## Quiz!

If you add annually to a portfolio that drops 50% in one year and recovers the next year, what penalty or benefit do you get when compared to a portfolio with the same returns (0%) and no volatility?

1. -50%
2. No impact.
3. +50%

## How to Use Volatility to Make Money

Investment volatility is the investment’s movements up and down away from its average growth. It is commonly viewed as a negative, but for a disciplined long-term saver, it is typically a positive. A hypothetical example can demonstrate it. Let’s compare 2 portfolios with identical returns, and different volatility:

 Portfolio 1 Portfolio 2 Year 1 0% -50% Year 2 0% 100% Average 0% 0%

If you start with \$100, both portfolios will be worth \$100 after 2 years. Specifically, Portfolio 2 will go through the following values: (Year 1) \$100 – 50% = \$50. (Year 2) \$50 + 100% = \$100. The portfolios have identical average growth, but Portfolio 2 is far more volatile.

Let’s see the final balance if you add \$100 in the beginning of each year:

 Portfolio 1 Portfolio 2 Year 1 (\$100 + 0%) = \$100 (\$100 – 50%) = \$50 Year 2 (\$100 + \$100) + 0% = \$200 (\$50 + \$100) + 100% = \$300

Even though both portfolios have the same average growth, when adding to both portfolios identical amounts each year, the more volatile portfolio ended up 50% higher (\$300 vs. \$200).

How is this possible? The percentage going back up is greater than the original percentage going down. When a portfolio recovers from a 50% decline it goes up 100%. This is because the percentage going up is relative to a lower starting amount. While old money simply recovers, new money that was invested low goes up \$100 – double the -\$50 impact of the decline.

Notes:

1. Some investors lose faith in their portfolio after declines, and hold off on investing (or even sell). If you do that, you can negate the entire benefit of volatility and even hurt your returns.
2. Even with discipline, there is a special case that can lead to a negative effect. The case involves no up period after a down period, for example, only up years followed by only down years. This is not a concern for disciplined lifelong investors, because such a sequence is limited to one cycle or less.

If you add annually to a portfolio that drops 50% in one year and recovers the next year, what penalty or benefit do you get when compared to a portfolio with the same returns (0%) and no volatility?

1. -50%
2. No impact.

Explanation: See this month’s article for an analysis of this scenario.

Disclosures Including Backtested Performance Data

## Quiz!

Which of the following are common to Warren Buffett and Quality Asset Management?

1. Value investing
2. Home bias
3. Profitability bias
4. Reduced volatility

## Warren Buffett’s Strategy vs. Quality Asset Management’s

Warren Buffet is one of the greatest investors of all times. Given that his fund, Berkshire Hathaway, holds a small number of stocks, you may think that his strong performance was the result of superior stock selection (a.k.a. alpha). A study that was published in 2013 (https://www.nber.org/papers/w19681) found that the benefit of his stock selection was statistically insignificant, attributing virtually the entire performance to structural decisions. Below I review the sources of his performance that are in common with Quality Asset Management (QAM), and those that are different.

In common:

1. Value: Both invest in companies with a low price relative to the company’s book value (low P/B).
2. Quality: Both invest in profitable companies.
3. Reduced Volatility: Buffett buys low volatility stocks that historically resulted in excess returns. QAM achieves similar results (reduced volatility, excess returns) by excluding extremely small and expensive (high P/B) stocks as well as stocks experiencing negative momentum.

Buffett’s benefits:

1. Leverage: Buffett employs leverage of 1.4 to 1.6, with very low costs of borrowing thanks to using capital from his insurance business (premiums received until claims where paid), and interest-free loans: differed tax on depreciation, accounts payable and option contract liabilities. QAM helps clients use home mortgages & HELOCs (home equity lines of credit) to generate leverage, when desired, possible (the client can qualify for the loans) & subject to a risk analysis. In addition, it invests deferred obligations, including income taxes until due (e.g. when the client pays 110% of past year’s taxes in estimated taxes, and enjoys faster growing income). QAM uses very low cost margin for loans backed by unused HELOCs, and other sources. While there are some similarities, this strategy is not used for all of QAM’s client’s, and the leverage level declines with the growth of the portfolio relative to the client’s home value. In addition, the interest rate that Buffett gets from his insurance arm is lower than the interest rates that QAM’s clients get. Therefore, this is usually a benefit to Buffett relative to QAM.

