Smart401k Blog

Yesterday, both of traditional measures of the overall US Markets dropped to levels that fit the textbook definition of a correction.  The benchmark S&P 500 dropped 2.3% Monday, erasing its 2007 gains and leaving it 10.1% below its October 9th high (down .8% for the year).  The other key benchmark, the Dow Jones Industrial Average fell 237.44 points to show a 10% decline since its October 9th high. The Dow still shows a gain of 2.2% for the year.  The S&P 500 has been hit a little harder than the Dow primarily because it is more heavily weighted with financial stocks, which have declined more than the rest of the market.

Here are a few statistics and comments to put things into perspective (please refer to our prior blog on Corrections and Bear Markets):

• Historically, corrections are fairly common occurances -there have been 43 corrections since World War II.  Corrections have occured less frequently since the 1990’s. The last correction we had was in 2003.
• The average correction is a decline of 15% off of a market high.
• One in four corrections turn into Bear Markets (market declines of 20% or more) according to Ned Davis Research in Vinice, Florida.
• The length of time from the market high on October 9th to yesterday was less than 50 days. The last 16 corrections have averaged 148 days to the low point, and 111 days to recover back to the original high point in the market.

A final note: the label market correction is important to near term market performance because it is indicative of a broad drop in the market and it has a near-term impact on investor behavior.

By Matt Koppenheffer for Smart401k

[Editors note:  Considering correllation is a cornerstone of investment diversification.  It's especially critical for long-term retirement investing.  For some people, the idea of trying to build a solid portfolio based on quality funds in a variety of different -- and low correlated -- asset classes may seem a bit overwhelming. That's where Smart401k comes into play as an option for retirement savings investors.  Considering asset classes and their relative correllation is a guiding principal of our system of allocating investments each quarter - Scott Revare.]Let’s start with a bit of an illustration. Imagine you’re a feudal lord and you are laying out the defenses for your town. The first thing you do is build a massive wall around the town. You’re very proud of your wall and think that it alone should be able to withstand just about any attack. However, you know that it’s never good to rely solely on a single defense, so you decide to supplement the wall.First you strategically position some archers on the top two corners of the wall and tell them to spray arrows down on attackers. Then, you grab some peasants from the streets and give them buckets of oil, telling them that when the town is under attack they should heat up the oil and drop it on the attackers. Finally, you install massive spikes at the top third of the wall to hinder anyone that tries to breach it.Though you certainly didn’t wish for an attack, in the days of the feudal lords (and to make my story illustrative at all!) attack was somewhat inevitable. You got all of your defenses at the ready, and thought that there was no chance that this army could touch you. Unfortunately, the attackers were on the leading edge of the use of gunpowder. Though a few hapless attackers were hit with the archer’s arrows and scalded by the hot oil, they very easily planted dynamite in strategic spots along your beloved wall and brought it crumbling down — and with it your archers, oil dumpers, and scary-looking spikes.Am I in the right place?

Of course this is a blog about investing, not about the finer points of feudal military strategy. However, the unfortunate experience for this warlord of the Middle Ages mirrors what ends up happening to many investors. That is, they build their portfolio around an asset or asset class that they believe to be rock solid, and then, hoping to protect themselves further through diversification, buy additional assets or asset classes that will rise and fall right along with the one that they started with. They are then caught by surprise when something that affects their “wall” simultaneously brings down the rest of their portfolio.

The Rexed portfolio

For an example, let’s visit an investor named Rex Portfolio. Rex is a big fan of large cap growth stocks because he believes that they offer the ideal combination of safety and growth potential. Accordingly, Rex has invested a big chunk of his retirement savings in a large cap growth mutual fund run by the very well respected John B. Goode.

Now Rex had heard the adages about the power of diversification, and decided that, as fantastic a manager as Mr. Goode is, he would put some of his money elsewhere. So in addition to the Goode mutual fund, he bought two more large cap growth funds run by good (but not as good as Goode!) managers, and he also put a chunk of money in an S&P 500 index fund.

You have never seen a baby sleep as soundly as Rex did after he had this allocation strategy worked out.

Part of the reason Rex had been so taken with large cap growth was due to the fact that it was the best performing asset class over the past five years. After Rex made his investments the class continued to perform well for a little while, but, as asset classes have a tendency to do from time to time, the performance reigns were passed — this time to small cap value. In addition, a handful of the most popular, and formerly best performing, large cap growth names started to have some trouble and their stock prices sagged badly.

So what did this all mean for poor Rex? Well, the core of his portfolio, Goode’s fund, took a beating since it had outsized exposure to large cap growth in general and those formerly hot large cap growth stocks in particular. Unfortunately, his diversification strategy didn’t help him at all — the two additional mutual funds that he owned were exposed to exactly the same problems that the Goode fund was, and the S&P 500 index fund, though not hurt as badly, did not hold up well either since many of its constituents are large cap growth stocks.

Rex’s solution: mind your correlation

What is it, then, that Rex and our feudal lord could have done differently to better prepare for the vagaries of the future? The answer is working with asset classes that have a low, or negative, correlation to each other.

