A A I C A , F C R , S E T Y S S J . O E i n L A E C H C M I C U N S R U T a L OO WR - L R DE UASTNIOND UGA TB CPREHIEHSIREAKFV VOMEI ROAMMRNAAAARLN GKFCIEENEMT AENNCTE O W Success in a Low-Return World Michael J. Oyster Success in a Low- Return World Using Risk Management and Behavioral Finance to Achieve Market Outperformance Michael J. Oyster Chief Investment Strategist Cincinnati, OH, USA ISBN 978-3-319-99854-1 ISBN 978-3-319-99855-8 (eBook) https://doi.org/10.1007/978-3-319-99855-8 Library of Congress Control Number: 2018960925 © The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Switzerland AG, part of Springer Nature 2018 This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, express or implied, with respect to the material contained herein or for any errors or omissions that may have been made. The publisher remains neutral with regard to jurisdictional claims in published maps and institutional affiliations. Cover image © anyaberkut/ iStock/ Getty Images Plus Cover design by Akihiro Nakayama Edited by Catherine Lennon Author portrait: Peggy Joseph Photography This Palgrave Macmillan imprint is published by the registered company Springer Nature Switzerland AG The registered company address is: Gewerbestrasse 11, 6330 Cham, Switzerland For Catherine Preface In 1999, I was a brash, 29-year-old know-it-all investment analyst. I remem- ber remarking to my CIO, at the time Chris Meyer, that it was interesting to think that never again in our lifetimes would we see the index value of the Dow Jones Industrial Average (DJIA) below 10,000. The stock market was on a tear and I was caught up in the excitement of the dot-com boom. Chris, who had then, and retains today, a galvanized understanding of investment history, knew such bravado was foolhardy and tamped down my enthusiasm. I brushed it off as a guy just being a Debbie downer (he is anything but). Not only was Chris correct in his skepticism, he was doubly so. Within three years, the DJIA had dropped to below 7300. Then after moving back above 10,000 and pressing close to 15,000 a few years later, it crashed again falling to the unimaginably low level of 6547 on March 9, 2009. Boy was I wrong. The best lessons are those hardest learned. From that expe- rience and others like it, I learned that human emotion and natural cognitive biases can inhibit the quality of investment decisions. To this day, my friend Chris brings up my late 1990s misplaced optimism about once every three times we get together. He probably thinks about it every time but mercifully keeps it to himself 67 percent of the time. I owe him a debt of gratitude. For 19 years, I was part of an organization known as FEG Investment Advisors, serving as an investment consultant and provider of outsourced investment solutions. I studied markets and the economy and met with/con- ducted in-depth research on hundreds of different investment managers. Prior to FEG, I spent five years with options-advisory firm Schaeffer’s Investment Research, where I conducted quantitative analysis on options and volatility metrics while managing a number of proprietary investment products. The combination of those experiences provides me with a unique vantage point vii viii Preface from which to view the world of investing. I’ve seen a lot of investment strate- gies that work well, some that are truly unique and differentiated. I’ve seen others that provide nothing worth paying for. I’ve seen some investment strat- egies blow up in spectacular fashion and I’ve even seen a few frauds. Covering the entire spectrum of the investment universe, studying the history of mar- kets and economies, and doing so with a background in derivatives gives me a distinct perspective on the past, present, and likely future of investing. I don’t have all the answers, but I do know that if events were to unfold in a way that provided investors with the same US stock market returns in the future that had been enjoyed in the near decade following the end of the Great Financial Crisis (GFC), it would be truly monumental and highly unexpected. Far more likely is a lower-return world, maybe not like the lost decade following the end of the dot-com bubble where the US stock market failed to break even, but perhaps positive returns that don’t keep up with the long-term averages of 11 percent or so. With an objective view, we should expect 5 to 7 percent. We start out with a treatment of what actually makes up a stock market’s performance number. Looking at the components that sum to total return, a healthy dose of skepticism is necessary. We then spend time looking at stock pickers, the common philosophy shared by many, and the vast challenges they face. This is not meant to suggest that stock-picking active managers are mis- taken in what they do, rather to shed light on how challenging their world has become in recent years. And it is becoming even more so. Most of the discussion in this book is localized to the large capitalization subset of the US stock market. I will grant that stock picking and security selection in general stands a better chance of adding value in less efficient marketplaces such as micro caps and frontier