BFM Sample Newsletter 2011

Be Aware of your Emotions - Step Away from Yourself

© 2011 Bourbon Financial Management, LLC ~ All Rights Reserved ~ [email protected] ~ (+1) 312 909 6539 1

November, 2011

Be aware of your own emotions and cognitive traps to make smarter decisions.

Step away from yourselves to be more rational.

Remember that we unconsciously make decisions based on positive memories.

Learn about financial history to reduce the number of mistakes. Do not extrapolate recent past.

Keep a well-diversified portfolio and an investment diary.

Have a Financial Plan.

What are some of the behavioral traps that

investors fall into at times like today?

According to Dr. Statman, the first issue is emotion.

We need to be aware of our emotions to be able to

step aside and watch ourselves.

Of course, the emotion of the day is fear. And we all

understand that fear causes us to be very risk-averse,

very pessimistic about the future, and we tend to

make mistakes along the way.

When the market was at a low, like in 2002 (or in

2009 when we founded BFM), people were fearful;

many thought that now was not a good time to

invest, and we know what happened after that

- a 100% bull run until 2007 (and another bull run of

85% of the S&P 500 from March 2009 to November

2011). In opposition, when the market was at a high

in early 2000, people felt no fear; they thought that

the market would provide high returns with no risk-

which, we know is not true.

Now we are fearful and so we must be aware of that

and counter our emotions.

The other part of our decision making derives from

cognition. We tend to extrapolate from recent

events, and it‘s clear that since 2007, our assets have

gone down and we feel down. While we tend to

extrapolate from the recent past, thinking that low

returns will generate low returns in the future may be

wrong. In fact, on average, pessimism and fear are

actually followed by relatively high returns rather

than low returns.

So how do investors get beyond those emotional

and cognitive mistakes that they tend to make,

where they might be feeling irrationally pessimistic

at a time like this?

What is needed for us is to step away from

ourselves. Fortunately, we can do it. After all, we do

it when we watch a scary movie. We know that we

feel scared, but we know that the threat is not real so

we don‘t get up and rush out of the theater. We can

do the same with the financial markets.


We should tell ourselves, ‗I am afraid‘. We have to

temper our emotions by our reasoning. It is not

trivial, but we do that all the time, and we have to do

it now.

Nowadays a large amount of investment is rushing

into gold bullion. Would it benefit investors?

No, says Dr. Statman, because investors are acting

out of excessive fear or misjudgment. There is

nothing wrong with having some gold in a portfolio,

but putting a big chunk of a portfolio in gold would

be considered very risky.

Research shows, there are some assets that people

love, and if you love it, you think it will have both

high return and low risk. And obviously, gold is an

asset that many investors love today, and they think

that it will have high returns in the future as it has

had in the past 10 years. In fact, the returns can be

high or low, so if you overdo it, you may end up

being very rich, but you also may end up being very

poor. Thus, we recommend well-diversified

investment strategies that maximize the potential

for growth.

Are there any tips for countering those behavioral

mistakes and the tendency to feel excessively

fearful during a market or an economic

environment like the current one?

Dr. Statman* says that we can control our own

behavior. We can control our own saving and

consumption rates. We can control our own

portfolios, and so, the smart thing we can do is to

keep a diversified portfolio.

We hope that everyday would show an increase in

the value of that portfolio, but we know that this will

not happen. We learn to step away from ourselves

and monitor our own emotions and thinking, so that

we make smarter decisions rather than poorer ones.

Should investors stay away from some stimuli like

watching business TV programs or watching their

investment statements like a hawk?

This varies by person. If you feel that watching

television programs and reading newspapers that

show scary things is really doing harm to you, stop

doing that, and if you are able to shrug, then go

ahead.

Some investors are very concerned about the safety

of their portfolio. A lot of seniors are living on their

portfolios. What should this group of investors do?

Keep in mind that we want two things in life. One is

not to be poor and the other is to be rich.

For retired people it is not being poor that is

paramount. What is important is not only to have a

diversified portfolio, but also a portfolio that is less

risky, a portfolio that has more bonds even though

the returns are very low. There is a need to calibrate

consumption.

Investing is really a matter of prudence, of being

able to calm yourself and being able to think

logically.

Summary

In general, be aware of emotional issues and try to

counter them. Be aware of cognitive traps, and

separate your emotion from reasoning. Never put all

your resources in one basket, and consider the factor

that you will live long but not forever so keep a

reasonable asset structure.

