Coping with Randomness
Thursday, March 20, 2014
Charles Rotblut, CFA
AAII Journal Editor

AAII Resources

The Role of Luck and Skill
Luck will influence your investing returns more than skill.

Diversification in a Portfolio
Holding several investments protects against random events.

AAII Discussion Boards
How much do you rely on forecasts?

Most Popular AAII Articles

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Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 36.8%, down 4.6 points
  Neutral: 37.1%, up 5.2 points
  Bearish: 26.1%, down 0.7 points

Long-term averages:
  Bullish: 39.0%
  Neutral: 30.5%
  Bearish: 30.5%

Take the AAII Sentiment Survey »

I found myself struggling with my NCAA Basketball Tournament picks more this year than in the past. Partially it’s because of the parity that has evolved in men’s college basketball. Partially it’s because there are teams whose chances are tough to assess (e.g. North Carolina, Michigan State, my Kansas Jayhawks, etc.). Then there is the sheer randomness of the event that wrecks bracket picks.

The statistical odds of the tournament favor going with the top-ranked seeds, but upsets can and do happen. Fourth-seeded teams have lost during the first full round of play (now technically the second round of the tournament) more than 20% of the time since 1985. Seventh-seeded teams face nearly a 40% chance of not making it to the round of 32. Top-seeded teams may look invincible with a perfect record during the round of 64, but it’s only a matter of time one is beaten by a 16th seed. (For those of you who don’t follow college basketball, the NCAA tournament has seven single-elimination rounds, whittling a field of 68 teams to just two.)

As the tournament goes on, unexpected teams gain momentum and win more games than anyone predicted. Wichita State, Butler, VCU and George Mason all surprised expectations and busted tournament brackets by making it to the Final Four in past years. I don’t recall any of the major college basketball commentators advising to take a chance on any of those teams. (This year, Wichita State is a #1 seed and is certainly not an underdog. The Las Vegas Sun listed the school’s odds of winning the national championship as 4-to-1.)

No amount of analysis can help you pick the correct outcome of every game. This is why Quicken Loans is able to run a contest with a $1 billion prize; the chances of picking a perfect bracket are astronomical. USA Today cited DePaul University mathematician Jeff Bergen as calculating the odds to be one in 9,223,372,036,854,775,808. Yet many have scrutinized their picks this week, including myself, in hopes of getting them right. It’s a reflection of our inability to cope with random events.

We see this all the time with investing. Every day, market reporters are tasked with explaining why stock prices are up or down, even when the only reason is the occurrence of more buying than selling (or vice versa). Investors pay attention to analysts’ ratings, earnings estimates and price targets, despite the lousy track record analysts have in making recommendations and forecasts. A great amount of effort is placed into foretelling the direction of the market and the economy in defiance of the likelihood of an unanticipated or low probability event leading to a completely different outcome.

We humans simply don’t do well with uncertainty. While having guidance may help assure us and can provide some odds for us to consider, the best we can do is to learn from the past. In terms of investing (be it either stocks or bonds), fundamental strength and value matter more than popularity. Looking where others aren’t for bargains also helps, as does adhering to a sound, disciplined strategy for buying and selling.

As far as picking teams to the win the NCAA tournament goes, I eventually accepted the fact that the quantitative models are better overall judges of a team’s prospects than I am. So I took Ken Pomeroy’s ratings and weighted them by a random factor to account for the surprises that will likely happen. This resulted in a projected Final Four match up of Kansas, Arizona, Louisville and Michigan State. Arizona is my forecast national champion, even though I’ll be rooting for Kansas to win it all.

AAII Model Portfolios

There was one transaction in the Model Shadow Stock portfolio. Gilat Satellite Networks, Ltd. (GILT) was removed from the portfolio due to reporting negative earnings while on earnings probation. The proceeds were invested in SigmaTron International (SGMA). The maximum price to pay for SigmaTron is a price-to-book ratio of 0.9, or $12.20 per share.

Visit the Model Shadow Stock Portfolio page to see which portfolio stocks qualified for purchase as of February 28, 2014. A qualified stock is one that is currently held by the Model Shadow Stock Portfolio and meets the requirements for purchase.

In February, the Model Shadow Stock Portfolio gained 4.3%, underperforming the Vanguard Small Cap Index fund (NAESX), which gained 5.1%, but beating the DFA US Micro Cap Index fund (DFSCX), which was up 4.2%. For the year, the Model Shadow Stock Portfolio is still down 3.6%, which trails NAESX, which is up 2.9%, and DFSCX, which is down 0.4%. The Model Shadow Stock Portfolio has a compound annual return of 17.9% from its inception in 1993, while the Vanguard Total Stock Market Index fund (VTSMX) has gained 9.3% annually over the same period.

