In our ongoing effort to clarify and simplify, we keep the financial jargon to a minimum. But even where we may succeed, you’re likely to encounter references elsewhere that can turn valuable information into mumbo-jumbo. Consider us your interpreter. Today, we’ll explore correlation, and why it matters to investing.
A Quick Take: Correlation Helps People Invest More Efficiently
Expressed as a number between –1.0 and +1.0, correlation quantifies whether, and by how much two holdings have behaved differently or alike in various markets. If we can identify holdings with weak or no expected correlation among one another, we can combine these diverse “pieces” (individual investments) into a greater “whole” (an investment portfolio), to help investors better weather the market’s many moods.
As suggested above, correlation is more than just a quality; it’s also a quantity – a measurement – offering two important insights along a spectrum of possibilities between –1.0 and +1.0:
- Correlation can be positive or negative, which tells us whether two correlated subjects are behaving similar to or opposite of one another.
- Correlation can be strong or weak (or high/low), which tells us how powerful the similar or opposite behavior has been.
Most investors are aware of the benefits of diversification, or owning many, as well as many different kinds of holdings. A well-diversified portfolio helps you invest more efficiently and effectively over time. Diversification also offers a smoother ride, which helps you better stay on course toward your personal financial goals.
But in a world of nearly infinite possibilities, how do we:
- Compare existing funds – If one fund is expected to perform a certain way according to its averages, and another fund is supposed to perform differently according to its own averages, how do you know if they’re really performing differently as expected?
- Compare new factors – What about when a researcher claims they’ve found a new factor, or source of expected returns? As this University of Chicago paper explains, “factors are being discovered almost as quickly as they can be packaged and sold to the waiting public.” How do we determine which are actually worth considering out of the hundreds proposed?
- Compare one portfolio to another – Even perfectly good factors don’t always fit well together. You want factors that are not only strong on their own, but that are expected to create the strongest possible total portfolio once they’re combined.
Correlation is the answer to these and other portfolio analysis challenges. By quantifying and comparing the behaviors and relationships found among various funds, factors and portfolios, we can better determine which combinations are expected to produce optimal outcomes over time.
Heeding correlation data is a lot like having a full line-up on your favorite sports team. If each player on the roster adds a distinct, useful and well-played talent to the mix, odds are, your team will go far. Similarly, your investment portfolio is best built from a global “team” of distinct factors, or sources of returns. A winning approach combines quality components that exhibit weak or no correlation among or between them across varied, long-term market conditions.
Let us know if we can use our experience and expertise to help you build a more diversified and less correlated portfolio.
One of the things that differentiates Hill Investment Group (HIG) is the simple, transparent philosophy behind our investment strategy. As we like to remind clients, the data and evidence tell us that one of the best ways to pursue long-term financial goals is to essentially own the world and, of course, take the long view with our ownership – relying on the expected long-term gains of global capitalism to deliver growth.
This philosophy does NOT mean our portfolios operate on auto-pilot. In fact, we’re regularly reviewing the latest academic research and innovations in financial products to evaluate available options. Like other aspects of our investment process, we tackle this job through a rigorous, disciplined approach guided by our internal Investment Policy Committee (IPC), comprised of me (John Reagan), Rick Hill and Nell Schiffer.
Our IPC assesses the ongoing performance of our current holdings and occasionally adds new investment opportunities when they make sense within our evidence-based infrastructure. (Remember, as fiduciaries by choice and design, it’s our legal duty to make decisions that are in our clients’ best financial interests.) In addition, it may be even more important for us to assess and reject countless supposedly “new and improved” offerings when closer analysis reveals them as pointless distractions to our Take the Long View® strategies.
To accomplish these missions, our IPC follows a regular process that includes:
- Monthly reviews of our model portfolios and individual fund performance
- Quarterly IPC meetings and semi-annual meetings with financial product providers
- Regular communication with the rest of the firm through meeting minutes
Our processes are grounded in the following key principles that help the IPC perform due diligence and make recommendations.
- Factor-based investing beats traditional active management. Roughly 85% of active funds trail their benchmarks over periods of 15-20 years, compared to factors such as small size, value and momentum that have demonstrated long-term return premiums. For that reason, we won’t even consider traditional actively managed funds. We opt for evidence-based strategies, which helps weed out a lot of options that simply don’t fit with the way we serve our clients.