QAM’s benefits:

1. Size: Early on, Buffett focused on small companies. Given the size of his fund, he cannot practically focus on a small number of small companies, and he developed a bias towards large companies. QAM has a bias towards small companies that is likely generate a return premium relative to Buffett. This benefit is likely to be sustainable for a very long time, given QAM’s strong diversification.
2. Country: Buffett has a bias towards American companies. QAM doesn’t have this bias, and it focuses on companies from less developed countries. This is likely to generate a return premium.

Which of the following are common to Warren Buffett and Quality Asset Management?

2. Home bias

Disclosures Including Backtested Performance Data

## Quiz!

In the past 20 years, how did Extended-Term Component perform in a period of rising rates from low rates?

1. It gained more often than declined.
2. It declined more often than gained.
3. It gained consistently in all cases.
4. It declined consistently in all cases.
5. As with most things, the results were mixed.

## What do Stocks do when Interest Rates Rise?

This article reviews the impact of rising rates from a low point on the high-volatility high-growth stock portfolio Extended-Term Component, both empirically and logically.

Empirically: We have 2 cases of rising rates from a low point in the live history since 1998:

 Increase Date Starting Rate Trend information Performance since rate increases started Duration Rates before peak portfolio 6/30/2004 1% Gain started 1.5 years earlier +277% 3.3 years Reduced for a month after plateaued for over a year 12/17/2015 0%-0.25% Gain started after a short-lived (35 days) 12% decline +61% so far (including the initial decline) 2.2 years so far Peak not established yet

So far, we enjoyed phenomenal gains in both cases. While this data is not statistically significant, these strong results dispel the myth that you should expect declines when rates go up. So far, all [2] cases go against this theory.

Logically: The Fed acts in reaction to US and non-US economic activity. It lowered rates as a result of poor economic performance, in an attempt to stimulate the economies. Very low rates tend to be a result of big financial shocks, as we have seen in 2000-2002 and 2008. After these big shocks, the Fed was slow to reverse course and raise rates, because the risk of deflation seemed greater than the risk of inflation. By the time it raised rates, there were clear signs of economic improvement around the world. Additional rate increases were done cautiously after the economies continued to improve. The positive effect of economic improvements was greater than the negative effect of rising rates, by design. In addition, with such low starting rates, it took a long while for rates to stop being accommodative to the economy.

More Good News: While stocks did well as rates went up from low levels, you may expect stocks to get hurt when rates reach higher levels. In the history we have since 1998, the 1-year return leading to high peaks, when interest rates reached a cycle-high, was not only positive, but unusually high: The 1-year return was 92% leading to the 2000 peak, and 73% leading to the 2007 peak.

In the past 20 years, how did Extended-Term Component perform in a period of rising rates from low rates?

1. It gained more often than declined.
2. It declined more often than gained.
3. It gained consistently in all cases. [The Correct Answer]
4. It declined consistently in all cases.
5. As with most things, the results were mixed.

Explanation: Please read this month’s article for an explanation. Note that while the results were consistent, there were only two instances in total over 20 years, so these results are not statistically significant. A conclusion that is safe to make: we cannot count on high odds of declines as rates go up, because the history so far goes strongly against this theory.

Disclosures Including Backtested Performance Data

## Quiz!

Which of the following investment strategies are based on biases, and can lead to poor performance? (May be multiple answers)

1. Buy investments that exhibited rapid growth of 15% in the past 5 years, relative to their long-term average of 5%.
2. Buy well established companies that are not going anywhere.
3. Buy obscure small companies that you don’t understand.
4. Buy companies you clearly understand.