Princeton’s website defines correlation as “a statistical relation between two or more variables such that systematic changes in the value of one variable are accompanied by systematic changes in the other.” In other words, correlation is a measure of how changes in one thing ripple through to something else. The level of correlation is measured on a continuum from -1 to +1. Two things that move in the same direction — crude oil prices and jet diesel prices, for instance — have a positive correlation between 0 and 1. Two things that move in opposite directions — say, gasoline prices and the amount people drive — have a negative correlation. Two things that are totally unrelated, such as the rainfall in

Nevada and the stock price of Microsoft, have a correlation at or near zero.

In the story of the feudal lord, the effectiveness of his defenses was very highly correlated with the performance of the wall. As long as the wall stayed intact, they could help battle off raiders, but when the wall fell they all became moot very quickly. Similarly, for Rex, the performance of his retirement funds were highly tied to the performance of large cap growth stocks, and as soon as that one group started to deteriorate all of the funds that he owned — which were highly positively correlated — took a turn for the worse.

We’ve all seen plenty of movies, so I’m sure we all have some ideas of what the warlord could have done differently. A moat around the wall, catapults set on the ground inside the wall, and some soldiers attacking from outside the wall’s confines all could have been good additions which would have performance far less correlated with the performance of the wall.

When it comes to Rex’s problem, though, there haven’t been too many movies made on effective portfolio allocation, so the solution is a bit trickier. What he needs to do is start shopping outside of his comfort zone of large cap growth, and add funds to his portfolio that don’t live and die on the performance of that one group. Examples of areas that could help Rex achieve some true diversification include value funds, small cap funds, international funds, bond funds, money market funds, and even sector funds. Though Rex might complain initially that diversifying his savings in all of these different areas will water down his returns as long as large cap growth does well, in the long term the diversification will help Rex achieve returns that are far more stable and balanced.

[Editors note:  There is a wealth of evidence that people tend to let emotions drive their investment decisions - at the worst possible times.  Our job at Smart401k is to help you think and act rationally when making decisions. For investors looking for a helping hand making their long term investing decisions, this can offer great peace of mind through the best times in the market and the worst - Scott.]

by Matt Koppenheffer for Smart401k

We all want to think that we’re rational. In fact, when it comes to investing, many people like to think about themselves as not only rational, but above average. But are we?

First, I should define what exactly rational is. When it comes to economics and finance, rationality has traditionally been defined as making choices based on the greatest expected utility. Expected utility, then, is a calculation based on the probabilities of various outcomes combined with the value of each outcome.

For example, say you faced the choice of three new jobs. The only difference between the three was the pay package. In the first, you are guaranteed a $50,000 salary. In the second, you are guaranteed a $25,000 salary with a 50% chance of a $50,000 bonus and a 50% of no bonus. In the third, you are guaranteed a $40,000 salary with a 50% chance of a $10,000 bonus and a 50% chance of a $20,000 bonus. A perfectly rational person (in the world of economics) working on expected utility would choose the third job since the expected total payout of the first two jobs is $50,000, while the expected payout of the third is $55,000.

But how rational are we? Here’s a quick exercise. The following are two gambles, and in each are presented the potential payouts and the probabilities of those payouts. Read through both, and pick which gamble you’d choose for each group.

Gamble 1

(A) $500 with 100% probability

(B) $1,000 with 50% probability and $0 with 50% probability

Gamble 2

(A) -$500 with 100% probability

(B) -$1,000 with 50% probability $0 with 50% probability

What were your answers? If you chose (A) in Gamble 1 and (B) in Gamble 2, then you made the same choices that I made the first time I saw this, and the same choices that most people make when the take this gamble.

In fact, the choice combination makes no sense (from the rational economics standpoint) since the expected outcome of the pairs in both gambles is the same. In the first, the expected utility for both is $500, while in the second it’s -$500. According to economic theory, anyone who chooses the “sure thing” in the first gamble should also choose the “sure thing” in the second. Likewise, someone who chose (B) in the first gamble should also choose (B) in the second.

As part of their work in behavioral finance, Daniel Kahneman and the late Amos Tversky came up with what they called Prospect Theory — a theory which Kahneman ended up winning a Nobel Price in Economics for. Prospect Theory says that the apparent anomaly above is explained by the fact that across the board, people are generally risk averse when it comes to gains, but risk seekers when it comes to losses. In other words, we’re more likely to take a gamble when it comes to taking losses.

So how does this come back around to us and our investing decisions? Well, an effective investor is a rational one. Unfortunately, though, for many investors the preferences identified by Prospect Theory carry over to their investing. These investors are far more likely to “gamble” on a stock that is currently a loser for them, hoping that it will get back to break-even, while at the same time being too unwilling to risk gains that they’ve made on stocks that are up, and consequently selling far too soon.

So taken as a whole, this means that to be a good investor it takes more than knowing the nuts and bolts of financial metrics, valuation, and business analysis — it means identifying and mastering self-destructive psychological tendencies.

Scott Revare, CEO of Smart401k appeared on the TV program “Your Investments with Adam Bold” on Friday, October 19th.  To view the segment on the web, go to:

http://www.yourinvestmentsshow.com/shows.shtml

Be sure and watch the October 19th show (Scott’s segment is at the beginning of the show).