markets. But considering the astronomical amount of money that remains in large-cap US stock-picking funds, despite the surge of assets flowing out of them into passive index funds, it’s a discussion worth having. Interspersed throughout this work is the concept of behavioral finance, the idea that psychology can help identify how and when ingrained human instincts can inhibit decision-making. Chapter 6 takes a deep dive into cogni- tive biases featuring a really smart categorization scheme from Buster Benson. You will also notice that I frequently cite academic research to support a point. I am a person who needs evidence and can be more comfortable enter- ing the dark unknown that follows an investment decision when I am holding the hand of a demonstrated bit of statistical significance. This is why Chap. 9: Intuition (of Part II: Solutions) is so important and will provide somewhat of an interlude in financial theory between the first and second half of the book. The chapter includes a discussion of intuition, more specifically, the use of Preface ix practical intuition and how gut feel can help with decision-making written by my wife, Catherine Lennon. Intuition can provide guidance beyond that which can be found in the data alone. Investors who are able to draw upon it in a positive way give themselves an additional tool and improve their chances of outperforming. While fees and regulations make the stock picker’s job all the more difficult, I wouldn’t simply suggest that your only recourse as an investor is to buy an index fund and cheerfully accept the market’s return less a fee. We can do bet- ter than that. That’s not to say indexing is a bad idea; it has shown to outper- form the average active manager. We will spend some time on that. Additionally, outperforming the stock market isn’t the only way to add value in a low-return world. There are some interesting big picture asset allocation ideas worth discussing as well as how applying the concept of momentum can help with subcategory asset-allocation decisions. And there are others. Opportunities to outperform are available and are perhaps more numerous than you think. Private equity, high active share stock picking, and smart beta, all offer the potential for outperformance. We will spend some time with each. Among the concluding points is a statement to which I assign a staunch belief—the Volatility Risk Premium, the persistent overpricing of options, stands as the most significant, untapped investment resource available today. What that is and how it can be monetized are a big part of later chapters, with a conclusion focused on portable alpha—a terrific strategy shunned by many investors who were burned by its misuse, but one worthy of our attention in the future as we seek opportunities to outperform in what stands to be a low- return world. Thank you for reading. I hope the time doing so is productive and enjoyable. Michael Acknowledgments I feel tremendously grateful for the opportunity to acknowledge the people who mean so much to me and have meant so much to this project. First and foremost, my wife Catherine. Your love, support, and encourage- ment to write this book helped make it happen and your contributions to it are co-author worthy. You stepped in and applied your attention to detail and expert editing skill, significantly improving the quality of the work. The insight you provided for Chap. 9 on intuition added tremendous value and differentiation while contributing meaningfully to the investment narrative. I would also like to thank my mentor and friend, Chris Meyer. Your stal- wart commitment to the established fundamentals of investing continues to inspire. Thank you also to Price Headley and Bernie Schaeffer who opened the world of options and derivatives for me, as well as the Cboe’s wealth of knowledge, Matt Moran. A big thank you to the many smart and dedicated professionals at FEG Investment Advisors including but certainly not limited to Greg Dowling, Alan Lenahan, Greg Houser, Mike O’Connor, Dan Regan, Gary Price, Andy Boedecker, Nolan Bean, Tony Festa, Keith Berlin, Christian Busken, Devinne Kelly, Matt Schwier, Mark Koenig, Phil Scherrer, Mike Aluise, Brian Hooper, Jere Whiteley, Brad Derflinger, and Scott Stumpf. Thank you to the many educators and researchers for your insight and work having either guided me, inspired me, or both including Eugene Fama, Ken French, Myron Scholes, Burton Malkiel, Mark Carhart, Rob Arnott, Cliff Asness, Roni Israelov, Toby Moskowitz, Robert Shiller, Jeremy Siegel, Daniel Kahneman, Richard Thaler, and last but certainly not least, my high school math teacher, Fred Feichter, who taught me the importance of critical thinking. xi xii Acknowledgments To my children and stepchildren, Zach, Nick, Lucas, and Makena, thank you for being the amazing individuals each of you are! To my parents, Jim and Betty Oyster, thank you for love and guidance in both word and deed. Thank you to my siblings, Brian Oyster, Greg Oyster, and Erin Keller and their fami- lies and to my many friends including Charles Conour, Mike Muse, and most notably Clint Hines, thank you for your sage advice and can-do attitude.