Are You Smarter Than a Monkey? Course Syllabus. How Are Our Stocks Doing? 9/30/2017

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David Thompson
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1 Are You Smarter Than a Monkey? Course Syllabus Human Psychology with Investing / Indices and Exchanges Behavioral Finance / Stocks vs Mutual Funds vs ETFs / Introduction to Technology Analysis Our Economy & The Stock Market / Style Investing Managing Risk / Understanding Sectors & Industries / Using Relative Strength / Factor Investing Investing for Income / Using REITs, MLPs, CEFs and Preferreds Guest Speaker: Travels of a Self Taught Investor Understanding Important Fundamental Ratios / International Investing / Learning from the Masters Portfolio Construction & Risk Management / The Importance of Diversification / When to Sell How Are Our Stocks Doing? 1

2 Morningstar Clarification Question of the Day What s the Difference Between Mid-Cap and Equal-Weight? Plug for Market Cap Weighted Indexes The strength in larger stocks masks some underlying trends in the market when viewing market-capweighted indexes. According to Strategas Research Group, 24% of the S&P 500 has experienced a correction of 10% to 20% from their 52-week highs through the end of the first quarter. In addition, another 14% are off more than 20% from their highs. SPY grew 4.5% in 1Q

3 So Why Use Equal Weighting? The direct link between prices and weights is pointed out by critics of market cap-weighted indexes as the main source of potential drag on their returns, as it might result in overweighting over-valued companies and underweighting under-valued companies. Equal weighting severs the link between a stock s price and its weight in the index in the simplest possible way. Doing so negates the bet on size (as measured by market cap) implicit in the S&P 500, produces a naturally contrarian perspective, and has shown long-term outperformance. Capital Asset Pricing Model The CAPM formula is: r a = r rf + B a (r m -r rf ) + (Uncompensated) Noise where: r a = return of asset r rf = the rate of return for a risk-free security r m = the broad market's expected rate of return B a = beta of the asset Systematic risk Managing Your Investment Risk Beta. A measure of a fund's sensitivity to market movements. Beta 1.5 means a stock is 50% more volatile than the market. Most popular metric for personal risk. Alpha. A measure of the difference between a fund's actual returns and its expected performance, given its level of risk as measured by beta. R-Squared. R-squared measures the relationship between a portfolio and its benchmark. Standard Deviation. A measure of how much an investment's returns can vary from its average return. Taking the standard deviation of a fund s return and comparing that risk measure to other funds risk is a straightforward way to get a handle on the risk of a fund. Sharpe Ratio. Measurement of the risk-adjusted performance for securities by factoring in the risk-free rate and the standard deviation of the asset. 3

standard deviation of its average return 68% of the time and

4 What is Standard Deviation? For most funds, future monthly returns will fall within one standard deviation of its average return 68% of the time and within two standard deviations 95% of the time. Less is More Standard Deviation is Your Friend? 4

Good Way to Swing Trade The greater the variance or the standard deviation around the average, the less the average return will signify about what the outcome is likely to be.

5 Good Way to Swing Trade The greater the variance or the standard deviation around the average, the less the average return will signify about what the outcome is likely to be. Risk Adjusted Returns A refinement to standard deviation of an investable asset or fund. Beta compares the standard deviation of a fund to the standard deviation of the market itself. This is opposed to standard deviation which measures how much a fund can vary from its own average return. Taking the standard deviation of a fund s return and comparing that risk measure to other funds risk is a straightforward way to get a handle on the risk of a fund. Risk-Adjusted Returns Beta A measure of a fund's sensitivity to market movements. Beta 1.5 means a stock is 50% more volatile than the market. Most popular metric for personal risk. Alpha A measure of the difference between a fund's actual returns and its expected performance, given its level of risk as measured by Beta. 5

Example: Beta vs Alpha Let s assume company XYZ s stock has a return on investment of 12% for the year and a beta of + 1.5 Our benchmark is the S&P500 which was up 10% during the period.

