BFM Sample Newsletter 2011

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Be Aware of your Emotions - Step Away from Yourself

How to Pick Better Mutual Funds

Let's Put Things in Perspective

Human Brain and Decision-Making

Challenges in Financial Advising from the scope of Behavioral Finance

Countries and Culture in Behavioral Finance

Investment Decision Making

Markets Trends: Bullish, But How Long?

Rationality & Decision Making

Investors Fail do Capture the Returns they Expected + Chasing Performance May Lower your Returns

Let's Be Positive!

Humans Can't Analyze all the Information Received

Train your Brain to Win Big

So That's Why Investors Can't Think for Themselves

www.bourbonfm.com
http://www.linkedin.com/in/patrickbourbon







Published in: Economy & Finance, Business
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BFM Sample Newsletter 2011

  1. 1. Be Aware of your Emotions - Step Away from Yourself November, 2011  Be aware of your own emotions and cognitive traps to make smarter decisions.  Step away from yourselves to be more rational.  Remember that we unconsciously make decisions based on positive memories.  Learn about financial history to reduce the number of mistakes. Do not extrapolate recent past.  Keep a well-diversified portfolio and an investment diary.  Have a Financial Plan.What are some of the behavioral traps that The other part of our decision making derives frominvestors fall into at times like today? cognition. We tend to extrapolate from recent events, and it‘s clear that since 2007, our assets haveAccording to Dr. Statman, the first issue is emotion. gone down and we feel down. While we tend toWe need to be aware of our emotions to be able to extrapolate from the recent past, thinking that lowstep aside and watch ourselves. returns will generate low returns in the future may beOf course, the emotion of the day is fear. And we all wrong. In fact, on average, pessimism and fear areunderstand that fear causes us to be very risk-averse, actually followed by relatively high returns rathervery pessimistic about the future, and we tend to than low returns.make mistakes along the way.When the market was at a low, like in 2002 (or in2009 when we founded BFM), people were fearful;many thought that now was not a good time to So how do investors get beyond those emotionalinvest, and we know what happened after that and cognitive mistakes that they tend to make,- a 100% bull run until 2007 (and another bull run of where they might be feeling irrationally pessimistic85% of the S&P 500 from March 2009 to November at a time like this?2011). In opposition, when the market was at a high What is needed for us is to step away fromin early 2000, people felt no fear; they thought that ourselves. Fortunately, we can do it. After all, we dothe market would provide high returns with no risk- it when we watch a scary movie. We know that wewhich, we know is not true. feel scared, but we know that the threat is not real soNow we are fearful and so we must be aware of that we don‘t get up and rush out of the theater. We canand counter our emotions. do the same with the financial markets. © 2011 Bourbon Financial Management, LLC ~ All Rights Reserved ~ Info@bourbonfm.com ~ (+1) 312 909 6539 1
  2. 2. We should tell ourselves, ‗I am afraid‘. We have to Should investors stay away from some stimuli like temper our emotions by our reasoning. It is not watching business TV programs or watching their trivial, but we do that all the time, and we have to do investment statements like a hawk? it now. Nowadays a large amount of investment is rushing This varies by person. If you feel that watching into gold bullion. Would it benefit investors? television programs and reading newspapers that No, says Dr. Statman, because investors are acting show scary things is really doing harm to you, stop out of excessive fear or misjudgment. There is doing that, and if you are able to shrug, then go nothing wrong with having some gold in a portfolio, ahead. but putting a big chunk of a portfolio in gold would Some investors are very concerned about the safety be considered very risky. of their portfolio. A lot of seniors are living on their Research shows, there are some assets that people portfolios. What should this group of investors do? love, and if you love it, you think it will have both Keep in mind that we want two things in life. One is high return and low risk. And obviously, gold is an not to be poor and the other is to be rich. asset that many investors love today, and they think that it will have high returns in the future as it has For retired people it is not being poor that is had in the past 10 years. In fact, the returns can be paramount. What is important is not only to have a high or low, so if you overdo it, you may end up diversified portfolio, but also a portfolio that is less being very rich, but you also may end up being very risky, a portfolio that has more bonds even though poor. Thus, we recommend well-diversified the returns are very low. There is a need to calibrate investment strategies that maximize the potential consumption. for growth. Investing is really a matter of prudence, of being able to calm yourself and being able to think Are there any tips for countering those behavioral logically. mistakes and the tendency to feel excessively fearful during a market or an economic environment like the current one? Summary Dr. Statman* says that we can control our own behavior. We can control our own saving and consumption rates. We can control our own In general, be aware of emotional issues and try to portfolios, and so, the smart thing we can do is to counter them. Be aware of cognitive traps, and keep a diversified portfolio. separate your emotion from reasoning. Never put all We hope that everyday would show an increase in your resources in one basket, and consider the factor the value of that portfolio, but we know that this will that you will live long but not forever so keep a not happen. We learn to step away from ourselves reasonable asset structure. and monitor our own emotions and thinking, so that we make smarter decisions rather than poorer ones.*Dr. Statman is a Finance professor at Santa Clara University. BFM can help you make better, and more informed financial decisions by giving you straightforward and conflict-free investment “The investor„s chief problem strategies. We make sure that you have enough money as long as you live so that you can enjoy a – and even his worst enemy – comfortable retirement at a chosen lifestyle with a is likely to be himself” secured income while keeping your money safe. Benjamin Graham © 2011 Bourbon Financial Management, LLC ~ All Rights Reserved ~ Info@bourbonfm.com ~ (+1) 312 909 6539 2
  3. 3. The Flaws of our Financial Memory Declarative memories are memories that people are conscious of. It can be classified as either episodic or semantic. In which, episodic memories are memoriesThe following chart shows the percentage of of significant things that happen to us or events thatcountries in default over the last 200 years. The we experience, such as a wedding day, vacations,peaks in sovereign defaults seem to recur without birthdays, or the first day at school. Semanticexception every 30–40 years. This pattern is memories are factual memories that can be retrievedoccurring not only in emerging countries but also in at any point in time. It is factual information that youdeveloped countries. A similar pattern is also visible know, but you probably will not know where youfor currencies and in equity markets. It causes Mr. were when you first learned about it.Klement (C.I.O. of Wellershoff) to consider whyinvestors tend to forget lessons of history. Non-declarative memories are the subconscious or unconscious memories people have, such as how to ride a bike or how to drive a car. We remember how to do those activities, but after some practice, we do not consciously focus on all the processes involved in driving a car or riding a bike. Classical Conditioning Classical conditioning is best summarized by the well-known Pavlov‘s dog experiments of the 1920s. Mr. Klement believes