Here is our latest market commentary from RGA Investment Advisors, taking a look at the psychology of markets trading at all-time highs. This is an interesting moment, for it is the first time in my professional investment career that markets are in fact at highs. This is our attempt to put things into perspective:

The Market at an All-Time High

Last month, we pointed out the significance of all the major market indices (sans the NASDAQ) surging to record highs. April was an interesting month in a very different way. While the major indices digested their gains, there was absolute carnage in the commodity space. Most notably, gold, the safe-haven of choice for investors over these last few tumultuous years, shed 7.57% on the month. In one day alone, gold lost 9.6% of its value. Many continue to blame the decline in gold on some sinister plot or dismiss it as a warning sign for the broader economy. We think these explanations are far more indicative of the “religion” around gold as an asset, than it is of something meaningful for the economy; we discussed this in our February 2013 Investment Commentary. To that end, we attribute the decline in gold to two important forces: 1) gold’s failure as a safe-haven during the worst of the Euro crisis, during which the price actually declined; and, 2) the market’s continued resilience at all-time high levels. Today, we would like to focus on this second point and what it means for the broader investment environment.

First, a necessary digression: we are pleased to say this is the first time in the history of RGA Investment Advisors with the U.S. stock market in milestone, record high territory. This company was founded amidst the biggest financial crisis since the Great Depression and we take pride in how we have navigated through what even the most experienced sages of market wisdom declare as one of the least forgiving, most challenging investment environments ever. We promise both to you and ourselves that these years will serve as an important lesson in patience, strategy and humility, for we all know that while today the market giveth, it can just as easily taketh away.

We are self-reflexive at this moment because we think it’s important to be cognizant of the many emotions induced by the market over time. Further, we constantly want to learn more about how and why the market does what it does from a behavioral perspective, and to that end, have studied the great thinkers in that arena. One particularly intriguing school of thought is Prospect Theory, which we have introduced in commentaries past. Investopedia defines prospect theory as “A theory that people value gains and losses differently and, as such, will base decisions on perceived gains rather than perceived losses. Thus, if a person were given two equal choices, one expressed in terms of possible gains and the other in possible losses, people would choose the former.”[1] To that end, it is the study of how people make probabilistic decisions when there is a degree of both risk and reward, and it holds that people are more sensitive to losses than they are to gains. In other words, the pain from losses leaves a more profound impact on the human psyche than the pleasure derived from gains. This idea was introduced by Daniel Kahneman and Amos Tversky in 1979 in a paper entitled Prospect Theory: An Analysis of Decision Under Risk[2] and has been expanded upon ever since.

A corollary of Prospect Theory is an idea known as “the disposition effect.” This idea holds that people sell stocks that have gone up far quicker than stocks that have gone down. The disposition effect is closely tied to the concept of “myopic loss aversion” covered in our January 2013 commentary. Why are these ideas relevant today? Interestingly, the disposition effect has particularly strong consequences with markets in all-time high territory, and we feel it is important to review them in light of today’s investment environment. Since people sell gains quicker than they do losses, there is a greater propensity for selling above all-time highs than below. Therefore, when markets are at all-time highs, selling pressure tends to increase, leading to greater portfolio turnover in Bull than Bear markets.[3]

Drawing this out further is the important idea that loss aversion does not exist in a vacuum, and as such, there is a reflexive relationship between the success (or lack thereof) of prior decisions and the nature of present and future decisions to be made. For the typical investor, “after prior gains, he becomes less loss averse.”[4] In other words, people are most risk-seeking after periods of success and most risk-averse after periods of failure. Meanwhile, prudence would dictate practicing the converse. This pendulum of risk tolerance fluctuates back and forth dependent on the most recent market action. Collectively, these ideas relate to another concept we have long discussed—the notion that people fear a crisis most in its aftermath, rather than its inception. It is thus no surprise that some of the biggest doomsayers in today’s press are those who were caught most off-guard by the crisis in 2007-2009.

So where do we stand today on this sliding scale of risk aversion? We think it remains clear that investors have been severely impacted by the recent crisis. Investors are so risk averse in today’s environment, that in aggregate, they would rather flee into the perceived safety and certainty of returns in bond markets, while simultaneously ignoring longer-term bond market risks and foregoing a more reasonable tradeoff between risk and reward in equity markets. Despite markets making all-time highs, there remains a healthy skepticism, and even anger, at the very fact this is happening amidst what remains an economy performing closer to trough than peak levels.

