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April 1 - July 8, 2024
Many investors may feel that if they hold on to a losing position, it will eventually recover and feelings of regret will be avoided. These emotions of pride and regret may be behind the tendency of investors to hold on to their losing positions and to sell their winners.
Selling a stock that has risen enables investors to realize profits and build their self-esteem. If they sold their losing stocks, they would realize the painful effects of regret and loss.
Rational traders are expected to offset the impact of behavioral traders.
The market can remain irrational longer than the arbitrageur can remain solvent.
the passive buy-and-hold indexing approach recommended in this book.
Avoid Herd Behavior
social households—those who interact with their neighbors, or attend church—are substantially more likely to invest in the market than nonsocial households.
Any investment that has become a topic of widespread conversation is likely to be hazardous to your wealth. It was true of gold in the early 1980s and Japanese real estate and stocks in the late 1980s. It was true of Internet-related stocks in the late 1990s and condominiums in California, Nevada, and Florida in the first decade of the 2000s, as well as bitcoin, GameStop, and AMC Entertainment in 2021.
The media tend to encourage such self-destructive behavior by hyping the severity of market declines and blowing the events out of proportion to gain viewers and listeners.
large market movements encourage buy and sell decisions that are based on emotion rather than on logic.
Avoid Overtrading
Behavioral finance specialists have found that investors tend to be overconfident in their judgments and invariably do too much trading for their own financial well-being.
Remember the advice of the legendary investor Warren Buffett: Lethargy bordering on sloth remains the best investment style.
The correct holding period for the stock market is forever.
The evidence suggests that trading too much is hazardous to your wealth.
If You Do Trade: Sell Losers, Not Winners
Sometimes, it is sensible to hold on to a stock that has declined during a market meltdown, especially if you have reason to believe the company is still successful.
Be Wary of New Issues.
My advice is that you should not buy IPOs at their initial offering price and that you should never buy an IPO just after it begins trading at prices that are generally higher than the IPO price.
IPOs underperform the total stock market by about 4 percentage points per year.
Stay Cool to Hot Tips.
Distrust Foolproof Schemes.
The three new investment strategies are called smart beta, risk parity, and ESG investing.
There is no universally accepted definition of “smart beta” investment strategies.
By holding a portfolio containing all the stocks in the market, in proportion to their relative size or capitalization (the number of shares outstanding times the price of their shares), the investor would be guaranteed to receive the market return. Index funds have generally provided higher net returns for investors than actively managed funds that try to beat the market.
By assuming the risk of being in the stock market the investor earns a risk premium, defined as the excess return from the market over and above the safe returns that can be earned by holding U.S. Treasury bills.
Since 1927 stocks have rewarded investors with returns (including dividends and price increases) of about 7 percentage points per year greater than Treasury bill returns.
Sharpe Ratio. This eponymous statistic was created by William Sharpe, one of the developers of the capital-asset pricing model (CAPM). We know that investors desire high rewards (high returns) and low risk (low volatility). The Sharpe Ratio combines both of those elements in one statistic. The numerator is the return from the strategy, or more commonly, the excess return over the three-month Treasury bill rate. The denominator is the risk or volatility of the strategy measured by the standard deviation of the returns (how variable they have been over time).
What the “smart beta” investment managers would have us believe is that pure indexing, where each company has a weight in the portfolio given by the size of the company’s total capitalization, is not an optimal strategy. A better risk-return tradeoff (i.e., a higher Sharpe Ratio) can be obtained.
They argued that “value” wins over time. To find “value,” investors should look for stocks with metrics such as low price-earnings ratios and low prices relative to book value. “Value” is based on current realities rather than on projections of future growth.
There is historical evidence that a portfolio of stocks with relatively low earnings multiples (as well as low multiples of book value, cash flow, and/or sales) produces above-average rates of return even after adjustment for risk, as measured by the capital-asset pricing model.
The standard measurement of the value factor is referred to as HML—the return on the 30 percent of stocks selling at the highest ratios of book-to-market value minus the 30 percent of stocks selling at the lowest ratios of book-to-market value.
Another pattern that academic investigators have found is the tendency over long periods of time for small-company stocks to generate larger returns than large-company stocks.
But more recent work has indicated that the random-walk model does not strictly hold. Some patterns appear to exist in the development of stock prices. Over the short holding periods, there is some evidence of momentum in the stock market. Increases in stock prices are slightly more likely to be followed by further increases than by price declines. For longer holding periods, reversion to the mean appears to be the pattern.
When large price increases have been experienced over a period of months or years, such increases are often followed by sharp reversals.
Individuals see stock prices rising and are drawn into the market in a kind of “bandwagon effect.”
Abnormally high returns often follow positive earnings surprises as market prices appear to respond only gradually to earnings information.
Momentum is typically measured by looking at the last twelve months’ return excluding the most recent month. (The most recent month is eliminated because it often exhibits a reversal.)
Smart beta portfolios of single-factor funds have not proved to be a superior way to invest.
The founder of Research Affiliates, Robert Arnott, argues that capitalization weighting (i.e., weighting by the market value of each company) implies that holders of such portfolios will always be holding too big a share of overpriced growth stocks. He avoids this so-called “inefficiency” by adjusting the weight of each stock to its economic footprint such as earnings, assets, and the like. He calls this “Fundamental Indexing.”
Equally-weighted portfolios have different diversification and risk characteristics than capitalization-weighted portfolios. They are also tax inefficient. The rebalancing to maintain equal weight involves selling stocks that have risen the most in price so as to reduce their weight in the portfolio.
“Smart beta” strategies rely on a type of active management. Rather than selecting individual stocks, they tilt the portfolio toward various characteristics that have historically appeared to generate larger than market returns. In their favor, the “smart beta” portfolios provide these factor tilts at expense ratios that are often considerably lower than those charged by traditional active managers.
Strategies that become well known often lose their effectiveness after publication of their results.
If you do want to take a chance that some risk factors will generate improved risk-adjusted returns in the future, you can do so most prudently if the core of your portfolio consists of capitalization-weighted broad-based index funds.
The evidence-based principle on which it rests is that relatively safe assets often provide higher returns than are appropriate for their level of risk, while riskier assets can be relatively overpriced and return less than they should. Investors can therefore improve their results by leveraging low-risk assets, buying them with some borrowed money, so as to increase their risk and return.
There are two methods by which an investor can hope to increase the return and risk of a portfolio. One technique is to overweight the portfolio with higher risk assets such as common stock. A second plan is to invest in a broadly diversified portfolio of relatively safer assets promising modest returns and relatively low expected volatility. The relatively safe assets can then be leveraged up to increase both their risk and return and offer the investor a better expected return per unit of risk.
A striking similarity between payoffs in the stock market and at the race track is that there is a tendency for people to overpay for investments with high risks but a possibility for unusually high returns. Very safe stocks appear to offer higher returns than their risk would warrant.
If the historical pattern of a flat return-beta relationship continues, it will be optimal to buy low-beta assets on margin to increase risk and return of the portfolio to the level the investor desires.
The volatility of bond returns is about 50 percent lower than stock returns (2 percent standard deviation of returns for stocks versus less than 1 percent for bonds). But corporate bonds produced average returns of 5.9 percent versus stock returns of 10.3 percent over a more than 90-year period ending in 2022.
As between concentrating the portfolio in higher return investments or enhancing returns with leverage, the latter strategy can be more effective.
