Stress Hormone Alters Tolerances for Financial Risk
Posted on September 19, 2014 | AAII Journal
A sustained increase in the stress hormone cortisol leads to both a reduced tolerance for risk and an increased preference for perceived safer, but lower-return outcomes. This physiological response to stress may be a contributing cause to financial market instability, particularly during times of increased uncertainty.
A team of British and Australian researchers reached these conclusions after conducting a study on participants using a combination of cortisol dosing and computerized lottery games. The study was designed to measure risk preferences under placebo-treated, acutely elevated cortisol and chronically elevated cortisol conditions. Though the researchers had previously tested cortisol levels on London traders, this experiment allow them to test responses under controlled conditions.
The researchers focused on cortisol because long-term exposure to raised levels can impair behavioral flexibility and promote anxiety, depression and learned helplessness. The researchers said the effects associated with long-term exposure to elevated cortisol “could be expected to discourage risk taking.”
First, they looked at the average utility curve. The flatter the utility curve is, the less marginal benefit is derived from each incremental increase in the amount of benefit. In other words, a flatter utility curve implies that a person is less willing to incur greater risk in order to reap bigger potential rewards. Participants receiving acute doses of cortisol showed no significant difference in risk aversion than the control (placebo) group did. Participants with chronically elevated cortisol had a “large” increase in risk aversion, however.
Allocate by Market Weight (And Adjust for Personal Circumstances)
Posted on September 16, 2014 | AAII Journal
Charles Rotblut (CR): I’d like to discuss allocation, starting with rebalancing. A lot of people either psychologically have a problem doing it or just won’t do it. What are your thoughts?
William Sharpe (WS): I think, by and large, people probably shouldn’t do it. In particular, rebalancing by selling winners and buying losers. Basically, if you’re going to sell your winners and buy your losers, then you have to trade with someone. And that person has to take the other side of the trades. If you’re smart doing that, then the other person must be dumb to trade with you. So the questions are: Why is that a good thing to do, and what’s the matter with the other person for trading with you?
We can’t all rebalance, because rebalancing to pre-selected proportions means selling relative winners and buying relative losers. Since we can’t all do that, the question is: If this is the obvious thing to do, with whom are you going to trade? Who is it? And why should the other person trade with you? In an efficient, sensible or informed market, such rebalancing will not be a good strategy.
I would like to see a very-low-cost index fund that buys proportionate shares of all the traded stocks and bonds in the world. Unfortunately, there are none at present. It would be good if there were one or more used by a great many investors as their main investment vehicle. While such a fund is not available, you can construct one from existing index funds, but then you have to monitor the current world values of the components—for example, the value of all the U.S. bonds for the U.S. bond index fund, the value of all the non-U.S. bonds for that fund and the value of all the world stocks for that fund. I’ve talked to my friends in the index fund business, and thus far nobody seems to be interested in producing that. It is a huge hole and individual investors could really use such a fund.
CR: What about adaptive allocation? I know you’ve written about the subject.
WS: Here is a simple way to think about this. Assume that at the moment stock values are 60% of the total value of bonds and stocks, that bond values are 40% and that you just want to have the risk and return of the average investor. Then you should invest 60% in stocks, 40% in bonds. And now, let’s say, stocks go up and bonds go down, so the market values are now 70%/30%. If you want to continue to be the average investor, you should have 70%/30% proportions. But when you look at your portfolio values, you are likely to find that they are already close to 70%/30%. And you didn’t have to do anything. This won’t be exactly the case due to new security issues and things of that sort, so you might have make some minor adjustments, probably when reinvesting dividends and bond payments. But the trades will be small. The idea is to have a policy that indicates what proportions you want when the market proportions are, say 60%/40%, and then keep your relative risk constant as market values change (Figure 1). The formula that I suggest for adaptive asset allocation works from this basic policy and indicates the proportions that you should have as market proportions change.
In the simplest case where you just want to take the risk of the average investor, the formula just says that your policy should be to hold the same proportions as the market. If you want to have a policy of being more risky than the average investor, then you have to look at the formula. But it’s a very easy formula.
Figure 1. How Adaptive Allocation Works
An Inside Look at Exchange-Traded Funds
Posted on September 10, 2014 | AAII Journal
Exchange-traded funds (ETFs) have been one of the most successful financial innovations in recent years.
Since the introduction of ETFs in the early 1990s, demand for these funds has grown markedly in the United States, as both institutional and individual investors have increasingly found their features appealing.
Driving Emotions From Your Investment Process: A 12-Step Program
Posted on September 5, 2014 | AAII Journal
For many years, I conducted an AAII Stock Analysis seminar in which I presented a variety of techniques for analyzing and valuing stocks.
