Over the last 20 years, the market has returned an average of 11% annually. The "average" investor however, only enjoys 4.5% per year.* At this rate, individual investors are barely outpacing inflation (which is around 3% over the same time period). Why are so many investors failing to take full advantage of the opportunities the market affords them? The root of this problem is investment behavior (also known as the psychology of investing). In fact, studies have shown that emotionally driven investor behavior has a bigger impact on investment success than the actual performance of the market. To understand why, let's take a look at the Cycle of Market Emotions.
*Source: 2008 Dalbar Quantitive Analysis of Investor Behavior Report
The Upturn
• Optimism—The average investor enters the market feeling optimistic (Point 1). They may also have high expectations for the returns they will experience.
• Excitement—When the market goes up, the expectations start to become a reality and the investor experiences excitement (Point 2).
• Thrill—The market continues up and the investor is thrilled (Point 3).
• Euphoria—As the market reaches its peak, the investor is euphoric and quite confident that the market will continue up (Point 4).
By the time the investor reaches the point of Maximum Financial Risk, they should be extremely cautious. Instead the investor ignores the reality of the inevitable downturn and feels very over-confident, thinking "Prices keep going up. I can't lose!" Often, they will throw more money into the market or switch to more aggressive strategies, in an effort to chase higher returns. These are emotional decisions driven by greed. But as history has shown time and time again, no bull run lasts forever. And so begins the negative emotions that accompany a downturn in the market cycle.
The Downturn
• Anxiety—The market begins to dip, generating feelings of anxiety (Point 5).
• Denial—The market continues to fall, and the investor goes through denial with such thoughts as "It's ok, I'm in it for the long run," and "This is just a temporary setback," (Point 6).
• Desperation and Panic—As the market cycles lower still, feelings of desperation and panic ensue (Points 7 and 8, respectively).
• Surrender—Panic eventually gives way to surrender, when the investor thinks "How could I have been so wrong? I just can't handle being in the market any longer. I can't take any more losses," (Point 9).
Ironically, at this juncture the market is just one step away from the point of Maximum Financial Opportunity. This is the best time to invest, while buying power is at its highest. Unfortunately it is also the point where the emotional investor succumbs to fear and throws in the towel, abandoning the market entirely.
There are three major negatives that occur hot on the heels of this emotion-based decision: One, it makes paper losses real (and usually quite significant). Two, the investor is now on the sidelines when they should be investing. And three, because the investor is out of the market (waiting to regain the confidence to reinvest), they generally miss out on the first 1/3 of the next bull market. Historically, the first third of the bull market accounts for 60% of the total performance of that bull trend.
The Bottom and the Recovery
• Depression—While the investor wallows in depression (point 10), the market hits bottom and gives way to a new bull.
• Hope—As the market continues to strengthen, the investor is hopeful that the market will continue up (Point 11).
• Relief—Once the market confirms it is in an uptrend, the investor feels relief, but they are still not confident enough to invest (Point 12).
• Optimism—The investor waits until they feel optimistic again (Point 1 or often much later) before re-entering the market. As we described above, this usually doesn't happen until they have already missed a large portion of the up move, and their chance to recoup losses with it.
The market cycle has now come full-circle, ending right back where it began. And the cycle will repeat itself over and over. It is no surprise that average investors underperform the market when emotions weigh so heavily on their investment decisions. And the investor will keep making the same mistakes again and again (which by the way, is a variation on the definition of insanity, i.e., "doing the same thing over and over again and expecting different results"). But one can't be a successful investor without remaining invested. The key is to learn how to keep emotions in check.
At Niemann, we believe the best way to achieve investment success is to take the emotion out of investing. As we've just seen, there will be times during a downturn when your emotions shout, "Get out of the market!" At these times it is tantalizingly easy to make significant investment mistakes, but that's exactly when—with your advisor's help and support—you need to resist the temptation to abandon the market. Our history shows the best way to be a successful investor is to stay disciplined, stay invested, and stick to the plan that you and your advisor have crafted. Our process is designed to help you do just that. All we ask is that you give us the time to prove our process.
Past performance does not guarantee future results.
*Source: 2008 Dalbar Quantitive Analysis of Investor Behavior Report
Perception vs. Reality
The Upturn
• Optimism—The average investor enters the market feeling optimistic (Point 1). They may also have high expectations for the returns they will experience.