BFM can help you make better, and more

informed financial decisions by giving you

straightforward and conflict-free investment

strategies. We make sure that you have enough

money as long as you live so that you can enjoy a

comfortable retirement at a chosen lifestyle with a

secured income while keeping your money safe.

“The investor„s chief problem

– and even his worst enemy –

is likely to be himself”

Benjamin Graham

*Dr. Statman is a Finance professor at Santa Clara University.


The Flaws of our Financial Memory

The following chart shows the percentage of

countries in default over the last 200 years. The

peaks in sovereign defaults seem to recur without

exception every 30–40 years. This pattern is

occurring not only in emerging countries but also in

developed countries. A similar pattern is also visible

for currencies and in equity markets. It causes Mr.

Klement (C.I.O. of Wellershoff) to consider why

investors tend to forget lessons of history.

With his background in mathematics and physics,

Mr. Klement was naturally inclined to look to the

natural sciences for explanations, especially the

neurosciences, cognitive psychology, cognitive

neuroscience, and research about memory.

Types of Memories

Memories can be divided into long-term memories

and short-term memories. Long-term memories are

the things that people remember for months, years,

or even decades. In opposition, short-term memories

are the things that people are consciously aware of

that they can use and remember for a few minutes.

To remember things is the process of short-term

memories becoming long-term memories.

Long-term memories can be further divided into

declarative and non-declarative memories.

Declarative memories are memories that people are

conscious of. It can be classified as either episodic or

semantic. In which, episodic memories are memories

of significant things that happen to us or events that

we experience, such as a wedding day, vacations,

birthdays, or the first day at school. Semantic

memories are factual memories that can be retrieved

at any point in time. It is factual information that you

know, but you probably will not know where you

were when you first learned about it.

Non-declarative memories are the subconscious or

unconscious memories people have, such as how to

ride a bike or how to drive a car. We remember how

to do those activities, but after some practice, we do

not consciously focus on all the processes involved

in driving a car or riding a bike.

Classical Conditioning

Classical conditioning is best summarized by the

well-known Pavlov‘s dog experiments of the 1920s.

Mr. Klement believes that classical conditioning is

happening in the financial markets. For example,

during the technology bubble in 1999, Computer

Literacy Inc. changed its name to fatbrain.com. On

the day of the name change, its stock rose by 33

percent simply because it had renamed itself as a

dot-com.

Most investors during that time were trained to

equate dot-coms with a profitable investment, and it

became a self-fulfilling prophecy. The same thing

happened during 2004-2007, with companies that

added oil or petroleum to their name. The same thing

is happening today for companies with ‗China‘ in

their name.

If we looked for companies from around the world

that had changed their name to include the country

name ‗China‘ between 2000 and 2010, excluding

companies that located in mainland China, Hong

Kong and Taiwan, you would find at least 90

companies in the US, UK, Australia, and Germany

that added China to their names. Interestingly, in the

four months around the name change, the stocks of

those companies, on average, almost quadrupled in

price.


This example illustrates how individuals

unconsciously make decisions based on positive

memories from the past. Because of good

experiences with Chinese stocks or Chinese

investments, investors equate China with a good

investment, and it becomes a self-fulfilling prophecy

for some stocks.

Seven Flaws of Memories

There are 7 flaws of memories that can be grouped

into 3 categories:

Forgetting Things

This category includes transience, absentmindedness,

and blocking, which all have something to do with

forgetting. It‘s natural that we tend to remember the

gist of important things that we need to know or that

have happened to us. Otherwise, if we never forget

anything, there would be too much information for

our brain to process.

False Memories

The second category includes misattribution,

suggestibility, and biases, which contribute to

remembering things that did not happen the way they

are remembered or might not have happened at all.

Traumatic Memories

It only includes persistence, which is about memories

that people wish they could forget but cannot.

Flaws of Memory & Investors

Transience

Remembering a sequence of 10 colors is called a

digit span test, and if it‘s performed systemically, an

interesting effect occurs: people tend to remember 7

things (+/- 2) at a time, and they tend to remember

the first few and last few and forget the ones in

between.

Remembering the last few things that a person sees

or hears is called the ―recency effect.‖ The recency

effect may be the scientific underpinning of the

recency bias in behavioral economics.

Behavioralists know that people tend to extrapolate

the recent past into the future and act accordingly

in their investment decisions.

Remembering the first few colors or numbers that a

person sees or hears is called the ―primacy effect.‖

The primacy effect is related to how people shape

their behavior throughout their lives based on the

memories of what investment decisions they made

when they first started investing.

