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Brent G. Schutte, CFA, CFP®Market Strategist

Vice President(312) 461-3192

Current Market Update

Psst…It is Almost February…Remember those New Year’s Promises

As the holidays drift further into the past and the promise of a new year turns into the reality of the present, it is helpful to remind ourselves of the goals that we made as the clock struck midnight on December 31st. For most of us these New Year’s “pledges” include a dose of healthier living and a heavy helping of increased financial well-being. While I would love to be able to claim expertise in healthy living, I’ll stick to my knitting and focus on the financial aspects of life.

Financial markets and planning are often perplexing to individuals who struggle to make decisions when confronted with many uncertain and unknown variables. How does one decide a path forward when they hear two supposed market experts outlining two very different outcomes for financial markets over the subsequent years? Inevitably emotions take over and well intentioned strategies go awry. In order to help individuals understand and avoid common investing pitfalls, we believe the use of sports as an example may offer an opportunity to develop a checklist for financial success.

Sports provide a small microcosm of life and the biases that inevitably creep into our daily routines and decision making process. Perhaps no sport defines this reality more than golf. Much like financial markets and planning, golf is a sport that places a premium on risk and reward decisions amongst a backdrop of ever changing conditions and outlooks. The professional golfer enters each round with a strategy for navigating through the course but this plan must be tweaked and altered as their position on the course and the leaderboard changes.

The Uniqueness of the Waste Management Phoenix Open

This week the PGA tour returns to the TPC Stadium Course in Scottsdale, Arizona for the Waste Management Phoenix Open. Over the recent past this tournament has become known for its record breaking “vocal” crowds and position opposite the NFL’s Super Bowl. Perhaps no hole in golf has become more publicized and critiqued more than TPC’s Par 3 16th hole. With bleachers completely encircling it, the hole has become unique on the PGA tour, not because of its difficulty, but rather because of the oft rowdy crowds that gather to watch golf’s super stars.

This year’s returning champ, Kyle Stanley, is as famous for what he did the week before the last year’s Phoenix Open as he is for winning the tournament. At the 2012 Farmers Insurance Open, Mr. Stanley possessed a seemingly insurmountable seven shot lead during the final round. Needing only a double bogey on the par 5 18th to defeat his nearest competitor, Mr. Stanley attempted to play the hole safe. However, the strategy back-fired and Mr. Stanley was only able to muster a triple bogey and a spot in playoff which he ultimately lost.

January 29, 2013

The Waste Management Phoenix Open A Behavioral Finance Laboratory

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In a twist of fate, Mr. Stanley entered the final round of the 2012 Phoenix Open trailing the leader, Spencer Levin, by eight shots. Brilliantly he shot a bogey free round of 65 and ended up taking the title and a bit of redemption. Pressure was the differentiator…right? Perhaps this is the case, however, we contend and recent research indicates that other behavioral factors may have also been at play.

The Link between Behavioral Finance and Golf

Over the past few decades, a field of economics known as Behavioral Finance has taken root. Essentially, the advocates of this field relax the principal assumption of economic models; namely that agents in an economy react in a rational manner and attempt to maximize their own utility. In other words, “Behavorialists” believe that biases and human emotion play a critical role in the decision making process and can lead to irrational outcomes. One of the foundations for this field was laid in 1979 when Nobel Prize winning professor, Daniel Kahneman and his colleague at Princeton, Amos Tversky, developed Prospect Theory. Their research defined how individuals make decisions under risk and uncertainty. Without delving too deeply into the geeky details, Prospect Theory asserts that humans make decisions based upon the value of individual gains and losses (reference value) rather than the more important final outcome and that they internalize losses more than gains (loss aversion).

So how does this relate to golf? Recent research has shown that professional golfers are subject to Prospect Theory and loss aversion. In a 2009 study, Professors Devin G. Pope and Maurice E Schweitzer, both then each at the Wharton School of the University of Pennsylvania, analyzed putting data from the PGA Tour during the years 2004-2009. Controlling for a number of variables, the authors found that 94% of golfers they analyzed made par putts about 2% - 4% more often than they did birdie putts of a similar distance and difficulty. Birdie putts were left short of the hole, while par puts finished past the whole. The Professors found that golfers were willing to sacrifice success in putting for a birdie (gains) to avoid encoding the loss of missing a par (loss). In other words, golfers view making birdie as less important than missing par, although rationally they should be indifferent between a birdie (-1) and bogey (+1) in aggregate. The golfers that the authors interviewed quipped that gaining a stroke was not as important as just not losing one. Interestingly this phenomenon decreased as the rounds progressed. The authors hypothesized that the reason was their reference point changed from their own performance versus par on Thursday and Friday to the golfer’s score who resided at the top (or behind them) on Saturday and Sunday.

