Thinking Through Cryptocurrencies | Part 1

Thinking Through Cryptocurrencies | Part 1

 

It seems like everyone nowadays is talking about cryptocurrencies. Whether it’s the proselytizers on CNBC or the techie next door, it feels as if everyone is either talking about or buying into this next big thing.

Trying to adequately explain an emerging technology and it’s economic impact in less then a few thousand words is bound to neglect certain facets of the subject. This series attempts to cover the technical specification of cryptocurrencies, how they can be viewed in an investment environment, the narratives that accompany this new technology, and the future impact, applications, and risk of the cryptocurrency universe.

 

What Is a Cryptocurrency?

The first cryptocurrency, Bitcoin, was originally imagined as a system of value exchange that could bypass institutions and instead allow users to make transactions on a peer-to-peer basis. For such a network to succeed, there had to be a way to verify the veracity of the transaction for both parties.

This is where the revolutionary technology called the blockchain comes in. The blockchain can be visualized as its name suggests: a chain made up of individual blocks of transactions. At its heart, this is what Bitcoin is: a series of transactions leading up to the current moment. When an individual buys Bitcoin, they are simply adding their name to the transaction list (or ledger), saying, “I have bought x number of Bitcoins.” Of course, it’s not as simple as adding a line.

Bitcoin works by having computers (or nodes) confirm and document transfers. When a transaction between Person A and Person B occurs, this transaction is sent out over the Bitcoin network. These nodes then verify that Person A has the right amount of Bitcoin to transfer to Person B by looking at the blocks of historical transactions on the chain. Once the majority of nodes on the network (50%) verify that a transaction can take place, it is added to the blockchain transaction log.

This verification process is where Bitcoin miners come into the picture. Miners provide the computers and computer power needed to verify transactions. They provide this service and get “paid” for it by having the opportunity to mint a new Bitcoin. To mint a new Bitcoin, a miner must verify 1MB worth of transactions and find a solution to a cryptographic hash function, which is the difficult part. The Bitcoin miner who verifies the transactions and is the first one to determine the target hash is the one who gets to include a new transaction for themselves, essentially minting a Bitcoin. While cryptocurrencies differ in the exact way that they go about transactions and the minting of new coins, the Bitcoin method is a solid enough base to understand cryptocurrencies at their base level.

 

Where Do Cryptocurrencies Fit in the Investment Landscape?

Cryptocurrencies, especially Bitcoin, are sometimes referred to as digital gold. Like gold and other currencies, they are something that derives their value from the belief that they can be exchanged in the future for something else of value and that the future value will be greater than the present value. The term that is frequently used is “a store of value.” Perceptions of value can change much more quickly than physical objects, which leads to the volatility that has always been present in currency markets, digital and fiat.

One of the advantages of cryptocurrencies, unlike gold or silver, is the ability to store value in an even more concentrated physical form. A 100-gram gold bullion cost about $6,000 dollars in 2020. This gold bullion could be slipped into your pocket or placed in a safe. A small flash drive, smaller than the gold bullion, could essentially hold billions of dollars in Bitcoin.

As with gold, there is a physical limit to the number of Bitcoins that can be produced. There can only be 21 million Bitcoins in the current Bitcoin network. So far, almost 19 million have been mined. Many believe this commodity-like supply will result in the value of Bitcoin rising with inflation—or possibly even faster.

Cryptocurrency advocates have discussed how this feature also makes digital currencies immune to the hyperinflation that can result from governments printing money. On the one hand, that is true. However, on the other side of the coin, the creation of a new Bitcoin or other cryptocurrency via mining injects new money into the supply. And as has been seen with gold historically, short-term, localized abundance of even a limited supply commodity can result in hyperinflation. The famous 1849 Gold Rush in California is a perfect example of the phenomenon. The prices for various goods like eggs, bread, and boots in the local area rose to more than three times the original price. Allowing for the lower accuracy of CPI data from the late 1800s, there is general consensus that the various gold rushes of the era from the U.S., Australia, and South Africa all resulted in increased inflation rates. So, while cryptocurrencies may be more immune from government influence, it is unlikely that they are immune to supply and demand shocks.