Thus, investors buy stocks that have gone up

dramatically over the previous 3–6 months and

avoid stocks or funds that have gone down over the

previous 6–12 months. And the experiences people

have during their first years as investors will shape

the way they think about markets for the rest of their

lives.

However, these effects can be overcome through

training. If something is practiced and repeated,

then it can be memorized. The value of repeated

experience can also be reviewed as people tend to

use their investment experience to their own

advantage.

A study by Greenwood and Nagel demonstrated the

importance of experience (figure 2). During 2000-

2002, the managers who were 25–35 years old

underperformed their peer group, whereas the fund

managers who were more than 45 years of age

outperformed their peer group. Recall that if

managers were older than 45 in 2000, they likely had

vivid memories of previous severe bubbles and

crises in the markets, such as those in the late 1970s

and early 1980s.

“Only buy something that

you'd be perfectly happy to

hold if the market shut down

for 10 years”

Warren Buffet


In 2000-2002, the young managers stuck to

technology stocks and on average underperformed

their peer group, whereas the older managers started

to outperform quite dramatically because they did

not buy into the hype around the technology

securities as much as the younger fund managers.

Both positive and negative experiences can be used

to train our memories.

Misattribution

Research shows that we tend to remember things in

what is called a ―mind map.‖ We group similar

information together, and the result is that

sometimes information is mixed up in our memory

with other information that is stored nearby in our

brain.

The human propensity for sometimes not

remembering things or remembering false things is

often used in marketing materials.

Persistence

An example of how traumatic memories may affect

investors is seen in those who grew up during the

Great Depression in the 1930s in the United States.

Check the difference in stock market participation

and returns by the year of 1968, older investors (over

40 years old) had on average almost 5 percent fewer

stocks in their portfolios than the younger investors.

Because most of the older ones experienced the

Great Depression in the 1930s and they can never

forget that.

A similar example is Germany, which is well known

for having a high savings rate. Most of the German

population suffered disproportionately from the

effects of two catastrophic wars and a disastrous

period of hyperinflation—all within a short time.

Thus the influence on the succeeding generations has

resulted in consumers who avoid investment in stock

markets and do not buy houses.

“Risk comes from not

knowing what you‟re doing”

Warren Buffet


What can we do to be better investors?

First is to have an Investment Policy Statement or

a Financial Plan. Agreeing to and writing down

investment goals along with all the restrictions and

constraints, and then regularly auditing or reviewing

them. It helps managers to avoid going astray with

investments or following the latest fashion or

technique, and it guides managers by keeping the

client‘s stated goals at the forefront of their mind.

Another technique is to keep an investment diary.

For every investment decision good investors make,

they write down the action, the reason why they did

it, and what could possibly go wrong (the risks).

This tool helps prevent mistakes due to forget bad

decisions you have made.

Some lessons we might have forgotten

It is instructive to consider the concept of a portfolio

being underwater (current value of the assets is

below the initial value) from one starting point, and

compare three types of portfolios for a U.S. investor:

a pure bond (government-only) portfolio, a balanced

50/50 stock and bond portfolio, and a pure equity

portfolio. For a pure bond portfolio since 1985, the

maximum time underwater is about 19 months. For

an equity portfolio, the maximum time underwater is

81 months. For a balanced portfolio, the maximum

time underwater is 58 months.

Thus the longer the time horizon, the more

investors can invest in equities because they have

the time to bear the risks, suffer the downturns, and

wait for the markets to recover.

The problem is that investing in times of rising

yields means that bond investments may not create

good returns. This observation is based simply on

the numerical effect that rising interest rates have on

bond prices and does not take credit risk into

consideration, which is a separate issue.

In the current markets, many people believe that

interest rates will go up for the next 10 years. As a

result, it is likely that the most conservative

investors—that is, the ones with the most bonds in

their portfolios—will be impacted from that effect.

―We simply attempt to be

fearful when others are

greedy and to be greedy only

when others are fearful.‖

Warren Buffet


Summary

We all have flawed memories that can lead to

making poor decisions or repeating mistakes.

Memory flaws are observed not only in individuals

but also in the overall market. Financial market

participants seem to forget things that happened in

the past or be persistently influenced by recent past

financial events. Thus, learning about financial

history may be one of the best ways to prevent

mistakes in the future.

