In wine there is truth. Over the weekend, The Wall Street Journal helped bring this truth to light.

People have different tastes, and expectations and environment can drastically alter what they taste. It’s all very psychological. A bottle of Bordeaux that costs $150, and has won numerous awards is believed to be spectacular before the bottle is opened. No matter your personal preferences, this Bordeaux has got be good. Put it in a box with a push-button dispenser instead of a crystal decanter, and I think we can all agree that our expectations will change. It begs the question of the accuracy of ratings and the personal biases that are applied when a neutral perspective would really be more valued.

The various studies speak to so many of the human biases that we apply to all things. One study of wine competitions illustrates “that the probability that a wine [that] won a gold medal in one competition would win nothing in others was high.” To follow up on this study, defining parameters were set and it was found that “the distribution of medals…mirrors what might be expected should a gold medal be awarded by chance alone.” Even with a purportedly systematic rating system, randomness persisted.

Asset class performance is random, and so fund performance is also random. We cannot truly compare stocks to grapes, or indexes to grape vines, though certainly some metaphors can be poetically woven. What we can do is take a step back and recognize our own behavior patterns and the effect they have on our decisions.

Leonard Mlodinow is the author of the WSJ article, for his bio and other information, please click here.

One of my favorite graphics is this “periodic table” - periodic in the sense that it shows asset class performance on an interval basis.  Not only is it colorful, but it tells a big story.  The moral of the story is simple - diversify across global markets and invest for the long-term.

After investors understand what they’re looking at, they usually do two things.  First, they look to see the top performers and attempt to confirm that their past beliefs were correct.  Second, they usually look to establish a pattern over the years.  It’s human nature to look for patterns.  Something about the appeal of symmetry causes us to seek a familiar trend, even amid complete randomness.  Volatility and unpredictability becomes a bit more visible in this graph, and going back over longer time periods would show even more random behavior.

(To read these charts, look at the asset classes on the left, then follow the color code throughout the returns data - this will show how each asset class stacks up.)

If Randomness persists, what is the solution?  In this next table, we sort the asset classes from the highest to lowest growth of wealth, over the same 9-year period.  If one had held only Emerging Markets for the last 9-years, one would have had the highest annualized return, the second highest risk profile, and the second worst growth of wealth total return.

There are many ways to analyze this data, but what we hope to illustrate is that even a simple portfolio construction of equally weighted asset classes beat 7 out of 11 asset classes over this time period.  When faced with moderate returns and moderate risk, investors often snub the idea since people tend to be competitive and want to be the best (which often means taking more risk).  In the long-term, a well-constructed portfolio that delivers consistent “middle of the road” returns, along with calculated risk, would almost certainly outperform individual asset classes.  The reason is that such a strategy enables investors to capture all of the return premiums provided by the market.  Putting such a portfolio together is not difficult; it is our human element that is difficult to control.  Discipline may be boring and may feel restrictive, but it is at the core of what helps us achieve our personal benchmarks.

We have data on longer time periods, please contact us if you’d like more information.

Disclosures:
This matrix shows annual total returns per asset class, starting 11/2000 and ending 10/31/2009. Returns data is provided by the Center for Research on Security Prices (CRSP). While data is retrieved from sources believed to be reliable, McLean Asset Management Corporation can not guarantee the accuracy of this data.  One cannot invest directly in an index. No investor earned the exact returns displayed. Past Performance is not an indicator of future performance.

Indexes used:
US Large Market = S&P 500
US Large Value = Russell 1000 Value
US Small Market = Russell 2000
US Small Value = Russell 2000 Value
US Micro Cap = Russell Microcap
US REIT = DJ Wilshire REIT Index
Emerging Markets = MSCI EAFE Emerging Markets
Intl Large Cap Market = MSCI EAFE Index
Intl Large Cap Value = MSCI EAFE Value Index
Intl Small Cap Market = MSCI EAFE Small Cap Index

Active managers swing and miss, again and again.  Third time’s a charm - so we wish them luck.

Back on September 16th, we posted the “Cost of Volatility,” which discussed a Morningstar study that showed that investors that held specific sector funds tended to do worse than the fund itself - the reason being that investors could not comfortably bear the volatility of the fund. Morningstar has provided some more data, and Sam Mamudi covers the results in his article, “Active Management Loses in Risk Study.”

Mamudi reports that, “The study by Morningstar Inc. found that, over the past three years, while about half of actively managed funds outperformed their respective Morningstar indexes - which cover the nine different Morningstar investment styles -only 37% [outperformed] on a risk-, size- and style-adjusted basis. The numbers are similar for five and 10-year returns.”

In our Inflation Risk and Portfolio Decisions blog, we touch on the danger of managing a portfolio based on a specific risk factor. But what about taking on more risk with the notion of earning greater returns? In theory, increasing risk should mean increasing potential returns (and potential losses). As the “Cost of Volatility” study showed us, investors have a hard time dealing with high volatility. This recent Morningstar study illustrates that not only do actively managed funds deliver more risk, but 63% of them underperform on a risk-, size-, and style-adjusted basis.

Studies continue to show that index funds generally outperform actively managed funds on a significant scale. Also, that index funds tend to take on less risk, and so are easier to digest through a full time-horizon (preferably long-term).  Taking controlled risk is good for a portfolio, and in our view, tilting a portfolio towards small-cap and value funds helps to increase expected returns.

In our previous blog, the Cost of Volatility, we conclude by saying that “Having a well-constructed portfolio means having a palatable portfolio that is naturally diversified, where the risk is just right, unforced errors are mitigated, and discipline requires little action.” Achieving a diversified portfolio is fairly easy, but removing unforced errors and establishing low-action discipline is a bit more difficult.

Robert Arnott and John West from IndexUniverse.com take a look at negative alpha, and in their article, they do a good job at uncovering what some of those unforced errors might be.

Negative alpha is defined as “the slippage investors unnecessarily incur in the execution of their investment strategies.” There are three main aspects of negative alpha, including equity concentration of a portfolio, failure to rebalance, and chasing winning funds with high returns. Ultimately, one’s risk tolerance needs to be properly assessed to deliver a palatable portfolio of equity and fixed income. Within that portfolio, we believe that equities should be globally diversified with a tilt to small-cap and value-style exposure. Once that’s achieved, rebalancing guidelines need to be established. As long as the rebalancing mandate is not too restrictive or too loose, then it becomes easy to avoid chasing top-performing asset classes as rebalancing will naturally sell high and buy low.

For more in-depth analysis, please visit “A Crisis Review of Negative Alpha” at IndexUniverse.com.

Self-preservation is universal across all organisms. In the face of danger or pain, it is just in the nature of life to stop the pain and avoid the danger. Some organisms are more effective than others, and thus some species have been able to evolve and flourish more readily. Humans take self-preservation to another level and apply the concept to more than just oneself. We apply it to our friends and family members, strangers, our pets, and of course, to our investments.

As fortune would have it, we naturally associate losses with danger and the instinct is to Sell, Sell, Sell! Then, when returns turn positive, we become euphoric and our gut tells us to Buy, Buy, Buy! The following chart shows equity mutual fund cash inflows (in blue) alongside bond fund cash inflows. An overwhelming number of investors sold at the bottom, missed the rebound, and bought back in at more expensive levels.

Timing the market may appear to be a primordial result of the desire to self-preserve. Successful investing requires resisting these urges that may be quite adaptive in other avenues of behavior.