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Education Library

January Behavioral Vulnerabilities

Inside This Issue
2010
1 Behavioral Vulnerabilities
2 Mistake #1: Bear Markets
3 Mistake #2: Risk Myopia
4 Mistake #3: Precision vs.
Accuracy
5 Mistake #4: Fees vs. Value
Modern Portfolio Theory contends that investors are rational, dispassionate,
and understand the odds. Fifty years of financial evidence and behavioral
research contradicts this theory. Behavioral Economics is a relatively new
discipline that attempts to define the way investors actually make choices.
Researchers have repeatedly found that investors regularly violate the basic
rules of rational decision making - to their detriment.
Image 1: Behavioral Vulnerabilities

Butler|Philbrick &
Associates
Source: Butler|Philbrick & Associates
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Tel: 1 (866) 358-2783

Fax: (416) 941-6729 It is important to recognize these weaknesses, as they are the primary
www.ButlerPhilbrick.com barrier to your financial independence. Unless properly managed, these
vulnerabilities may compel you to sell winning stocks too early or hold on to
Adam Butler CFA, CAIA,
AIF losing stocks too long. We do this to avoid the pain and shame of lost
Director, Private Client opportunity or realized losses. Your biases may drive you to focus on near-
Associate Portfolio term portfolio returns, and to lose sight of your long-term objectives. They
Manager may cause you to question your investment strategy at precisely the wrong
Tel: (416) 941-6742
Email:
moment. Overall, these vulnerabilities have been demonstrated to cause
adam@butlerphilbrick.com investors to dramatically underperform the markets over time.

Michael Philbrick CIM, AIF Research firm Dalbar Inc. studied the returns to mutual-fund investors from
Director, Private Client
Associate Portfolio 1989 through 2008. They discovered that, due to small investors’
Manager susceptibility to behavioral vulnerabilities, investors’ actual returns
Branch Manager dramatically lagged the market. Balanced investors grew their savings at
Tel: (416) 941-6703 1.67% while the market delivered balanced returns of 7.98% over this time
horizon. For perspective, a $100,000 investment in the S&P would have
yielded $464,372 over this 20 year period while retail investors turned
The opinions expressed in this report are the opinions of the author and readers should not assume they reflect the opinions or recommendations of
Richardson GMP Limited or its affiliates. Assumptions, opinions and estimates constitute our judgment as of the date of this material and are subject to
change without notice. We do not warrant the completeness or accuracy of this material, and it should not be relied upon as such. Before acting on any
recommendation, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Past
performance is not indicative of future results.
Richardson GMP Limited is a member of CIPF. Richardson is a trade-mark of James Richardson & Sons, Limited. GMP is a registered trade-mark of GMP
Securities L.P. Both used under license by Richardson GMP Limited.
 PAGE 2 Butler | Philbrick & Associates
Acting CFOs for Canadian Healthcare Professionals and their
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Chart 1: Behavioral Vulnerabilities Caused Small Investors to Underperform

Source: Dalbar Inc., Butler|Philbrick & Associates

Most small investors also fail to realize that they bring advantages to investing that can offset many
of their disadvantages. For example, small investors can have nimble portfolios that respond quickly
to changes in market signals. They can take substantial positions in smaller companies without
incurring the market impact and liquidity costs that large investors bear. Further, small investors
can change strategies to adapt to changing market conditions, focusing on growth companies,
commodities, real-estate, emerging markets, etc. as warranted.

Image 2: Small investors have unique advantages.

Source: Butler|Philbrick & Associates

Now that we have discussed some of the behavioral challenges that investors face, and discussed
some of the unique advantages that small investors possess, we will discuss the four common
mistakes that you, as a healthcare professional, risk making. The impact of these missteps may
seem small in the near-term, but they have the potential to delay or derail your dreams of financial
 PAGE 3 Butler | Philbrick & Associates
Acting CFOs for Canadian Healthcare Professionals and their
Families

Mistake #1
: Bear Markets are Unavoidable
Around the turn of each year, the top investment journals organize a roundtable of the top
investment strategists and gather their opinions about what markets are likely to do over the next
12 months. In December 2007, top financial paper Barron’s gathered 12 of the top investment
strategists from the world’s biggest investment firms and asked them a simple question: “Where
will the S&P 500 index be at the end of 2008?”