“A man who does not

plan long ahead will find

trouble at his door”

Confucius

Patrick Bourbon, CFA

BOURBON FINANCIAL MANAGEMENT, LLC

Excellence ~ Experience ~ Ethics

616 W. Fulton St., Suite 411, Chicago, IL 60661

+1 312-909-6539 ~ www.bourbonfm.com

Member of the Financial Planning Association

Academic Affiliate of the National Association of Personal Financial Advisors

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How to Pick Better Mutual Funds? * PEOPLE + PROCESS + PHILOSOPHY = PERFORMANCE * October, 2011

Dear friends,

If you have the time, desire, experience and knowledge of building your own investment and retirement portfolios, this newsletter is for you!

At BFM, we are very analytical and we believe that asset allocation is more important than stocks or mutual fund selection… but many of you have asked us to share our disciplined due diligence process to selecting investment managers and mutual funds.

Selecting a good mutual fund is extremely difficult. Only 20% of funds may outperform their benchmark over the long run. 40% of funds that were in business 10 years ago are now gone. A fund can be at the top one period and be at the bottom the next one.

As you can see, mutual fund returns can be very different (international fund category).

The debate between active and passive management (investing in index, passive funds and ETFs) is a constant discussion among individuals in the financial world. There are qualitative and quantitative factors that need to be understood and analyzed correctly before picking a good fund.

You should decide to be either patient with active managers or seek a passively managed approach. The vast majority of long-term top performing managers will endure periods of lousy performance.

· 85 percent of all ten-year top quartile funds spent at least one three-year stretch in the bottom half of their peer group (they spent about 23 percent of all their three-year periods in the bottom half of their peer groups).

· 62 percent of ten-year top quartile funds spent at least one five-year stretch in the bottom half (19 percent of rolling five-year periods in the bottom half of their peer groups). Source DiMeo.

Short-term greed and impatience will lead investors to fail. Before investing you should develop confidence in the fund and the patience required for long-term success. Otherwise, you should invest in index and passive funds (low costs).

“Do not wish for quick results, nor look for small advantages. If you seek quick results, you will not attain the ultimate goal.” Confucius.

Human emotions are the biggest obstacle to investor success. Proper research goes well beyond the numbers. It also requires regular meetings or calls with the managers. Natural human behavioral tendencies during the manager selection and termination process generally leads to failure so we recommend a rigorous process. We believe that qualitative metrics for selecting mutual funds are as important as quantitative metrics.

Name

10-year

Return

Value of

$10,000

Old Mutual Copper Intl Sm Cap 50% $14,988

Invesco International Sm Cap 417% $51,716


What traits and factors do we look for, review carefully, and monitor constantly?

Qualitative factors:

1. People: education, qualifications, experience, depth, stability, diversity, quality and diligence of the investment team (portfolio managers, analysts, traders, auditors…)

2. Investment philosophy that is consistent, clearly articulated and understandable

3. Investment process and style based on meritocracy that are transparent, repeatable, consistent, and definable with good buy and sell discipline and risk management procedures

4. Stewardship: a corporate culture of excellence, with clean regulatory history, board integrity, independence, ownership and compensation who will put your interests first

5. Firm ownership structure

6. Manager compensation and incentives structure (salary, bonus, stocks, shares…) that reward individual contributions

7. High conviction approach that is distinct and with potential to outperform. “Worldly wisdom teaches that it is better for reputations to fail conventionally than succeed unconventionally.” J. M. Keynes.

8. What percentage of research is generated internally (vs. sell-side research from Wall Street)?

We also review the portfolio composition, size (small or large cap) and style of the funds, manager concentration, and if a manager has closed a fund to new investors in the past and ask how they decide to close it in the future.

Such data may not available by directly looking

into sources like Bloomberg, Morningstar, and

Lipper. This requires contacting every fund and

requesting them to provide the data.

Quantitative factors:

1. Fees*/ Expense ratio: Funds in the cheapest quintile were more than twice as likely to beat the average for their categories than the most expensive quintile

2. Tenure / Experience / Track Record of the Portfolio Managers and Analysts. The average tenure maybe close to 6 years only…

3. Fund ownership** by the portfolio management team

4. 5 and 10-year Information Ratio (IR) and peer ranking. The IR measures the risk-adjusted return for assessing the performance of active portfolio managers

5. Long-term after tax return / performance: GMO Emerging Country Debt had a 10-year annual return was 14.54% ($10,000 became $38,880) but after tax, the post-tax return was 9.80% ($10,000 became $25,468 or 35% less)

