Individual Portfolio Asset Allocation(in bear markets)

Adrian Mitroi, CFA

CFA Café: Investment Management - New Frontiers, CFA Romania, June 2008

Key points• Bulls, bears and foxes• Investment is a risk business• The power of investment discipline• Who we are up against to• Dire Straits• Contrarian investing• Chimps do it better• Investment decisions are heavily informed

by emotions• Emotional finance• Favorite references

Bulls, bears and foxes• Once upon a time, in a small mountain village of

Transylvania, a man appeared and announcedvillagers that he would buy foxes for Ron 100

• The villagers seeing that there were many foxesaround, went out to the forest and startedcatching them. The man bought thousands atRon 100 and as supply started to diminish, thevillagers stopped their effort

• He further announced that he would now buy atRon 200. This renewed the efforts of the villagersand they started catching foxes again. Soon, thesupply diminished further and people went backto their farms. The offer rate increased to Ron250, supply became so little that it was an effortto even see a fox let alone catch one

• The man now announced that he would buy foxesat Ron 500! However, since he had to go to thecity on some business, his assistant would nowbuy on behalf of him. In the absence of the man,the assistant told the villagers:

“Look at all these foxes in the big cage thatthe man has collected. I will sell them to youat Ron 350 and when the man returns fromthe city, you can sell it to him for Ron500."

• The villagers squeezed up with all their savings tobuy the foxes. Then they never saw the man norhis assistant, only foxes everywhere!! !!

Welcome to the Market!

Rational Analysis in Stock picking and Portfolio management

Investment is a risky business

• Financial behavior analysis relaxes the fundamental analysis requirement for convergence of price and value. The difference between the two is seldom systematic, so it can be exploited by a rational and disciplined investor

• Can an informed investor make money systematically by exploitation of behavioral, cognitive and psychological inefficiencies of the market?

• There can be no reward, without risk. Gaining an advantage over so many skilled and knowledgeable competitors, in a free market, is extraordinary difficult

• Managing in bear market is the skill. Bear correlations can easily destroy the hard earned return

January 2008: obvious……..in hindsight

The power of investment discipline

• In general, those that succeed on the market on longterm, make small gains, systematically (or wins extraand more times than they loose). Their success is nota result of a continuous stream of rational and correctmaterial decisions, but of a disciplined and focusedapproach. How do we stay alive in this bear market?

• The disciplined approach of investment managementprinciples relies most importantly on common sense:full diversification of the portfolio, investment horizonelongation, efficient mix of different investment stylesrebalancing asset composition, event-driven timing

• Investment managers have to prove their repeatableprofessional ability and sustainable value-addingcapability on a continuous basis to their employers,employees and investment public

The Ultimate Investment Club destroyed 14% vs. the Market!

First Rate Investing Minds

-2.4%

+11.5%US Stock Market

Source: Yahoo Finance

THE STORY MONEY MAGAZINE NEVER PUBLISHED

Financial decisions are influenced by psychological factors

•The cornerstone of investment evaluation should not berelated to past performance, since the correlation between pastand future performance is, in general, very low. Past highperformers (high betas) are most exposed to downturns

•Past success attributed to professional skill can be a matter ofluck rather than knack. Suboptimal investment decisions canbe related to non-rational resorts. If this apparent nonrationality is recurrent, it can be associated with predictablecognitive errors. Can we make, or lose less, money on these?

•In a world of uncertainty, good decisions can lead to badoutcomes and vice versa. Risk management is not equal withdiversification. Risk means that more things can happen thanwill happen

•Market advice for a fee is a paradox. Anybody whoreally knew, just wouldn’t share her knowledge.Why should she? In three years, she could be very rich.Why pass the word on?

Risk appetite increases at the wrong moment and for the wrong reason, when risk capacity decreases, since loss portfolio

Effective net return decreases with increased portfolio turnover. Efficient market takes time.

Who we are up against to

•By fear of losing opportunity for additional profit, investors donot keep temper, act impulsively, extrapolate short-term trendinto a medium and long-term investment attraction. Risk profileis changed and the investors appear to be able to bear morerisk that would be otherwise reasonable, advisable and rational

•Investors overestimate their individual abilities in terms ofluck, education, intellect and aptitude to process, disseminateand understand Mrs. Market; she fools most of us, most of time

•The market price is supported and resisted by a multitude ofeducated, determined, intelligent, psychologically toughindividuals that act for one single scope – to maintain the funand privilege, to survive as market player

•Job security is the most important argument and constraintthat prevails in the decision mind of investment managers

•“We have met the enemy and he is us”. Pogo, Cartoon Character

Investment managers often feel beset by forces beyond their control: yet, if they probe the matter home, may find that the fault lies not in their stars, but in themselves*