that classical conditioning is happening in the financial markets. For example, during the technology bubble in 1999, Computer Literacy Inc. changed its name to fatbrain.com. OnWith his background in mathematics and physics, the day of the name change, its stock rose by 33Mr. Klement was naturally inclined to look to the percent simply because it had renamed itself as anatural sciences for explanations, especially the dot-com.neurosciences, cognitive psychology, cognitiveneuroscience, and research about memory. Most investors during that time were trained to equate dot-coms with a profitable investment, and it became a self-fulfilling prophecy. The same thingTypes of Memories happened during 2004-2007, with companies that added oil or petroleum to their name. The same thingMemories can be divided into long-term memories is happening today for companies with ‗China‘ inand short-term memories. Long-term memories are their name.the things that people remember for months, years,or even decades. In opposition, short-term memories If we looked for companies from around the worldare the things that people are consciously aware of that had changed their name to include the countrythat they can use and remember for a few minutes. name ‗China‘ between 2000 and 2010, excludingTo remember things is the process of short-term companies that located in mainland China, Hongmemories becoming long-term memories. Kong and Taiwan, you would find at least 90 companies in the US, UK, Australia, and Germany that added China to their names. Interestingly, in theLong-term memories can be further divided into four months around the name change, the stocks ofdeclarative and non-declarative memories. those companies, on average, almost quadrupled in price. © 2011 Bourbon Financial Management, LLC ~ All Rights Reserved ~ Info@bourbonfm.com ~ (+1) 312 909 6539 3
  4. 4. This example illustrates how individuals Flaws of Memory & Investorsunconsciously make decisions based on positivememories from the past. Because of good Transienceexperiences with Chinese stocks or Chineseinvestments, investors equate China with a good Remembering a sequence of 10 colors is called ainvestment, and it becomes a self-fulfilling prophecy digit span test, and if it‘s performed systemically, anfor some stocks. interesting effect occurs: people tend to remember 7 things (+/- 2) at a time, and they tend to remember the first few and last few and forget the ones in between.Seven Flaws of Memories Remembering the last few things that a person seesThere are 7 flaws of memories that can be grouped or hears is called the ―recency effect.‖ The recencyinto 3 categories: effect may be the scientific underpinning of the recency bias in behavioral economics. Behavioralists know that people tend to extrapolateForgetting Things the recent past into the future and act accordingly in their investment decisions.This category includes transience, absentmindedness,and blocking, which all have something to do with Remembering the first few colors or numbers that aforgetting. It‘s natural that we tend to remember the person sees or hears is called the ―primacy effect.‖gist of important things that we need to know or that The primacy effect is related to how people shapehave happened to us. Otherwise, if we never forget their behavior throughout their lives based on theanything, there would be too much information for memories of what investment decisions they madeour brain to process. when they first started investing.False Memories Thus, investors buy stocks that have gone up dramatically over the previous 3–6 months andThe second category includes misattribution, avoid stocks or funds that have gone down over thesuggestibility, and biases, which contribute to previous 6–12 months. And the experiences peopleremembering things that did not happen the way they have during their first years as investors will shapeare remembered or might not have happened at all. the way they think about markets for the rest of their lives.Traumatic Memories However, these effects can be overcome throughIt only includes persistence, which is about memories training. If something is practiced and repeated,that people wish they could forget but cannot. then it can be memorized. The value of repeated experience can also be reviewed as people tend to use their investment experience to their own advantage. “Only buy something that A study by Greenwood and Nagel demonstrated the importance of experience (figure 2). During 2000- youd be perfectly happy to 2002, the managers who were 25–35 years old hold if the market shut down underperformed their peer group, whereas the fund managers who were more than 45 years of age for 10 years” outperformed their peer group. Recall that if managers were older than 45 in 2000, they likely had Warren Buffet vivid memories of previous severe bubbles and crises in the markets, such as those in the late 1970s and early 1980s. © 2011 Bourbon Financial Management, LLC ~ All Rights Reserved ~ Info@bourbonfm.com ~ (+1) 312 909 6539 4
  5. 5. In 2000-2002, the young managers stuck to Persistencetechnology stocks and on average underperformedtheir peer group, whereas the older managers started An example of how traumatic memories may affectto outperform quite dramatically because they did investors is seen in those who grew up during thenot buy into the hype around the technology Great Depression in the 1930s in the United States.securities as much as the younger fund managers. Check the difference in stock market participationBoth positive and negative experiences can be used and returns by the year of 1968, older investors (overto train our memories. 40 years old) had on average almost 5 percent fewer stocks in their portfolios than the younger investors. Because most of the older ones experienced theMisattribution Great Depression in the 1930s and they can never forget that.Research shows that we tend to remember things inwhat is called a ―mind map.‖ We group similar A similar example is Germany, which is well knowninformation together, and the result is that for having a high savings rate. Most of the Germansometimes information is mixed up in our memory population suffered disproportionately from thewith other information that is stored nearby in our effects of two catastrophic wars and a disastrousbrain. period of hyperinflation—all within a short time. Thus the influence on the succeeding generations hasThe human propensity for sometimes not resulted in consumers who avoid investment in stockremembering things or remembering false things is markets and do not buy houses.often used in marketing materials. “Risk comes from not knowing what you‟re doing” Warren Buffet © 2011 Bourbon Financial Management, LLC ~ All Rights Reserved ~ Info@bourbonfm.com ~ (+1) 312 909 6539 5
  6. 6. What can we do to be better investors? Thus the longer the time horizon, the more investors can invest in equities because they haveFirst is to have an Investment Policy Statement or the time to bear the risks, suffer the downturns, anda Financial Plan. Agreeing to and writing down wait for the markets to recover.investment goals along with all the restrictions andconstraints, and then regularly auditing or reviewing The problem is that investing in times of risingthem. It helps managers to avoid going astray with yields means that bond investments may not createinvestments or following the latest fashion or good returns. This observation is based simply ontechnique, and it guides managers by keeping the the numerical effect that rising interest rates have onclient‘s stated goals at the forefront of their mind. bond prices and does not take credit risk into consideration, which is a separate issue.Another technique is to keep an investment diary.For every investment decision good investors make, In the current markets, many people believe thatthey write down the action, the reason why they did interest rates will go up for the next 10 years. As ait, and what could possibly go wrong (the risks). result, it is likely that the most conservativeThis tool helps prevent mistakes due to forget bad investors—that is, the ones with the most bonds indecisions you have made. their portfolios—will be impacted from that effect.Some lessons we might have forgottenIt is instructive to consider the concept of a portfolio ―We simply attempt to bebeing underwater (current value of the assets isbelow the initial value) from one starting point, and fearful when others arecompare three types of portfolios for a U.S. investor: greedy and to be greedy onlya pure bond (government-only) portfolio, a balanced50/50 stock and bond portfolio, and a pure equity when others are fearful.‖portfolio. For a pure bond portfolio since 1985, themaximum time underwater is about 19 months. For Warren Buffetan equity portfolio, the maximum time underwater is81 months. For a balanced portfolio, the maximumtime underwater is 58 months. © 2011 Bourbon Financial Management, LLC ~ All Rights Reserved ~ Info@bourbonfm.com ~ (+1) 312 909 6539 6
