Mullooly Asset Management

Fiduciary Fee-Only Financial Planner | Investment Advisor in Wall, NJ

Investor Behavior

We believe that an investor's behavior can seriously impact their market returns. This category page is dedicated to informing our readers of certain behaviors that are known to damage investor's returns over time. We also discuss strategies to avoiding these damaging behaviors.

Risk Tolerance Shouldn’t Change with the Market

by

When it comes to investing, risk tolerance is the amount of risk you’re willing to take as an investor. We all have to take some degree of risk to enjoy any type of return. Different investors are comfortable with different levels of risk taking. Some advisors and investors like to categorize risk as being aggressive, moderate, or conservative. Others assign their risk tolerance a number between 1-10. No matter how you or your advisor decide quantify risk tolerance, one thing is certain: yours should not be changing frequently.

Andy Racheleff of Wealthfront recently blogged about the right and wrong reasons to change your risk tolerance. He listed good reasons for a risk tolerance change as: a major life change, a significant change in your liquid net worth, or a significant change in your income.

These reasons make complete sense, and I agree wholeheartedly with Andy. Things we cannot control happen during life, and these are all viable reasons to reassess your risk tolerance. Side note, if you’re working with an advisor and a major life event occurs, he or she absolutely must be informed.

“I want to be aggressive when the market is going up, and conservative when the market is going down.” Sounds great, right? So many investors feel this way regarding their risk tolerance, but market action is a terrible reason to alter your risk tolerance. Do you actually feel more comfortable taking additional risk or are you upset your more aggressive buddy made more than you last quarter? Likewise, have your time horizon and risk tolerance actually changed during a pullback or are you simply realizing that the market constantly fluctuates?

I get that everybody wants to have their cake and eat it too, but your risk tolerance cannot be in constant motion based on the stock market.

Source:

https://blog.wealthfront.com/right-and-wrong-reasons-to-change-risk-tolerance/

Important Questions to Ask an Advisor

by

So you’ve found an investment advisor you’re potentially interested in working with, sounds great. What are the important questions you need to ask him or her before getting started? As an advisor, I know a few questions that investors absolutely need to ask. Unfortunately, these aren’t always the questions that get asked.

What Should I Be Asking a Prospective Advisor?

DO ask how much their advice will cost you. This is super important. Not only do you want to know how much their advice will cost you, but you also want to know if they receive any additional forms of compensation. Additional forms of compensation may include (but are not limited to) commissions, fees, kickbacks, bonuses, vacations, etc. Carl Richards, writer of a popular New York Times finance column, recently wrote:

“I suggest asking financial professionals two questions: How much do I pay you? And who else is paying you?”

It’s crucial to know whether you’re getting unbiased investment advice or being sold products. When somebody gives advice while also receiving compensation from a third party, it’s tough to believe their advice won’t have a conflict of interest baked into it. Do they really think that universal life insurance policy is necessary or do they just want the juicy commission attached to it? Ask them if they’re a fiduciary and also if they’re dually registered? Too many investors don’t ask the right questions, and end up regretting their hasty decision years later. I wish investors could simply trust that advisors will always do that right thing for them, but that’s not the world we live in. Do yourself a favor and find out how any prospective advisor will be paid. I recommend avoiding advisors with conflicts of interest, but that’s just my opinion.

DO ask about the prospective advisor’s strategy. While you might believe that investment strategies are a foreign language you’ll never understand, it’s really important to have a grasp on how your money will be invested. An advisor should be able to easily explain their strategy to you. Albert Einstein once said that:

“Everything should be made as simple as possible, but not simpler.”

We believe this applies to investing as well. If an advisor really believes in their strategy, they’ll be able to simplify it into a digestible, uncomplicated format and share it with you. The strategy should be something that you believe in and feel comfortable sticking with. No investment strategy is going to be the best every year. In fact, most strategies experience stretches of underperformance that can last longer than a year. That’s why you need to be sold on your advisor’s strategy, their ability to stick with it, and (most importantly) your ability to stick with it.

DON’T base your decision to invest off of last year’s performance numbers. I’m not naive, I know that most investors really only care about performance numbers. That’s why I’ll never stop stressing the importance of strategy over returns. A really excellent way to underperform over time is to jump around from strategy to strategy every year. Michael Batnick of Ritholtz Wealth Management did a great study last year that applies well here. He measured several different smart beta strategies vs. the S&P 500 from 2007 through November 18, 2014 (the date of his post). The results tell the story:

“What’s funny is that the only strategy that didn’t hold up to the S&P 500 is jumping from winner to winner. If every January you invested in the prior year’s best performing strategy, you would have substantially under performed.”

Investors need to find a method of investing that works for them. By “works for them”, I mean makes you feel as comfortable as possible. An investor’s best bet at long term success lies in finding their strategy and sticking with it. If you’re not willing to give a method time, you’re likely to be disappointed by the results.