Beyond presenting specific techniques, I also discussed ways to remove emotions from a decision process. Now that I manage money professionally and have delved into the ever-growing body of behavioral science research, I am more convinced than ever that ruthlessly driving emotions from stock-picking decisions is essential to generating superior returns. In fact, if you don’t, you cannot outperform.
There is now a large body of research showing that investors depend on emotions and anecdotal information when making decisions. You are no doubt aware of this and are familiar with the resulting cognitive investment errors. There have been numerous articles dealing with how investors can avoid such errors and, as a result, do a better job of managing investment portfolios.
Unfortunately, industry professionals apply techniques and put policies in place that encourage investors to continue making emotional decisions. So even if the investor wants to drive emotions out of the investment process, the industry is set up to encourage them to do otherwise.
To help you make this transition, I present a 12-step program to show how to ruthlessly drive out emotions and thus make it possible for you to make superior investment decisions.
How to Safely Navigate Through Crowded ETF Waters
Posted on August 28, 2014 | AAII Journal
I once interviewed a successful exchange-traded fund (ETF) sponsor and had the temerity to offer some suggestions where some ETFs were needed.
The response from this person was: “Look, we’re not interested in filling needs as much as we are in building a business.” This made an important point: Investors must align their investments to match their needs versus the business interests of sponsors.
The market for exchange-traded funds has never been more robust and expansionary. The most prominent activity for sponsors is similar to a game of Battleship in which the winner fills all the slots before the next guy. Why? Because the “first mover advantage” to a sector and index cements their brand as “the go-to shop.”
The most important activity for investors remains focusing on those ETFs that work and matter to them versus any sponsor’s marketing campaign.
It’s hard to imagine that in 2005 we published an essay in our newsletter, the ETF Digest, entitled “The ETF Tsunami” that discussed the then-impending flood of new ETF issues about to hit the markets. Obviously, it seemed even then the sector was undergoing explosive growth, but with today’s level of issuance “tsunami” seems an understatement.
Retirement Planning May Improve Your Health
Posted on August 25, 2014 | AAII Journal
Whether or not a person contributes to a 401(k) plan may influence his or her health. Commenting on their study of employees with access to company-sponsored wellness testing, Timothy Gubler and Lamar Pierce of Washington University said they found that “retirement savings and health-improvement behaviors were highly correlated. Individuals who had previously chosen to save for the future by making 401(k) contributions improved their health significantly more than non-contributors did, even though there were few health differences between the two groups prior to program implementation.”
The study was limited in scope, but its authors believe the results demonstrate the impact of time-discounting preferences. Time discounting refers to whether a person prefers to realize a benefit now (e.g., the payment of cash) or prefers to postpone in exchange for a better benefit in the future (e.g., a larger payment of cash). The authors opine that if discounting preferences can be changed in one domain, such as the setting aside of a portion of current pay for retirement, discounting preferences are also easier to change in other domains, such as health.
Finding Growth Stock Winners: Focus on 8 Fundamental Factors
Posted on August 14, 2014 | AAII Journal
There are eight tried-and-true key fundamental factors that drive stellar stock price performance and have stood the test of time.
ETFs and ETNs: Knowing What You Own
Posted on August 13, 2014 | AAII Journal
The liquidity composition of a fund’s underlying assets, the historical tracking error and fees are important characteristics to consider when investing in an ETF.
ETFs are one of the fastest-growing investment vehicles, with total assets reaching $1.4 trillion in 2012 (Figure 1). Like open-end mutual funds, exchange-traded funds typically hold a basket of underlying securities. The basket can consist of stocks, bonds, futures, options, forwards (a non-publicly traded contract to deliver a cash commodity at a specified date in the future), the rights to physical commodities, or any combination thereof.
Figure 1. U.S. ETP Assets & Number of ETPs by Year
Real Returns Favor Holding Stocks
Posted on August 12, 2014 | AAII Journal
Stocks are good hedges against inflation, preserve purchasing power, and, over long periods, are less risky than bonds.
CBOE’s Volatility Index (VIX)
Posted on August 6, 2014 | AAII Journal
An explanation of the so-called “fear gauge” and insight into how it is used.
The VIX is a measure of the implied or expected volatility of S&P 500 options over the next 30 days. Implied volatility is the market’s estimated future volatility and is reflected in the premiums paid for options.
Originally launched in 1993, the VIX underwent a change in calculation in September 2003. The “original” VIX was calculated using at-the-money put and call options on the S&P 100 index OEX. Furthermore, the original VIX was based on prices of only eight at-the-money OEX puts and calls, the most actively traded index options at the time.
By 2003, the S&P 500 index SPX option market was the most actively traded option market, while trading volume in OEX index options had fallen off significantly. Also, portfolio managers were using options more as a means of insuring their portfolios, specifically with out-of-the-money and at-the-money index puts. Therefore, the new VIX calculation includes put and call options with a wide range of strike prices, including those in-the-money, at-the-money and out-of-the-money.