  7. 7. SummaryWe all have flawed memories that can lead tomaking poor decisions or repeating mistakes.Memory flaws are observed not only in individualsbut also in the overall market. Financial marketparticipants seem to forget things that happened inthe past or be persistently influenced by recent pastfinancial events. Thus, learning about financialhistory may be one of the best ways to prevent “A man who does notmistakes in the future. plan long ahead will find trouble at his door” Confucius Patrick Bourbon, CFA BOURBON FINANCIAL MANAGEMENT, LLC Excellence ~ Experience ~ Ethics 616 W. Fulton St., Suite 411, Chicago, IL 60661 +1 312-909-6539 ~ www.bourbonfm.com Member of the Financial Planning Association Academic Affiliate of the National Association of Personal Financial AdvisorsPLEASE SHARE OUR NEWSLETTER: Our newsletter readership is not limited to our clients. Please tellthose you feel may be interested that they can subscribe to their own free copy of the newsletter atinfo@bourbonfm.com. 100% of our clients have chosen to stay with BFM since inception in 2009 to help themmake better, more informed financial decisions. Our clients want to make sure that they have enough money aslong as they live so that they enjoy a comfortable retirement at a chosen lifestyle. We give them straightforwardand conflict-free investment strategies. Thank you for your time and the opportunity to be of assistance. © 2011 Bourbon Financial Management, LLC ~ All Rights Reserved ~ Info@bourbonfm.com ~ (+1) 312 909 6539 7
  8. 8. How to Pick Better Mutual Funds?* PEOPLE + PROCESS + PHILOSOPHY = PERFORMANCE * October, 2011Dear friends, You should decide to be either patient with active managers or seek a passively managedIf you have the time, desire, experience and approach. The vast majority of long-term topknowledge of building your own investment and performing managers will endure periods of lousyretirement portfolios, this newsletter is for you! performance.At BFM, we are very analytical and we believe · 85 percent of all ten-year top quartile fundsthat asset allocation is more important than spent at least one three-year stretch in the bottomstocks or mutual fund selection… but many of half of their peer group (they spent about 23you have asked us to share our disciplined due percent of all their three-year periods in thediligence process to selecting investment bottom half of their peer groups).managers and mutual funds. · 62 percent of ten-year top quartile fundsSelecting a good mutual fund is extremely spent at least one five-year stretch in the bottomdifficult. Only 20% of funds may outperform half (19 percent of rolling five-year periods in thetheir benchmark over the long run. 40% of funds bottom half of their peer groups). Source DiMeo.that were in business 10 years ago are now gone.A fund can be at the top one period and be at the Short-term greed and impatience will leadbottom the next one. investors to fail. Before investing you should develop confidence in the fund and theAs you can see, mutual fund returns can be very patience required for long-term success.different (international fund category). Otherwise, you should invest in index and passive funds (low costs). 10-year Value ofName Return $10,000 “Do not wish for quick results, nor look for small advantages. If you seek quick results, you will notOld Mutual Copper Intl Sm Cap 50% $14,988 attain the ultimate goal.” Confucius.Invesco International Sm Cap 417% $51,716 Human emotions are the biggest obstacle to investor success. Proper research goes well beyond the numbers. It also requires regular The debate between active and passive meetings or calls with the managers. Naturalmanagement (investing in index, passive funds human behavioral tendencies during the managerand ETFs) is a constant discussion among selection and termination process generally leadsindividuals in the financial world. There are to failure so we recommend a rigorous process.qualitative and quantitative factors that need to be We believe that qualitative metrics for selectingunderstood and analyzed correctly before picking mutual funds are as important as quantitativea good fund. metrics. © 2011 Bourbon Financial Management, LLC ~ All Rights Reserved ~ Info@bourbonfm.com ~ (+1) 312 909 6539 1
  9. 9. What traits and factors do we look for, review Such data may not available by directly lookingcarefully, and monitor constantly? into sources like Bloomberg, Morningstar, and Lipper. This requires contacting every fund andQualitative factors: requesting them to provide the data.1. People: education, qualifications, experience, depth, stability, diversity, quality and diligence of the investment team (portfolio managers, Quantitative factors: analysts, traders, auditors…) 1. Fees*/ Expense ratio: Funds in the cheapest2. Investment philosophy that is consistent, quintile were more than twice as likely to beat clearly articulated and understandable the average for their categories than the most expensive quintile3. Investment process and style based on meritocracy that are transparent, repeatable, 2. Tenure / Experience / Track Record of the consistent, and definable with good buy and Portfolio Managers and Analysts. The average sell discipline and risk management tenure maybe close to 6 years only… procedures 3. Fund ownership** by the portfolio4. Stewardship: a corporate culture of management team excellence, with clean regulatory history, board integrity, independence, ownership and 4. 5 and 10-year Information Ratio (IR) and compensation who will put your interests first peer ranking. The IR measures the risk- adjusted return for assessing the performance5. Firm ownership structure of active portfolio managers6. Manager compensation and incentives 5. Long-term after tax return / performance: structure (salary, bonus, stocks, shares…) that GMO Emerging Country Debt had a 10-year reward individual contributions annual return was 14.54% ($10,000 became $38,880) but after tax, the post-tax return was7. High conviction approach that is distinct and 9.80% ($10,000 became $25,468 or 35% less) with potential to outperform. “Worldly wisdom teaches that it is better for reputations 6. Consistency of portfolio returns with the to fail conventionally than succeed investment process (attribution reports) unconventionally.” J. M. Keynes. 7. Funds concentration8. What percentage of research is generated internally (vs. sell-side research from Wall 8. Tracking Error and Active Share: these Street)? numbers represent how much the fund returns deviate from the benchmarkWe also review the portfolio composition, size 9. Beta and Correlation with the fund’s true(small or large cap) and style of the funds, Benchmark (R square)manager concentration, and if a manager hasclosed a fund to new investors in the past and ask 10. Inflows/Outflows and total assets in the fundhow they decide to close it in the future. today and 5 years ago © 2011 Bourbon Financial Management, LLC ~ All Rights Reserved ~ Info@bourbonfm.com ~ (+1) 312 909 6539 2