6 Example: Beta vs Alpha Let s assume company XYZ s stock has a return on investment of 12% for the year and a beta of Our benchmark is the S&P500 which was up 10% during the period. Is this a good investment? Taking More Risk Than Necessary A beta of 1.5 implies volatility 50% greater than the benchmark; therefore the stock should have had a return of 15% (S&P index was 10%) to compensate for the additional risk taken by owning a higher risk investment. The stock only had a return of 12%; three percent lower than the rate of return needed to compensate for the additional risk. The Alpha for this stock was -3 and tells us it was not a good investment even though the return was higher than the benchmark. And Now We Have Smart Beta Funds! 6

Finding Beta http://www.nasdaq.com Caveat Emptor Before investing in a fund, determine the fund s relative and absolute risk.

7 Finding Beta Caveat Emptor Before investing in a fund, determine the fund s relative and absolute risk. Beta measures sensitivity to the return of the overall market (magnitude of the relationship). Standard deviation measures variation in return for an stock or fund no matter what the cause. It is important to note that a low beta for a fund does not necessarily imply that the fund has a low level of volatility. A low beta signifies only that the fund's market-related risk is low. Standard deviation is a measure of a fund's absolute volatility. Risk & Uncertainty Risk is not volatility. It is drawdown (loss of capital). However, in the short term, volatility is a reasonable proxy for risk. But over the longer term, drawdown is a much better measure of risk. Volatility does contribute to risk but it also contributes to market gains. 7

Measuring Risk Source: http://investspy.

strategies. If you want alpha, primarily use active & other sector rotating strategies (aka. smart beta).

8 Measuring Risk Source: Risk & Reward Investing Strategies If you want beta, go with passive ETFs or income generating strategies. If you want alpha, primarily use active & other sector rotating strategies (aka. smart beta). You can build your own smart beta portfolio simply by combining passive ETFs, sectors, styles and factors. Equal weighting different sectors (or factors) gives you more of a value tilt! 8

We re Going to Peel the Onion Different Equity Asset Classifications

class, there are an infinite number of ways to slice and dice the universe

For instance, you could have high-yield bonds issued from companies in the

9 We re Going to Peel the Onion Different Equity Asset Classifications Styles & Size Sectors & Industry Groups Loosely referred as an asset class, there are an infinite number of ways to slice and dice the universe of stocks and bonds to create a subset or trading basket. For instance, you could have high-yield bonds issued from companies in the energy space, emerging market healthcare stocks, or dollar-hedged European stocks. Why Sectors Matter 9

10 What are the Sectors? Now There s 11 Sectors You Can Also Consider Telecom XTL, VOX Regional Banking KRE Biotech XBI, IBB Real Estate XLRE, VNQ Aerospace and Defense ITA Retail RTH 10

11 Sectors & Industry Groups And Sub-Industry Groups Why Care About Sectors? Small Group Outperforms Large Group Underperforms S&P % 10 15% stocks will perform market returns and only 10% will outperform. 11

Stocks Will Rotate From Outperforming to Underperforming Stocks Can Rotate Between Being in Favor and Being Out of Favor S&P 500 +12%

12 Stocks Will Rotate From Outperforming to Underperforming Stocks Can Rotate Between Being in Favor and Being Out of Favor S&P % Margin of safety should always be on the top of your investment list. But How Do You Find the Top 25% of Stocks? Single Stock Alternative 12

returns for periods of time, but in the end they eventually tend to move back

13 Opportunistic Investing S&P 500 Sector Performance Mean Reversion is simply the fact that investments can trade far above or far below their long-term average returns for periods of time, but in the end they eventually tend to move back towards their average. Outperformance is followed by underperformance and vice versa. 13

Causal Explanations Mean reversion explains how the corporate performance of companies included in famous business books like In Search of

Do the successful firms became complacent and the less successful firms try harder?

the lagging performance of the rest. A statistical fact of life: regression to the mean.