It’s incredibly important to find out how any prospective advisor will be paid for their services. It’s equally important to find an advisor who utilizes a strategy you believe in. They should be able to provide details on their fees and strategy in a completely transparent and understandable format. Josh Brown of Ritholtz Wealth Management put it perfectly writing:

“Smart investors don’t obsess over performance track records, they ask about costs and conflicts.”

Sources

http://www.nytimes.com/2015/03/02/your-money/financial-planners/questions-to-ask-a-prospective-financial-adviser.html

http://theirrelevantinvestor.tumblr.com/post/102977746523/its-investor-behavior-not-investment-behavior

http://thereformedbroker.com/2015/03/03/the-smart-questions-clients-ask/

An Investor’s Worst Enemy

by

What’s your worst enemy when it comes to investing? Well, for starters the answer is a who, not a what. It’s not Janet Yellen, President Obama, or Mario Draghi. You are your own worst enemy. That’s right! Josh Brown of Ritholtz Wealth Management recently blogged over on his site (The Reformed Broker) about this topic explaining:

“China is not threatening your portfolio, nor is the price of oil or the level of the Fed Funds rate. What’s threatening your portfolio is the way in which you may react to any of these items, plain and simple. Your emotions and the actions you take during times of increased volatility or drawdown will ultimately have more impact on your long-term returns than any exogenous thing that may come along.”

Josh is spot-on with this assessment. Far too frequently investors let their emotions get in the way of otherwise sound strategies. When you choose a particular investment strategy, the last thing you want to do is stray from it. This is precisely what so many investors do though. Mike Tyson once said, “Everybody has a plan until they get punched in the face”, and that applies to investing just as well as it does to boxing. When investors need to stick with their plan the most, they abandon it because they get “punched in the face”.

An investment strategy needs to be something you can stick with when the market is going up, down, sideways and everything in between. Here at Mullooly Asset Management, we believe in point and figure charting and relative strength. Other investors and advisors may have different methods that work for them, that’s great. What matters is being able to stick with whatever your chosen strategy is. Don’t become your own worst enemy!

Source:

http://thereformedbroker.com/2015/02/19/the-biggest-threat-to-your-portfolio/

Being Realistic About Time Horizons

by

Subscribe: RSS

One of the most frequently quoted time periods in finance is the ambiguous “long term”. We’re all supposed to be long-term investors, and studies show that “over the long term” results will be desirable. This sounds nice, but what is this mythical “long term”? Is there a defined period of time that qualifies as “long term”? Tom and Brendan dig into what “long term” is and why it’s important to be realistic about investing time horizons on this week’s Mullooly Asset Management podcast.

The meaning of long term really comes down to you and your personal definition of it. What’s considered long term by one investor may not be by another. All sorts of variables like age, risk  tolerance, and goals go into determining your version of “long term”. Market theories and studies are almost always based on a specific period of time. Sometimes that period is 10 years, 20 years, 30 years or more. A commonly cited period of time is “1929 through today”. For the record, that’s an 86 year time period. This long a time period is good at showing us very “long term” concepts, but bad at showing us realistic results that individual investors might achieve. Very few, if any, investors actually have a time horizon of 86 years. As Ed Easterling wrote in his excellent book Unexpected Returns:

“Most investors do not invest over 75 year periods. Shorter periods of time- a decade or two- are more relevant for most investors.”

Investors must consider the reality that long term average returns hardly occur during shorter term periods, like those experienced by most investors. Over a 75-85 year time horizon, the picture painted by stock market returns looks beautiful. Buying and holding through market turmoil sounds great on paper. However, over 10, 20, and 30 year time horizons (periods that real investors might actually expect to invest over) we’ve seen everything from substantial returns, to disappointing returns, to negative returns.

Cullen Roche of Orcam Financial recently blogged on this topic. He wonders how well the concept of “long term” really applies to someone’s life. Cullen explained it like this: Most people begin investing in their 20’s, but don’t accumulate significant assets until their 30’s or 40’s. This gives most investors 25-35 years to work with. There are plenty of intangibles to consider during that time frame as well (wedding, kids, college tuition, house, cars, and retirement!). Cullen summarized his beliefs writing:

“Our financial lives don’t actually reflect a “long term” at all. They’re more like a series of short terms inside of a long term.”

We agree with Cullen on this one and recommend checking out his post, which we’ve linked to below.

To blend the views of Ed Easterling, Cullen Roche and Mullooly Asset Management we’d say that the market goes through structural bull and structural bear markets. We must be aware of these structural market conditions and create a game plan accordingly. Simply waiting it out for the mythical “long term” to save us is not an investment strategy because few, if any, investors have long enough time horizons to see the average returns lauded in many market studies.