  10. 10. 11. Up/Down capture ratio and maximum drawdown *: Of domestic stock funds, 47% in the cheapest12. Sortino Ratio which measures the risk- quintile beat the average over a 10-year period, adjusted return while just 19 percent of the most expensive quintile beat the category average. The cheapest13. Volatility quintile of domestic-stock funds survived and beat the cheapest index fund 29% of the time, compared with just 17% of the most expensive14. Turnover which measures the number of quintile. There is a high correlation between times securities/shares are replaced/traded costs and survivorship, as high-cost funds have a large attrition rate. Looking at rolling 5 and 10- year periods for US stock funds, the cheapest group had an attrition rate of 13% over 5-yrThe quantitative data is available from a variety of periods and 25% over 10-year periods. Thesources like Morningstar, Lipper, Bloomberg, attrition rate for the most expensive group wasfund prospectus, fund statement of additional double that: over 5-year periods, 29% of the high-information, shareholder reports, fund cost funds had merged or liquidated and 49% hadcompanies… merged or liquidated over 10-year rolling periods.You can see that these lists could include manymore factors. Also important is that these factors **: We like managers to have skin in the game.are not available easily. You need time and a Does your Manager eat his own cooking? Wouldgood network to obtain all the necessary you invest in a fund when its portfolio managerinformation. does not even invest in it? 46% of the US stock funds managers report no ownership! 59% forIt does not end there. You may want to look at a international foreign funds managers. Thisfunds correlation with other assets/funds in your information can easily be found atportfolio to optimize your portfolio risk level and www.morningstar.com/goto/fundspy or in thedecide what capital allocation would be best to fund prospectus (statement of additionalminimize your downside risk. Short-term information. Higher investment levels aren’t aperformance is not important. guarantee of success or an ethical manager, but it shows that managers believe in the funds. © 2011 Bourbon Financial Management, LLC ~ All Rights Reserved ~ Info@bourbonfm.com ~ (+1) 312 909 6539 3
  11. 11. DETAILS Investment knowledge is imparted by investment and finance professionals. These professionalsThe world is a mix of different professionals. include individuals with professional degrees likeEvery professional has his or her own duty to an MBA, Masters, CFA, CFP, CPA...perform well, be it as a teacher, mechanic orbartender. Many times individuals try to But in spite of the experience and educationexperiment with ideas outside their expertise. professional investors possess it is difficult toThere is nothing wrong in learning new ideas; attain the highest skills in all the differentthey rejuvenate you and can bring a fresh investment arenas. So, being a common personperspective to your daily routine. But what is who does not work intensively in the world ofimportant is that you should not be over finance, you can see the complexities in makingconfident in pursuing activities beyond your investment decisions.expertise. For example, practicing skydivingwithout a professional skydiver or dancing Balletwithout a ballerina’s guidance can harm yourbody. What Are Mutual Funds? A mutual fund is a company that pools moneyInvesting your wealth, just like skydiving and from many investors and invests the money in aballet dancing, is an art. Investing without combination of stocks, bonds, and other securitiesknowledge is like jumping into a valley or assets. The combined holdings that the mutualwithout a parachute. fund owns are known as its portfolio. Each share represents an investors proportionate ownership of the funds holdings and the income thoseThere are two main categories of investments: holdings generate.  Equity  Fixed Income © 2011 Bourbon Financial Management, LLC ~ All Rights Reserved ~ Info@bourbonfm.com ~ (+1) 312 909 6539 4
  12. 12. Which Strategy to Choose: Active vs. Passive Management?Passive Management is an investment strategy Active Management, on the other hand believesthat attempts to replicate the returns of an index the market can be inefficient sometimes.or benchmark by owning the same assets, in the Managers attempt to add value over the returns ofsame proportions, as the underlying index. Passive an index by picking assets based on models,investing does not seek to capture any excess insights, and analytical research. Managers aim toreturns, but rather tries to match the performance achieve a higher return then the benchmark byof the index. Indexed Mutual Funds and ETFs are selecting a superior stock, currency, market, orcommon vehicles used for passive investing. sector, etc. Active managers will try to exploit pricing inefficiencies to obtain excess return. (Source: SPDR University). Percentage of Active Funds are Underperforming the BenchmarkEfficient wealth management is a tedious and large-cap value and large-cap growth, all the othertime-consuming activity. It requires a categories have more than 75% of the fundspsychological self-understanding along with underperforming the benchmark.excellent analytical and technical skills. Here welook at how actively managed mutual funds have By looking at the numbers we can say thatperformed across the years compared to their selecting a good mutual fund is extremelyrespective benchmarks and the numbers are very difficult. Thus, effective organized financialsurprising. planning is important. The finance professional cannot guarantee above average returns but someThe figures below are Equity and Fixed Income of them will be more adept and skillful inmutual funds style boxes after adjusting for managing investments than a layman.survivorship bias. We see that all the categorieshave more than half of the fundsunderperforming the benchmark. Also, except forEQUITY FIXED % below Value Blend Growth INCOMEbenchmark % below Government Corporate GNMA benchmark Large 56% 83% 73% Short 94% 99% 100% Mid 99% 96% 98% Intermediate 80% 91% N/A Small 84% 93% 76%Sources: Vanguard calculations, using data from Morningstar, Inc., MSCI, Standard & Poor’s, and Barclays Capital © 2011 Bourbon Financial Management, LLC ~ All Rights Reserved ~ Info@bourbonfm.com ~ (+1) 312 909 6539 5
  13. 13. Why do active managements underperform active managers outperformed the relative indexesbenchmarks so poorly? An indexing investment only in three asset classes—small cap blend, smallstrategy performs favorably in relation to actively cap growth, and international as shown in themanaged investment strategies because of figure below.indexing’s low costs, broad diversification,minimal cash drag, and, for taxable investors, the Research conducted in the 1960s by Jensenpotential for tax efficiency. Combined, these (1968), Sharpe (1966) and Treynor (1965) foundfactors represent a significant hurdle that an active that, on average, active funds underperform theirmanager must overcome just to break even with a benchmarks on a risk-adjusted basis and that thelow-cost index strategy over time. magnitude of underperformance directly relates to the level of expenses.Some studies support the notion that active fundscan sometimes outperform passive funds in less This debate about Active and Passiveefficient markets over certain down market Management is of constant discussion amongperiods and sustained time horizons. individuals in the financial world. Thus, instead of trying to find the winner the fundamentalA research report by State Street Global Advisors approach should be to ask: “How can I make theand SPDR® ETFs for the 15-year period ended best decisions with respect to my goals andDecember 31, 2010 found that more than 50% of objectives?”Percent of Active Managers Outperforming Indices ~ 15-Year Annualized Fixed Income 15% Emerging Markets 42% International 65% Small Cap Blend 54% Small Cap Growth 59% Large Cap Blend 35% Large Cap Growth 43% 0% 10% 20% 30% 40% 50% 60% 70% Source: Morningstar Direct, SSgA Global ETF Strategy & Research as of 12/31/2010. © 2011 Bourbon Financial Management, LLC ~ All Rights Reserved ~ Info@bourbonfm.com ~ (+1) 312 909 6539 6