- Data and evidence drives decision making. Academics and practitioners are constantly producing new research into how markets work, and the IPC is committed to following these developments. We read academic and financial journals, attend conferences, and speak with experts to ensure that our investment options reflect what the evidence is telling us.
- We always seek to add value to portfolios. With fund companies continually developing new products – and sometimes changing the way they manage existing funds – the IPC must re-assess whether the funds we’ve chosen are the best possible options. We examine whether there are new fund variations that target established premiums in a better way, or if new factors could help boost returns, decrease volatility, or provide another distinct advantage.
- Costs matter. Because the fees charged by mutual fund companies directly affect our clients’ returns, we’re diligent about finding the best possible balance between cost and value in every fund we select.
As touched on above, thanks to our disciplines, the IPC only recommends changing our investment lineup when there’s a clear reason to do so. Changes don’t happen overnight either. If a new opportunity is sustainable, there’s no need to rush into it. If it’s not, it won’t be in our clients’ best interest to chase after it.
For example, our IPC recently recommended adding a new fund that targets evidence-based factors, using an investing strategy to hedge against scenarios when all asset classes decline at the same time, like in 2007-2008. A fund like this essentially didn’t exist then, but it does now, in what we deem to be a cost-effective vehicle. So we have added it to our lineup.
Again, more often, our IPC looks at new opportunities and decides not to make a change. For example, in 2017 we also examined a new kind of fund that claims to provide a hedge against widespread downturns by investing in an asset class with low correlation to the equity market. Upon careful review, the IPC found the fund to be incredibly complex – to the point that we couldn’t easily understand exactly how it would accomplish what it claimed to do. It was also extraordinarily expensive! When a product is this complicated and expensive, and we’re not clear on the benefit it would provide our clients, it’s just not right for us.
Putting the pieces in place
Besides establishing our investment lineup, the IPC has another important role: Creating the proper asset allocations for our model portfolios. This task involves understanding correlations between factors and asset classes, and analyzing expected returns/volatility, to develop portfolios that offer the highest potential returns for the amount of risk a client is comfortable taking. It’s akin to cooking a soup: You might have the same set of ingredients, but depending on how much you add of each one, the result is going to taste very different. The IPC uses our standard set of ingredients to develop different portfolio “recipes” to suit each client’s taste.
We hope you’ve enjoyed this close-up look at our long-view IPC, and the process and principles that guide our decisions. Our IPC plays a crucial role in our mission to do what’s right for our clients – period – while simplifying the otherwise complex world of investing. If you have any questions for us, feel free to reach out.
Congratulations to University of Chicago’s Richard Thaler for his recent Nobel Prize in economics! This isn’t the first time we’ve mentioned Professor Thaler. I referenced his work last year. And here, Rick Hill shared a conversation between Professor Thaler and fellow Nobel Laureate and University of Chicago colleague Eugene Fama. Thaler also is well known for his groundbreaking book, Nudge: Improving Decisions About Health, Wealth, and Happiness.”
Why do we keep mentioning the guy, and why does the Nobel committee agree that his work is worth recognizing? I can’t speak for the Nobel committee, but I can say that understanding Thaler’s many contributions to behavioral economics is essential to anyone who wants to Take the Long View® with their wealth. Just as financial economics focuses on how to best manage the market’s idiosyncrasies, behavioral economics focuses on how to curb our own behavioral biases, which often pose the greatest threat to our financial well-being.
When it comes to defending against your behavioral biases, forewarned is forearmed, so here’s a summary of some of our most damaging, if all-too-human traits.
The Bias: Anchoring
- Symptoms: Anchors aweigh! It’s easy for us to fixate and base ongoing decisions on an initial piece of information (the “anchor”), even if it’s no longer relevant to the decision at hand.
- Damage Done: “I paid $11/share for this stock and now it’s only worth $9. I won’t sell it until I’ve broken even.”
The Bias: Blind Spot
- Symptoms: The mirror might lie after all. We can assess others’ behavioral biases, but we often remain blind to our own.
- Damage Done: “We are often confident even when we are wrong, and an objective observer is more likely to detect our errors than we are.” (Daniel Kahneman)
The Bias: Confirmation
- Symptoms: This “I thought so” bias causes you to seek news that supports your beliefs and ignore conflicting evidence.
- Damage Done: After forming initial reactions, we’ll ignore new facts and find false affirmations to justify our chosen course … even if it would be in our best financial interest to consider a change.
The Bias: Familiarity
- Symptoms: Familiarity breeds complacency. We forget that “familiar” doesn’t always mean “safer” or “better.”