As always, we continue to make our decisions based on our sensitivity to price in each and every individual investment that we make, though we are equally cognizant of the sentiment towards risk and reward around us. When markets are making highs, so many want to be “the one who called the market top” yet we can assure you of only this—on the way up there will be many tops before there is THE top, and it is our belief that through prudent bottoms-up fundamental analysis and disciplined asset allocation we will best insulate ourselves from the type of risks that were borne out in 2007-09.

Past performance is not necessarily indicative of future results. The views expressed above are those of RGA Investment Advisors LLC (RGA). These views are subject to change at any time based on market and other conditions, and RGA disclaims any responsibility to update such views. Past performance is no guarantee of future results. No forecasts can be guaranteed. These views may not be relied upon as investment advice. The investment process may change over time. The characteristics set forth above are intended as a general illustration of some of the criteria the team considers in selecting securities for the portfolio. Not all investments meet such criteria. In the event that a recommendation for the purchase or sale of any security is presented herein, RGA shall furnish to any person upon request a tabular presentation of: (i) The total number of shares or other units of the security held by RGA or its investment adviser representatives for its own account or for the account of officers, directors, trustees, partners or affiliates of RGA or for discretionary accounts of RGA or its investment adviser representatives, as maintained for clients. (ii) The price or price range at which the securities listed in item (i) were purchased. (iii) The date or range of dates during which the securities listed in response to item (i) were purchased.

[1] http://www.investopedia.com/terms/p/prospecttheory.asp

[2] http://www.jstor.org/discover/10.2307/1914185?uid=3739808&uid=2&uid=4&uid=3739256&sid=21102235131477

[3] Notes from Nicholas Barberis at Sante Fe Institute’s Risk: The Human Factor conference. /compounding-the-blog/?currentPage=2

[4] http://forum.johnson.cornell.edu/faculty/huang/prospect.pdf

It's official, I'm Managing Director at RGA Investment Advisors! Here's our first commentary with some of my input, be sure to check it out:

RGA 2011 in Review and a Top Down Plan for 2012

For years many professionals in finance have been touting the benefits of diversification, however there remains a long-standing debate about how best to pursue the objective—should investors have a concentrated yet diverse portfolio, a diverse portfolio, or should they just index and buy as broadly as possible? 2011 was a year in which we saw all kinds of problems with the pursuit of diversification and it highlights exactly how and why we like to approach this problem a little differently. First, the important math. The theoretical reason behind diversification is to eliminate single-stock risk to the point where a problem with one portfolio company or holding does not overly infect the entirety of the portfolio. Joel Greenblatt, a Columbia University professor, hedge fund manager and author did some interesting work to quantify this factor of risk. Owning two stocks eliminates 46% of the risk associated with individual stocks, eight stocks eliminates 81% of the risk, sixteen stocks eliminates 93%, and thirty-two stocks eliminates 96% of the risk. In order to mitigate 99% of the single-stock risk one most own 500 holdings. The clear point here is that mathematically speaking, the benefits to diversification continually diminish when the portfolio holds more than sixteen total stocks.

Why do we bring this up now? Well in 2011, correlations were as high as they ever were. In other words, every stock, and just about every asset class moved in the exact same direction. This implies that what was a risk to one stock, was also a risk to another. While in aggregate that statement appears to be true, it’s not entirely true. Directionally, stocks moved consistently in tandem, but in terms of magnitude of the move, there were vast differences. Plenty of stocks finished the year up nicely, while others finished the year down badly. Many diversified portfolios took substantial hits and the key factor lies in how diversification had been pursued.

Simply diversifying holdings is not enough. Importantly, 2011 highlighted the fact that people need to diversify their correlations. That means that investors must expose their portfolios to as many different catalysts as possible. It means buying quality companies in a variety of sectors, with a variety of strengths and weaknesses, which should overlap as little as possible in aggregate. Some might say, well why not just index then and achieve ultimate diversification? And that question, while a legitimate one, further confirms the initial point. An overly broad, diversified portfolio is exposed to nothing other than just economic growth. Without economic growth it’s nearly impossible for the market in aggregate to move higher, but that’s not entirely true for a well-selected, diversified basket of stocks, bonds and cash that are rebalanced tactically with layered and stratified correlations.

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