6. Consistency of portfolio returns with the investment process (attribution reports)

7. Funds concentration

8. Tracking Error and Active Share: these numbers represent how much the fund returns deviate from the benchmark

9. Beta and Correlation with the fund’s true Benchmark (R square)

10. Inflows/Outflows and total assets in the fund today and 5 years ago


11. Up/Down capture ratio and maximum drawdown

12. Sortino Ratio which measures the risk-

adjusted return

13. Volatility

14. Turnover which measures the number of times securities/shares are replaced/traded

The quantitative data is available from a variety of

sources like Morningstar, Lipper, Bloomberg,

fund prospectus, fund statement of additional

information, shareholder reports, fund

companies…

You can see that these lists could include many

more factors. Also important is that these factors

are not available easily. You need time and a

good network to obtain all the necessary

information.

It does not end there. You may want to look at a

fund's correlation with other assets/funds in your

portfolio to optimize your portfolio risk level and

decide what capital allocation would be best to

minimize your downside risk. Short-term

performance is not important.

*: Of domestic stock funds, 47% in the cheapest quintile beat the average over a 10-year period, while just 19 percent of the most expensive quintile beat the category average. The cheapest quintile of domestic-stock funds survived and beat the cheapest index fund 29% of the time, compared with just 17% of the most expensive quintile. There is a high correlation between costs and survivorship, as high-cost funds have a large attrition rate. Looking at rolling 5 and 10-year periods for US stock funds, the cheapest group had an attrition rate of 13% over 5-yr periods and 25% over 10-year periods. The attrition rate for the most expensive group was double that: over 5-year periods, 29% of the high-cost funds had merged or liquidated and 49% had merged or liquidated over 10-year rolling periods.

**: We like managers to have skin in the game. Does your Manager eat his own cooking? Would you invest in a fund when its portfolio manager does not even invest in it? 46% of the US stock funds managers report no ownership! 59% for international foreign funds managers. This information can easily be found at www.morningstar.com/goto/fundspy or in the fund prospectus (statement of additional information. Higher investment levels aren’t a guarantee of success or an ethical manager, but it shows that managers believe in the funds.

http://www.morningstar.com/goto/fundspy


DETAILS

The world is a mix of different professionals.

Every professional has his or her own duty to

perform well, be it as a teacher, mechanic or

bartender. Many times individuals try to

experiment with ideas outside their expertise.

There is nothing wrong in learning new ideas;

they rejuvenate you and can bring a fresh

perspective to your daily routine. But what is

important is that you should not be over

confident in pursuing activities beyond your

expertise. For example, practicing skydiving

without a professional skydiver or dancing Ballet

without a ballerina’s guidance can harm your

body.

Investing your wealth, just like skydiving and

ballet dancing, is an art. Investing without

knowledge is like jumping into a valley

without a parachute.

There are two main categories of investments:

Equity

Fixed Income

Investment knowledge is imparted by investment

and finance professionals. These professionals

include individuals with professional degrees like

an MBA, Masters, CFA, CFP, CPA...

But in spite of the experience and education

professional investors possess it is difficult to

attain the highest skills in all the different

investment arenas. So, being a common person

who does not work intensively in the world of

finance, you can see the complexities in making

investment decisions.

What Are Mutual Funds?

A mutual fund is a company that pools money

from many investors and invests the money in a

combination of stocks, bonds, and other securities

or assets. The combined holdings that the mutual

fund owns are known as its portfolio. Each share

represents an investor's proportionate ownership

of the fund's holdings and the income those

holdings generate.


Which Strategy to Choose: Active vs. Passive Management?

Passive Management is an investment strategy

that attempts to replicate the returns of an index

or benchmark by owning the same assets, in the

same proportions, as the underlying index. Passive

investing does not seek to capture any excess

returns, but rather tries to match the performance

of the index. Indexed Mutual Funds and ETFs are

common vehicles used for passive investing.

Active Management, on the other hand believes

the market can be inefficient sometimes.

Managers attempt to add value over the returns of

an index by picking assets based on models,

insights, and analytical research. Managers aim to

achieve a higher return then the benchmark by

selecting a superior stock, currency, market, or

sector, etc. Active managers will try to exploit

pricing inefficiencies to obtain excess return. (Source: SPDR University).

Percentage of Active Funds are Underperforming the Benchmark

Efficient wealth management is a tedious and

time-consuming activity. It requires a

psychological self-understanding along with

excellent analytical and technical skills. Here we

look at how actively managed mutual funds have

performed across the years compared to their

respective benchmarks and the numbers are very

surprising.

