, owners of real estate do not receive a statement on a monthly or quarterly basis reflecting the value of their property. They have an idea of the market value, but what they really know is the income: the cash that flows into their bank account on a monthly basis. Stock market investors, on the other hand, often have no idea what the income generation of their portfolio is and only focus on the value (price) of their investment; therefore, they perceive the value of their investments to be exactly what is reflected on the bottom line of their quarterly statement.
Click images to enlarge.
Cash flow generates two main benefits:
- It reminds us that we are continually earning money and inhibits us from making rash selling decisions, and
- It allows us to reallocate cash to other investments at opportunities when values may be lower. We are forced to attend to asset allocation, not simply by buying and selling what is already owned, but by using the new cash flow to add to the portfolio.
Understanding that most of our investor decisions are probably driven by emotion and not reason, it follows that investors should willingly seek guidance in these matters. An objective, reasonable and analytical third party (your advisor) could likely have helped the average Dalbar study investor improve their dismal return. It is here that a good advisor provides true value.
The media continue to write articles proclaiming that MERs (management fees) on mutual funds are expensive and erode investor returns. In many cases this is true. However, while fees and costs are an important factor in choosing an investment strategy, they pale in comparison to a disciplined approach that is diversified, value oriented and compels investors to see the advantage in picking unpopular assets when they least want to.
It is our job to show our clients that the nominal fees most professional money managers charge these days (1% or less), is money well spent, particularly when you consider the empirical data which suggests that without sound advice, investors may miss out on over 5% per year. Cycles are normal, so it is important for advisors and clients to work together and manage expectations.
The Dalbar study is not just an analysis of investor behavior; it is evidence of human nature. Investors get scared when they see nothing but losses with little to no gains – they panic. Nevertheless, there is a way to steady the ship: creating a portfolio that includes assets that provide cash flow can offer peace of mind.
In order to help our clients understand the value of their investment cash flow, NWM has created exclusive Historical and Projected Cash Flow Statements, which are part of their ongoing comprehensive reporting. These reports explain how the flow of income being produced by a portfolio reduces volatility and enhances returns. Seeing a steady income in the face of losses is exactly the kind of reassurance investors need. It quells the panic and eases the fear. And any time we can eliminate those two problems, there’s a good chance we’ll be able to employ reason before an investment action, instead of finding excuses for poor outcomes.
As Gordon Gecko explains in his Wall Street tirade, greed is a powerful motivator. Investors’ innate desire for “more” is what drove the excess of the 80’s and is partially to blame for the credit crisis and equity rout of 2008. Today, investors are piling into cash and bonds in droves – this, despite the fact that some great opportunities may now be available. Good investors do not invest in “markets,” they acquire specific assets at prices that make sense. Greed has now been replaced by fear, and the hardest thing for an investor to do is take a contrarian stand and not flinch in the face of market volatility.
It may surprise many to learn that when Oliver Stone was casting for his award-winning film, Wall Street, Richard Gere turned down the part of Gordon Gekko. After losing their first choice, the studio pushed hard for Warren Beatty and leaned heavily on Stone to cast him. Stone, however, was adamant that Michael Douglas be given the role, much to the studio’s chagrin. Douglas would go on to create a cinematic icon of corporate greed and win the 1988 Oscar for Best Actor.