Expenses sustained by the Diversified Portfolio

60.000 €

70.000 €

80.000 €

90.000 €

100.000 €

110.000 €

120.000 €

60000 € 55.000 € 50.000 € 45.000 € 40.000 € 35.000 € 30.000 € 25.000 €

Gai

n: G

row

ing

sust

aina

ble

expe

nses

Risk: Decrease in sustainable expense rate

100% Equity

70% Equity + 30 % Bonds/Deposits/TBills

20% Equity + 80 % Debt

100 % Debt, Deposits

*CFA Magazine, May/June 2008

Succesful active management recognize the gap between theory and practice. They invest in unpopular sectors and do not see the trend as their friend; they do not rebalance aggresively, in response to their emotional impulses or clouded logic, making changes for the sake of change and fooled by the illusion of action

Investment managers change their styles in a period of dissapointmentto fix a present perfect underperformance just before results of their style rebounds. Relentless chasing of short term performance reflectsthe human nature of competitiveness and the need for constant action,but rarely benefits results

Succesful investors are disciplined. They make disciplined changes even when they are performing well; they endure dissapointment patiently. Disciplined investment process adds value, by providing an objective basis for confidence in an uncomforatable investment action

There is no better practice than a good theory.In the investment management, when one has too much company, success is improbable

Dire Straits of 2008/9

•2007 was the year of Rasdaq, capital increase, new shares, freedistributions made the fun and profitability of Rasdaq 007.The Dire Straits of 2008: a deeper and longer than expected Bear Market

•The rational expectations are form by two methods:- Intellectual reasoning and evaluation, logical processing ofinformation (sector, specific, market) construction of an informedopinion about the intrinsic value of the asset- Estimation of psychological reasoning of other marketparticipants behavior; their actions can have a decisive effect onown success or failure; formation of expectations is subjected totime pressure and omniscient uncertainty

•Even-driven investor perception is shaped by the autobiographicmemory; the memory register records events in a highly organized andselective manner, based on their emotional significance and relevance

•The outcome of the events is perceived in the light of experience andpossible repercussions of an eventual decision. Information processing isperformed at the semantic level (personal knowledge accumulatedduring lifetime) and then at emotional level (autobiographic memory andpersonal experiences during lifetime)

Contrarians decisions that resulted in negative results are penalized much more severely that are rewarded those with positive results

•It is a common behavior for the investors to be almost indifferent tobuying opportunities at the incipient phase of a bull market, but theystart to be interested when upside trend is obvious for everybody in themarket. From this moment on, the buying spree of increased volumesmakes a clear upward trend. Is it the same on the downward market

• Nobody wants to be just a spectator of the game; everybody wants apiece of action because of a non-rational herd instinct. From a rationalstandpoint, however, it should be clear that the upward trend need notto continue indefinitely

•To compound the problem, the objects of investor affection isrepresented by those stocks that performed dearly lately and areobvious most exposed to the eventual correction•Jun’07>Dec’07>June ’08 Should we sell in this market?

Contrarian investing

•Fundamentals of the market prices result from correlation betweeninvestor experience and expectations and market momentum. Slowchanges in market sentiment are emotionally contagious, theyinsinuate slowly but strongly in the market trend

•The insatisfaction of a negative result, after a contrarian decision,weights significantly higher than eventual satisfaction from a contrariandecision, so investors find it difficult to assume au contraire decisons

•If investor deviates from a conservative diversified portfolio shebecomes especially vulnerable to the pain of regret if things go badly(as in the last months) because it is easy to imagine having done theappropriate action (fully diversify or reduce equity exposure)

•Strategic asset allocation is a disciplined rebalancing: disciplined sale, reduced exposure to outperformers and increased exposure to underperformers, ie, selling high and buying low

•When it comes to the long term, we mostly regret inaction. In theshort term, we regret action. Sell your winners, stay with your losers(but not for so long)

If the market is efficient, what is the use of stock picking ability?

• Value investment style seems to be one of the most enduringinvesting winning strategies: portfolio’ s overall P/E should beless (75%) than the market P/E (2008: 12?). Total return isequal with growth rate+yield (it provides a good marginalreturn, build-in into the value of the stock, since usuallystocks sell on their growth rate, so a value strategy implicitlyincorporates this build-in advantage): BRD, SIFs, TLV

• Value strategy (value is in the eye of the beholder) differsfrom low P/E strategy (which is quantifiable and measurable).For the low P/E strategy, of critical importance is theinvestment discipline, i.e. when you are right in yourinvestment decision (when to buy). Growth strategy – isinterested in the denominator of the P/E fraction, i.e. E factor(earnings/growth), so that the critical decision is when to sell

Investor financial behavior

• Although there is a low correlation between professionalabilities and investment success, investors have highconfidence that somehow, someday they will succeed inbeating the markets

