Investing against the herd, Part 3, Testing the theory

From a behavioral perspective, I think it's easier to explain these investment strategies in terms of risk, rather than reward. People consciously focus on reward, but subconsciously act on risk.

Diversification is a risk reduction strategy and liquidity is a risk factor. The key to risk is management and control - if one can manage and control the risk through some competitive advantage (like Warren Buffett's due diligence), then the rewards for taking on more risk though financial leverage makes sense on a risk-adjusted basis. Buffett is confident he knows his companies well, and always pays less than perceived value. Thus, he feels confident in leveraging up with debt.

But Buffett IS diversified through Berkshire Hathaway. He uses portfolio theory quite effectively by having a portfolio of companies across industries. It should be obvious from his investments that he sees the fundamental value in cash flow to reinvest with a portfolio diversification strategy. These are the reasons he has stayed away from industries such as tech and banking for the most part, in favor of manufacturing, retail, and insurance.

Risk and loss aversion are the keys to behavior, and that applies to any activity; financial investment most of all. As an author you probably know the problem with investment books is that there are too many on the market: excess supply + insufficient demand = low price, fewer sales, less revenue. And it's a winner-take-all market, so the distribution of success is a power law: a few big winners and lots of losers. C'est la vie.

I do not think that taking money off the table when stock went up is the most important thing. True, risk and stock price are correlated. But as I understand that, for Buffett there is no gaming table. Just well managed financially healthy and understandable companies at reasonable prices (these you buy) and the rest (these you avoid). If there are no companies to buy, you hoard money. And, every time an "eisenreserve" is being kept, for 2008 - like events.

hi warren,
On the timing - the survey released in say mid June is used for the re-weighting decision at end of June, so there is effectively a 1-month lag.
(re Harry's prior comment, the turnover rate is rather high for a "passive" strategy because of monthly re-balancing. I generally use quarterly re-balancing in actuual portfolios, which results in much lower turn-over (around half). Relative outcomes are vitrually the same as with monthly rebals. But I used monthly here because that particular survey is monthly and I was trying to capture the effects of "current" sentiment - ie the latest month)

On the data sources I use All Ords accumulation index since end 1979, then the Sydney All Ords since 1958, then the Sydney 34 Ords since 1936, then the Sydney Commercial & Industrial Index since 1875. Dividend series uses the adjusted Lamberton series since 1882. (The lack of low cost ETFs in early years of course raises the issue of investability for an investor, but in Australia the big 20 or stocks have always dominated market returns, and so the return relativities betwen the strategies would be very similar if virtually any basket of big cap stocks were used)

For cash, I use the greater of 3 month t-bills or bank bill yields since 1959 (since the yield on bills is the total return), and then the greater of bank bills and bank short term bank term deposits since 1851.
good luck with it!

I have a few simple questions, to assist with understanding how this analysis might be replicated.

First, the consumer sentiment index is based on a survey that is usually conducted in the first week of a month. The data are then released around the 9th of the month. For example, the June 2013 index was released on 9 June, based on sampling undertaken at the beginning of that month.

Has the analysis then aligned this with end-June ASX levels, or with end-May?

Second, what ASX index has been used? I presume that it's the All Ordinaries Accumulation Index because the ASX200 doesn't go back to 1974.

Third, how has the return on cash been calculated? The standard index these days is the UBS Bank Bill index, but it doesn't go back to the 1970's either.

Fourth, how was the dividend reinvestment calculated prior to 1979. The All Ordinaries index was developed in that year, but the analysis has 5 years of history before then.

hi harry,
to keep it simple I did that example before transaction costs and taxes, but the relative results of the three strategies are not materially different if transaction costs and taxes (including franking credits) are included. It is the relative returns from the three strategies that are important. The relativities remain the same and the differences in tax/cost drag are minor compared to the differences in returns.