14 Causal Explanations Mean reversion explains how the corporate performance of companies included in famous business books like In Search of Excellence and Good to Great regressed to the mean after the books were written, a now well-known phenomenon. Do the successful firms became complacent and the less successful firms try harder? The average gap must shrink, because the original gap was due in good part to luck, which contributed both to the success of the top firms and to the lagging performance of the rest. A statistical fact of life: regression to the mean. It s Why We (Should) Rebalance Asset allocation doesn t work without diversification; Which doesn t work without rebalancing; Which doesn t work without mean reversion. Make sense? This forces you to take profits and reinvest them at lower prices. Another example of buy low, sell high. Sectors and The Economy Cyclical 14

15 Defensive vs Cyclical Sectors Sell in May and Go Away Defensive in Summer, Cyclical in Winter A *good* dividend-stock strategy has been buy in fall and sell in spring Sell in May and Go Away (over last 20 years) 15

16 Why Sectors Matter Significant Driver of Returns Clearer Patterns of Volatility 16

Low Correlations Provide Risk Mitigation Investing in sectors produced better results than investing in the median-performing stock in each sector.

17 Low Correlations Provide Risk Mitigation Investing in sectors produced better results than investing in the median-performing stock in each sector. During the past decade, the likelihood of outperforming a sector by randomly picking individual stocks was lower than 50% in nine out of 10 sectors. Not owning the 10% of best-performing stocks in a given sector can lead to significant underperformance Highlighting the benefit of investing in a sector vs. an individual stock to gain exposure to a particular market segment. Downside risk is significantly higher when investing in individual stocks vs. sectors. Correlations Lower Than Style Boxes 17

Walmart (WMT) is in the consumer stable sector (XLP).

18 Intuitive, Stable Classifications Stable, But Sometimes Weird Amazon (AMZN) is in the discretionary sector (XLY). But AMZN is the top holdings in QQQ? Walmart (WMT) is in the consumer stable sector (XLP). And Target (TGT) is in the consumer discretionary sector? Exxon Mobil (XOM) is in Basic Materials on Yahoo Finance. Check the Weighting! 18

19 Might Be Better To Use EW? Market Cap Weight 38% Equal Weight If You're Going to Stay in the Market You are not going to catch a wave if you are not in the ocean The percentage of days (in a year) that contribute to the trend is 12 to 13%. The remaining price movements are either sideways or counter-trend. Ergo, be in the market with strong *safe* sectors What I ve Discovered Economic forecasting is fruitless The economy doesn t always dictate how the stock market will perform Stock picking is hard (and risky). Sectors are generally *safe*. If you make a mistake, they often will mean revert They all pay dividends! Be clear on your weighting strategy. Use equal weight for small and mid cap exposure, or for less exposure to top names in the index (e.g. XLE or XLY). Market cap weight for momentum and dividends. 19

What is Factor Investing? (aka. style premia) It is the implementation of systematic portfolio rules in effort to harvest positive active returns. Where do these positive active returns come from?

20 What is Factor Investing? (aka. style premia) It is the implementation of systematic portfolio rules in effort to harvest positive active returns. Where do these positive active returns come from? Risk Liquidity Behavioral biases Market structure The Rise of Factor Investing The Fama-French four factor model. Now it includes a fifth factor, profitability. Major Factors Today Value Size Momentum High Dividend Quality Volatility Yield 20

disclosed daily, unlike active mutual funds that

21 Evolution of Factor Analysis *Smart beta ETFs have an added element of transparency in that holdings are disclosed daily, unlike active mutual funds that typically display holdings only quarterly. Factor Tilting 21

22 Momentum s Top Holdings 22

Majority of shortfall is due to trading or implementation costs for factor investing.

23 Are Investors Believing in Impossible Things? Factor investing is gaining popularity. From , factors have experienced substantial shortfalls in capturing factor returns or no benefit whatsoever. Majority of shortfall is due to trading or implementation costs for factor investing. BlackRock ishares Factor ETFs Asset Allocation ETFs The Rise of Factor Investing One thing you have to understand related to the growth of ETFs is that a large component of the growth is not people seeking beta; it s active managers navigating beta for alpha. They re doing asset allocation. It s cheaper; it s more efficient; you have less idiosyncratic risk than in any one stock. So I actually believe one of the unknown secrets about the growth of ETFs is that they re heavily used by active managers. Larry Fink, CEO Blackrock 23

Are You Smarter Than. Monkey?

Are You Smarter Than. Monkey? Are You Smarter Than Advanced Systems a Group Monkey? Course Syllabus 1 Questions from Last Week? How Are Our Stocks Doing? 2 Question of the Day What s the Difference Between Mid-Cap and Equal-Weight?