“Super investors take pain better than everybody else.”

Wesley Gray, CEO and CIO of Alpha Architect, made this observation at last week’s Financial Analysts Seminar, an annual CFA Institute event hosted with CFA Society Chicago. He was referencing the ability of successful investors to stick with a strategy.

Gray raised the point as part of a discussion about factor investing. Factor investing is selecting investments based on certain quantitative characteristics such as a low valuation (value), higher relative returns (momentum) or a smaller market capitalization (size). He could have easily made a comment about any other investment strategy.

Pain in the world of investing is incurring a loss. It can be a drawdown, a drop in the value of your portfolio. It can also be the loss of upside returns. Even if your investment is appreciating in price, the perceived loss of not being in a better-performing investment can be discomforting. Either way, loss is a powerful driver of human emotions and decision-making. Psychologist Daniel Kahneman says the pain of a loss exceeds the pleasure of a gain by a measure of 2:1.

Pain is also very personal. A strategy one person finds easy to follow can be extremely difficult for another person to adhere to. Similarly, the pain threshold at which one investor panics or otherwise abandons a strategy can be different for another investor. Gray said he knows of one person who has been able to withstand “multiple” drawdowns of up to 75%. (This energy investor has accumulated significant wealth by sticking to a disciplined strategy over the long term. You can ask Gray about it at our forthcoming Investor Conference.) Other investors begin to get very worried when the stock market falls by 10%—not an uncommon occurrence. (In their defense, I have yet to experience a market correction without strategists and pundits warning about it being the start of the next recession and/or bear market. Whenever Mr. Market’s mood turns sour, Chicken Little warms up his voice.)

As much as nobody likes discomfort (including myself), investors are rewarded for enduring it. If there was no discomfort, there wouldn’t be as much of a reward for investing.

There are things you can do to better cope with the discomfort of down or otherwise unfavorable market conditions. One is to simply look less often at the market and your portfolio. The longer you ignore the stock market, the less volatile it will seem. Another is to realize the advantage of being a long-term investor. Gray believes “patience” is very much an investor’s “alpha.” (Alpha is outperformance attributable to an investor or money manager.) A third thing is to be very focused on your process. Michael Falk, a partner with Focus Consulting Group, told attendees at a different session that process is six times more important than analysis in terms of realizing higher returns. (Good analysis is still required, though.) Part of a good process is having pre-established sell rules—not just for when things go right, but also for when things go wrong. He also advocates for creating a personal behavioral checklist. If you can determine what influenced your decision at the time you made a buy or sell decision, you can start to create safeguards and systems to help prevent repeating the same behavioral mistakes in the future.

• The Case for Systematic Decision-Making – Wesley Gray explained how relying on models can help make you a better investor in this 2014 AAII Journal article.
  
• Oakmark Funds’ Long-Term Approach to Stock Investing – William Nygren discussed his firm’s disciplined, low turnover approach, which includes a five- to seven-year time horizon.
  

• The Individual Investor’s Guide to Exchange-Traded Funds 2017 – Our annual ETF Guide has been updated and enhanced with new features.
  
• Model Fund Portfolio: Two ETFs Replaced With Lower-Cost Equivalents – The new mid-cap and small-cap ETFs have lower expense ratios and lower trading costs than the funds they are replacing.
  

Though second-quarter earnings season is rotating to smaller companies, the calendar lists 33 S&P 500 member companies as being scheduled to report. Included in this group is one Dow component: Walt Disney Co. (DIS), which will report on Tuesday.

The week’s first economic reports will be June JOLTS report on Tuesday. Wednesday will feature the initial estimate of second-quarter productivity. On Thursday, the July producer price index (PPI) will be released. Ending the week, the July consumer price index (CPI) will be released on Friday.

Three Federal Reserve officials will make public appearances. St. Louis president James Bullard will speak on Monday. Minneapolis president Neel Kashkari will speak on Monday and on Friday. New York president William Dudley will speak on Thursday.

The Treasury Department will auction $24 billion of three-year notes on Tuesday, $23 billion of 10-year notes on Wednesday and $15 billion of 30-year bonds on Thursday.

Pessimism in the latest AAII Sentiment Survey surged to its highest level since mid-May, as neutral sentiment plunged to nearly a four-month low. Optimism rebounded modestly.

Bullish sentiment, expectations that stock prices will rise over the next six months, rebounded by 1.7 percentage points to 36.1%. Optimism was last higher on May 3, 2017 (38.1%). This is the 23rd consecutive week and the 28th time out of the last 29 weeks that bullish sentiment is below its historical average of 38.5%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, plunged 9.4 percentage points to 31.8%. Neutral sentiment was last lower on April 26, 2017 (30.2%). Even with this week’s drop, neutral sentiment is above its historical average of 31.0% for the 14th consecutive week and the 19th time out of the last 20 weeks.

Bearish sentiment, expectations that stock prices will fall over the next six months, rose 7.8 percentage points to 32.1%. Pessimism was last higher on May 17, 2017 (34.3%). This is the also the first time in nine weeks that bearish sentiment is above its historical average of 30.5%.