The figures below are Equity and Fixed Income

mutual funds style boxes after adjusting for

survivorship bias. We see that all the categories

have more than half of the funds

underperforming the benchmark. Also, except for

large-cap value and large-cap growth, all the other

categories have more than 75% of the funds

underperforming the benchmark.

By looking at the numbers we can say that

selecting a good mutual fund is extremely

difficult. Thus, effective organized financial

planning is important. The finance professional

cannot guarantee above average returns but some

of them will be more adept and skillful in

managing investments than a layman.

EQUITY % below

benchmark Value Blend Growth

Large 56% 83% 73%

Mid 99% 96% 98%

Small 84% 93% 76%

Sources: Vanguard calculations, using data from Morningstar, Inc., MSCI, Standard & Poor’s, and Barclays Capital

FIXED INCOME % below

benchmark

Government Corporate GNMA

Short 94% 99% 100%

Intermediate 80% 91% N/A


Why do active managements underperform

benchmarks so poorly? An indexing investment

strategy performs favorably in relation to actively

managed investment strategies because of

indexing’s low costs, broad diversification,

minimal cash drag, and, for taxable investors, the

potential for tax efficiency. Combined, these

factors represent a significant hurdle that an active

manager must overcome just to break even with a

low-cost index strategy over time.

Some studies support the notion that active funds

can sometimes outperform passive funds in less

efficient markets over certain down market

periods and sustained time horizons.

A research report by State Street Global Advisors

and SPDR® ETFs for the 15-year period ended

December 31, 2010 found that more than 50% of

active managers outperformed the relative indexes

only in three asset classes—small cap blend, small

cap growth, and international as shown in the

figure below.

Research conducted in the 1960s by Jensen

(1968), Sharpe (1966) and Treynor (1965) found

that, on average, active funds underperform their

benchmarks on a risk-adjusted basis and that the

magnitude of underperformance directly relates to

the level of expenses.

This debate about Active and Passive

Management is of constant discussion among

individuals in the financial world. Thus, instead of

trying to find the winner the fundamental

approach should be to ask: “How can I make the

best decisions with respect to my goals and

objectives?”

Percent of Active Managers Outperforming Indices ~ 15-Year Annualized

Source: Morningstar Direct, SSgA Global ETF Strategy & Research as of 12/31/2010.

43%

35%

59%

54%

65%

42%

15%

0% 10% 20% 30% 40% 50% 60% 70%

Large Cap Growth

Large Cap Blend

Small Cap Growth

Small Cap Blend

International

Emerging Markets

Fixed Income


The decision to pursue passive or active management strategy should be decided based on understanding

your objectives by asking certain questions as shown in the figure below.

Do you believe that markets are

generally inefficient?

Do you believe that there are

some managers who can

consistently beat the benchmark?

How comfortable are you with

taking on active risk?

Do you believe that you can find

these skillfull managers?

YES

ACTIVE MANAGEMENT


Passive strategies should be relied upon when

the potential to beat the market is relatively poor

and to minimize tax liabilities related to capital

gains.

Active Strategies should be pursued in those

markets which are less efficient and when you

have high confidence.

You should make a decision as to which is the

correct and advisable strategy after accounting for

your objectives, and understanding the factors like

taxes, fees and risk tolerance. The best investor

would be the one who can identify market

segments which are not efficient and employ

active strategies among those segments. In

addition, one must identify superior active

managers in asset classes where the manager has a

greater chance of outperforming.

(Source: Passive and Active Management , A Balanced Perspective

Thomas Guarini, ETF Strategies, Global ETF Strategy & Research, State

Street Global Advisor)

We just saw the strenuous procedure involved

into opting for passive or active management.

Now the active investor needs to create a universe

of Mutual Funds to choose from. Creating this

universe of funds involves tremendous skills in all

aspects. The active investor needs to have good

analytical as well as technical skills. Also

important are qualitative aspects like good

networking skills and having knowledge of

behavioral finance.

Picking the right mutual funds is not an easy

task. There are qualitative and quantitative factors

that need to be understood observed and more

importantly analyzed correctly.

Manager Due Diligence

It is very important to perform diligence on the

company and its management, to know whether

the management is engaged in costly litigation or

is involved in finding innovative ideas for the

firm.

The performance of a mutual fund is largely

driven by the manager and his/her team.