• Beating the index by outsmart moves, ahead of competition,finding undervalued and overvalued securities andimplementing the buying and selling decision at the righttiming is difficult, if not impossible, in the long run

• Investors put too much weight into most recent financialexperiences and ignore a longer term, larger perspective.They evaluate other players decisions as discretional andnon-rational and assume their own decision to be logical andrational, and in conformity with all exiting information

• The fusion between classical analysis and behavioralevaluation should help investors to a larger, more informedperspective of the market. What your competitors do isequally important with what you do

Chimps Score:

Sophisticated Chimps1. Money’s top Advisors MBAs,CFAs X

Picking Stocks

2. Wall Street Analysts X“Sell” vs. “Buy or Hold”

3. WSJ Top 50 Economists X

Score 0 3

Investment decisions are heavily informed by emotions

• The central difficulty of investing, both for retail and forprofessional investors is that we are all our worst enemies:we buy high and sell low and we do worst possible thing atthe worst possible time because we are most certain thatwe are right just when we are are most likely to be wrong

• Feasibility of an investment decision is critical. People dowhat is feasible/doable not what is theoretically sound andattractive. Critical is not what investors ought to do to getoptimal results but what they can do, what is feasible forthem to do

• A good investing advice is not theoretically ideal bypsychologically practical. Investors need something to do;i.e., impulse urge for the “illusion of control”; it is why wepush the elevator button several times after we havepushed it the first time – we think we can make theelevator arrive more quickly if wee keep pushing the button

Does active stock picking add investment value?

• In evolutionary terms, we are more adaptive to learn from negative than from positive surprises, since at the most biological level, a negative surprise is more powerful than a negative one; better err on positive than be surprised by negative

• “The speculative public is incorrigible. In financial terms it cannot count beyond 3.” - B. Graham

• Investors should kept the margin of safety at all times and should not focus exclusively on how much money can be made but on how much money can be lost, because even the best investors are wrong 45% of all time (B. Graham, The Intelligent Investor, rev.ed. updated by Jason Zweig)

• CNNMoney on the article Is your brain wired forwealth? Jason Zweig, Investing Columnist, MoneyMagazine: “Suddenly, sunning investment insightsare coming from the frontier of one of the least likelyfields you could imagine: neuroscience

• Neuroscience of investing helps explain one puzzleafter another: why we chronically buy high and selllow, why “predictable” growth stocks sell at such highprices, why it’s so hard to understand our owntolerance for risk until we lose money, why we keepbuying IPOs and “hot shares” despite all the evidencethat we shouldn’t, why stocks that miss earningsforecasts by a penny can lose billions on dollars ofmarket value in seconds

The best way to succeed in this market is to act on the advice you give to others

Sector Covariance Economy (2008-2009) Probability A (TLV) B (BCC)

Boom 0.25. 20% 5%

Normal 0.50 10% 10%

Recession 0.25 0% 15%

•Ra = (0.25) (0.20) + (0.50) (0.10) + (0.25) (0.00) = 0.10

•Rb = (0.25) (0.05) + (0.5) (0.10) + (0.25) (0.15) = 0.10

•Σ2a = (0.25) (0.20-0.10)2 + (0.5) (0.10-0.10)2 + (0.25) (0.00-0.10)2 = 0.005

•σ2b = (0.25)(0.05-0.10)2 + (0.5)(0.10-0.10)2 + (0.25)(0.15-0.10)2 = 0.00125

•σa = (0.005)1/2 = 0.07071 = 7.071%

• σb = (0.00125)1/2 = 0.03536 = 3.536 %

•Covab = (0.25)[(0.20-0.10)(0.05-0.10)]+ (0.50)[(0.10-0.10)]+ (0.25)[(0.00-0.10)(0.15-0.10)]= - 0.0025

•ρ(a,b) = cov (a,b) / σ2a σ2

b = - 1 25

2008 Portfolio diversification: 50% stocks + 50% bondsProbability Equity fund % Bond fund % 50% equity +

50 % bond

Recession 1/3 - 7 17 + 5

Normal 1/3 + 12 + 7 + 9.5

Boom 1/3 + 28 - 3 +12.5

Expected return 11 7 9

Variance 204.7 66.7 9.5

Standard deviation 14.3 8.2 3.1

•Cov(s,b) = 0,3333(-7-11)(17-7)+0.3333(12-11)(7-7)+0.3333(28-11)(-3-7)= -116.67

•ρ(s,b) = cov (s,b) / σaσb= -116.66 / [(14.3) (8,2)] = - 0.9926

Some Behavioral Traits and Patterns of Individual Investors

Illusion of controlConservationism

Mistaken CausalityExtrapolation

Mental AccountingRisk Compensation

FramingHouse Money EffectSelective Memory

Protection of BlameRationalization

Denial Herd InstinctExtremism

Ambiguity AversionHeuristicsAnchoring

HeroicsOverconfidenceOverweighting Recent

Stereotyping Narrow FramingDisposition Effect

Hindsight BiasRegret

IdealizationAvoidance

Loss AversionOptimism

RepresentativenessCategorizationPain of regretPain of loss

Three is a trend

• Two guys are sitting around a campfire at night when Guy One asks his buddy a question.