  14. 14. The decision to pursue passive or active management strategy should be decided based on understandingyour objectives by asking certain questions as shown in the figure below. Do you believe Do you believe that there are that markets are some managers generally who can inefficient? consistently beat the benchmark? How comfortable Do you believe are you with that you can find taking on active these skillfull risk? managers? YES ACTIVE MANAGEMENT © 2011 Bourbon Financial Management, LLC ~ All Rights Reserved ~ Info@bourbonfm.com ~ (+1) 312 909 6539 7
  15. 15. Passive strategies should be relied upon when your objectives, and understanding the factors likethe potential to beat the market is relatively poor taxes, fees and risk tolerance. The best investorand to minimize tax liabilities related to capital would be the one who can identify marketgains. segments which are not efficient and employ active strategies among those segments. InActive Strategies should be pursued in those addition, one must identify superior activemarkets which are less efficient and when you managers in asset classes where the manager has ahave high confidence. greater chance of outperforming.You should make a decision as to which is the (Source: Passive and Active Management , A Balanced Perspectivecorrect and advisable strategy after accounting for Thomas Guarini, ETF Strategies, Global ETF Strategy & Research, State Street Global Advisor)We just saw the strenuous procedure involved Picking the right mutual funds is not an easyinto opting for passive or active management. task. There are qualitative and quantitative factorsNow the active investor needs to create a universe that need to be understood observed and moreof Mutual Funds to choose from. Creating this importantly analyzed correctly.universe of funds involves tremendous skills in allaspects. The active investor needs to have goodanalytical as well as technical skills. Alsoimportant are qualitative aspects like goodnetworking skills and having knowledge ofbehavioral finance. Manager Due DiligenceIt is very important to perform diligence on the team changes every year. We would want thecompany and its management, to know whether same management for at least 10 years. Wethe management is engaged in costly litigation or need to evaluate how a manager has done in theis involved in finding innovative ideas for the long-term. Why?firm. Short-term performance is of little use in pickingThe performance of a mutual fund is largely a fund that you’re going to hold for the long term.driven by the manager and his/her team. Funds with the top trailing one- and three-year returns may continue well over the next shortInvestment style, people, philosophy and term period, but may fare poorly over the longperformance are all carefully reviewed in the term.manager search and selection process. How big is the team? We prefer firms with aThe fund’s manager tenure period is looked at. strong team of analysts.You would not want a fund whose manager and © 2011 Bourbon Financial Management, LLC ~ All Rights Reserved ~ Info@bourbonfm.com ~ (+1) 312 909 6539 8
  16. 16. How is the management team compensated? We expensive 20% of equity funds. (Source: Fund Spy byare more interested in private firms, where Russell Kinnell)managers receive ownership stakes in the firm. We review how managers performed in the past,We want funds with at least enough assets under during bull markets and bear markets. We likemanagement because this will generate enough downside protection. Once a manager’s pastrevenue to pay the salaries of good analysts and performance is understood, expectations can bekeep them for many years. set for future performance. These performanceWe like for managers to have skin in the expectations and an investor’s tolerance for riskgame. We look at a manager’s ownership in his should be explicitly discussed and accepted whenor her own fund and like to see ownership valued selecting a manager.at $500,000 or more. You wouldn’t like to see a Even after a manager is selected, constantCEO who doesn’t own any stock in his own monitoring and reviewing is a difficult task.company and for that reason we demand it in Unfortunately, ongoing manager review oftenfund managers. becomes an afterthought or is not even discussed.With regard to the fund’s portfolio, we want a low We review if a manager has closed a fund to newturnover because it gives a low tax impact. investors in the past and ask how they decide to close it in the future. Closing a fund means a fundWe want funds to have concentrated company is passing up fee income and hurting itsportfolios with fewer stocks. If the mutual fund own short-term profits in order to avoid lettingowns so many stocks, it may be better to just buy asset growth harm performance of the fund.the index which is cheaper. We pay managers totake risks. The managers selected should remain true to the style and asset class for which they are beingWhat is the investment strategy? Funds that rely selected. A large-cap growth manager should noton momentum strategies to buy hot stocks incur deviate drastically from his/her intended strategy.greater trading costs than those more contrarian Any change to the investment team should bestrategies that involve buying the stocks that immediately reviewed. Changes to senioreveryone is desperate to sell. Like Warren management or to the structure or ownership ofBuffett, we believe in buying stocks and the firm should also be evaluated with a criticalholding it for the long-term. eye as to their impact on the investment team’sWe prefer no-load mutual funds with low time, resources and capabilities.expenses for several reasons. First, it shows that amanager keeps business costs under control.There is a high correlation between costs andsurvivorship, as high-cost funds have a largeattrition rate. Second, fees reduce investor * People + Process + Philosophy = Performance *return. When the cheapest 20% of equity funds iscompared to the cheap index fund, it is twice aslikely to beat the index as compared to the most © 2011 Bourbon Financial Management, LLC ~ All Rights Reserved ~ Info@bourbonfm.com ~ (+1) 312 909 6539 9
  17. 17. Let’s Put Things in Perspective September 2011
  18. 18. Summary• This summer’s stock decline was nothing exceptional (only down8% in July/August)• The economy doesn’t look that bad• Equity valuations are O. K.• Equities tend to perform well over the long-term, sometimes rightafter a major correction and/or spike in volatility © 2011 Bourbon Financial Management, LLC 2
  19. 19. Details• U.S. Stocks have been going up in the long run and outperformed bonds most of the time over any 5-year periods• Historically stock market declines have been much worse: down 86% in 1929-32, 49% in 2001, 57% in 2007-09…• Other asset classes have seen much worse decline: • Long U.S. Treasury Bond real return was negative 67% between 1941 and 1981. • Gold was down 62% between 1980 and 1986 • Japan Stocks were down 82% between 1990 and 2009• Most declines have been followed by 5 years of gains• Nearly every significant up year for the markets had also a significant intra-year decline• When the volatility is high, markets often rise• U.S. Companies are in much better shape (profits, cash holdings, dividend payouts) than in 2000• The Yield curve is usually flat before recessions. It is far from flat now• When consumer sentiment bottoms, the following 12 months tend to be good for stocks. Extreme pessimism inconsumer confidence may be a bullish sign for the market• Moderate GDP Growth (2%-3%) has not been bad for stocks historically. But can we keep a 2%+ growth?• DIVERSIFICATION WORKS! © 2011 Bourbon Financial Management, LLC 3
  20. 20. U.S. Stock Market History: Volatile but Going Up © 2011 Bourbon Financial Management, LLC 4
  21. 21. Stocks Outperformed Bonds Most of 5-Year Periods © 2011 Bourbon Financial Management, LLC 5
  22. 22. Historical Markets Declines: We Have Seen Much Worse Trough=Bottom - As of Mid August 2011 © 2011 Bourbon Financial Management, LLC 6
  23. 23. Many Declines Have Been Followed by 5 Years of Gains © 2011 Bourbon Financial Management, LLC 7
  24. 24. Intra-Year Declines Happen Very Often © 2011 Bourbon Financial Management, LLC 8
  25. 25. When the Volatility is High, Markets Often Increase © 2011 Bourbon Financial Management, LLC 9