Other types of cryptocurrencies, such as Ethereum or Cardano, offer different use cases by allowing the creation of new cryptocurrency assets or non-proof-of-work methods. The full effect of these other types of cryptocurrencies remains to be seen. One Ethereum-based crypto asset that has seen a lot of recent attention is the rise of Non-Fungible Tokens (NFTs). These tokens represent a unique digital item and are not interchangeable. This has created a marketplace for artists to sell digital items with the authenticity guaranteed by the blockchain. Many of the applications of varying alternative cryptocurrencies are still being figured out at this time. It has yet to be seen whether these become alternate stores of value or simply new, more efficient ways to transact.

 

Watch for the next installment where we discuss cryptocurrencies and recent market conditions.

Disclosure: The material is presented solely for information purposes and has been gathered from sources believed to be reliable, however Merriman cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Merriman does not provide tax, legal or accounting advice, and nothing contained in these materials should be relied upon as such.

It is not intended to serve as a substitute for personalized investment advice or as a recommendation or solicitation of any particular security, strategy or investment product. Opinions expressed by Merriman are based on economic or market conditions at the time this material was written.  Economies and markets fluctuate.  Actual economic or market events may turn out differently than anticipated.  Any reference to an index is included for illustrative purposes only, as an index is not a security in which an investment can be made.  Indices are unmanaged vehicles that serve as market indicators and do not account for the deduction of management fees and/or transaction costs generally associated with investable products. As always please remember investing involves risk and possible loss of principal capital and past performance does not guarantee future returns; please seek advice from a licensed professional.  Advisory services are only offered to clients or prospective clients where Merriman and its representatives are properly licensed or exempt from licensure. No advice may be rendered by Merriman unless a client service agreement is in place. All composite data and corresponding calculations are available upon request.

The Role of Bonds

The Role of Bonds

 

In Berkshire Hathaway’s most recent annual shareholder letter, Warren Buffett shared his dire forecast for bond investors:

 

And bonds are not the place to be these days. Can you believe that the income recently available from a 10-year U.S. Treasury bond – the yield was 0.93% at yearend – had fallen 94% from the 15.8% yield available in September 1981? In certain large and important countries, such as Germany and Japan, investors earn a negative return on trillions of dollars of sovereign debt. Fixed-income investors worldwide – whether pension funds, insurance companies or retirees – face a bleak future.

Thus far, Warren’s negative outlook has proven correct with the yield on the 10-year U.S. Treasury bond rising to 1.74% through the first quarter, leaving bond investors with a negative (3.4%) return.* And with inflation expectations heating up, it is certainly difficult to build a bullish case for bonds. However, most individual investors do not have all their investable assets in bonds. Buffett only considers the investment merits as a standalone investment. Given that most of our clients own bonds within a diversified mix of equities, real estate, and other asset classes, we thought this would be an opportune time to revisit the role bonds play within the portfolio.  

In its most basic form, a bond is a loan to a government entity, corporation, or individual consumer. The investor in a bond is the lender and expects to receive back the original principal along with interest over the life of the loan. Bonds have two main characteristics: quality and maturity.

Quality is a measure of credit risk or the likelihood that the entity will repay the loan. High-quality bonds carry lower interest rates to reflect the low risk of default. In Buffett’s example above, he discusses the U.S. Treasury bond, which has the highest quality and thus a lower interest rate. On the other end of the spectrum, a corporation with a “junk” credit rating will have a much higher interest rate to compensate investors for the additional risk of default. 

Maturity is a measure of interest rate risk. Using bond terms, duration provides an estimate of how sensitive a portfolio of bonds is to changes in interest rates. As an example, if interest rates rise across all maturities by 1%, a bond portfolio with a duration of 10 years can expect to lose 10% in value without including interest payments. The interest rate risk increases with duration and vice versa.