The average of the estimates offered by this panel of experts was a level of 1650. Estimates
ranged from a high of 1750 to a low of 1525. The index actually closed at 903 on December 31,
2008, representing a 45% discount to the average analysts’ estimate. Table 1 summarizes the
grisly results.

Ironically, the National Bureau of Economic Research identified December 2007 as the month in
which the current recession began – the very month strategists delivered their upbeat projections.

Table 1: Barron’s Round Table Results, Dec. 2007

Predicted
Strategist Firm
S&P Level
Merrill Lynch (B
Richard Bernstein 1525
of A)
Thomas Lee J.P. Morgan 1590
Bank of
Tom McManus 1625
America
Lehman
Ian Scott 1630
Brothers
Larry Adam Deutsche Bank 1640
Abhijit Chakrabortti Morgan Stanley 1650
Jonathon Morton Credit Suisse 1650
Abby Cohen Goldman Sachs 1675
Tobias Levkovich Citigroup 1675
David Bianco UBS Securities 1700
Jonathon Golub Bear Stearns 1700
Francois Trahan ISI Group 1750
Average 1650
Actual Close 903.25

A recent study by James Montier of Societe Generale suggests that stock strategists at Wall
Street’s biggest banks -- including Citigroup Inc., MorganStanley and Goldman Sachs Group Inc. --
have failed to predict returns for the Standard & Poor’s 500 Index every year this decade except
2005. Their forecasts were wrong by an average of 18 percentage points, according to data
compiled by Bloomberg.

If the most highly regarded economists and market strategists cannot predict bear markets, then
how can small investors hope to avoid them? The answer lies in a relatively simple strategy that
large investors cannot utilize. Large institutional investors embrace ‘buy and hold’ out of
necessity. A large pension plan managing billions of dollars in assets takes many weeks to enter
and exit positions without substantially moving the markets. For this reason, they are forced to
stay the course regardless of current market conditions. However, by leveraging some of the
small-investor advantages discussed above (Image 2), we have an opportunity to deliver long-
term returns that outperform pure stock portfolios, and with a fraction of the risk.

Our strategy leverages disciplines from large, successful endowments like Yale University.
 PAGE 4 Butler | Philbrick & Associates
Acting CFOs for Canadian Healthcare Professionals and their
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We have borrowed from endowments to construct our asset allocation. Aside from investing in
conventional asset categories like domestic stocks, U.S. stocks, foreign stocks and domestic bonds,
our strategy includes allocations to alternative strategies, as well as commodities, and global real-
estate. As shown in Image 3, the asset allocation is then broken down further.

Image 3: Overall portfolio allocations are subdivided into ‘Buy and Hold’ and ‘Tactical’
buckets.

Source: Butler|Philbrick &

Associates

Our tactical model is applied to the trade-able asset classes (domestic and foreign stocks,
commodities and global real-estate). Bonds and alternative strategies are considered ‘Buy and
Hold’ allocations, with alternative managers subject to regular reviews.

Our Tactical Asset Allocation strategy uses techniques described in Jeremy Siegel’s investment
bible, “Stocks for the Long Run”. These techniques have been further refined by Mebane Faber at
Cambria Investment Management, Doug Short at Dshort.com, Tom Forest, Wilcox and Crittendon
from Blackstar Funds, and our own team using data from Robert Shiller and Computerized Portfolio
Management Service (CPMS).
Table 1: Annual Chart 2: Performance of Tactical Strategy and U.S. Stocks
Return 1973 - 2008

Source: A Quantitative Approach to Tactical Asset Allocation, Mebane T. Faber, February 2009, Working Paper Update.
Gary Shiller, Yale, 2009, Butler|Philbrick & Associates
 PAGE 5 Butler | Philbrick & Associates
Acting CFOs for Canadian Healthcare Professionals and their
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Note that the timing, or tactical, strategy tracks the performance of U.S. stocks fairly closely, but it
eliminates the major negative years. This results in a much more predictable return path,
characterized by the tight return distribution seen below in Chart 3. The predictable returns
generated by this strategy make it ideal for financial planning purposes for reasons discussed below
(see Chart 8 [red line] and Chart 9). By combining a quantitative stock-picking strategy with our
Tactical strategy, we can provide even better returns over time (Chart 4).
Chart 3: Tactical system achieves a more predictable (narrow)
range of returns.