• Excitement—When the market goes up, the expectations start to become a reality and the investor experiences excitement (Point 2).
• Thrill—The market continues up and the investor is thrilled (Point 3).
• Euphoria—As the market reaches its peak, the investor is euphoric and quite confident that the market will continue up (Point 4).
By the time the investor reaches the point of Maximum Financial Risk, they should be extremely cautious. Instead the investor ignores the reality of the inevitable downturn and feels very over-confident, thinking "Prices keep going up. I can't lose!" Often, they will throw more money into the market or switch to more aggressive strategies, in an effort to chase higher returns. These are emotional decisions driven by greed. But as history has shown time and time again, no bull run lasts forever. And so begins the negative emotions that accompany a downturn in the market cycle.
The Downturn
• Anxiety—The market begins to dip, generating feelings of anxiety (Point 5).
• Denial—The market continues to fall, and the investor goes through denial with such thoughts as "It's ok, I'm in it for the long run," and "This is just a temporary setback," (Point 6).
• Desperation and Panic—As the market cycles lower still, feelings of desperation and panic ensue (Points 7 and 8, respectively).
• Surrender—Panic eventually gives way to surrender, when the investor thinks "How could I have been so wrong? I just can't handle being in the market any longer. I can't take any more losses," (Point 9).
Ironically, at this juncture the market is just one step away from the point of Maximum Financial Opportunity. This is the best time to invest, while buying power is at its highest. Unfortunately it is also the point where the emotional investor succumbs to fear and throws in the towel, abandoning the market entirely.
There are three major negatives that occur hot on the heels of this emotion-based decision: One, it makes paper losses real (and usually quite significant). Two, the investor is now on the sidelines when they should be investing. And three, because the investor is out of the market (waiting to regain the confidence to reinvest), they generally miss out on the first 1/3 of the next bull market. Historically, the first third of the bull market accounts for 60% of the total performance of that bull trend.
The Bottom and the Recovery
• Depression—While the investor wallows in depression (point 10), the market hits bottom and gives way to a new bull.
• Hope—As the market continues to strengthen, the investor is hopeful that the market will continue up (Point 11).
• Relief—Once the market confirms it is in an uptrend, the investor feels relief, but they are still not confident enough to invest (Point 12).
• Optimism—The investor waits until they feel optimistic again (Point 1 or often much later) before re-entering the market. As we described above, this usually doesn't happen until they have already missed a large portion of the up move, and their chance to recoup losses with it.
The market cycle has now come full-circle, ending right back where it began. And the cycle will repeat itself over and over. It is no surprise that average investors underperform the market when emotions weigh so heavily on their investment decisions. And the investor will keep making the same mistakes again and again (which by the way, is a variation on the definition of insanity, i.e., "doing the same thing over and over again and expecting different results"). But one can't be a successful investor without remaining invested. The key is to learn how to keep emotions in check.
Escaping the Vicious Cycle
At Niemann, we believe the best way to achieve investment success is to take the emotion out of investing. As we've just seen, there will be times during a downturn when your emotions shout, "Get out of the market!" At these times it is tantalizingly easy to make significant investment mistakes, but that's exactly when—with your advisor's help and support—you need to resist the temptation to abandon the market. Our history shows the best way to be a successful investor is to stay disciplined, stay invested, and stick to the plan that you and your advisor have crafted. Our process is designed to help you do just that. All we ask is that you give us the time to prove our process.
Past performance does not guarantee future results.
No single industry group, investment style, or approach to the market can remain in favor forever.
No single industry group, investment style, or approach to the market can remain in favor forever. At some point, every investment methodology will under-perform its benchmarks.
To validate this concept, examine the market indices listed below, and the periods of time when various approaches proved successful.
For a better understanding of theme rotation in the market see:
Understanding the Rotation of Themes.
To validate this concept, examine the market indices listed below, and the periods of time when various approaches proved successful.
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S&P 500—1995 thru September 1998. Large, diversified, growth oriented strategies dominate. Anyone looking for undervalued companies or specializing in small stocks lags badly. Cash puts a huge drag on any portfolio.
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NASDAQ—October 1998 thru March 2000. Growth strategies take completely over. Technology is the dominant sector. Anything with a value emphasis badly underperforms. Cash continues to be an anchor.
