In Investing, Simpler Can Often Be Better
Thursday, September 11, 2014

The financial industry loves complexity. There is an ever-growing number of computerized models designed to maximize the returns from securities and optimize portfolio allocations, among other things (including executing trades faster). This complexity has led to new research, new strategies and new products.

Complexity can lead to unintended consequences, however. We saw this in 1998, when hedge fund Long-Term Capital Management imploded. We saw it again during the last financial crisis. Wall Street’s process of stripping and repackaging mortgage loans resulted in securities that looked good on a spreadsheet, but were disastrous in a portfolio.

Complexity also exists at the individual investor level. The investment industry is currently pitching alternative funds designed to follow hedge fund-like strategies. The strategies used by these funds often are not easy to understand (even by the advisers selling them). Complexity even exists at the stock selection level, where it is very possible for a strategy to be misunderstood by all but a small group of investors.

What is complex to one person may seem simple to another. Answering three questions can determine whether a strategy is too complex for you: Do you understand what the strategy is designed to look for? Can you easily follow the strategy? Do you understand what its potential risks are? If you cannot answer yes to these questions, then the strategy may not be right for you. At the very least, you need to learn more about the strategy before proceeding.

I’m bringing this up because a few weeks ago, Jim O’Shaughnessy wrote a column for Yahoo Finance entitled The Power of a Simple Strategy. In it, he discussed the importance of having to actually follow a strategy in order for it to work. Though this may seem like a “no duh!” observation, it’s also one of critical importance. The inability to stick to a consistent, well-defined approach to investing is disastrous for a portfolio.

Jim used the Dogs of the Dow strategy to prove his point, and I think it is a good choice to use as an example as to what a simple strategy is. The Dogs of the Dow requires an investor to buy the 10 highest-yielding stocks in the Dow Jones industrial average and reconstruct the portfolio annually with the newest highest yielders. (An alternative version says to buy the five highest yielders.) It is a value-oriented, large-cap-driven strategy. On the downside, it picks from a very limited universe of stocks, the selected companies may be struggling and high-yield strategies aren’t always in favor.

Jim uses a more complex strategy. His approach uses composite scores based on a stock’s value, financial strength and earnings quality. The idea is to consider a variety of characteristics to ensure that a stock is a bargain instead of merely cheap. On the surface, the general concepts underpinning the strategy are easy to understand. Implementation may be too complex for some investors given the number of criteria and the ranking mechanisms used, however.

In investing, as is the case with many other activities, it is always best to start simple and get more complex as your skill and comfort levels evolve. (The amount of time you have to devote to investing also matters.) While there is no standard for where the line should be drawn, more complexity does not mean better results. Our Model Shadow Stock Portfolio has greatly outperformed the S&P 500 index since its inception in 1993 and it follows just three sell rules: 12-month earnings turn and stay negative, the price-to-book ratio goes above three times the maximum value for purchasing and the market capitalization grows three times above the maximum value for purchasing. Its simplicity makes it easy to follow, and because it’s easy to follow, it keeps us disciplined.

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The Week Ahead

Computerized Investing editor Wayne Thorp will speak to our Long Island Chapter on Wednesday and our Connecticut Chapter on Thursday.

We’ll get a preliminary look at third-quarter earnings. Among the group of early reporters are S&P 500 companies Adobe Systems (ADBE) on Tuesday; FedEx (FDX), General Mills (GIS) and Lennar (LEN) on Wednesday; and ConAgra Foods (CAG), Oracle (ORCL) and Red Hat (RHT) on Thursday.

The Federal Open Market Committee (FOMC) will hold a two-day meeting starting on Tuesday. Quarterly forecasts will be released along with the meeting statement at 2:00 p.m. EST on Wednesday. Fed Chair Janet Yellen will hold a press conference at 2:30 p.m. EST.