Source: A Quantitative Approach to Tactical Asset Allocation, Mebane T. Faber, February 2009, Working Paper Update.
Gary Shiller, Yale, 2009, Butler|Philbrick & Associates

Chart 4: Combining our evidence-based trading systems our market timing

system has the potential to deliver more growth with greater predictability.

Source: Computerized Portfolio Management Solutions (CPMS), Butler|Philbrick & Associates

 PAGE 6 Butler | Philbrick & Associates
Acting CFOs for Canadian Healthcare Professionals and their
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Mistake #2: Focusing on short-term instead of long-
term risks.
In this digital age, where investors can access near real-time snapshots of their portfolios over the
internet at any time of the day or night, investors can’t help but focus on the month-to-month or,
worse, day-to-day gyrations in the value of their investments. What few investors realize is that the
more often they check their portfolios, the worse they will sleep at night.

If anxiety is measured as a function of portfolio volatility, then anxiety can be plotted against
portfolio observation frequency as in Chart 5 below. An investor should question why they are
paying their advisor to watch their portfolio if they intend to manage the pressure of daily
observations themselves.

Chart 5: Investor anxiety depends on the frequency of observation.

Source: Bulter|Philbrick & Associates

This focus on short-term portfolio performance obfuscates the true risks to your portfolio: inflation
and longevity. In fact, over your investment horizon of 15 years or more, your likelihood of
regretting your allocation to equities over cash in the bank is very small, as demonstrated in Chart
6.

Chart 6: Probability that cash outperforms stocks over various time horizons.

Source: Moshe Milevsky, Butler|Philbrick & Associates

 PAGE 7 Butler | Philbrick & Associates
Acting CFOs for Canadian Healthcare Professionals and their
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Of far greater importance to most investors is the risk that their portfolio will not support their
lifestyle goals over the long term because of inflation. As shown below in Chart 7, inflation
reduces the value of each dollar of income over time; and the impact of even small levels of
inflation over long periods can devastate your retirement dreams unless steps are taken to
offset it. For example, if one assumes a 4% inflation rate going forward, $100,000 of income in
year 1 buys just $70,000 worth of goods in year 10, and $40,000 worth of goods in year 25.

Chart 7: Purchasing power of income erodes over time due to inflation.

Source: Butler|Philbrick & Associates

Another long-term risk that investors often overlook is the variability of lifespan. Fortunately,
insurance companies have done copious research on this subject. If you are a 60 year old male
non-smoker, for example, you have a Median Remaining Lifespan (MRL) of 20.36 years using the
most recent actuarial tables. A woman of the same age is most likely to live another 23.53
years. The range of probable life spans around these median ages is highly predictable, so we
can factor this information into your financial plan.

Source: Butler|Philbrick & Associates

If your current plan is modeled on a specific lifespan estimate, say 85 years, instead of a lifespan
range, your plan does not effectively manage your longevity risk. If you live too long, you may
run out of money. If you die much earlier than expected, you may have sacrificed your lifestyle
unnecessarily. Further, you may be able to provide information that would alter your MRL.
Maybe your grandparents and parents had longer life spans, so you are genetically more likely
to live longer. A good financial plan will optimize your saving and spending against your personal
lifespan range to minimize the risks of sacrificing too much, or saving too little.
 PAGE 8 Butler | Philbrick & Associates
Acting CFOs for Canadian Healthcare Professionals and their
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In summary, investors tend to focus on recent portfolio performance while losing sight of longer-
term risks and objectives because they are vulnerable to behavioral biases like ‘myopic loss
aversion’ and ‘availability error’. This focus on short-term losses often compels investors to alter
their strategy at the wrong time, making them susceptible to longer-term risks. Once you have
placed your savings with a competent advisor, in a proven strategy you believe in, you would be
wise to ignore the day-to-day value of your portfolio and stick to it – no matter what.

Mistake #3:Mistaking precision for accuracy

Most financial plans have many flaws, but perhaps their most critical, yet least discussed, flaw
involves sacrificing the accuracy of the plan for a high degree of precision. This requires some
explanation.