  26. 26. U.S. Companies Today vs. 2000 © 2011 Bourbon Financial Management, LLC 10
  27. 27. Slowdowns Do Not Mean Recessions All the Time © 2011 Bourbon Financial Management, LLC 11
  28. 28. Initial Job Claims Is Down: Usually, it is Up Before Recession Recessions are in Grey © 2011 Bourbon Financial Management, LLC 12
  29. 29. Yield Curve is Not Flat: Usually, it is Flat Before a Recession © 2011 Bourbon Financial Management, LLC 13
  30. 30. The Current P/E Ratio is Not High © 2011 Bourbon Financial Management, LLC 14
  31. 31. Consumer Sentiment Bottoms = Good 1-Year Stocks Returns © 2011 Bourbon Financial Management, LLC 15
  32. 32. Leading Indicators Index Does Not Yet Predict a Recession © 2011 Bourbon Financial Management, LLC 16
  33. 33. Moderate GDP Growth (2% - 3%) Has Not Been Bad for Stocks © 2011 Bourbon Financial Management, LLC 17
  34. 34. Cash Underperformed Historically Over 1-Year Periods © 2011 Bourbon Financial Management, LLC 18
  35. 35. Diversification Works• If you had a “All Cash Portfolio” between January 2008 to April 2011, your portfolioreturns would have been 0.2%.• If you had a “All Stock Portfolio” between January 2008 to April 2011, your portfolioreturns would have been 3.1%. Your portfolio would have been very volatile. Down 48%then up 20%.• If you had a “Diversified Portfolio” between January 2008 to April 2011, your portfolioreturns would have been 8.1%. © 2011 Bourbon Financial Management, LLC 19
  36. 36. Quote© 2011 Bourbon Financial Management, LLC 20
  37. 37. Disclosures• This material was prepared by BFM, Copyright by Bourbon Financial Management, LLC. All rights reserved. BFM is a trademark of Bourbon Financial Management, LLC. No part of this publication may be copied or distributed, transmitted, transcribed, stored in a retrieval system, transferred in any form or any means-electronic, mechanical, magnetic, manual, or otherwise-or disclose to third parties without the express written permission of Bourbon Financial Management, LLC, 616 W. Fulton #411, Chicago IL 60661. The information contained in this presentation is not written or intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek advice from your own tax or legal counsel. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. BFM assumes no responsibility for statements made in this publication including, but not limited to, typographical errors or omissions, or statements regarding legal, tax, securities, and financial matters. Qualified legal, tax, securities, and financial advisors should always be consulted before acting on any information concerning these fields.• All figures represent past performance and are not a guarantee of future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. The views expressed in this presentation are not intended to be a forecast of future events, a guarantee of future results or investment advice. The information contained herein has been prepared from sources believed to be reliable, but it is not guaranteed by Bourbon Financial Management, LLC as to its accuracy or completeness. Forecasts and predictions are inherently limited and should not be construed as a solicitation or recommendation or be used as the sole basis for any investment decision. All investments are subject to risk including the loss of principal.• The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. We believe the information obtained from third-party sources to be reliable, but neither Schwab nor its affiliates guarantee its accuracy, timeliness, or completeness. The views, opinions and estimates herein are as of the date of the material and are subject to change without notice at any time in reaction to shifting market conditions. Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance. Examples provided are for illustrative purposes only and not intended to be reflective of results you should expect to attain. © 2011 Bourbon Financial Management, LLC 21
  38. 38. Human Brain and Decision-MakingFactors behind Investor Choices August, 2011Dear Friends, In research conducted by Loewenstein & Kalyanaraman (1999), a group of people wereThe age old phrase: “You Reap What You Sow” asked to pick one movie (out of 24 titles) foremphasizes the fact that it is very important to the same night, one week later and two weeksmake the right choices now to reap the desired later. These movies were broadly classified intobenefits later. But making a choice is not always two segments:easy. Today’s world offers so many options ineverything that a simple decision--like ordering  Highbrow (e.g. Schindler’s List)from a menu at a new restaurant--becomes a  Lowbrow (e.g. Four Weddings and atime and effort consuming process. Funeral)Every available choice in a decision making About 66% of the group picked a lowbrowprocess offers a level of utility to us. Utility (or movie title to watch on the same night. Whileexpected utility) can be defined as the level of choosing a movie for next week, only 34%relative satisfaction that can be achieved from picked a lowbrow movie. When they werethe outcome (or expected outcome) of a asked to pick a movie to watch two weeks later,decision. 29% of the group chose from the lowbrow titles.There are many factors that can affect theutility associated with an option. But one of the The results indicate that people appear to havemain factors that affect the utility of an option a preference towards immediate rewards andis the time delay between making a decision discount the value of all delayed benefits.and receiving its outcome or benefit. Theresearch that we cover in this newsletter deals To get a clearer understanding of how theprecisely with how utility varies with time increase or decrease in time affects the utilitydifferences and how our brain makes decisions of a choice, let’s take a look at anotherbased on it. We first discuss some ground experiment by McClure, Ericson, Laibson,breaking experiments and results in decision- Loewenstein and Cohen, 2007.making, then we link those results to makinginvestment decisions and finally, based on theresearch, we suggest some best practices toimprove financial decision-making.‘Tonight I want to have fun; Next week Iwant things that are good for me’ © 2011 Bourbon Financial Management, LLC. All Rights Reserved. Info@bourbonfm.com. +1 312 909 6539. 1
  39. 39. The Effect of Time Delay on Decision b) The second observation was that short termMaking: discounting was greater than long term discounting. In other words, a delay of 5In this experiment a group of extremely thirsty minutes between now and receiving actualpeople, were presented with the choice of two benefit was a bigger factor in deterioratingoptions: the utility of a choice than the same One cup of orange juice immediately. difference 20 minutes into the future.* c) A choice that appears to be rewarding to Two cups of orange juice after 5 minutes. the brain may not necessarily be a result ofAlthough the common notion may be that a analytical thinking. It could also be a resultgreater quantity is preferable, the results of emotions. For example, the decision tostrikingly differed from this expectation.. About have a slice of chocolate cake instead of60% of the group chose to immediately have fruit salad, when following a low calorie dietjust one cup of orange juice. In this situation, is not a logical decision but is based onthe 5 minute time gap played a huge role in feelings of temptation.diminishing the utility of two cups of orange Another experiment quoted in research byjuice relative to just one cup--even though the Choi, Laibson, Madrian, Metrick (2002)quantity possible was plainly greater in the demonstrates a similar behavior where thesecond option. In another round of a similar subjects of the experiment do not make logicalexperiment, the thirsty subjects were given a choices even when it concerns their owndifferent set of options: savings. In a survey that was conducted One cup of orange juice after 20 minutes amongst 590 employees of a company, each Two cups of orange juice after 25 minutes. employee was asked the following two questions:When given the above set of choices,approximately 70% of the people chose the  Do they feel they are saving too little?second option. In this scenario the utility of  If yes, then would they raise their savingshigher quantity of juice was not diminished by a rate in the next 2 months?5 minute difference. Remarkable! Isn’t it? This 68% of all the 590 employees thought that theyexperiment helped establish the relationship were saving too little. Despite this initialbetween the delay in the reward and answer, of 590 people surveyed, only 24%discounting of its utility. There were two planned to raise their savings rate. After twoimportant observations from this experiment: months, administrative data on their savingsa) The first observation was that the human was collected to find out how many people brain discounts the utility of a delayed actually increased their savings. Surprisingly, reward. only 3 percent of all those who were surveyed, actually followed through on their thoughts. © 2011 Bourbon Financial Management, LLC. All Rights Reserved. Info@bourbonfm.com. +1 312 909 6539. 2
