Alpha Power Investing Newsletter


January 13, 2011

Experts and Human Nature

The last time I looked at the research, about 90% of all domestic equity mutual funds and private equity managers are benchmarked to the S&P 500 or a similar index. Over rolling five-year periods, about 60% of these funds and managers fail to outperform the index. Over rolling ten-year periods, the failure rate jumps to about 80%. Of the funds that beat the benchmark over the course of a decade, it's virtually impossible to predict which ones will continue to outperform since probability theory predicts that about 10% of all funds will outperform by sheer luck, not by skill.

This is not to say that there are not skillful active managers out there - they are just hard to identify based on performance alone. My advice to investors who want the long-term market return of the largest American companies is to just buy an S&P 500 index fund and go to sleep.

To beat the market, you have to separate yourself from the herd and herd mentality. This means ignoring conventional thinking.

How about benchmarking your portfolio to the Alpha Mid-Cap Power Index, which we'll call the Alpha 400? Let's start with the fact that the Alpha 400 (index) has generated annual returns over the past 25 years that are 80% higher than the S&P 500: 18.0% vs. 10.2%. Over the past decade, the annual return advantage is impossible to state statistically: 12.9% vs. -0.43%. For a $1,000,000 investment, that's the difference between an ending value of $3,380,000 vs. $960,000.

Did this superior performance come from higher risk and higher volatility? Actually, the Alpha 400 is 40% less risky than the S&P 500 each and every year. This is due to the fact that the Alpha 400 is invested in intermediate treasury bonds from June 1 to October 31 every year (using the Barclays Capital Intermediate Treasury Index). As for volatility, see for yourself. The most volatile period for the index was 2008-2009, when two sharp losses were quickly reversed, resulting in no calendar year losses. Today, the index is soaring to new highs after successfully avoiding most of the 17% drop in the market in mid-2010.

When the Alpha 400 is not in treasury bonds, it's in mid-cap stocks (using the S&P MidCap 400 Index). This part of the capitalization structure is an investment sweet spot, as the S&P MidCap 400 Index has outperformed the S&P 500 by 30% a year over the past 30 years (13.6% vs. 10.4%).

So I ask you, what makes more sense - benchmarking your equity portfolio to the S&P 500 or to the Alpha 400?

"But Jerry," you say, "what if the market goes nowhere for the next ten years?"

Hold on ... I'm not talking about "the market". I'm talking about the S&P MidCap 400 Index between November and June (the annual "power zone"). See the past ten years as a reference.

"But Jerry," you say, "how do I know that the mid-cap index returns will be skewed into the "power zone" as they have in the past?"

Okay, fair enough.

How do we know that if we drop ten bucks on a crowded street that it won't be there for long? How do we know that economists (as a group) will fail to predict the next recession (as they have for the past 50 years)? How do we know that Ponzi schemes will never go away? How do we know that the future contains stock market bubbles and crashes? How do we know that investors will seek out and follow gurus who claim to be able to predict market outcomes?

The answer to all of the above is the same: human nature.

Human nature is the constant in the investment equation which explains why market returns will, over time, be skewed into the six to seven month period from November through May, and why market weakness, over time, will be skewed into the rest of the year.

Psychological research over the past 30 years has shed a great deal of light on the way we humans make decisions. First, we tend to be optimistic by nature - overvaluing the positive possibilities and undervaluing the negative. We tend to believe that we know more than we do. We view the world through our prejudices and fill in the gaps between our selectively chosen "facts" with a "story" that makes sense of the big picture. We are strongly influenced by the "herd" we identify with and tend to ignore contrary opinions. In short, we aren't rational the way most investment theories presume ... and neither are the "experts".

Investment analysts, stock analysts, economists, and other market "gurus" are human and subject to the same flaws as the rest of us in spite of their claim to "expertness".

At the end of the year, stock analysts and other forecasters put forward their expectations for the coming year. These expectations tend to be optimistic and usually are wide of the mark. Because these highly paid, well-spoken and confident "experts" exert significant influence in the investment world (why else are they there?), investor confidence rises and the positive force for market gains increases. Of course, this force can be overwhelmed temporarily by negative events (like the start of a war), but over the course of time this force emerges as a statistical "fact". For example, between November and May the Dow Industrials, since 1950, has appreciated at an daily rate that is 27.5 times greater than its appreciation during the other six months.* Furthermore, it is a worldwide phenomenon, showing up in more than 30 developed markets, as you would expect.

Long-term, the market is statistically weaker from May to November because "real" earnings start to emerge about mid-year and the overconfident, overly-optimistic "experts" begin to revise their estimates downward. This downward revision usually continues for the rest of the year.

So here's the bottom line: like it or not, all investors are long-term investors - until you die or run out of money. Frankly, I'd rather be the casino and put the long-term odds solidly in my favor. By understanding that the long-term "skewing" of returns into the annual "power zone" is caused by a constant factor (human nature) one can be confident that the effect will persist into the future, just like Ponzi schemes, market bubbles, and other "behavioral events".

Alpha's Mid-Cap Power Index Managed Account adds a number of enhancements to the index which seek to produce the index return net of fees and expenses. To review this program, go to the Programs and Performance section of our website at www.alphaim.net.

If you would like to discuss this program, please call me at 1-877-229-9400.

Sincerely,
Jerry Minton, Ph.D.
President
1-877-229-9400, Ext. 11


Past performance is not a guarantee of future performance.
*Seasonal Stock Market Trends, Jay Kaeppel, 2008, Wiley


© 2011 Alpha Investment Management Inc.

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