The Model Fund Portfolio performed slightly better, gaining 5.0% in February, and the Conservative Portfolio (75% Model Fund Portfolio and 25% iShares Barclays 1-3 Year Treasury Bond ETF) was up 3.8%. This compares to a 4.7% gain for the Vanguard Total Stock Market Index fund (VTSMX). For the year, the Model Fund Portfolio is up 2.9%, ahead of VTSMX, which has gained 1.5%. The Model Fund Portfolio has a compound annual return of 9.7% from its inception in June of 2003, while the Vanguard Total Stock Market Index fund has gained 9.2% annually over the same time period.

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The Week Ahead

Eight members of the S&P 500 will report earnings: Carnival (CCL), McCormick & Co. (MKC), PVH Corp. (PVH) and Walgreen (WAG) on Tuesday; Paychex (PAYX) on Wednesday; and Accenture (ACN), GameStop (GME) and Red Hat (RHT) on Thursday.

The week’s first economic report will be the PMI’s manufacturing index on Monday. Tuesday will feature February new home sales, the December Case-Shiller home price index and the Conference Board's March consumer confidence survey. February durable goods orders will be released on Wednesday. Thursday will feature revised fourth-quarter GDP and February pending home sales. January personal income and spending and the final March University of Michigan consumer sentiment survey will be released on Friday.

Several Federal Reserve officials will make public appearances: Dallas president Richard Fisher on Monday, Atlanta president Dennis Lockhart and Philadelphia president Charles Plosser on Tuesday; St. Louis Federal Reserve president James Bullard on Wednesday; Cleveland president Sandra Pianalto and Chicago president Charles Evans on Thursday; and Kansas City president Esther George on Friday.

The Treasury Department will auction $32 billion of two-year notes on Tuesday, $35 billion of five-year notes on Wednesday and $29 billion of seven-year notes on Thursday. The Treasury Department will also auction $13 billion of two-year floating rate notes on Wednesday.

AAII Sentiment Survey

Optimism fell to a six-week low as expectations for a flat market rebounded in the latest AAII Sentiment Survey. Pessimism stayed below average for the sixth consecutive week.

Bullish sentiment, expectations that stock prices will rise over the next six months, fell 4.6 percentage points to 36.8%. This is the lowest level of optimism recorded by our survey since February 6, 2014. It also ends a streak of five consecutive weeks with bullish sentiment above its historical average of 39.0%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged, rose 5.2 percentage points to 37.1%. This is the 11th consecutive week with neutral sentiment above its historical average of 30.5%.

Bearish sentiment, expectations that stock prices will fall over the next six months, declined by 0.7 percentage points to 26.1%. Pessimism is below its historical average of 30.5% for the 24th time in 28 weeks.

The decline in bullish sentiment is not significant, especially when one considers that the level of optimism remains close to its historical average. Weakness in the stock market over the survey period may have moved some investors from the bullish camp and into the neutral camp. Bearish sentiment has not moved much over the past three weeks, fluctuating within a 0.7 percentage point range.

Many AAII members are encouraged by the overall upward momentum of stock prices, earnings growth, economic expansion, the Federal Reserve’s tapering of bond purchases and low interest rates. Some AAII members are fretting about elevated stock valuations, the pace of revenue growth, the slow rate of economic expansion and Washington politics.

This week’s special question asked AAII members if the Federal Reserve should keep, get rid of or adjust its 6.5% unemployment rate target. Respondents were mixed with 39% voting to get rid of the target, 22% saying it should be adjusted and 21% wanting to keep it unchanged. Those who wanted to keep the target unchanged thought the economy is not strong enough or worried about a negative market reaction. Those who wanted to adjust it suggested either lowering the target rate or having it encompass other employment measures. Those who want to get rid of it didn’t think the target was contributing to job growth or that the Federal Reserve should be focused on job growth. (Nearly all of the responses were given before the fixed target was rescinded in yesterday’s Federal Open Market Committee meeting statement.)

Many AAII members questioned the validity of the unemployment rate as an accurate measure of the health of the job market. This skepticism existed regardless if a respondent thought the target should be kept, adjusted or removed.

Here is a sampling of the responses:

  • “Keep! The 6.5% rate seems to be working satisfactorily. No boat rocking please.”
  • “Adjust. The target is too high. There will always be many more unemployed than appear in the numbers.”
  • “Get rid of it. The Federal Reserve cannot significantly affect the unemployment rate.”
  • “Get rid of the target since the federal government is not providing a full or true unemployment picture.”
  • “I think 6.5% is deceiving. There are many people who have just given up and are no longer looking for work.”

» Take the AAII Sentiment Survey