Now that we have the basics in place, let’s discuss more specifically the role bonds play in a diversified portfolio. MarketWise is designed to produce the highest risk-adjusted returns, taking into consideration the long-term expected returns, volatility, and correlations produced by the different asset classes. Bonds play a critical role in that mix. We invest in high-quality U.S. government bonds with short to intermediate (two to five year) maturities with the sole purpose of mitigating risk and providing stability. For taxable accounts, we invest in municipal bonds, which play a similar role while producing tax-free interest. We also own Treasury Inflation Protected Securities (TIPS), which provide protection during inflationary environments. 

The main function of bonds in a portfolio is downside protection. If stocks always went up, there would be little need for bonds or any other asset class. But as we were recently reminded last March, stocks do go down, and when they do, bonds provide that counterbalance, as they typically rise in value during equity bear markets or economic recessions. In fact, since 1976, there have been eight years in which stocks were lower. In each of those years, bonds finished higher to help cushion the blow. This allows us to rebalance during those periods and sell bonds when they are up and buy stocks when they are down in value.

Bonds also have very low overall correlation to stocks. During negative months for stocks, that correlation drops even further. But that also does not mean bonds always have negative returns when stocks are up. In fact, bonds are slightly positively correlated to stocks during up periods. We recently saw this in 2020 with both stocks and bonds finishing with positive total returns for the year. 

So, despite the lower expected returns for bonds going forward, it is important to understand the characteristics of bonds and why we own them. That said, our team continues to research ways to improve the fixed income slice of the portfolio. Over the past several years, we added two specialized asset classes in Alternative Lending and Reinsurance to increase returns that are uncorrelated to both equities and bonds. Going forward, we will continue to investigate ways to enhance the role that bonds play within the portfolio.

 

 

Disclosure: The material is presented solely for information purposes and has been gathered from sources believed to be reliable, however Merriman cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Merriman does not provide tax, legal or accounting advice, and nothing contained in these materials should be relied upon as such.  Any reference to an index is included for illustrative purposes only, as an index is not a security in which an investment can be made. Indices are unmanaged vehicles that serve as market indicators and do not account for the deduction of management fees and/or transaction costs generally associated with investable products.  The Bloomberg Barclays US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market.  All composite data and corresponding calculations are available upon request.

 

Pitfalls of Buffered and Levered ETFs to Achieve Your Financial Goals

Pitfalls of Buffered and Levered ETFs to Achieve Your Financial Goals

 

The marketplace for exchange-traded funds (ETFs) grows each day, and more and more different and innovative products are being created. One new type utilizes derivatives. A derivative is a financial object that derives its value from an underlying financial security. An example of this is what is called an option. An option is a contract between two parties that gives the buyer the choice to buy or sell a security at a predetermined fixed price. The original purpose for options was to balance risk in a concentrated portfolio. You could hedge a bet by securing a selling price or buying price of a stock. Nowadays, some ETFs are using derivatives for very different purposes, such as increasing their exposure (levered ETFs) or setting a buffer on the equity returns (defined-outcome ETFs). While these ETFs are innovative and flashy, it’s important to think about the ramifications of investing in such a product.

A levered ETF uses either derivatives or borrowed capital to increase exposure to the underlying assets (e.g., stocks). This increase is a double-edged sword. Not only are the ups larger but the downs are larger as well. In a portfolio, the increase in the drawdowns makes the leverage ineffective for increasing risk-adjusted returns, unless paired with volatility or drawdown-reducing strategies such as trend following. In March of 2020, the S&P 500 Index fell by -12.5%. For a theoretical 2x levered portfolio, the drawdown would have been -25%. An unlevered portfolio would need a return
of 14.3% to get back to breakeven. A 2x levered portfolio would need a return of 33.3% to get back to breakeven. Astute readers will notice that 33.3% is MORE than double 14.3%. This simple aspect of leverage is one of the many reasons it should be taken on with caution. Successful investing is often more about not losing than it is about winning.