## The Secret to Getting Rich

Have you ever heard a secret for getting rich? As an investment advisor, I hear such ideas frequently, and evaluate each of them with a critical eye. There is one thing in common with most, maybe all, ideas that work: they go against human nature, or deeply engrained human biases. If this sounds surprising, a few examples may help:

 Good Action Bias Biased Action / Human Nature Defer spending to invest, and enjoy compounded growth Present Bias Emphasize the present over the less tangible future Invest in fast growing (and volatile) investment classes Myopic Loss Aversion Avoid declines, even temporary Buy low: value stocks (low Price/Book), AND investments at a low point of the cycle (after years of declines) Recency Bias Prefer investments that did best in the recent 5-10 years Diversify across countries Home Bias Buy familiar stocks that are close to home Own small stocks Familiarity Bias Buy large stocks that are more familiar Enjoy momentum Disposition Effect Sell too soon, after seeing a gain, and too late after seeing a loss Buy small & unknown profitable companies Familiarity Bias Focus on known profitable companies over less known ones

A couple of notes about the list above:

1. If some of the profitable actions listed in the first column seem natural to you, you are in luck, having strategies that are uncomfortable to others, but comfortable to you, letting you likely enjoy excess gains compared to the average investor.
2. An issue that makes most of the above especially difficult is that they tend to show poor results for extended series of years. It requires a big commitment, to enjoy the long-term benefits.

If you hear of an idea for getting rich that is easy to implement, both technically and also in terms of human nature, you should be skeptical. The ideas that survive the test of time tend to be difficult or go against human nature. Otherwise, many people will pursue the investment, bidding up its price and hurting future returns.

Now that you realize how difficult it is to follow the good advice for growing your money, should you give up? No. Here are some ideas:

1. Think of tangible examples for the tradeoffs. For example, would you give up spending \$10,000/year for the next 20 years, in return for \$38,700/year for the following 20 years (assuming 7% real growth), or one lump sum of \$521,000 in 20 years? Think about a specific dream you can fulfill with these amounts.
2. Get the longest data you can, for the asset classes of your investments (e.g. US large stocks, International value stocks, real estate in various locations), and get a sense for the length of cycles. If some past cycles reached 15 years, never use the past 5-10 years to conclude that there is a new normal.
3. After a long tough stretch, when the media may be most discouraging, try to identify the recent peak or bottom. If the peak was a good number of years back, or the bottom was fairly recent, you should become more optimistic. If you see low valuations (low Price/Book for stocks or high affordability for real estate), it should further support your optimism.

Which of the following investment strategies are based on biases, and can lead to poor performance? (May be multiple answers)

1. Buy investments that exhibited rapid growth of 15% in the past 5 years, relative to their long-term average of 5%. [Correct Answer]
2. Buy well established companies that are not going anywhere. [Correct Answer]
3. Buy obscure small companies that you don’t understand.

Explanations:

1. Recency Bias. An investment that did exceptionally well (relative to its average) for 5 years may be overvalued, and is at an elevated risk.
2. Familiarity Bias. Well established companies tend to be well known, and you may pay a premium for the comfort of the familiar, well established name.
3. As long as you stay diversified, and stick with small companies throughout the cycle, you are likely to get a return premium for holding these less familiar and less comfortable investments.
4. Familiarity Bias. See #2.
Disclosures Including Backtested Performance Data

## Quiz!

Brazil is in the midst of a devastating recession – the worst on record, with GDP of -3.5% for 2016 following -3.8% for 2015. Can you guess the returns of Brazil’s stock market for 2016?

1. -70%
2. -62%
3. -14%
4. 0%
5. +24%
6. +66%

## Can you Guess the Top Performing Country Last Year?

As an Investment Advisor, a fiduciary that is responsible for the life’s savings of entire families, you would expect to count on me to follow the economic news closely and be ready to react to any new developments. Do I do this? I do the exact opposite – I separate my investment decisions from economic news. If I were to depend on the news for investment decisions, I could hurt your life’s savings badly.

A recent example from 2016 can demonstrate this counterintuitive point. Brazil spent the entire year in a devastating recession – the worst on record (over more than 100 years). Unemployment climbed throughout the year from 9% to 11.9%. The president was impeached and there were numerous corruption scandals. Predicting this year could have made you a fortune by shorting (making money when stocks decline) Brazilian stocks in 2016, right? Not so fast. The Brazilian stock market gained +66% in 2016. Not only did it not decline – it was the top performing country for the year.