For example a "passive" portfolio does not mean zero turnover because it is still rebalanced back to the neutral weight. Passive turnover in this type of portfolio would be around 30% pa, which would generate transaction cost drag of around 3 bp pa (based on 10bp per trade each side) and tax drag of around 140bp pa (at 15% tax rate and including franking after June 1987). Turnover in both Active portfolios is around 80% which is much higher. Transaction cost drag is around 8bp pa and tax drag is around 160bp pa after franking credits.
So the differences in tax/cost drag between active and passive is around 20 basis points pa, compared to the 100+ basis point difference in returns. Importantly, the differences between the two active portfolios ("With" and "Against" the heard) are even smaller because they are taking opposite sides of the same trades.

But this is just detail. The main point is that the differences in returns are large and make a big difference to the investor's wealth and standard of living. Again, I'm not advocating doing this (the models we use are much more powerful than this), but it shows the differences if investors did follow or against the confidence index.
cheers

ashley

Hello Ashley, thanks for the thought provoking articles, but I’m hopeful you can clear something up for me.

I understand that in your example the passive portfolio is not passive in the truest sense of the word – as you point out the portfolio has about a 30% annual turnover at a cost of roughly 143bp. My question (which I could answer myself if I had your model) is, how does the passive (but active) portfolio stack up against a simple buy and hold strategy for the same period - assuming $1000 capital was allocated to 50% cash and 50% shares in September 1974?

Perhaps this is too simple. However, if we suppose for the sake of the example that our shares were bought in companies within the ASX top 20 - all offering dividend re-investment programs to remove the burden of brokerage (I’m only 30, you can correct me if that’s a new thing) - then it seems reasonable to assume the 143bp difference between your “actively passive” portfolio and your “active” portfolios should be added to the gains of a “truly” passive portfolio to give an annualised return of 12.53% (your 11.1% +143bp for fees - I understand I could have deducted 1.43% from your 11.1%, but the point remains the same).

In this scenario $1000 compounded over 39 years becomes $96,808 – which is a 30%+ greater return than your benchmark portfolio. If this is right then surely churn is creating drag that is quite material.

Moreover I should mention that we’ve spoken before and while “devotee” would be too strong a word, it’s true that I’ve followed the advice laid out in your books and articles to a degree that has required tremendous devotion and self discipline. So far I’ve done very, very well following the plans laid out by your good self (thank you), but given one of the key messages I’ve taken away from your previous writing is that growth assets should never be sold (if bought well in the first place – I use ETF’s), you can see why perhaps I’m confused you didn’t include a passive portfolio in the truest sense of the term for comparison.

Perhaps my math is wrong, and like you said these are just details, but I would be interested in your thoughts.

Ashley, I'm struggling to draw the same conclusions you have from the results of your back-test. It's probably me, but perhaps you could help clarify a few issues.

First, you mentioned that "all returns are before taxes and transaction costs but before franking credits". Did you mean to say "after taxes and transaction costs…"? If the 'active' portfolios were re-balancing to either 30% or 70% Australian equities (potentially each month) then brokerage costs would have been very material, as would have taxes after the introduction of capital gains tax in 1985.

You indicated that the impact of taxes and transaction costs would be "similar in all portfolios since all three would need to be rebalanced each month due to market movements alone". Yes and no. Yes, all three would be rebalanced each month. But rebalancing the 50/50 'passive' portfolio would only require minor monthly adjustments, compared to a potential +/- 40% change in the other two portfolios. Turnover and hence costs (both execution and taxes) would be significantly higher in the two dynamic portfolios compared with the passive portfolio. Hence my desire to understand whether the end results were net of costs and tax.

Next, the data in the accompanying chart shows that contrarian investing (against herd) would have produced a superior end wealth result compared to the 'with herd' portfolio over the roughly 39 year period between September 1974 and June 2013. But over shorter periods this advantage appears to be less conclusive, and actually reverses in times of extreme stress. Take for example the 1987 crash. The cumulative % difference bar chart suggests that between October 1987 and March 1988 the against herd portfolio fell much more than the with herd portfolio (something in the order of 25% to 40% more).