These ETFs offer certain upsides and downsides. These upsides and downsides are calculated for the lifetime of these funds. Depending on when the investor buys into the fund, they could experience a very different return, including one outside of the promised range. This limitation can particularly be a problem if the market increased prior to the purchase, as the upside return at that point can be severely capped. The forward-looking return of these products decreases exponentially as the market increases.

Levered ETFs also suffer from underperformance compared to their benchmark. This drag comes from the imperfect way that leverage is acquired either through derivatives or borrowed capital. Out of 22 standard levered ETFs in the market today, every single one of them has underperformed their prospectus benchmark when the same amount of leverage was provided for the past five years. We believe this underperformance, when combined with the issue of large drawdowns, high tax costs due to inefficiency of derivatives, and high fees, makes these levered ETFs ill-advised as long-term investments.

Another new instrument that has captured the attention of many is the so-called “buffer ETF.” Buffer ETFs advertise guaranteed returns in a specific range. While these products offer a solution to specific problems, like the levered ETFs, we believe they are an ill-advised investment for long-term investors looking to grow their principal or provide income in retirement.

The biggest drawback of buffered ETFs is that investors pay too much for the downside protection that they receive.

The most widely held products advertise options for reducing annual downside risk by 9%, 15%, or 30%. In return, the investor relinquishes upside growth.

The plot below shows how the annual return distribution of a buffered approach compares to the return of the underlying index. The index is represented by the historical annual returns of the S&P 500 minus 0.05% which is an estimated cost for a low cost S&P 500 index fund. The buffered approach simulates applying a 9% reduction in downside risk and capping the upside at 15%. It is intended to be representative of the types of products currently on the market. It also includes a 0.75% reduction to simulate the fees associated with typical defined-outcome products.

 

 

The plot shows clearly that while the buffering provides some downside protection in large drawdown years, there have been very few of those historically. Let’s see how this affects an investor’s outcome in some real-life scenarios.

For the years 2017, 2018, and 2019, the S&P 500 has returned 22%, -4%, and 32%. A 13% buffer ETF would have reduced the cumulative 53% gain to an approximate 25% gain. When we apply this same methodology of a 15% top buffer and a -9% bottom buffer to the S&P 500 since 1928 (94 years) on an annual basis, we get a stark difference in returns. During the 94 years surveyed, the S&P 500 index minus an average index fund expense ratio (“Net S&P 500 Index”- see important disclosures regarding these calculations below) had an annualized return of 10.2%, while a the model for a rolling buffer ETF on the S&P 500 Index starting January 1st would have a return of 6.1%. To further illustrate this point, for example, start with $100,000 and invest it for 25 years, and at these annualized rates of return an investor may see the Net S&P 500 Index outperform the rolling buffer ETF model by $600,000. This underperformance can seriously affect the probability of successfully reaching one’s goals.

While an investor is buying drawdown protection by using a buffer ETF on a 5-year timescale since 1928 this has only yielded better returns 18% of the time as compared to utilizing alternative vehicles in seeking to protect against downside risk. Historically, a more efficient and higher return way of decreasing downside risk is using fixed income solutions such as treasury bonds. By way of an example utilizing the historical data described above, if an investor used 20% of the portfolio allocated to 5-year treasury bonds and the rest to the S&P 500 index model referenced above, the investor has reduced the historical possibility of underperformance to 13% and will maintain, pursuant to the historical data, a return that’s over 3% of the buffer ETF model. When done with multiple types of fixed income and alternative asset classes such as reinsurance or alternative lending the probability of underperformance continues to decrease. Do take note that the return and underperformance possibilities are based upon historical performance data and, therefore, future performance is in no way guaranteed and may be subject to wide variances due to unforeseen market, economic and other conditions. Peace of mind is something we all seek. In many cases, purchasing insurance to guard against risks one can’t control is an excellent choice. However, if the premium you pay is greater than the insurance you receive, it doesn’t make financial sense.