How is it possible to get stellar returns during the worst economic decline on record? The answer is simple – ignoring prices. The consensus view was for a long and deep economic decline, which would hurt Brazilian companies. In reaction, people sold Brazilian stocks to avoid the declines. The problem was that people kept selling these stocks without regard to prices. Why is this a problem? Say that in normal times a basket of Brazilian stocks is worth \$100. Now comes a big recession, and the new realistic value is, say, \$80. You would expect rational people to sell until the price reaches \$80. But many investors see a struggling economy and sell with disregard to the price. Others cannot imagine a turnaround and sell to reflect a multi-year depression. So, the continued selling brought the basket to a much lower value, say \$40. This reflects an unusually bad expectation – far worse than reality. Now comes additional moderately negative news, lowering the realistic value from \$80 to \$75. With the news being far less negative than expected, people become more positive, and are more likely to accept a value closer to reality. They are ready to correct some of the excess decline, leading to a surge from \$40 to, say, \$66.40 (a gain of 66%), all while the economy is doing poorly. While the numbers in this example where made up, the mechanism explains what could have led to the surge of Brazilian stocks.

As of 9/30/2016, Brazil represented 6.82% of emerging markets, while the allocation to it in the emerging market portion of QAM’s portfolios was 9.19%. This emphasis reflects the deep value focus (a focus on low priced stocks) of these portfolios, something that often leads to outperformance compared to the general market during recovery years.

Brazil is in the midst of a devastating recession – the worst on record, with GDP of -3.5% for 2016 following -3.8% for 2015. Can you guess the returns of Brazil’s stock market for 2016?

1. -70%
2. -62%
3. -14%
4. 0%
5. +24%
Disclosures Including Backtested Performance Data

## Quiz!

What are the outcomes of consistently adding to a portfolio during declines of 20% + 20% followed by a 2 year recovery (25% + 25%), instead of using a stable 10%-per-year investment for the new money?

1. You throw good money after bad – you lose money while feeling lousy.
2. You lose money, but at least you stay conservative by sticking with your plan. Once there are new peaks, your entire investment will enjoy future growth.
3. Not only you make money by buying low – you magically outperform the consistent 10% portfolio.
4. You make money by buying low, and with the new peak your entire investment will enjoy future growth.

## Can You Make Money in a Down Market?

Imagine living through a long decline period. If you are retired and your entire life’s savings are invested in your portfolio according to your plan, you can relax knowing that your low withdrawal rate is likely to sustain your money for as long as you live.

If you are still in saving mode, or have money that was not put to work in your portfolio, you have choices. Let’s review two different options:

1. You wait for the portfolio to recover to gain more comfort, and after it proved itself, you add more money to it. You don’t add money to a losing portfolio.
2. You add all money available, whether it is savings from work, money invested elsewhere, equity in your home that you can borrow (subject to a risk assessment), or an inheritance.

Let’s continue with an example: Say you had 1M that declined for 2 years, and then recovered in 2 years. Also, say you had 100k to add per year. During the declining period, you choose between diverting to a portfolio that gained 10% per year and adding to the portfolio that simply declined and recovered with no new gains (as described in 1 & 2 above, respectively). Let’s see the financial impact of the 2 options:

1M Portfolio state Value of

original 1M

Value of new investments
Option #1: Invest at 10% Option #2: Invest in portfolio
20% decline + saved 100k 800k 100k 100k
20% decline + saved 100k 640k 100k + 10% + 100k = 210k 100k – 20% + 100k = 180k
25% gain + saved 100k 800k 210k + 10% + 100k = 331k 180k + 25% + 100k = 325k
25% gain to full recovery 1M 331k + 10% = 364k 325k + 25% + 100k = 506k
Performance of deposits 364k / 300k – 1 = 21% 506k / 300k -1 = 69%

After 4 years, option #1 would result in 364k, while option #2 would result in 506k.

In option #1, your entire mental focus is on the wait for a recovery, to regain comfort with the portfolio. You have no good feelings about the portfolio until you fully regained the lost grounds. In the meantime, you feel good about growing your new savings at 10% per year, and are happy that you did at least one smart thing.

