Alpha Power Investing Newsletter


March 3, 2011

Behavioral Investing

Long-term investment returns are the only ones that count. This is blatantly obvious.

Yet the average investor engages in investment practices which are driven by short-term concerns and/or opportunities. A continuous flow of research into investor behavior over the past 30 years has confirmed that these behavior patterns are extremely costly to long-term performance. The same psychological factors which cause this self-destructive behavior also cause investors to ignore or rationalize their own systematically flawed investment decisions.

One particularly interesting study was done by DALBAR, a leading research firm. DALBAR examined the long-term returns of mutual funds and compared them to the actual returns of the investors who owned the funds. As it turns out, over the 20-year period ending 12/31/09, the average equity mutual fund had an annual return of 8.2%. The average investor, on the other hand, had a return of 3.2% annually - less than half the return of the funds.

How could this be? Well, it turns out that the average holding period of an equity fund over that time span was just 3.22 years. So investors were busy switching funds - buying and selling at inopportune moments.

This behavior is really not surprising. It is well known that investors chase performance and love "hot" stories. It is also well documented that stories become "hot" late in the game and that superior short-term performance is almost always due to factors which are mean-reverting. An average holding period of three to four years fits this behavioral cycle nicely. A fund gets hot for one or two years, investors pile in late, the good returns persist for another year or so, then turn sour as mean-reversion kicks in. Disappointed and now convinced that the "story" has disappeared, investors sell and either drop out for a while or move on to the next "hot" story.

This behavior is reflective of human nature and will never change. It is caused by a couple of psychological programs that are built into the human psyche. The first program is self-confident optimism. Human beings tend to expect good things will happen to them and bad things will happen to other people. We tend to overemphasize the factors which appear to be favorable to our point of view, while ignoring the factors that would count as evidence against us. We also believe in "experts" and allow ourselves to be persuaded by individuals who appear to be smart, educated, highly paid, confident and respected. Yet in the investment world, it is a discouraging fact that expert opinion is mostly wrong because the "experts" have the same flaws as everybody else.

Of course, as almost every investor concedes, the key to superior long-term investment returns is discipline. Discipline, as I understand it, refers to the application of systematic rules to the investment situation which have proven value when applied consistently year after year. The idea of proven value requires two things: 1) the historical production of superior returns over long stretches of time, and 2) a reasonable explanation as to the causes of the over-performance. The common practice of chasing top-performing mutual funds or stocks based on a "hot" story fails on both counts.

Alpha's investment method could be called "behavioral investing" because it exploits systematic flaws in human nature - the same flaws that cause the average investor so much heartburn.

We know, for example, that since World War II the returns of stock markets globally have been "skewed" into the six-month period from November through April. In the U.S. this has resulted in a 60-year phenomenon where the average daily returns during this six-month "power zone" has been 27.4x greater than the average daily returns of the other days of the year. We know that during the six-month "dead zone" the market has been up 55% of the time and that 80% of all market damage is done during this period. During the "power zone", over the past 60 years, the market has been up 80% of the time and contains all the cumulative gains of the market held continuously.

We also know the behavioral factors which cause this phenomenon globally.

Research has shown that earnings analysts and other forecasters succumb to the optimism and over-confidence which is present in all of us. As a result, at the end of the year, when they make predictions covering the next calendar year, they tend to overestimate growth rates. Investors who are influenced by these respected forecasters turn upbeat late in the year and create a positive market climate which has an inordinately strong affect on small/mid-cap stocks (which tend to do best in a strong market). These forecasters hold on to their excessive optimism until mid-year when actual earnings are emerging and, more often than not, force them to revise their estimates downward. This often causes investor optimism to wane, resulting in lower returns from May to November.

To construct a discipline based on these factors is relatively simple: Own mid-cap stocks, in the form of the S&P MidCap 400 Index, from November through May (an extra month for mid-caps), then own the Intermediate Treasury Index during the "dead zone".

Here is the twenty-year result of this discipline, which I call the Alpha Mid-Cap Power Index:

My recommendation to investors is to get out of the "guessing game". For most investors it's a guaranteed losing proposition to believe that you can win over the long-term by making a series of correct short-term decisions based on stories about funds or stocks or economic events. This is really investing as entertainment, and if you must do it, restrict it to a small portion of your total portfolio.

Instead, get yourself into the "casino game", where you are the casino. Casinos consistently win because they stack the odds in their favor. The laws of probability are their business partners. The Alpha Mid-Cap Power Index is a casino. The 30-year track record proves it. As of December 31, 2010, the index has been up 29 out of 30 years (down 6.7% in 1994) with a compound annual rate of return of 18.4%, which is 80% more per year than the market, with 40% less risk each and every year. Over the last ten years, as the S&P 500 has gone nowhere and investors have received little to no return on their equity portfolios, this index has delivered a 14% annual return.

Alpha's Mid-Cap Power Index Managed Account seeks to duplicate the index performance after fees and expenses. To read about our enhancements to the index go to the Programs and Performance section of our website at www.alphaim.net.

If you would like to discuss this or any of our investment programs, 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.

© 2011 Alpha Investment Management Inc.

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