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Russell 2000—April 2000 thru 2002. Strategies uncovering smaller, undervalued companies begin to emerge as the premier performers. Growth is out of favor, and technology is shot and left for dead. Cash is the safe haven of choice as the preservation of an investor's capital becomes more important than the potential return on that capital.
The examples illustrate a demand for the ability to move your money from one theme to another in order to achieve long-term success. And that's why Niemann has adopted and perfected its style of active porfolio management.
For a better understanding of theme rotation in the market see:
Understanding the Rotation of Themes.
The Rotation of Themes Chart (sometimes called a Callan Chart after its creator) illustrates the performance of the equity markets over a 20 year period.Each column represents a calendar year and shows, in descending order from top to bottom, the best performing investment category to the worst performing category.
Each category represents a specific style, theme or sector (i.e., Large Cap, Small Cap, Growth or Value). The category listed at the top of each column, therefore, generated the most return that year. Those at the bottom of the chart either returned the least or lost the most. In other words, certain styles or themes prevailed that year, while others did not.
Advisors employ this chart to illustrate one key point in support of active management: The themes are constantly rotating. No one theme performs at the top of the market, year after year.
As an active money manager, Niemann Capital Management has the flexibility to follow the rotation of themes and position assets to take advantage of leadership and avoid the laggards.
We believe this gives our clients the greatest opportunity for success.
Why is Niemann so focused on preserving capital above all else? Just take a look at "The mathematics of a declining asset base."
Let's say you've just invested $100,000. What's the real impact on your portfolio if you:
That's why a key element of our process is to keep your losses recoverable—to avoid catastrophic loss.
Let's say you've just invested $100,000. What's the real impact on your portfolio if you:
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Lose 25% of your investment? You now have $75,000 remaining. That means you'll need to earn a 33% return on the remaining $75,000 to get back to your original $100,000.
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Lose 50% of your investment? You now have $50,000. That means you'll need to earn a 100% return on the remaining $50,000 to get back to your original $100,000.
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Lose 80% of your investment? You now have just $20,000. Unfortunately, that means you'll need to earn a 400% return on the remaining $20,000 to get back your original $100,000.
Perhaps more chilling than the return needed to come back from a sizable loss is the time it takes to do so. Using 11% as the average return on stocks over the last 75 years, it would take just short of 7 years to recoup a 50% loss of capital. And remember, that's just to break even - to recoup your original investment!That's why a key element of our process is to keep your losses recoverable—to avoid catastrophic loss.
A Case Study of Niemann's Risk-Managed Strategy in the
year 2000
Niemann's approach to active portfolio management is particularly beneficial to investors during a market downturn. This process is the essence of active management: identifying, confirming and acting on emerging investment themes as they occur.
By reviewing the year quarter by quarter, you can easily see the steps Niemann took to rotate assets away from weakening themes, and into strengthening themes.
Situation: The year 2000 marked a global rotation from growth to value funds, from large cap to small cap, as the tech bull market of the '90s morphed into the bear market of the new century.
To illustrate the Niemann process at work during actual market conditions, we've chosen the period of Q4 '99 through Q4 '00. This year proved to be a turbulent time for the stock market, and the allocation changes we made in each quarter were in direct response to significant market trends
We ended 1999 primarily in cash, to control risk. Yet we also held a position in small cap growth—the lone sector of the market that was healthy. While conservative, we were in position to respond.
During Q1 '00, our analytics indicated that we should begin rotating from growth funds into value funds. The focus on value remained strong throughout the next three months.
In June, growth mutual funds performed better, so we added growth to the portfolio. From July through the end of the year, we maintained our focus on rotating away from weakness toward strength. Clearly, small and mid caps were the dominant themes at work.
By the end of September '00, large caps rebounded a bit as reflected by our expanded position in large value. Our allocation to cash continued to shrink as we committed more assets to the market.
Value funds played a larger role within the portfolio as we approached the end of 2000. By continuing to rotate throughout the year, we were able to consistently reallocate investor assets to those sectors of the market showing the most strength and the best opportunities for profit.
The Scorecard:
In 2000, the Russell 2000 dropped 4.2%. The Dow Jones fell 6.18%. The S&P was down 8.89%. And the Nasdaq Composite plummeted 39.29%.
By contrast, Niemann's Risk-Managed Mutual Fund Strategy ended the year up 20.50%.