Investment style, people, philosophy and

performance are all carefully reviewed in the

manager search and selection process.

The fund’s manager tenure period is looked at.

You would not want a fund whose manager and

team changes every year. We would want the

same management for at least 10 years. We

need to evaluate how a manager has done in the

long-term. Why?

Short-term performance is of little use in picking

a fund that you’re going to hold for the long term.

Funds with the top trailing one- and three-year

returns may continue well over the next short

term period, but may fare poorly over the long

term.

How big is the team? We prefer firms with a

strong team of analysts.


How is the management team compensated? We

are more interested in private firms, where

managers receive ownership stakes in the firm.

We want funds with at least enough assets under

management because this will generate enough

revenue to pay the salaries of good analysts and

keep them for many years.

We like for managers to have skin in the

game. We look at a manager’s ownership in his

or her own fund and like to see ownership valued

at $500,000 or more. You wouldn’t like to see a

CEO who doesn’t own any stock in his own

company and for that reason we demand it in

fund managers.

With regard to the fund’s portfolio, we want a low

turnover because it gives a low tax impact.

We want funds to have concentrated

portfolios with fewer stocks. If the mutual fund

owns so many stocks, it may be better to just buy

the index which is cheaper. We pay managers to

take risks.

What is the investment strategy? Funds that rely

on momentum strategies to buy hot stocks incur

greater trading costs than those more contrarian

strategies that involve buying the stocks that

everyone is desperate to sell. Like Warren

Buffett, we believe in buying stocks and

holding it for the long-term.

We prefer no-load mutual funds with low

expenses for several reasons. First, it shows that a

manager keeps business costs under control.

There is a high correlation between costs and

survivorship, as high-cost funds have a large

attrition rate. Second, fees reduce investor

return. When the cheapest 20% of equity funds is

compared to the cheap index fund, it is twice as

likely to beat the index as compared to the most

expensive 20% of equity funds. (Source: Fund Spy by

Russell Kinnell)

We review how managers performed in the past,

during bull markets and bear markets. We like

downside protection. Once a manager’s past

performance is understood, expectations can be

set for future performance. These performance

expectations and an investor’s tolerance for risk

should be explicitly discussed and accepted when

selecting a manager.

Even after a manager is selected, constant

monitoring and reviewing is a difficult task.

Unfortunately, ongoing manager review often

becomes an afterthought or is not even discussed.

We review if a manager has closed a fund to new

investors in the past and ask how they decide to

close it in the future. Closing a fund means a fund

company is passing up fee income and hurting its

own short-term profits in order to avoid letting

asset growth harm performance of the fund.

The managers selected should remain true to the

style and asset class for which they are being

selected. A large-cap growth manager should not

deviate drastically from his/her intended strategy.

Any change to the investment team should be

immediately reviewed. Changes to senior

management or to the structure or ownership of

the firm should also be evaluated with a critical

eye as to their impact on the investment team’s

time, resources and capabilities.

* People + Process + Philosophy = Performance *

Let’s Put Things in Perspective

September 2011

2 © 2011 Bourbon Financial Management, LLC

Summary

• This summer’s stock decline was nothing exceptional (only down

8% in July/August)

• The economy doesn’t look that bad

• Equity valuations are O. K.

• Equities tend to perform well over the long-term, sometimes right

after a major correction and/or spike in volatility


Details

• U.S. Stocks have been going up in the long run and outperformed bonds most of the time over any 5-year periods

• Historically stock market declines have been much worse: down 86% in 1929-32, 49% in 2001, 57% in 2007-09…

• Other asset classes have seen much worse decline:

• Long U.S. Treasury Bond real return was negative 67% between 1941 and 1981.

• Gold was down 62% between 1980 and 1986

• Japan Stocks were down 82% between 1990 and 2009

• Most declines have been followed by 5 years of gains

• Nearly every significant up year for the markets had also a significant intra-year decline

• When the volatility is high, markets often rise

• U.S. Companies are in much better shape (profits, cash holdings, dividend payouts) than in 2000

• The Yield curve is usually flat before recessions. It is far from flat now

• When consumer sentiment bottoms, the following 12 months tend to be good for stocks. Extreme pessimism in

consumer confidence may be a bullish sign for the market

• Moderate GDP Growth (2%-3%) has not been bad for stocks historically. But can we keep a 2%+ growth?

• DIVERSIFICATION WORKS!