Though the Dow Jones industrial average continued to set record highs over the survey period (Thursday through Wednesday), other major indexes declined. The changes in this week’s readings also follow both unusually high levels of neutral sentiment and an eight-month low for pessimism.

While some individual investors are encouraged by this year’s record highs for the major indexes (even given the modest declines in several of the major indexes over the past seven days), many others have expressed concern about the possibility of a pullback and/or the prevailing level of valuations. The Trump administration remains at the forefront of many investors’ minds and is having a significant impact on sentiment. Other factors playing roles are earnings and interest rates/monetary policy.

This week’s special question asked AAII members how their sentiment toward the stock market is being influenced by the prospects for tax reform. The majority of respondents (56%) said it’s not influencing their sentiment. Many of these respondents clarified their response by saying they do not anticipate that tax reform will actually occur. Slightly more than 26% say the passing of tax reform, particularly significant tax reform, would boost stock prices. Approximately 5% believe that if meaningful tax reform is not passed, stock prices will fall.

Here is a sampling of the responses:

• “The probability of meaningful tax reform is vanishingly small, so it’s not factored into my thinking about investments.”
• “I don’t put much weight on anything getting done. There is so much divisiveness in politics.”
• “I am assuming no tax reform. A significant tax cut would make me more bullish.”
• “Any tax reform will be around the edges, nothing major.”
• “If tax reform should fail or continues to be delayed, a major correction will ensue.”

Historical averages:

• Bullish: 38.5%
• Neutral: 31.0%
• Bearish: 30.5%

Bullish: 36.1%, up 1.7 points
Neutral: 31.8%, down 9.4 points
Bearish: 32.1%, up 7.8 points


Bullish: 38.5%
Neutral: 31.0%
Bearish: 30.5%

Last month, individual investors’ proportionate cash allocations were the smallest they’ve been in 17½ years. The July AAII Asset Allocation Survey also showed a small decline in equity holdings and a rebound in fixed-income holdings.

Stock and stock fund allocations pulled back by 0.9 percentage points 67.9%. The modest decline follows what had been a 12-year high for equity allocations. July was the 52nd consecutive month that equity allocations were above their historical average of 60.5%.

Bond and bond fund allocations rose 2.7 percentage points to 17.7%. The rebound follows what had been an eight-month low for fixed-income allocations in June. Bond and bond fund allocations have been between 17.0% and 18.0% during four out the past six months. The historical average is 16.0%.

Cash allocations fell 1.8 percentage points to 14.5%. This is the smallest allocation to cash since January 2000 (14.0%). July was the 68th consecutive month that cash allocations were below their historical average of 23.5%.

In June, we asked survey respondents what determines how much they allocate to cash. More than three out of five respondents (62%) said projected needs [required minimum distributions (RMDs), living expenses, emergencies, etc.] and/or future investment opportunities. Nearly 26% said their cash allocations were primarily determined by their short-term expectations for the stock market.

Nothing occurred in July that would lead us to believe these reasons have changed. Cash allocations were below 17% three times between March and June. In addition, differences in the composition of the group of AAII members who take the Asset Allocation Survey on a month-to-month basis can cause some fluctuations in the results.

Yields on the benchmark 10-year Treasury bond were generally higher in July than in June. At the same time, the major stock indexes set new highs in July. Many AAII members have described the ongoing low interest rate environment as making bonds look unattractive and pushing them to allocate more to stocks instead. Individual investors, in aggregate, aren’t overly enthusiastic about the short-term outlook for stocks, however. The percentage of investors describing their short-term outlook as “neutral” largely stayed a little above 40% throughout July.

Last month’s special question asked AAII members whether they think they are overweighting or underweighting stocks relative to their age. Nearly three out of every five respondents (59%) said they are overweighting stocks. The higher returns realized by stocks, especially relative to bonds, were cited by many of these respondents. Others listed dividend income and AAII founder and chairman James Cloonan’s book, “Investing at Level3” as the reason for their overweight positions in stocks. About 18% believe they are appropriately weighted to stocks. Nearly 17% described themselves as being underweight. Concerns about prevailing valuations, a forthcoming drop in stock prices and Washington politics were given as reasons.

Here is a sampling of the responses:

• “Overweighting. Returns are much better than bonds.”
• “At age 70, I believe I’m just right with my asset allocation given my tolerance for risk.”
• “Underweight, but I’m preparing for a downturn in the market.”
• “Overweighting. Probably taking more risk than necessary.”
• “Overweighting. I’m 78 and feel that I have enough liquid reserves to get me through a typical market pullback or even a normal bear market.”

• Stocks and stock funds: 67.9%, down 0.9 percentage points
• Bonds and bond funds: 17.7%, up 2.7 percentage points
• Cash: 14.5%, down 1.8 percentage points

• Stocks: 33.8%, up 0.2 percentage points
• Stock funds: 34.1%, down 1.1 percentage points
• Bonds: 3.9%, up 1.3 percentage points
• Bond funds: 13.8%, up 1.3 percentage points

Take the Asset Allocation Survey.

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