You may recall early science classes where you learned the difference between accuracy and
precision. A useful analogy involves arrows shot at a target. If a person aims for the bulls-eye and
hits it, she is accurate. If a person shoots many arrows at the target which all land close together,
she is precise. However, if the many arrows are clustered near the edge of the target instead of in
the middle, the person is not very accurate.

In the same way, traditional financial plans provide a lot of very precise information. For example,
your plan may assume a long-term investment return of 8.61% based on the historical returns that
resulted from a similar portfolio over the past 20 years. This is very precise. Or as discussed above,
your plan may assume a lifespan of exactly 85 years. Is it realistic to think that most people will live
exactly 85 years? You may think that this precision is useful. However, you will see that it can be
quite dangerous.

We discussed longevity risk in the previous section, so we will focus instead on the risk of using
absurdly precise return expectations. This danger results from the variability in the path of
investment returns. In your experience, do portfolios actually yield 8.61% returns every single year?
Your financial plan assumes that they do. This assumption has a dramatic impact on the results of
your plan, as illustrated in Chart 8 below.

Chart 8: Normal market return paths render traditional financial plans obsolete.

Source: Robert Shiller, Mebane Faber, Moshe Milevsky, Butler|Philbrick & Associates
 PAGE 9 Butler | Philbrick & Associates
Acting CFOs for Canadian Healthcare Professionals and their
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Chart 8 tracks the value of a $1 million portfolio over time under various market conditions. For now,
please focus on the blue, purple and orange lines. The blue line represents a traditional financial plan
with a consistent return every year, the plan your current Investment Advisor uses. The purple line
represents the experience of a person who retired in 1973 and passed away recently, and who
invested his retirement portfolio entirely in U.S. stocks. The orange line represents the theoretical
experience of a retiree who also invested his entire portfolio entirely in U.S. stocks, but who retired
recently and experienced the last 25 years of stock market returns in reverse. Importantly, each of
these lines assumes an average return of 10.98%, which is the return on U.S. stocks over the time
period in question. Further, each person withdrew $78,334 per year (adjusted for inflation at 4%),
which is the amount the traditional plan would have suggested as a safe income rate based on its
model.

How can three people with identical life spans; who each retired on their 60th birthday; who each
received the same 10.98% average annual returns, and; who each extracted the same (inflation
adjusted) amount every year, have such dramatically different experiences? The man with constant
10.98% returns under the traditional plan emptied his portfolio on his deathbed. The man who
invested in U.S. stocks was left with a $3,418,934 estate for his family and charities. In contrast, the
man who invested in U.S. stocks but experienced the returns in reverse order ran out of money in his
8th year of retirement!

Clearly the disparity between these outcomes is unacceptable from a planning perspective.
Unfortunately, few financial planners or Advisors understand how to account for the wide range of
potential investment return paths that you may experience over your investment horizon. Our unique
optimization process and proprietary investment system achieves both accuracy and precision. We
call this powerful combination The Gestalt Architecture. The predictability of returns and reduction
in the likelihood of large losses that results, coupled with the robust returns to our strategy, have a
dramatic effect on our clients’ sustainable retirement income, as illustrated in Chart 9.

Chart 9: Our Tactical Asset Allocation System May Substantially Improve Your Retirement
Lifestyle

Source: Faber (2009), Shiller (2009), Milevsky (2005), Butler|Philbrick &

Associates.
Results are pro-forma and are for illustrative purposes only.
 PAGE 10 Butler | Philbrick & Associates
Acting CFOs for Canadian Healthcare Professionals and their
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In order to account for the variability of potential investment return paths, lifespan, and inflation
rates, we have introduced a ‘Confidence Interval’. The Confidence Interval describes the likelihood
of achieving your lifestyle goals while preserving your desired estate. By applying this method, you
are able to tailor your plan to fit your personal priorities. For example, you may be willing to work a
little longer to maintain a higher income level in retirement. Or you may be comfortable with a
slightly lower Confidence Interval to maintain a better lifestyle early in your retirement. Your
priorities drive your ‘Financial Sweet Spot’, which drives your personal plan.

Source: Butler|Philbrick & Associates

Mistake #4:Focusing on fees rather than value

Fees are perhaps the most frequently discussed, and least well understood, factor in financial
product marketing. Financial organizations that serve professional groups often focus on low fees
to obscure the fact that the organizations are understaffed, under qualified, and deliver poor
service. The simple fact is that, in your quest for financial independence, you get what you pay for.