The 2012 Waste Management Phoenix Open – A Behavioral Examination

Connecting the dots to our earlier comments about the 2012 Phoenix Open provides interesting commentary on Prospect Theory and loss aversion. Without a doubt, Mr. Stanley’s reference point changed on that Sunday at the Farmers Insurance Open. No longer was he playing for the best score but rather his reference point shifted to holding off whoever was in second place. In other words his actions where consistent with loss aversion as he likely became more risk averse in the positive domain (avoid loss).

Contrast this with his starting position on the following Sunday in Scottsdale where he found himself trailing. In his post tournament comments, Mr. Stanley stated, “When you have a big lead, its human nature to want to protect it. I think it is a little easier kind of being on the chasing side.” Interestingly, the man Mr. Stanley overtook for the victory, Spencer Levin, seemed to understand the potential pitfalls of loss aversion but this wasn’t enough to stop the bleeding. After he raced into the lead on Friday, Mr. Levin stated, “You don’t want to get too tentative or play away from shots. If you want to play well and make birdies you can’t do that, so I’m just going to try and stay as aggressive as I can the next two days.” Interestingly, Mr. Stanley made 62 out of 65 putts from within ten feet during the Phoenix Open. This suggests that he must have been exerting equal energy on the birdie and the par putts. Conversely, most commentators have pegged Mr. Levin’s downfall specifically to his double bogey on the par 5 15th hole that dropped him 2 shots off the lead on

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Sunday afternoon. Then again we’d point out that Mr. Levin failed to birdie or eagle either 16 or 17, two holes which he had played the previous 3 days in a cumulative 6 under par. In fact, Mr. Levin posted a par on 17, after having recorded two birdies and an eagle on the hole during the previous rounds.

Using the Lessons of Golf to Develop a Financial Strategy for 2013 and Beyond

1) Develop a game plan - This outline or document will provide the roadmap for your financial affairs. However this plan needs to be flexible and will have to evolve as the years pass. Your life and market conditions will change and as such your plan should also. Importantly, your reference point benchmark should not be your neighbor’s portfolio but rather performance relative to this financial plan, which is based upon your goals, objectives and risk tolerance.

2) Maintain a diversified portfolio - If your portfolio is properly diversified, there is a high likelihood that at any given

point some of your investments may not be keeping pace with others, perhaps they might even be negative. Don’t segregate these individual birdies (gains) and bogeys (losses) but rather focus on the aggregate scorecard (portfolio). Additionally, don’t focus on the short term. However before we move on we want to make one critical distinction that we believe is relevant. In the financial world, avoiding double and triple bogeys at the overall portfolio level does have its benefits as the math dictates that it is more harmful to have a 20% loss than 20% gain. After all a 20% loss requires a 25% gain to get back to even.

3) Accurately measure risks and the downside of a “bad swing” - While the 16th hole at the TPC has become famous, the 17th hole offers a better lesson for investors. On the tee, golfers are faced with a decision to take a seemingly riskier route and go for a green that is guarded by water or to safely lay up short of the green and attempt to hit the green with an easier 2nd shot. Interestingly, the average score for those who took the “risky path” and went for it last year was 3.5 versus 4.0 for those who laid up and made the “safe decision”. Much like the golfer standing on the tee, don’t be afraid to take calculated and appropriately sized risks if you have weighed the potential costs of the downside. As in golf you may sometime find that what you initially perceived to be risky or alternatively risk free behavior is wrong. We believe this currently describes investors who wrongly perceive that investing in bonds is riskless while equities are too risky. Over the short term this may be true and the equity investor may find their ball in the water, however, over the intermediate to longer term better scores will likely be had by investing in the equity markets.

4) Keep your eye on the prize and don’t let emotions change your plans – While financial plans need to be tweaked, emotions should not be the guiding force. Prospect Theory also shows that in the realm of a negative domain, individuals will engage in behavior (gambles) that they otherwise would not accept. Mr. Stanley didn’t make his comeback by simply taking every possible risk. As an investor if you have sat out most of the recent market gains following the financial collapse early this decade, don’t attempt to “get it all back” by taking unreasonable risks. If you are only now looking to re-enter financial markets, consider a dollar cost averaging program over a few months.

5) Consider hiring an advisor - Like a golfer looking for guidance and help through a caddie, consider hiring a financial advisor to help guide you through the ever evolving market, tax and legal environment. Mr. Stanley’s caddie, Brett Waldman, undoubtedly played a role in his success. Besides Mr. Stanley crediting him for “keeping him in the present”, Mr. Waldman also convinced Mr. Stanley to use a sand wedge rather than a pitching wedge on the par 4 17th on Sunday and the result was an important par.