Elsewhere on the economic calendar, the September Empire State manufacturing survey and August industrial production and capacity utilization will be released on Monday. Tuesday will feature the August Producer Price Index (PPI). The August Consumer Price Index (CPI) and the National Association of Home Builder’s September housing market index will be released on Wednesday. Thursday will feature August housing starts and building permits and the September Philadelphia Federal Reserve survey.

The Treasury Department will auction $13 billion of inflation-protected securities (TIPS) on Thursday.

Friday will be a quadruple witching day, meaning both options and futures contracts will expire.

What’s Trending on AAII
  1. Real Returns Favor Holding Stocks

  2. Managing Cash Flow in Retirement

  3. Allocate by Market Weight (And Adjust for Personal Circumstances)

AAII Sentiment Survey

Optimism among individual investors about the short-term direction of the market declined for a second week in the latest AAII Sentiment Survey. Even with the pullback, bullish sentiment is above average for the fifth consecutive week, the longest such streak since February 13 through March 13, 2014.

Bullish sentiment, expectations that stock prices will rise over the next six months, fell 4.3 percentage points to 40.4%. The historical average is 39.0%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rose 1.7 percentage points to 33.0%. The historical average is 30.5%.

Bearish sentiment, expectations that stock prices will fall over the next six months, rose by 2.6 points to 26.6%. Even with the increase, pessimism is below its historical average of 30.5% for the 42nd time in the past 48 weeks.

Bullish sentiment has declined by a cumulative 11.5 percentage points since nearly reaching 52% two weeks ago. The pullback represents a reversion to the mean following the unusually high level of optimism (bullish sentiment has only exceeded 50% four times since February 2011). This week’s reading is also likely somewhat influenced by the S&P 500’s recent inability to stay above 2,000.  It is worth noting that in the backdrop of the recent decline in bullish sentiment, pessimism remains below average.

Keeping many individual investors optimistic about the short-term direction of stock prices is the S&P 500’s overall upward momentum, earnings growth, sustained economic expansion and the Federal Reserve’s tapering of bond purchases. Causing other AAII members to be pessimistic are prevailing valuations, the failure of the S&P 500 to set new highs, events in the Middle East and Ukraine, the pace of economic growth and Washington politics.

This week’s special question asked AAII members how the Federal Reserve’s ongoing tapering of bond purchases is impacting their six-month outlook for stock prices. Slightly more than half of all respondents (51%) said the tapering is not having any impact. Several of them (accounting for about 10% of all respondents) believe the market has already priced in the gradual ending of bond purchases by the central bank. About 17% thought the ending of quantitative easing is a negative or could lead to either additional volatility or a correction. An additional 8% said the ending of bond purchases and potential rise in interest rates is causing them to become more cautious or view stocks less favorably. At the other end of the spectrum, six percent of respondents view the tapering as a positive for the stock market.

Here is a sampling of the responses:

  • “Old news, it should not affect the stock market.”
  • “Not at all. I am looking forward to the end of tapering and the gradual increase in interest rates to get us back to a normal state.”
  • “The ongoing tapering has already been figured in by the market and will have no impact on my forecast whatsoever.”
  • “Once the reality of higher rates sets in, it will increase volatility and either flatten or lower stock prices.”
  • “I find it generally encouraging. The economy must be getting better for the Fed to taper.”

This week’s Sentiment Survey results:

Bullish: 40.4%, down 4.3 points
Neutral: 33%, up 1.7 points
Bearish: 26.6%, up 2.6 points

Historical averages:

Bullish: 39.0%
Neutral: 30.5%
Bearish: 30.5%
Take the Sentiment Survey.

Local Chapter Meetings
AAII Local Chapter Meetings offer you a variety of presentations from expert speakers who will give you their view on the world of investing. A bonus of attending a Chapter Meeting near you is the opportunity to meet other AAII members who share your interest and enthusiasm for investing. You can even share the Chapter experience with your family and friends by inviting them to attend Chapter Meetings with you!