  40. 40. The result defied logic. Even though 68% of the are two separate neural systems in the brain,group felt their savings were low, only 3% took the Mesolimbic dopamine (M-D) system andmeasures to increase their savings. the Fronto-parietal (F-P) system.This behavioral phenomenon suggests that The M-D neural system was found to bedecision making by a human mind is affected involved with emotional activities and wasby many other factors and not just for more active when the subjects chose smalleranalytical reasons. and immediate rewards.*Ramsey (1930s), Strotz (1950s), & Herrnstein (1960s) were thefirst to understand that discount rates are higher in the short The F-P neural system was more active whenrun than in the long run. larger, delayed rewards were chosen which required analytical thinking.Decisions: Products of Analytical &Emotional Brains These two systems operate in conflict with each other. The brain then makes a decision based on the combined effect of the activity in these two systems For 14 female thirsty test subjects presented with delayed juice and water rewards, McClure, et al. observed neural activity which implied that brain areas produced a discount factor of 0.96/minute. Referring to our earlier example then, a discount rate of 0.9625 = 0.36; 0.9620 = 0.44; and 0.9605 = 0.82. (An 18% loss from the zero to 5th minute, versus a am 8% loss from the 20th to the 25th minute.) Perceived value declines steeply in the near term, but soon levels off to an analytical value. Or, in simpler words, all decisions, choices and actions are affected by both of these neural systems.Researchers are beginning to measure howpeople perceive time and discount value withfMRI scans. In a scientific study of human brainactivity (McClure, Laibson, Loewenstein, andCohen Science, 2004), it was found that there © 2011 Bourbon Financial Management, LLC. All Rights Reserved. Info@bourbonfm.com. +1 312 909 6539. 3
  41. 41. A question that may come to the mind at this principles like mean reversion, long termpoint is: How does all that scientific jazz relate investing and market efficiency have eitherto financial decision making? benefitted from such market movements or have been able to avoid major losses to theirWell, at BFM, we want our clients to be very investments.careful, patient, analytical and logical when itcomes to making important investmentdecisions.The recent times of economic slowdown andhighly volatile market activities have testedinvestors’ patience to a great extent. But amajority of those investors who believe inOur AdviceWe can point to some general practices that can help investors improve their investment decisionmaking: Thinking more analytically when making important financial decisions. Being pro-active, curious and non-assumptive at all times and spending time to evaluate Weigh your choices carefully! investments, possible risks and benefits. Continuously striving towards improving self- control and avoiding hastiness. “In the short run, the market is a Avoiding making any important investment voting machine. In the long run, decision while being in a passive state of mind. it’s a weighing machine.” – Creating a balance between being patient and Benjamin Graham being dynamic about investment choices. © 2011 Bourbon Financial Management, LLC. All Rights Reserved. Info@bourbonfm.com. +1 312 909 6539. 4
  42. 42. Challenges in Financial Advising From theScope of Behavioral Finance July, 2011Dear Friends,In today’s world, especially after the recent decisions but it could also lead to irrational orfinancial meltdown, understanding the human poor decisions, which could be a big issue ifemotions and sentiments before investing these are financial decisions.money is capturing interests of researchers and Reflective mind is the one which is slow,advisers. We too continue our long love with analytical and requires conscious effort. It leadsBehavioral Finance and present you some to more thoughtful and rational decisions.interesting findings by researchers in this area. Financial Adviser’s role is to understand theBefore we discuss the topics in detail here is a reflective mind of clients and help them tobrief introduction on Behavioral Finance. reduce the mistakes caused by intuitive mind.‘Behavioral Finance combines thepsychological characteristics with traditional Investor Paralysis:finance principles in evaluating an investment. The psychological fallout of the ‘08-‘09 financialBehavioral finance focuses on the cognitive crisis was very profound. Huge amounts of cashand emotional aspects of the investment were left idle for a long time as investorsdecision-making process.’ thought that the market was still bearish.At the start we discuss Intuitive and Reflective Financial Advisers themselves can become aminds. Following up are discussions on Investor subject to this behavior known as InvestorParalysis, Lack of Investor Discipline and Loss of Paralysis.Trust by Shlomo Benartzi, Ph.D, UCLA AndersonSchool of Management and some otherresearchers. We conclude by providing someinteresting solutions to overcome the 3mentioned behavioral finance challenges andwhy they should be understood by financialadvisers and clients. A solution to Investor Paralysis is ‘Invest MoreIntuitive and Reflective Minds: Tomorrow’ program which relies on overcoming loss aversion and procrastination.Intuitive mind is the one which forms quickjudgment with great ease, less effort and withno conscious input. Often it can lead to wise © 2011 Bourbon Financial Management, LLC. All Rights Reserved. Info@bourbonfm.com. +1 312 909 6539. 5
  43. 43. Lack of Investor Discipline: affected if the national team loses a big trophy (Source:Edmans et al., 2007) .From years it has been noted that investors buyhigh and sell low. They also often buy the Thus we see that investors lack discipline inwrong stocks, sell the wrong stocks and, in making sound investment choices and havenormal times, do far too much buying and their emotions, peers and intuitive mind takeselling. A winning stock offers the opportunity decisions. The challenge for behavioral financeto sell, and lock in a gain and hence the is to find ways to help people not go with theinvestors do so to experience the pleasure of crowd, and not be susceptible to the errors ofthat gain. This is a positive investing episode. A the intuitive mind. We discuss later the Ulysseslosing stock involves the prospect of incurring a Strategy as a recommended solution.loss. Investors hold on to such stocks in anattempt to avoid a negative investing episode(Source: Barberis, Xiong, 2010). This is not because Regaining and Maintaining Trust:people are stupid, they are just humans. Apart from Investor Paralysis, the recentA study of 66,465 individual investors over a financial meltdown has also had a huge impactsix-year period in the United States found that on the bond of trust between financial advisersthe average investor turned over 75 percent of and their clients. According to a survey byhis/her portfolio each year. Due to transaction Chicago Booth/Kellogg School Financial Trustcosts associated net performance was reduced Index, at the beginning of 2009 only 34 percentby 3.7%. (Source: Barber and Odean, 2000; Daniel et al., of Americans expressed trust in financial1998). institutions. Thus rebuilding trust is of top priority for financial advisors & institutions, even if their strategies did not lead directly to clients’ losses (Gounaris and Prout, 2009). The bruised psychological state of investors has been likened to the feelings of betrayalPeople buy stocks on a simple rule of thumb, or following the discovery of a partner’s affair.heuristic: Follow the news i.e. Buy the stocks if Demonstrating empathy and competence is thethe company is in news. This is the intuitive key to regain and maintain the trust.mind taking the easy way to making a choice,but the reflective mind might reject the choicewanting a more rational decision. Stockmarkets often move in response to manyfactors unrelated to true value. For example asoccer mania country’s stock market gets © 2011 Bourbon Financial Management, LLC. All Rights Reserved. Info@bourbonfm.com. +1 312 909 6539. 6