- Damage Done: By overconcentrating in familiar assets (domestic vs. foreign, or a company stock) you decrease global diversification and increase your exposure to unnecessary market risks.
The Bias: Fear
- Symptoms: Financial fear is that “Get me out, NOW” panic we feel whenever the markets turn brutal.
- Damage Done: “We’d never buy a shirt for full price then be O.K. returning it in exchange for the sale price. ‘Scary’ markets convince people this unequal exchange makes sense.” (Carl Richards)
The Bias: Framing
- Symptoms: Six of one or half a dozen of another? Different ways of considering the same information can lead to illogically different conclusions.
- Damage Done: Narrow framing can trick you into chasing or fleeing individual holdings, instead of managing everything you hold within the greater framework of your total portfolio.
The Bias: Greed
- Symptoms: Excitement is an investor’s enemy (to paraphrase Warren Buffett.)
- Damage Done: You can get burned in high-flying markets if you forget what really counts: managing risks, controlling costs, and sticking to plan.
The Bias: Herd Mentality
- Symptoms: “If everyone jumped off a bridge …” Your mother was right. Even if “everyone is doing it,” that doesn’t mean you should.
- Damage Done: Herd mentality intensifies our greedy or fearful financial reactions to the random events that generated the excitement to begin with.
The Bias: Hindsight
- Symptoms: “I knew it all along” (even if you didn’t). When your hindsight isn’t 20/20, your brain may subtly shift it until it is.
- Damage Done: If you trust your “gut” instead of a disciplined investment strategy, you may be hitching your financial future to a skewed view of the past.
The Bias: Loss Aversion
- Symptoms: No pain is even better than a gain. We humans are hardwired to abhor losing even more than we crave winning.
- Damage Done: Loss aversion causes investors to try to dodge bear markets, despite overwhelming evidence that market timing is more likely to increase costs and decrease expected returns.
The Bias: Mental Accounting
- Symptoms: Not all money is created equal. Mental accounting assigns different values to different dollars – such as inherited assets vs. lottery wins.
- Damage Done: Reluctant to sell an inherited holding? Want to blow a windfall as “fun money”? Mental accounting can play against you if you let it overrule your best financial interests.
The Bias: Outcome
- Symptoms: Luck or skill? Even when an outcome is just random luck, your biased brain still may attribute it to special skills.
- Damage Done: If you misattribute good or bad investment outcomes to a foresight you couldn’t possibly have had, it imperils your ability to remain an objective investor for the long haul.
The Bias: Overconfidence
- Symptoms: A “Lake Wobegon effect,” overconfidence creates a statistical impossibility: Everyone thinks they’re above average.
- Damage Done: Overconfidence puffs up your belief that you’ve got the rare luck or skill required to consistently “beat” the market, instead of patiently participating in its long-term returns.
The Bias: Pattern Recognition
- Symptoms: Looks can deceive. Our survival instincts strongly bias us toward finding predictive patterns, even in a random series.
- Damage Done: By being predisposed to mistake random market runs as reliable patterns, investors are often left chasing expensive mirages.
The Bias: Recency
- Symptoms: Out of sight, out of mind. We tend to let recent events most heavily influence us, even for our long-range planning.
- Damage Done: If you chase or flee the market’s most recent returns, you’ll end up piling into high-priced hot holdings and selling low during the downturns.
The Bias: Sunk Cost Fallacy
- Symptoms: Throwing good money after bad. It’s harder to lose something if you’ve already invested time, energy or money into it.
- Damage Done: Sunk cost fallacy can stop you from selling a holding at a loss, even when it is otherwise the right thing to do for your total portfolio.
The Bias: Tracking Error Regret
- Symptoms: Shoulda, coulda, woulda. Tracking error regret happens when you compare yourself to external standards and wish you were more like them.
- Damage Done: It can be deeply damaging to your investment returns if you compare your own performance against apples-to-oranges measures, and then trade in reaction to the mismatched numbers.
Even once you’re familiar with the behavioral biases that stand between you and clear-heading thinking, you’ll probably still be routinely tempted to react to the fear, greed, doubt, recklessness and similar hot emotions they generate. This is one reason an objective advisor can be such a critical ally, helping you move past your reactionary thinking into more deliberate decision-making for your long-term goals.
If you could use some help managing the behavioral biases that are likely lurking in your blind spot, give us a call. In combating that which you cannot see, two views are better than one.