The bottom line for most of these derivative investments is that while they seem very attractive on the surface, once you look at the mechanics and nuances, they turn out to be ineffective at generating the solid risk-adjusted returns most investors need and want to meet their financial goals.

 

 

IMPORTANT DISCLOSURE AND DATA INFORMATION

The distribution graph is for illustrative purposes only, and is not intended to serve as personalized tax and/or investment advice since the availability and effectiveness of any strategy is dependent upon your individual facts and circumstances. The information portrayed in these materials represents model performance and characteristics for the Merriman Model S&P 500 Index Fund or the Buffered S&P 500 and may not reflect the impact that material economic and market factors may have had on the adviser’s decision making. The make-up of any actual advisory program portfolio may differ as compared to the model portfolio provided herein, and is not meant to be representative of any one client or portfolio. In addition, the actual results of any of the adviser’s client portfolios may have been, or may be, materially different than the results of the hypothetical portfolio set forth herein. Market conditions, client restrictions, world events and any other macro variables may have a substantial impact on any of the adviser’s advisory program portfolios. The performance information does include the deduction of advisory fees and execution related fees, except custodial fees. To determine the Net S&P 500 Index, the average expense ratio used was determined by taking three of the largest and most liquid S&P 500 Index ETFs and averaging their fee. (IVV @ 0.04%, VOO @ 0.03%, and SPY @ 0.0945%) This averaged to 0.058% and then rounded down to 0.05% for ease of use and due to industry wide fee compression. The performance information does reflect the reinvestment of dividends and earnings. The information used for S&P 500 columns is based on historical index returns from 1928-2019. The information used for the “buffered” column is based on simulated data as described in the article. All data calculations are available upon request.

The information provided should not be considered a recommendation to purchase or sell any industry, sector or particular security. There is no assurance that any industry, sector or security discussed herein will remain in a client’s account at the time of reading this material or that any industry, sectors or securities sold have not been repurchased. The industries, sectors or securities discussed herein do not represent a client’s entire account and in the aggregate may only represent a small percentage of an account’s holdings. It should not be assumed that any of the securities, transactions or holdings discussed were, or will prove to be profitable, or that investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of the securities discussed herein. All investing entails the risk of loss.

The S&P 500 index includes 500 leading companies in the US and is widely regarded as the best single gauge of large-cap US equities. Any reference to an index is included for illustrative purposes only, as an index is not a security in which an investment can be made. Indices are unmanaged vehicles that serve as market indicators and do not account for the deduction of management fees and/or transaction costs generally associated with investable products. The holdings and performance of Merriman client accounts may vary widely from those of the presented indices. Advisory services are only offered to clients or prospective clients where Merriman and its representatives are properly licensed or exempt from licensure. No advice may be rendered by Merriman Wealth Management unless a client service agreement is in place.

With the World Working from Home, How Can Real Estate Be a Good Investment?

With the World Working from Home, How Can Real Estate Be a Good Investment?

 

One of the most noted and real impacts of the coronavirus is that employees are working from home. While it has been a huge shift, four plus months in, the results have been positive for many, and headlines in business publications are examining whether a substantial fraction of these employees may never return to the office. There is solid debate about how big the impact will ultimately be, but there is no doubt that companies will be revisiting their spaces.

This trend might lead one to worry that real estate values will plummet as demand falls and supply stays constant. To this I would offer two counter points. First and foremost, commercial real estate encompasses a wide range of investments. The pie chart below shows the sub-sector breakdown of the holdings of our most widely recommended real estate investment, the Dimensional Global Real Estate Fund (DFGEX).

REITs that focus on office properties as of June 30th, 2020, made up just 12% of the fund’s allocation. Office REITs do not just own high-rise commercial office buildings in downtown cores. Much of the space they own is in suburban office parks and includes space leased by dentists, hairstylists, lawyers, and small research and engineering firms. While many more things can be done virtually, there are still many businesses, such as orthodontists and spas, that will always require an in-person experience.

