Invest Like a Fox Not Like a Hedgehog Bob Carlson AAII-DC Editor, - PowerPoint PPT Presentation

Invest Like a Fox… Not Like a Hedgehog Bob Carlson AAII-DC Editor, Retirement Watch January 2008 800-552-1152 www.RetirementWatch.com 1

Foxes vs. Hedgehogs “The fox knows many things, but the hedgehog knows one big thing.” Archilochus, 7 th century BCE From Isaiah Berlin 2

Foxes Are… • Skeptical of big, central principles • Wary of simple historical analogies • Less likely to be swept away in their own rhetoric • Worried about judging the past too harshly 3

Foxes… • See more value in keeping passions under wraps • Make efforts to integrate conflicting beliefs, theories, and observations 4

Hedgehogs Always Believe in: The Pursuit of the ONE BIG THING 5

Hedgehogs Always Believe: The most dangerous words in the English language are: “It’s different this time.” 6

Point of Maximum Risk Euphoric I'm so It's just a Worried smart. Thrilled correction. Optimistic Anxious Excited Denial Hopeful Optimistic Scared Relieved Hopeful Depressed Desperate How did this happen? Panicked Point of Maximum Opportunity 7

180 160 140 120 100 80 60 40 SPDR ETF 20 0 1/3/2000 5/3/2000 9/3/2000 1/3/2001 5/3/2001 9/3/2001 1/3/2002 5/3/2002 9/3/2002 1/3/2003 5/3/2003 9/3/2003 1/3/2004 5/3/2004 9/3/2004 1/3/2005 5/3/2005 9/3/2005 1/3/2006 5/3/2006 9/3/2006 1/3/2007 5/3/2007 9/3/2007 1/3/2008 8

Questions Hedgehogs Cannot Answer  Why are prices of investments more volatile than fundamentals? • Why do stock prices change without a change in fundamentals?  Why does the equity risk premium exist? 9

Reasons Questions Are Not Answered  Returns in shorter periods differ from long-term average returns  Correlations and volatility change  Volatility is not risk to most investors  Long-term bull and bear markets are not explained 10

Return Portfolios on the Efficient Frontier Areas of Non- Efficient Portfolios The Efficient Frontier Risk 11

Correlations Change 12

Modern Portfolio Theory  Risk is as important as return  Risk of a portfolio is more important than risk of assets  True diversification reduces risk  Forecasting is essential to risk reduction and efficiency 13

What Foxes Believe  Markets are not always efficient and rational. They are dynamic.  Investors make mistakes.  Endogenous risk is significant.  Markets can reach extreme valuations.  Investors must act on forecasts. 14

Investing as Risk Management • MPT says risk as important as returns  Make forecasts  Consider probability of error  Reduce or eliminate unwanted risks  Contingency plans  Monitor and adjust 15

Relative Returns vs. Absolute Returns  Traditional strategy measures against index  Should measure against probability of achieving goals  Return pattern different from indexes, not dependent on them 16

What To Do Now  Investors should seek:  Absolute returns, more predictable returns  Reduced risk, volatility  Low correlation with major market indexes—True Diversification 17

Ways to Manage Risk • Add asset classes • Rebalance more frequently • Use value managers • Manage asset allocation • Use unconventional strategies • All-Weather Strategy • Hedge or use hedge funds 18

Indicators That Have Failed • Dividend yield  Price to book value  Price-earnings ratio  q ratio  Technical analysis  Extra-market factors 19

What Not to Do—Why Indicators Fail  Random events ≠ cause and effect  Too many variables  Fat tails: The unexpected happens  End points affect results  Correlation never is 100%  Markets are dynamic  Turning points obvious only in hindsight 20

Where Are We Now?  Unique Financial Markets:  Interest rates already low  Credit and borrowing crisis  Global growth supporting U.S.  Housing problems isolated?  Inflation still not contained 21

2001 or 2002? 160 140 120 100 80 60 SPDR ETF 40 20 0 1/3/2000 3/3/2000 5/3/2000 7/3/2000 9/3/2000 1/3/2001 3/3/2001 5/3/2001 7/3/2001 9/3/2001 1/3/2002 3/3/2002 5/3/2002 7/3/2002 9/3/2002 1/3/2003 3/3/2003 11/3/2000 11/3/2001 11/3/2002 22

Time to Bottom Fish? • Weakening labor market • Soft mortgage applications • Record profit margins • 21 of 27 measures turned negative • Export growth is slowing • Signs of weakness in Europe • Gradual deterioration of economy 23

Why Disasters Don’t Happen • Diverse, service-oriented economy • Regulators, investors aware of problem • Globalization, with weak linkages • Sectors not as correlated • Wealth effects are lagged 24