The Investment Scientist

Archive for August 2007

During this correction, the Russell 2000 Value Index tumbled 16.88% based on intra-day data. Comparatively, the peak-to-trough draw-down for the Russell 2000 Growth Index is 12.97%, for Nasdaq 100 12.38% and for S&P 500 11.91%.

This is quite usual! There are a few well-established effects in the stock market. Among them are the Small Cap Premium Effect and the Value Premium Effect. In plain English, small cap stocks outperform large cap stocks, and value stocks outperform growth stocks, in aggregate and over the long run. In the case of the Value Premium Effect, this is not due to risk. Lekonishok, Shleifer and Vishny in one of their researches, investigated how different types of stocks performed during the 25 worst months over the last 30 years. They found overall, value stocks held their value better than growth stocks. During this correction however, this pattern was broken. Why small cap value stocks fell so much, even more than small cap growth stocks? Is it an aberration? or does it portend something new academic researchers have not yet discovered?

I believe there are two reasons to small cap stocks falling more in this correction: exposure to financial sector and hedge fund liquidation.

This correction started with the news that two Bear Sterns hedge funds investing in CDOs (Collateralized Debt Obligations) and CMOs (Collateralized Mortgage Obligations) suffered severe losses and had to shutdown. That sudden event helped focus the market’s attention on that fact that subprime mortgage delinquency has jumped more than 100% in the past year. The market decided to punish all financial stocks, regardless of their subprime exposure. The value sector is over-weighted with financial stocks, mostly small community banks. For instance, 30% of the Russell 2000 Value Index made up of financial stocks. As the result, the Russell 2000 Value Index fell more than the Russell 2000 Growth Index.

The news that three BNP Paribus hedge funds also had to shutdown must have caused a run in hedge fund money that persist to this day. Overnight, Nikkei dropped more than 5% and in the previous night the South Korean Kospi dropped 7%. They do not have any subprime exposure, why punish them? Alas, hedge funds are unwinding their positions everywhere.

The run in hedge funds hit a specific type of funds called quantitative funds as well. The two Goldman hedge funds who got a $3 billion dollar bailout from Goldman Sachs belong to this type. They use long-short strategies to capture the Small Cap Premium Effect and the Value Premium Effect. The long portfolios tend be small cap and value stocks and the short portfolios tend to be large cap and growth stocks. According to a Wall Street Journal report, the two Goldman hedge funds are leveraged up to 6x. Goldman’s Global Equity Opportunities Fund had $5 billion in capital, with 6x leverage, they had $30 billion to play with. To unwind their positions, they were forced to sell their longs and buy back their shorts. With billions of dollar of selling from Goldman’s hedge funds alone, and unknown billions from other quantitative hedge funds, small cap value stocks were hit very hard.

I believe the effect of this sequence of events is transitory and small cap value investing remains fundamentally sound.

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I am an amateur pilot. I remember vividly an episode happened during one of my training classes a few years ago.

That was a very windy day. Up to that point, I had only experience flying in calm weather. As soon as my Cessna took off, I immediately felt the difference. My plane was tugged and pulled in all directions by cross winds. I felt like I was losing control of the plane, and fear swelled up from the bottom of my spine to the top of my head. I sat stiffen in the pilot seat and my sweaty palms grabbed tightly at the control handles like a sinking person grabbing onto a straw.

My trainer sensed my tenseness and she asked: “Are you OK?”. Not willing to acknowledge my fear, I asked her instead: “Is it more dangerous to fly in turbulent weather like this?” The trainer smiled and said: “It is not more dangerous to fly in turbulent weather. The plan was built to withstand any turbulences. But occasionally, an amateur pilot would lose his cool and do something stupid. That’s the real danger.”

The instruction given to me by my trainer is equally valid for investors who are piloting through this turbulent stock market. If you are like all other investors, you would be caught up by fear and anxiety. What should you do? Should you dump stocks and move to bonds? Should you abandon the small cap value style of investing? Should you rotate to “quality” (an euphemism for large cap growth stocks)? If you turn on the TV or open a newspaper, you would be bombarded with advices to do some or all of the above. My recommendation is to do nothing and just stay the course. Anything you do at this time are more likely out of fear than out of reason. If you allow yourself to be driven by fear (and greed), then it is truly to your detriment.

Paraphrasing my pilot trainer, the turbulent market is not more dangerous. Don’t lose your cool and do something stupid. (You can start by stopping listening to the cacophony of market punditry.)

market tumble and fear

On July 17th, the S&P 500 reached its peak after breaking a string of records. In a two week time however, both the S&P 500 and the Nasdaq Composite have lost 7.7%. The index that represents smaller stocks suffered a bigger loss of more than 10%. Are you feeling any pain and anxiety? I know I am.

Before I talk about how I deal with the pain and anxiety arising out of the market tumble, I’d like to first talk about the Equity Premium Puzzle and the Myopic Loss Aversion. These are weighty academic terms, but they would help us understand our psychology and how it could drive us to do stupid things.

Let’s suppose that John Doe has a 10 year investment horizon. He has $100k to invest. Should he invest in treasury bonds yielding 5% a year or in a S&P 500 index fund with long term average return of about 11%? If the money is invested in treasury bonds, 10 years later, John Doe will have $163k for sure unless the US government goes bankrupt. If the money is invested in the S&P 500 index, then John Doe can expect to have $284k. However, this is not sure money. He could end up with more or he could end up with less. The volatility of the S&P 500 is about 15% a year, so with 95% probability, John Doe’s money will be between $189k and $379k. There is a less than 2% probability that investing in treasury bonds will yield more in 10 years. If John Doe is rational, he should invest his money in a S&P 500 index fund.

What economists found out however is that the average John Does in America invest more of their money in treasury bond type fixed income securities. The economists call this the Equity Premium Puzzle, which can loosely be translated into “why on earth would any rational person look past the much better stock return to invest in bonds?”

The term Equity Premium Puzzle was coined in 1985. In 2002, psychologist Daniel Kahneman won the Nobel Prize in economics for his Prospect Theory which was developed decades earlier. Prospect Theory is a theory of how humans perceive gains and losses and how human decisions are driven by these perceptions. What Kahneman found was that the pain from losses is much stronger than the joy from gains of the same magnitude. For instance, when a baby is born, no doubt it is a joyful moment for the parents; but when a baby dies, the anguish felt by the parents is much stronger than the joy of birth. For another example, if you make $1000 in the stock market, you will be happy and excited; if you subsequently lose $1000, you will feel worse.

In 1995, Shlomo Benartzi and Richar Thaler used the Prospect Theory to explain the Equity Premium Puzzle. Here is my interpretation of their work. Regardless of his investment horizon, John Doe’s perception is instantaneous. An immediate gain in the stock market (which may not last) will elicit instantaneous joy and an immediate loss (which may not persist) will elicit instantaneous pain that is stronger than the joy. John Doe may be aware that over the long run, he will be ahead with stocks, but that long run result is unlikely to be in his mind. What is likely in his mind is the fear of the pain of losses he might suffer today or tomorrow. This fear is called Myopic Loss Aversion and it drives our investment decisions. For instance in the last two weeks, the 10 year treasury yield has dropped to 4.75% and blue chip stocks have fallen less than the broader market. These are evidences that people are rotating into bonds and blue chips out of the fear.

Do we want our investment decisions to be driven by fear? How do we harness the fear and even turn it to our advantage? Warren Buffet once said:” Be greedy when others are fearful, and fearful when others are greedy.” Daniel Kahneman also suggested that we looked at our investments quarterly instead of monthly. It would serve us well remembering their wisdom.


Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.


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