• Guy One: "Hey! What would you do if a HUGE Grizzly Bear came crashing through the bushes right now and let out a roar? What would you do?"

• Buddy: "Well, I guess I would take off and run like hell."

• Guy One (finding the answer funny): "Oh yeah? Don't you know that grizzly Bears can run 35 miles an hour in short bursts? You think you're going to outrun a huge Bear?“

• Buddy: "No. I just have to outrun you."

Emotional Finance: Loving, Hating, or Knowing(source: CFA Magazine, May/June 2008, S. Trammell, D. Tuckett, R. Taffler)

K n o w i n g

H a t i n g

L o v i n g

Paranoid schizoid  Depressive

•Aware of either good or bad, moody•Ambivalent Hate and Love situations•Prone to crushing reversals in trust or confidence (from unconscious anxiety)•Stock market exuberance, speculative•“what had been thought impossible might be attained after all”, omnipotence•After burst: panic, manic, blame others, guilt hunt, pain of loss, humiliation

•Aware of both good and bad in every investment•Realistic, appreciative, mature •See people and things as they are•Reality checks, mixed feelings•Experience the consequences of other’s imperfection plus enjoying the pleasure of good attributes

Investor emotional oscillations

..put the sandwich down• Too much credit in times of trouble hurts.

Welcome to the world of negative equity• Don’t acquire liabilities, but assets

Asset: grows up or pays incomeLiability: cost you € every month

• Avoid the most common mistake: extrapolation• The riskiest moment is when you're right. That's

when you're in the most trouble, because you tend to overstay the good decisions. So, in many ways, it's better not to be so right. That's what diversification is for. It's an explicit recognition of ignorance (Peter Bernstein).

favorite references

• Charles, M. C. 2002. ,,Fusion investing: integrating behavioral finance and fundamental analysis.” Lee-Cornell University

• Mike Gelsior Newsletters. http://www.afs-seminars.com• Kahneman, D. 2003. „Maps of bounded rationality: A perspective on

intuitive judgment and choice.” [Nobel Prizes 2002]. Stockholm • Kahneman, D., Tversky, A. 1979. „Prospect Theory: An Analysis of

Decision under Risk.” Econometrica, XLVII• Nofsinger, J. 2002. „The Psychology of Investing.”, Prentice Hall• Shefrin, Hersh and Statman, Meir. 2000. „Behavioral Portfolio

Theory.” The Journal of Financial and Quantitative Analysis• Statman, Meir. 2003. ,,Bubbles and portfolios: Investment lessons

from Kahneman and Smith, winners of the 2002 Nobel Prize in Economics.” Santa Clara University

• Jason Zweig 2007. ,,Your Money and Your Brain.” Simon & Schuster. www.jasonzweig.com

• www.neuroeconomics.net; neuroeconomics.org

• Does anybody has any questions?• Your thoughts and observations, welcome!

• Contact info: adrian.mitroi@gmail.com

The Times, June 16, 2008:House prices ‘will fall by 30%’

• House prices are set to fall farther for at least the next 18 months and will not recover for at least another four years, leading economists say today.

• Nearly two thirds of members of the Society of Business Economists said that house prices would not rise above last year’s peak until at least 2012. Nearly 15 per cent said that prices may not rise to last year’s levels until 2015.

The Times April 19, 2008:Citigroup writes off another $15.2 billion and

plans 9,000 job cuts

• The credit crunch took a further toll on Citigroup yesterday as America’s largest bank announced an extra $15.2 billion (£7.6 billion) hit and said that it would cut another 9,000 jobs worldwide

• The bank’s latest write-down gave it an overall loss of $5.11 billion for the first quarter and took its total hit from the credit crisis to $33 billion over the past nine months.

The Times, June 23, 2008: Citigroup and Goldman Sachs cut more staff as

effect of credit crunch lingers

• Investment bankers in London are steeling themselves for more job losses as Citigroup and Goldman Sachs eliminate thousands of roles

• Citigroup, America’s largest bank, is expected to cut up to 6,500 investment banking jobs – as much as 10 per cent of its roughly 65,000 headcount worldwide. Some staff could be told today that their services will no longer be required

• It is believed that entire trading desks in New York, London and other cities will be eliminated. Senior managing directors will not be immune from the layoffs, sources said last night.