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July 15, 2008

Making Better Investment Decisions with the Help of Empirical Research (Part I)
by Tom Madell

Summary: This article suggests that in order to make good investment decisions, investors can profit by largely basing their actions on solid empirical data. This is in contrast to the way in which most investment decisions are typically made, based on a much less rigorous application of data along with a large dose of an investor's intuitions, emotions, and prior experiences in investing (or these same factors as supplied by those who would advise them). The article presents and refers investors to examples of the kinds of data and research that can help them make decisions that will likely have a higher probably of success than those that rely heavily on hunches and psychological influences on investing.

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So far in 2008, I have previously published three articles on safehaven.com

Warnings Signs of a Bear Market? Mirror Images Between 2000 and 2007 was written in the closing days of 2007 and published here on Jan. 2, 2008. It presented a comparison of stock and bond fund performance patterns during 2007 with 2000. By researching these performance patterns, we were actually looking at extremely comprehensive data that reflects not just fund performance per se, but the buying and selling that results from the collective actions of virtually all investors within the markets in response to any and all factors that affect how people accumulate and sell investments. Put otherwise, how funds perform is certainly a result of how the totality of investors behave under varying market conditions, and as time passes.

Our point was that there seemed to be a great similarity between fund trends in 2000, the year the last bear market began, and 2007. We therefore suggested that a new bear market could be starting, or might have already started. This notion was nowhere on the radar screens of most investors at the time, although there was considerable talk about a possible recession. The prevailing view had been that the economy would start to improve during the 2nd half of 2008, and therefore, many investors subsequently began to put more money into stocks creating a bear market rally during the Spring.

Thus, this article was fully more than 6 months before most investors, via the media, were splashed the news on July 10th that a bear market had indeed been confirmed to have begun. Finally, investors could begin to include this into their thinking: We were indeed in a bear market which had become officially confirmed by a drop of over 20% of the S&P 500 Index the day before. In our article, we had warned readers to strongly consider taking defensive action even before it could be known for sure we were in a bear market if the prospects of a 20% or more drop would apparently threaten their economic well-being to such a large a degree that they would find it hard to cope with such a drop. This would be true unless one could be sure of being entirely comfortable and confident of being able to "just ride it out."

Our second 2008 article suggested that rising inflation would likely be followed by rising unemployment. This was based on data over the last 40 years showing whenever inflation began to significantly rise, unemployment usually began to follow upward with a lag of a few years. Subsequent to that March 2nd article, the unemployment rate jumped to 5.5% and we have continued to have monthly job losses. We suggested that this could mean a longer than anticipated slowdown, with a likely delay in how long it would be before it would be before one could wisely start buying stocks again in anticipation of a recovery. We also suggested that high quality bond funds might be expected to continue to do well under this scenario so long as inflation did not become even more severe. Since that writing, while many such bond funds have not being doing as well as earlier in the year, most remain well in the plus column year-to-date. And, of course, most stock funds have shown considerable year-to-date losses, including international stock funds.

Our most recent article, published on April 7th, was completely devoted to how bond funds can outperform stock funds (and cash), especially when stock returns are sub-par as they have been for the last year. As confirmation, We presented newly researched data to show how stock, bond, and money market funds have performed under a variety of market conditions.

Each of these articles are still entirely relevant today and we take some sense of accomplishment in having steered our readers mostly correctly (at least thus far) in advance of what later transpired.

What was the main modus operandi of the above articles? Generally speaking, we think it highly useful to present empirical data to help forecast the likelihood of certain events occurring. When data, either readily available or uncovered through new research, suggest that the odds of such an event seem enough better than 50/50 to justify acting, we think it makes sense to at least consider using such data to help in making complex, forward-looking decisions. Of course, reality will not always wind up backing up what appeared likely to be the case ahead of the fact, but by using well-researched data that suggests an outcome, our chances of success are certainly enhanced. Using past data to predict future happenings forms the basis for much scientific study, whether in the "hard" sciences or "softer" sciences such as economics and psychology.

But instead, most investors today seem to be largely swayed by their intuitions, fears, and hopes, taking essentially a non-rigorous approach to making decisions. It's no wonder that investment success based on such subjective, rather than what we would consider more objective approaches, often fails these investors.

Each of the above articles attempted to present what we consider solid, researched evidence to try to help investors cope with what appear to be great uncertainties and choices, upon which a great deal of importance will ultimately lie. Perhaps you have yourself noticed that articles are now regularly appearing documenting how large numbers of workers are planning to postpone retirement because, otherwise, they will have insufficient resources. (By way of background, my articles are not written in conjunction with any currently existing nor intended business aspirations. Rather, my work is strictly educational as a manifestation of a lifelong interest in research and education, with a nearly a 25 year interest in fund investing.)

One might think that a considerable number of investors would want to read the kind of information that I provide, including my monthly newsletters and other information at my website, http://funds-newsletter.com. But I need to GET REAL here: Investment information gleaned from one source as compared to another contains too much totally contradictory advice, even though each may be well-researched, that investors can have no real sense of confidence that any of it is really worth reading and following.

But even this fails to capture the "tuning out" of investment counsel in the majority of instances. There are far too many psychological pitfalls that usually prevent investors from much more than half-heartedly listening to, accepting, and following through on data they are presented with. Here are just a few:

- Money. Too important and scary a topic to ever totally rely on someone else's input, especially someone that you don't know personally.

- Losses in the past when following someone's advice. One (or more) times are enough; no one wants to chance feeling like they've allowed themselves to be complicit in losing again.

- Once investment ideas are learned, it's hard to ever change. Just to name a few: some people simply refuse to invest in stock mutual funds since they believe individual stocks are where it's at; ditto for bond funds, which many people have come believe are never a particularly profitable investment.

So I recognize that anyone who tries to counsel investors, whether it be through research, writing, or advising will always face a wall of resistance, for which there are only small in-roads possible. But since this is what I have chosen to do, I plan to continue to do so, not just by citing existing data to support investor decision-making, but by presenting new data as exemplified in my above safehaven.com articles.

In this vein, I am currently endeavoring to try to create an empirical technique by which an investor can decide whether to buy, sell, or hold funds from within the major categories of funds (such as, for example, Large Growth).

More about this in the continuation of this article; look for it in coming weeks.

Tom Madell, Ph.D.
Publisher
Mutual Fund Research Newsletter

Mutual Fund Research Newsletter is a free newsletter which began publication in 1999. It has become one of the most popular mutual fund newsletters on the Internet, ranking number 7 on the Google Directory page for Mutual Funds News and Media Newsletter websites. Since we began publishing our quarterly Model Portfolios, 29 out of the 36 Stock Portfolios have outperformed the S&P 500 Index over the following year (data as of Sept., 2009). Since 2000, 28 of our Model Stock Portfolios have had the opportunity for at least 3 years to pass since we first published it. 25 out of 28 of these Model Stock Portfolios have outperformed the S&P 500 Index over the following 3 years, and ALL Stock Portfolios (20 out of 20) have outperformed over 5 years as well. Mean level of outperformance has ranged from about 3% over 1 year to over 4% PER YEAR over 5 years.

Copyright © 2003-2009 Tom Madell

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