Likewise during the GFC the against herd portfolio fell significantly more than the with herd portfolio (around 30% to 40% more between June 2007 and March 2008). The 'peak to trough' drawdown levels for the against herd portfolio don't look all that encouraging at first glance. If anything the with herd portfolio seemed to have fared better in large market corrections than both the passive portfolio and the against herd portfolio over the back-test period.

Hi Thomas,
Buy and hold only works if you have a long, long, long investment horizon. A buy and hold investor who bought Dow index stocks at the market peak in 1929 had to wait until 1954 to get back to square - or 1959 after inflation! That's a long time to wait.

Buffett addressed this flaw by saying his "time horizon is fovever", which is fine since he never needs the money. He has never paid a dividend and he is giving it away to charity anyway.
On the other hand most investors need to be able to access their assets to live off. Retirees need to access their investments immediately and continuously for their living expenses, so for them timing is critical.

Using passive funds like index funds and passive asset allocation can take decades to get ahead if you buy at the wrong time. Every asset class, and every combination of asset classes, goes backwards for decades at a time after inflation (including and especially cash and so-called "risk-free" government bonds) so timing is critical. Unless of course your time horizon is forever and you are giving your money away anyway. cheers ashley

Which Warren Buffett advice should one follow? He has also said the average investor is better off investing in low cost index funds for the long-term; in other words, buy-and-hold.

This also confirms the other observations, which is that the average person, average active asset manager, the decision making processes based on voting systems will lead to sub-optimal outcomes in pretty much all aspects of life. There are good reasons for this and lack of opportunities in education, lack of access to information and reasoned debate, lack of understanding of numbers and risks are probably the key determinants.
In this sense it makes sense for the average person to be just invested in the markets.

We have some indicators that are similar that move from equities into bonds and prove that market sentiment indicators with more information in them generate much better signals compared with the market.

Paul Thind

Yes Herman I agree entirely - fear and greed are useful emotions for cavemen/women but not for investors, so we try to remove emotion from the investment decisions as much as possible. Instead focus on what really matters - your goals, needs, time horizon, etc then quietly go about finding good companies/assets at good prices.
Using that approach, we find that good assets are cheapest when most people are selling frantically, and conversely even great assets should be sold when crazy once-in-a-lifetime prices are offered.

ashley

Warren Buffetts’s famous edict about ‘being greedy when others are fearful and fearful when others are greedy’ has always struck me as rather poor advice. Although it is intuitively appealing, it doesn’t help if I happen to be one of the ‘others’. By definition, most investors have to be among the ‘others’ for Buffett to succeed. Perhaps a more useful counsel would be to be greedy when Warren is greedy and fearful when he is fearful or, quite simply, to be less greedy and less fearful, period.

"Successful investing is mostly about avoiding risks and not blowing up your money" -the most interesting statement of the article. Risk management is the key. Let's not get greedy people, when a stock price has increased significantly, and you have made money, take a little off the table and build cash for future opportunities. This is just common sense to me, but overall good statistical information.

hi grant,
yes, I have always found it very hard to convince people not to follow the herd - both at the top and at the bottom. But the main aim is to prevent them gearing up and betting the house buying assets at crazy prices in booms. Since the 1980s I have observed the people who can least afford to lose money are generally those who delay cautiously while the market rises for several years, but they finally decide to take the plunge very late in the boom and right before the bust, because they can see that everybody else is doing it. It is very sad and frustrating and completely avoidable.
cheers

ashley

I thought the p.a. difference would have been greater.

I am a big believer in the role human behaviour has in relative investment returns, normally to the detriment of performance.

I am surprised therefore that the differential between following the herd and against the herd portfolios was not greater particularly if active management fees were to be included.

Of course these benchmarks are measured against the index which is by its nature the collection of the herds investment views.

I firmly believe that professional active management , index unaware combined with against the herd investing leads to superior after tax returns over the medium to ling term.

Just ask Warren!