While demand for some types of office space may be dropping, demand for other types of real estate in the fund is growing. As of June 30th, the top three holdings in the Dimensional fund were American Tower Corporation, Crown Castle International Corporation, and Prologis Inc. American Tower and Crown Castle are owners and providers of infrastructure for wireless communication and fall into the Specialized category. Prologis is in the logistics real estate business, leasing distribution facilities to support direct fulfillment to customers. All three of the companies are poised to see substantial growth from increasing demand. The fund owns many other businesses, from cold storage warehouses to multi-family apartments to medical facilities, where demand remains high.

The second point is that changes always follow any societal upheaval. There is no doubt that COVID will have an impact on our world. However, it is unclear that the shifts will be as radical as some are predicting or that COVID alone will cause the demise of industries or institutions. Large scale change rarely happens that quickly or dramatically.

For example, the idea that demand for office real estate will suddenly drop 60–70% seems overblown. IBM was an early proponent of telecommuting. In a 2009 report, they boasted that “40 percent of IBM’s some 386,000 employees in 173 countries have no office at all.” According to an Atlantic article from 2017, they unloaded 58 million square feet of office space at a gain of nearly $2 billion. By all accounts, it sounded like a winning strategy. Only, it did not work out, and in March of 2017, IBM decided to move thousands of its workers back to physical company offices.

The problem was likely a drop in what the Atlantic terms “collaborative efficiency”—or the speed at which a group successfully solves a problem. Physical distance still mattered when it came to team creativity, and remaining competitive in a rapidly changing landscape more and more requires novel solutions to complex problems. Offices may look different, but I believe that more than ever people and employees will need places to gather and connect.

The future trajectory is never clear even to the greatest minds. What is clear is that people will always need spaces to live, work, and conduct business. What those spaces look like will evolve, but companies are motivated to adapt. And historically, they have changed industrial warehouses and former malls into Amazon fulfillment centers and multi-family apartment complexes. Despite the recent drawdowns and changing landscape, we believe that investing in a diversified real estate portfolio continues to offer the potential for equity-like returns, current income, and solid inflation protection, all important elements of a well-balanced portfolio.

 

Is the Market Running on Irrational Hope?

Is the Market Running on Irrational Hope?

 

With coronavirus cases rising, unemployment at historic levels, and ongoing protests across America, the strong market rebound feels like it could be driven by irrational hope. Are the markets assuming there is an effective vaccine by the fall? Are they ignoring the effects of a worldwide 100-year pandemic that has killed over 650,000 people as of July 30th?

While there are certainly times when markets can behave irrationally, such times are few and far between and usually concentrated in a certain asset class or sector. At this point, with the exception of the FAANG stocks (Facebook, Apple, Amazon, Netflix, and Google), we do not see signs that the global equity markets are acting irrationally. It is important to distinguish that this belief does not mean that the market might not experience another significant downturn.

Market prices represent the aggregate predictions of thousands of professional and individual investors regarding the value of the company’s future earnings plus the book value of its assets. The operative words here are prediction and future. The stock markets typically bottom when investors have the most fear and have the bleakest outlook on the future. Historically, bottoms have typically coincided with the point of peak unemployment. A rise in the stock market does not mean that the recession is over or that it might not continue for several more years. It simply means that investors are anticipating a better future down the road.

For example, according to Charles Schwab’s analysis of data from Refinitiv, the market consensus estimates for S&P 500 companies for Q3 2020 is a -23.5% drop from the previous year. That does not seem very optimistic to me. Ned Davis and Charles Schwab recently showed that historically the S&P 500 has performed best when year-over-year earnings growth was between -20% and 5%. It seems very counterintuitive that stocks would be rising when earnings growth is negative, but again, markets are predicting the future, not what is happening at present.