Sources:

http://www.pragcap.com/problems-with-the-long-term

http://www.crestmontresearch.com/books/

Even in Good Years the Market Pulls Back

by

Subscribe: RSS

Keeping things in perspective is important. Investors fall victim to cognitive biases sometimes, but we can do our best to avoid that type of behavior. With the strong markets seen in 2012, 2013, and 2014, investors are primed for recency bias to cloud their judgement. It’s imperative to remember that even in good years, the market pulls back. Tom and Brendan discuss this on the weekly Mullooly Asset Management podcast.

As you can see in the chart below (results through 2013), despite average intra-year drops of 14.7%, the S&P 500 has posted positive returns in 25 of the last 33 years. In fact, our friends at Dorsey Wright and Associates provided data in their October 16, 2014 Daily Equity Report that confirms the regularity of 10% pullbacks: since 1928, the S&P 500 has pulled back 10% 93 times. That’s 93 times in 86 years.

S&P 500 Intra Year Declines vs Calendar Year Returns

That’s not to say a 10% pullback MUST occur every year. Averages don’t always work out over the short term. Take the last two years for instance: we didn’t see a 10% pullback from the S&P 500 in 2013 or 2014. Data from the same Dorsey Wright report referenced above shows that precedent exists for this as well. For example, the S&P 500 took 4 1/2 years between 10% pullbacks from March 2003 to November 2007. Additionally, it went from August 1990 to October 1997 without pulling back 10%. Within larger data sets, it’s not uncommon to see outcomes contradict the overall average result. We’ve experienced consecutive years (2013 and 2014) that encapsulate this perfectly. However, we shouldn’t allow our judgment to be clouded by recency bias.

Recency bias can be very detrimental to investment results. After two years without a 10% pullback from the S&P 500, it’s necessary to remind ourselves that we haven’t been experiencing the norm. While we could see this streak continue in 2015, it’s also just as likely that it will come to an end. Markets pull back 5%, 10%, and more even in the midst of up years. If the streak ends and we do see a 10% pullback in 2015, that doesn’t necessarily signal anything ominous as far as the year’s results are concerned. 10% pullbacks regularly occur during very healthy, positive years from the S&P 500. However, the recent lack of them may make the next 10% pullback feel worse than it is.

One thing’s for sure: letting cognitive biases based on recent market action play with our emotions is foolish. This is why we rely on point and figure charting here at Mullooly Asset Management. We use a rules based, emotionless system to manage money for our clients. As Tom likes to say, “When the charts change, we will change”.

Avoiding Cognitive Biases: The Disposition Effect

by

Subscribe: RSS

On this week’s Mullooly Asset Management podcast, Tom and Brendan discuss a cognitive bias known as the disposition effect. Cognitive biases such as the disposition effect, loss aversion, confirmation bias, and others can negatively affect investment performance. Tom and Brendan specifically address the disposition effect and how our rules based approach at Mullooly Asset Management helps us to avoid irrational and emotional investing.

Hersh Shefrin and Meir Statman wrote about the disposition effect for The Journal of Finance in 1985. They define the disposition effect in their article titled The Disposition to Sell Winners Too Early and Ride Losers Too Long stating:

“Investors are more likely to sell a stock that has gone up in value than one that has gone down in value.”

In terms of decision making, this is obviously questionable behavior driven by the human tendency to avoid loss. Another area where this behavior is suspect pertains to taxes. Selling a stock that’s gone up means paying taxes on your gains, while selling a stock that’s gone down can mean lowering your capital gains tax at the year’s end. Tax efficiency is an important aspect of investing, so this should definitely be considered.

Wesley Gray, Ph.D. of Alpha Architect gave an easy to follow example of the disposition effect in action that we’ve paraphrased below:

Hypothetically, you bought two stocks for $50 each. Since purchase, one of them has risen to $60 and the other has fallen to $40. Life throws you a curveball and you need to take some money out of your account. Which position will you sell to raise the necessary cash?

Research has shown that people are more likely to sell the $60 stock and realize the gain associated with it than they are to sell the $40 stock and realize the loss associated with that.

Let’s simplify this even further: what do you associate taking a loss on a stock with? Probably losing, right? Nobody likes to lose. Referring to the example above, generally the correct decision would be to sell the loser, take the loss, and let the winner run. Not only are you sticking with the more successful investment, but you’re being more tax efficient as well. Not many investors are willing to accept “defeat” in a stock though. They’d rather take the “victory” and cash in their gain, while hoping the loser can right the ship. In most instances, this is wishful (and dangerous) thinking.

Cognitive biases get in the way of rational decision making all the time. So how do we combat them at Mullooly Asset Management?

Point and figure helps us avoid cognitive biases and irrational decisions. Having a rules based investment approach is a great way to take emotion out of the picture. These charts clearly display what’s happening right now with our investments. As we frequently say: when the charts change, we will change.

Sources:

http://mx1.shookrun.com/documents/disposition-shefstat.pdf

http://www.alphaarchitect.com/blog/2014/06/11/behavioral-bias-bingo-disposition-effect/#.VJmtYF4AAC