May 28, 2021

The Signals & Media Noise: Part 2

By Michael McKeown, CFA, CPA - Chief Investment Officer

The Signals & Media Noise: Part 2

We know that the stories in financial media are not helpful for long-term investing.  Yet these impact investor behavior.

Hyping up past performance ignites the animal spirits to chase assets. Scary headlines bring fear of further losses at the wrong times.

Let’s discuss the signals that actually work.

First, investors need to understand the game they are playing. For most, it is achieving an objective of his or her choice.  This could be funding retirement, education, or philanthropic goals. These can be applied across asset classes to varying degrees.

What asset mix is on the menu to fulfill those goals? The stalwarts are stocks, bonds, and real estate.  Now we can slice these up into sub-categories, but that’s unnecessary at this point.

What proportion of each of the assets meets the long-term return and risk goals? We cannot have one without the other.

Realizing there will always be narratives around a booming industry or asset class is necessary.

Remember pipeline a few years ago? It was a “can’t miss” investment. Energy prices were high. These companies were just a tollbooth collector for oil and gas.  But those investors that put 5% to 10% of their portfolios into pipelines were taking a very active bet, about 50 to 100 times the exposure of its relative market value.  That means people were very confident of their ability to forecast the outperformance.

The problem was in the price. Expectations were high and the stocks never hit the growth embedded in the price.  Energy prices collapsed.  It ended in large underperformance and most investors giving up on this theme.

The following are signals are for the more hands-on investor.

Valuation – The price you pay matters. At the end of the day, investing is simple. You are trading your capital today for a future stream of returns (either dividends or price appreciation).  This works across stocks, bonds, and real estate. Paying a high price relative to the past means lower expected returns, on average. Buying cheaply means a higher expected return on average.

It gets tricky when there are no cash flows, as with art, commodities, or cryptocurrencies. Is there a perceived value that is sustainable over the long-term? Or is there a better way to manage the risk of these positions?

Momentum – Objects in motion tend to stay in motion until another force acts upon them.  Meaning outperforming assets, both on an absolute and relative basis, tend to continue outperforming in the short-term. If taking this approach, strong risk management must be in place.  This could mean reversing course quickly if the momentum changes.

Investor Positioning / Sentiment / Market Structure – Understanding some of the more technical aspects of an asset class or security is important. What flows have gone into the asset relative to the past? How do investors currently feel about the investment? What structural forces are acting on the asset class, be it regulatory, leverage, or other factors?

These signals are inputs to an investment process. Looking at each alone or in a vacuum may lead to incorrect interpretation. An ensemble approach helps to form a more holistic view.

Knowing who you are as an investor is important.  If making an investment outside of the benchmark, there must be an edge.  What is the edge? Informational? Process? Time horizon? If there is no edge, being at market weight (in line with index or overall value) should be the default, assuming this asset fits within the long-term financial plan.

There will always be stories in the financial news. Deciding what to pay attention to is as important as anything else. In the end, the investor’s investment process will be the determining factor in long-term results.

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