Unfortunately, high fees do not necessarily result in superior service or investment performance.
You are, however, unlikely to receive superior service or performance for low fees. Investment
advisors who rely on low fees to capture and keep clients are often new advisors in the early
stages of building their businesses, or; advisors who focus on client volume instead of client
quality, or; advisors who do not offer differentiated value. Highly qualified professionals that
deliver differentiated value to their clients are confident charging a reasonable fee for their
services. Often one timely call to point out a tax-saving opportunity can pay for multiples of your
annual fee.

One caveat to this rule is that you must believe in the value of active investment management.
You must believe that the manager(s) you choose to invest with can add value, either by delivering
market returns with lower risk, or by delivering above-market returns at similar risk. One could be
forgiven for believing that active management does not consistently add value. Chart 10 illustrates
that large-capitalization Canadian equity mutual fund managers show very little performance
 PAGE 11 Butler | Philbrick & Associates
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Chart 10: Probability that top rated managers rank in the top half of managers
after 4 years.

Source: Gene Hochachka, February 2008.

2002008;200http://ssrn.com/abstract=1094246

On this basis, a legitimate strategy for skeptical investors is simple indexing. This is a low-cost
strategy which involves purchasing a diversified basket of broad-market Exchange-Traded Funds
and holding them forever, with periodic rebalancing. As demonstrated above (Chart 5), a buy and
hold strategy that emphasizes a diversified basket of equities is almost certain to outperform cash
in the bank over long periods. However, investors are vulnerable to behavioral biases that will make
it hard for them to stick with this strategy over the long-term. Further, the unpredictable path of
returns may have a substantial negative impact on your ability to achieve, or maintain, financial
independence.

Fortunately, there is substantial evidence supporting investment manager performance persistence

outside of main-stream equity mutual funds. This ability to consistently deliver better risk-adjusted
returns over long periods appears to be the result of three qualities which differentiate non-
traditional managers from traditional mutual-fund managers:

1. A systematic approach with very little qualitative interference based on manager ‘intuition’

2. A rigorous strategy for risk management

3. An ability to move quickly and decisively between a wide variety of asset classes, such as
stocks, commodities, REITS, bonds and cash.

Some of the largest, most successful university endowment funds, such as those of Yale and
Harvard, have large portions of their portfolios allocated to these types of managers. Endowments
have complex objectives that are similar to those of many professionals in retirement. The following
is a quote from the President of Yale University’s highly successful endowment program:

Effective management of a university endowment requires balancing fundamentally

competing objectives. On the one hand, the University requires immediate proceeds to
support the current generation of scholars. On the other hand, investment managers must
consider the needs of generations to come. The Endowment must be safeguarded so that it
 PAGE 12 Butler | Philbrick & Associates
Acting CFOs for Canadian Healthcare Professionals and their
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Your retirement may not go on ‘forever’, but in the investment domain a time horizon of 25 years or
more is very close to ‘forever’. Retirees need immediate annual income to support their lifestyle, but
they also must preserve most of their capital to support future income needs and potential gifts to
children, charities, etc.

As of their most recent annual reports, Yale had allocated just 25% of their capital to traditional buy
and hold equity strategies while allocating 55% of their portfolio to non-traditional managers, such
as hedge funds, and alternative assets like commodities and foreign real-estate. Harvard’s
allocations are substantially the same.

Many of these non-traditional managers charge hefty fees, but deliver remarkable long-term
performance. For example, Jim Simons’ Renaissance Medallion Fund charges 5% management fees
and a 44% (!!) performance fee. Despite these burdensome costs, Medallion has consistently
returned 35% per year in performance after deducting all fees. Unfortunately, this fund has been
closed to new investors since 1993. MAN Group’s AHL Diversified Fund (See Chart 11) has been
open to new investors since its inception in 1990. This fund has returned 16.8% per year for
Chart 11: MAN AHL Performance Comparison vs stocks and bonds.

Source: MAN Group

In summary, it makes eminent sense to pay higher fees if you receive differentiated value. This
value may be delivered in terms of superior service, robust financial planning and estate
management solutions, a specialized focus on the needs of your professional demographic, or a
superior investment strategy. The logical focus should be on achieving the maximum degree of
financial independence after all fees have been paid.