Many of you are probably still wondering or worried about the market going down from here. As the future is uncertain, the answer is, unfortunately, yes, the market could go down from here. But that does not mean you should pull all your money out.

Ironically, your risk of losing money in the markets today is less than it was in January. Markets account for uncertainty by keeping prices below fair value. The difference between true fair value and the market price is the compensation investors receive for taking risk. In times of perceived low uncertainty, market prices are close to fair value and investors get little compensation for taking risk. As the pandemic has taught us, risk is always with us whether we see it coming or not. Currently, because of the high degree of uncertainty, market prices incorporate more downside risk, and investors who stay in the market are getting higher compensation for taking that risk. Taking risk is a necessary part of investing, but as investors, one of the most important things we can do for long-term success is to ensure that we are being appropriately compensated for those risks. Staying in markets when we receive high compensation for taking risk is a key part.

I would love to have a crystal ball that could tell you how the market is going to move tomorrow or next month or next year. It seems very possible that the economic recovery could slow, and the market could go sideways or take another dip. It also seems very possible that through a combination of growing knowledge, human adaptation, and government stimulus, the economic impact will not be as severe as some fear, and the market will continue its steady climb. A wide variety of data suggests that current market valuations are not irrational and that markets are appropriately accounting for the high degree of uncertainty surrounding the trajectory of the economic recovery that will ultimately occur. There are plenty of investors who are pulling money out or who are continuing to sit on the sidelines as well as plenty of buyers. Our recommendation is to continue with your target equity allocation. This approach allows you to benefit from the relatively high compensation you are getting for taking on risk right now while providing sufficient downside protection that your financial well-being is not at risk.

 

 

Disclosure: Past performance is no guarantee of future results. No client should assume that future performance of any securities, asset classes, or strategy will be profitable, or equal to the previous described performance. The S&P 500 is a market capitalization-weighted index of 500 widely held stocks often used as a proxy for the U.S stock market.

Psychology of Investing

Psychology of Investing

 

 

“The world makes much less sense than you think. The coherence comes mostly from the way your mind works.”
– Daniel Kahneman, Thinking, Fast and Slow

“It’s not supposed to be easy. Anyone who finds it easy is stupid.”
– Charlie Munger, Berkshire Hathaway

 

In its most basic form, investing involves allocating money with the expectation of some benefit, or return, in the future that compensates us for the risk taken by investing in the first place. Investing is a decision: buy or sell, stock A or stock B, equities or bonds, invest now or later. But as the great Charlie Munger reminds us above, investing is far from easy. Prior to making an investment decision, we create statistical models, build spreadsheets, use fundamental and technical analysis, gather economic data, and analyze company financial statements. We compile historical information to project future return and risk measures. But no matter how much information we gather or the complexity of our investment process, there isn’t one rule that works all the time. Investing involves so much more than models and spreadsheets. It is an art rather than a science that involves humans interacting with each other—for every buyer, there is a seller. At its core, investing is a study of how we behave.

Daniel Kahneman and Amos Tversky are famous for their work on human behavior, particularly around judgment and decision making. Judgment is about estimating and thinking in probabilities. Decision making is about how we make choices under uncertainty (which is most of the time). Kahneman won the Nobel Prize in Economics for their work in 2002, an honor that would have certainly been shared with Tversky had he not passed away in 1996. Their findings challenged the basic premise under modern economic theory that human beings are rational when making judgments and decisions. Instead, they established that human errors are common, predictable, and typically arise from cognitive and emotional biases based on how our brains are designed.

In his book, Thinking, Fast and Slow, Kahneman describes our brains as having two different, though interconnected, systems. System 1 is emotional and instinctive. It lies in the brain’s amygdala and uses heuristics or “rules of thumb” to simplify information and allow for quick gut decisions. In contrast, System 2 is associated with the brain’s prefrontal cortex. It is slow, deliberate, and calculating. As an example, if I write “2 + 2 =”, your mind without any effort will come up with the answer. That is System 1 at work. If I write “23 x 41=”, your mind most likely switches over to the slower moving System 2. While Systems 1 and 2 are essential to our survival as humans, Kahneman found that both systems, and how they interact with each other, can often lead to poor (and sometimes irrational) decisions. We can apply much of what Kahneman and Tversky discovered to investor behavior. Let’s focus on some of the most common biases and how they impact our decision making.