  44. 44. Researchers’ advice and what we at BFM strive to practice!1) A potential solution to Investor Paralysis can be solved using ‘Invest More Tomorrow’ Strategy. Thisstrategy works on the lines of ‘Save More Tomorrow (SMarT)’ program. There are two parts to theInvest More Tomorrow strategy: first, overcoming the fear of seeing the value of the portfolio decline,or loss aversion; and second, overcoming the strong tendency to put off until tomorrow what oneshould be doing today, or procrastination.Overcoming Loss Aversion: Instead of investing all the cash at one go in the market, the investor caninvest periodically. The advantage here is that if market falls, the investor sees an opportunity to buycheap with the next purchase. In other words we can say intuitive mind does not react negativelybecause the reflective mind turns the downfall into an opportunity.Overcoming Procrastination: ‘SMarT’ worked by asking people to commit to increase theircontribution/saving rate in advance. In a similar way, Invest More Tomorrow involves clients to pre-commit going into the market in the future at a specific time chosen by the investor themselves. Pre-commitment is the important psychological element here as it results into a question of what to buy atthat point rather than whether to buy at that point.We can summarize the Invest More Tomorrow into the following 3 steps: 1 • Clients should pre- commit to invest at a certain future time and date. • Work with clients to 2 agree on the size & frequency of periodic investments. 3 • Decide in advance on nature of assets to be purchased. (Source: Shlomo Benartzi, Ph.D, Chief Behavioral Economist, Allianz Global Investors) © 2011 Bourbon Financial Management, LLC. All Rights Reserved. 7
  45. 45. 2) To overcome Lack of investor discipline one solution is The Ulysses Strategy. The phrase “Ulyssescontract” refers to a decision made in the present to bind oneself to a particular course of action in thefuture.In this strategy the clients are advised to engage their reflective mind to pre-commit to a rationalinvestment strategy. Pre-commitment to a rational investment plan is important; otherwise theintuitive mind might trigger irrational investment responses later when market conditions tempt themto follow the herd. Also a memorandum is signed. This memorandum is not binding, in the sense of alegal contract but it helps clients to stick with the plan when changes in market conditions tempt themto go with the herd. • Help clients 1 understand the impulsive nature of investment decisions. 2 • Discuss what action would be taken when, for example: index 30% down. 3 • Sign a commitment memorandum, with both client and advisors. (Source: Shlomo Benartzi, Ph.D, Chief Behavioral Economist, Allianz Global Investors)3) A 2010 Golin/Harris survey revealed that the most effective action to restore broken trust is to be“open and honest.” To regain or maintain trust demonstrating competence and empathy is important.When performance exceeds expectations, it is human tendency to proclaim full credit but duringdownfall the tendency is to blame luck and other external factors. However, this is unwise to do.Admitting luck at the good times portrays honesty to the shareholders. Warren Buffet himself is astudent of this belief. © 2011 Bourbon Financial Management, LLC. All Rights Reserved. 8
  46. 46. Talk about the downside before presenting the upside. By talking about the downside first, thefinancial advisor is displaying honesty that generates a greater willingness in the listener to trust whatis then said about the upside.Apart from making investment decisions for clients putting value on the human side of business hasbeen described as “relational intelligence”.Clients portray embarrassment i.e. even if they do not understand a strategy perfectly they will notadmit it openly. So instead of asking questions like: “Is there anything about our strategy you don’tunderstand one should ask “Is there anything about our strategy that I can clarify? Competence • Admit Luck. • Discuss downside before upside. Empathy • Have frequent contact with clients, especially in difficult times. • Allay embarrassment. • Seek feedback. Source: Shlomo Benartzi, Ph.D, Chief Behavioral Economist, Allianz Global Investors)Overall we advice that pre-committing to a strategy reaps future benefits. A good analogy for the discussion canbe with someone who wants to start going to the gym but keeps delaying: “I’ll start that exercise program nextweek, I promise! But it never happens. So do not make the same mistake with your investments!We at BFM understand investors look beyond financial advice and we are here to give you a whole newinvestment experience! © 2011 Bourbon Financial Management, LLC. All Rights Reserved. 9
  47. 47. Countries and Culture in Behavioral FinanceA cumulative overview June, 2011Dear Friends,Recently, the subject of Behavioral Finance has been of intense research for finance professionals.Contrary to the traditional principles of finance (risk and return), investors combine their psychologicalcharacteristics with finance principles in evaluating an investment.Every individual has his or her own opinions, interests, dislikes etc. But when researched deeply, it hasbeen understood that the surroundings and culture of the investor also play a decisive role in his or herbehavior.Behavioral finance focuses on the cognitive and emotional aspects of the investment decision-makingprocess. Although we can say that people are built mentally and physically the same everywhere, thecollective set of common experiences that people of the same culture share have will influence theirinvestment decisions. Thus, different cultures and countries show different behavior towardsinvestment decisions.We first discuss briefly different cultures with some real life incidents and surveys, and then wedescribe the difference in propensity for risk tolerance among countries and cultures and howindividualistic-collectivistic line affects the risk tolerance. In the end we give a brief summary aboutIslamic Finance which shows us how a culture affects investment decisions.Difference in CulturesIncident 1:Meir Statman, Professor at Santa Clara University experienced this incident when he came to the USfrom Israel to pursue a PhD at Columbia University. While sitting in a train Meir overheard aconversation: “I told my daughter that I would support her through college but she is on her ownafterward.” Meir was astonished. The culture in Israel was one in which parents continue to supporttheir children even after college and sometimes also after marriage. (Source: Countries and Cultures inBehavioral Finance, Meir Statman)Incident 2:A British National went to Saudi Arabia to work not aware of the cultural differences between thecountries. On his arrival the British Embassy handed him a guide which said “Sentences for alcoholoffences range from a few weeks or months imprisonment for consumption to several years for © 2011 Bourbon Financial Management, LLC. All Rights Reserved. 10

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