In option #2, you keep adding to the portfolio, ignoring its behavior. At first, you feel good buying low. As the decline continues, you are tempted to feel that you are throwing good money after bad, but you remind yourself that the portfolio is far more attractive the lower it gets, and the new money can enjoy this benefit. After one year of gains, you can already celebrate the impact on your recent deposit. So, instead of focusing on the remaining path to recovery, you can enjoy the hard dollars that you gained during the initial part of the recovery. By the full recovery, you enjoy far better results than 10% per year even though you added to a portfolio that had 0% returns from peak to the new peak.

What are the outcomes of consistently adding to a portfolio during declines of 20% & 20% followed by a 2 year recovery, instead of using a stable 10%-per-year investment for the new money?

1. You throw good money after bad – you lose money while feeling lousy.
2. You lose money, but at least you stay conservative by sticking with your plan. Once there are new peaks, your entire investment will enjoy future growth.
3. Not only you make money by buying low – you magically outperform the consistent 10% portfolio. [The Correct Answer]
4. You make money by buying low, and with the new peak your entire investment will enjoy future growth.

The article above provides an explanation.

Disclosures Including Backtested Performance Data

## Quiz!

Which are conditions that are all necessary for not thinking about small expenses?

2. You are withdrawing less than 3% or 4% of your portfolio, every year.
3. You are relaxed about your financial position, and have no concerns with investment volatility or surprise expenses when things go wrong.
4. You feel that you are using your money in a way that maximizes your happiness.

## Sweat the Small Stuff

You can skip this article if all of the following are true:

1. Your total annual spending equals less than 3% or 4% of your stock portfolio, depending on its allocation. Make sure to include infrequent items such as car upgrades, roof replacements, uncovered medical expenses, and a long stay in a nursing home. You can deduct amounts covered by guaranteed lifelong income such as social security payments, pensions or inflation-adjusted annuities.
2. You are relaxed about your financial position, and have no concerns with investment volatility or surprise expenses when things go wrong.
3. You feel that you are using your money in a way that maximizes your happiness.

Since I still have your attention, this article may help increase your happiness. You probably know that big financial decisions have a meaningful impact on your finances. Buying a large house, boat or a private jet will have substantial impact given the initial price and high maintenance costs. Having a high paying job, or two sources of income for a household can have a big positive impact.

As you work on getting the big picture right, you may follow the advice “don’t sweat the small stuff”. Indeed, you don’t need to sweat the small annoyances in life, but you may benefit from sweating the small expenses, especially the recurring ones. Here are examples.

1. Subscriptions that you don’t utilize significantly. This could be cable TV with many channels, various software & apps, credit cards with annual fees and infrequently visited clubs.
2. Infrequently used appliances that consume energy and require maintenance, including various refrigerators, lights, and computer systems.
3. More employees than necessary, including nannies for older children, cooks and various maintenance staff.
4. Eating out in expensive restaurants that you don’t appreciate in line with the cost.

The list above is a random sample of expenses. The list of expenses that can be reduced without a significant impact on your happiness is personal. You have to go through your expenses and find out what doesn’t makes you happy in line with the cost. One person may greatly appreciate a nice restaurant, while another may take great pleasure in having plenty of choices for TV programs.

Which are conditions that are all necessary for not thinking about small expenses?

2. You are withdrawing less than 3% or 4% of your portfolio, every year. [Correct Answer, but read below]
3. You are relaxed about your financial position, and have no concerns with investment volatility or surprise expenses when things go wrong. [Correct Answer]
4. You feel that you are using your money in a way that maximizes your happiness. [Correct Answer]

Explanations:

1. Jobs can come and go, bonuses can be reduced, and businesses can have fluctuating revenues. Income from work typically provides only temporary security.
2. It is true that you need to withdraw less than 3% or 4% of your portfolio annually, but there is a much stronger condition – the 3% or 4% should be your total spending, ignoring income from work. Also, this applies to a stock portfolio. Bonds don’t grow fast enough to support lifelong withdrawals at 3% or 4%, growing with inflation.
3. Even if you are at a sustainable withdrawal rate from your portfolio, if you are stressed with volatility or surprise expenses, you should build your resources to the point of a relaxed financial life.
4. If you are sustainable financially (explanation #2) & relaxed about finances, but feel constrained, and are not happy with what money can buy you, you can be careful with your small expenses to free up money for other spending that may improve your happiness.
Disclosures Including Backtested Performance Data

## Quiz!

As of March 31, 2000, US value stocks had underperformed growth stocks by 5.61% per year for the previous 10 years. How many years did it take for value stocks to make up for these 10 years of underperformance?