Loss Aversion

Kahneman and Tversky summarized loss aversion bias with the expression “losses loom larger than gains.” The key idea behind loss aversion is that humans react differently to gains and losses. Through various studies and experiments, Kahneman and Tversky concluded that the pain we experience from investing losses is twice as powerful as the pleasure we get from an equivalent gain. This can lead to several mistakes, such as selling winners too early for a small profit or selling during severe market downturns to avoid further losses. Loss aversion, if left unchecked, can lead to impulse decision making driven by the emotions of System 1.

Confirmation Bias

Confirmation bias leads people to validate incoming information that supports their preexisting beliefs and reject or ignore any contradictory information. In other words, it is seeing what you want to see and hearing what you want to hear. As investors, we are prone to spending more time looking for information that confirms our investment idea or philosophy. This can lead to holding on to poor investments when there is clear contradictory information available.

Hindsight Bias

Hindsight bias is very common with investor behavior. We convince ourselves that we made an accurate investment decision in the past which led to excellent future results. This can lead to overconfidence that our investment philosophy or process works all the time. On the flip side, hindsight can lead to regret if we missed an opportunity. Why didn’t I buy Amazon in 2001? Why didn’t I sell before this bear market? As I always say, I would put the results of my “Hindsight Portfolio” up against Warren Buffet’s any day!

Overconfidence

As mentioned above, investors can become overconfident if they have some success. This can lead to ignoring data or models because we think we know better. As Mike Tyson said, “Everyone has a plan until they get punched in the mouth.” Overconfidence can lead to a knockout, and investors must be flexible and open with their process.

Recency Bias

Recency bias is when investors emphasize or give too much weight to recent events when making decisions and give less weight to the past. This causes short-term thinking and allows us to lose focus on our long-term investment plan. It essentially explains why investors tend to be more confident during bull markets and fearful during bear markets.

 

I could write an entire book on investor psychology. The bottom line is that we cannot eliminate these biases. After all, we are all human. Even Kahneman, who made the study of human behavior his life work, admits he is constantly impacted by his own biases. However, there are certain actions or “nudges” that can help address such biases and avoid making costly mistakes. At Merriman, we have built the firm in such a way to use our knowledge about human behavior in the work we perform for our clients. Below are some of the main examples:

Evidence-Based

We build and design our investment strategies based on academic data going back hundreds of years. We are evidence-based rather than emotionally-driven investors. We think long term and do not let short term noise or recent events impact the process. We build globally diversified portfolios across different asset classes to produce the best risk-adjusted returns. That said, we are consistently researching and studying to find data that might contradict our investment philosophy and will make changes if the evidence supports it.

Financial Planning

A well-built financial plan is at the core of our client’s long-term success. It is a living document that requires frequent updates based on changes in our lives—retirement, education funding, taxes, change in job, business sale, and estate planning. This forces us to make investment decisions based on the relevant factors of that plan and not on emotions—because at the end of the day, investing is meant to help reach our goals.

Education

At Merriman, we do our best to help educate our clients on our investment philosophy. Blogs, quarterly letters, seminars, client events, and video content are all examples of tools we use to educate our firm and clients. Knowledge and awareness are powerful tools to help us make sound decisions.

 

We are all going through an extremely stressful situation right now—both personally and professionally. Now, more than ever, we need to lean on each other and show empathy and support through this unprecedented time. Remember, investing is a study of how humans behave. At Merriman, we want to be your resource to guide you through both calm and turbulent markets, helping you reach your financial goals. Please don’t hesitate to contact us if you’d like to discuss how we can help.