1. We are still waiting
2. 10 years
3. 5 years
4. 3 years
5. 1 year
6. Less than 1 year

By Weston Wellington, Vice President, Dimensional Fund Advisors

Value stocks underperformed growth stocks by a material margin in the US last year. However, the magnitude and duration of the recent negative value premium are not unprecedented. This column reviews a previous period when challenging performance caused many to question the benefits of value investing. The subsequent results serve as a reminder about the importance of discipline.

Measured by the difference between the Russell 1000 Growth and Russell 1000 Value indices, value stocks delivered the weakest relative performance in seven years. Moreover, as of year-end 2015, value stocks returned less than growth stocks over the past one, three, five, 10, and 13 years.

Unsurprisingly, some investors with a value tilt to their portfolios are finding their patience sorely tested. We suspect at least a few will find these results sufficiently discouraging and may contemplate abandoning value stocks entirely.

Total Return for 12 Months Ending December 31, 2015

 Russell 1000 Growth Index 5.67% Russell 1000 Value Index −3.83% Value minus Growth −9.49%

Before taking such a big step, let’s review a previous period when value strategies underperformed to gain some perspective.

As many growth stocks and technology-related firms soared in value in the mid- to late 1990s, value strategies delivered positive returns but fell far behind in the relative performance race. At year-end 1998, value stocks had underperformed growth stocks over the previous one, three, five, 10, 15, and 20 years. The inception of the Russell indices was January 1979, so all the available data (20 years) from the most widely followed benchmarks indicated superior performance for growth stocks. To some investors, it seemed foolish for money managers to hold “old economy” stocks like Caterpillar (−3.1% total return for 1998) while “new economy” stocks like Yahoo! Inc. appeared to be the wave of the future (743% total return for 1998).

Many value-oriented managers counseled patience, but for them the worst was yet to come. In 1999, growth stocks shone even brighter as value trailed by the largest calendar year margin in the history of the Russell indices—over 25%.

Total Return for 1999

 Russell 1000 Growth Index 33.16% Russell 1000 Value Index 7.36% Value minus Growth −25.80%

In the first quarter of 2000, growth stocks bolted out of the gate and streaked to a 7% return while value stocks returned only 0.48%. As of March 31, 2000, value stocks had underperformed growth stocks by 5.61% per year for the previous 10 years and by 1.49% per year since the inception of the Russell indices in 1979. A Wall Street Journal article appearing in January profiled a prominent value-oriented fund manager who regularly received angry letters and email messages; his fund shareholders ridiculed him for avoiding technology-related investments. Two months later he was replaced as portfolio manager amidst persistent shareholder redemptions.

With value stocks falling so far behind in the relative performance race, it seemed plausible that value stocks would need a lifetime to catch up, if they ever could.

It took less than a year.

By November 2000, value stocks had delivered modestly higher returns than growth stocks since index inception (21 years, 11 months). By month-end February 2001, value stocks had outperformed growth over the previous one, three, five, 10, and 20 years and since-inception periods.

The reversal was dramatic. Over the period April 2000 to November, value stocks outperformed growth stocks by 26.7% and by 39.7% from April 2000 to February 2001.

This type of result is not confined to the technology boom-and-bust experience of the late 1990s. Although less pronounced, a similar reversal took place following a lengthy period of value stock underperformance ending in December 1991.

We can find similar evidence with other premiums:

• From January 1995 to December 1999, the annualized size premium was negative by approximately 963 basis points (bps), amounting to a cumulative total return difference of approximately 113%. Within the next 18 months, the entire cumulative difference had been made up.
• From January 1995 to December 2001, the annualized size premium was positive by approximately 157 bps.

The moral of the story?

Prices are difficult to predict at either the individual security level or the asset class level, and dramatic changes in relative performance can take place in a short period of time.

While there is a sound economic rationale and empirical evidence to support our expectation that value stocks will outperform growth stocks and small caps will outperform large caps over longer periods, we know that value and small caps can underperform over any given period. Results from previous periods reinforce the importance of discipline in pursuing these premiums.