U.S. Stock Market History: Volatile but Going Up

5

Stocks Outperformed Bonds Most of 5-Year Periods

© 2011 Bourbon Financial Management, LLC

6

Historical Markets Declines: We Have Seen Much Worse


Trough=Bottom - As of Mid August 2011

7

Many Declines Have Been Followed by 5 Years of Gains


8

Intra-Year Declines Happen Very Often


9

When the Volatility is High, Markets Often Increase


10

U.S. Companies Today vs. 2000


11

Slowdowns Do Not Mean Recessions All the Time


12

Initial Job Claims Is Down: Usually, it is Up Before Recession


Recessions are in Grey

13

Yield Curve is Not Flat: Usually, it is Flat Before a Recession


14

The Current P/E Ratio is Not High


15

Consumer Sentiment Bottoms = Good 1-Year Stocks Returns


16

Leading Indicators Index Does Not Yet Predict a Recession


17

Moderate GDP Growth (2% - 3%) Has Not Been Bad for Stocks


18

Cash Underperformed Historically Over 1-Year Periods


19

Diversification Works


• If you had a “All Cash Portfolio” between January 2008 to April 2011, your portfolio

returns would have been 0.2%.

• If you had a “All Stock Portfolio” between January 2008 to April 2011, your portfolio

returns would have been 3.1%. Your portfolio would have been very volatile. Down 48%

then up 20%.

• If you had a “Diversified Portfolio” between January 2008 to April 2011, your portfolio

returns would have been 8.1%.

20

Quote



Disclosures

• This material was prepared by BFM, Copyright by Bourbon Financial Management, LLC. All rights reserved. BFM is a

trademark of Bourbon Financial Management, LLC. No part of this publication may be copied or distributed, transmitted,

transcribed, stored in a retrieval system, transferred in any form or any means-electronic, mechanical, magnetic, manual, or

otherwise-or disclose to third parties without the express written permission of Bourbon Financial Management, LLC, 616 W.

Fulton #411, Chicago IL 60661. The information contained in this presentation is not written or intended as tax or legal

advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek advice

from your own tax or legal counsel. The content is derived from sources believed to be accurate. Neither the information

presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. BFM assumes no

responsibility for statements made in this publication including, but not limited to, typographical errors or omissions, or

statements regarding legal, tax, securities, and financial matters. Qualified legal, tax, securities, and financial advisors should

always be consulted before acting on any information concerning these fields.

• All figures represent past performance and are not a guarantee of future results. Investment return and principal value of an

investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. The

views expressed in this presentation are not intended to be a forecast of future events, a guarantee of future results or

investment advice. The information contained herein has been prepared from sources believed to be reliable, but it is not

guaranteed by Bourbon Financial Management, LLC as to its accuracy or completeness. Forecasts and predictions are

inherently limited and should not be construed as a solicitation or recommendation or be used as the sole basis for any

investment decision. All investments are subject to risk including the loss of principal.

• The information provided here is for general informational purposes only and should not be considered an individualized

recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for

everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any

investment decision. We believe the information obtained from third-party sources to be reliable, but neither Schwab nor its

affiliates guarantee its accuracy, timeliness, or completeness. The views, opinions and estimates herein are as of the date of the

material and are subject to change without notice at any time in reaction to shifting market conditions. Past performance is no

guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance. Examples

provided are for illustrative purposes only and not intended to be reflective of results you should expect to attain.

© 2011 Bourbon Financial Management, LLC. All Rights Reserved. [email protected]. +1 312 909 6539. 1

Human Brain and Decision-Making Factors behind Investor Choices August, 2011

Dear Friends,

The age old phrase: “You Reap What You Sow”

emphasizes the fact that it is very important to

make the right choices now to reap the desired

benefits later. But making a choice is not always

easy. Today’s world offers so many options in

everything that a simple decision--like ordering

from a menu at a new restaurant--becomes a

time and effort consuming process.

Every available choice in a decision making

process offers a level of utility to us. Utility (or

expected utility) can be defined as the level of

relative satisfaction that can be achieved from

the outcome (or expected outcome) of a

decision.

There are many factors that can affect the

utility associated with an option. But one of the

main factors that affect the utility of an option

is the time delay between making a decision

and receiving its outcome or benefit. The

research that we cover in this newsletter deals

precisely with how utility varies with time

differences and how our brain makes decisions

based on it. We first discuss some ground

breaking experiments and results in decision-

making, then we link those results to making

investment decisions and finally, based on the

research, we suggest some best practices to

improve financial decision-making.

‘Tonight I want to have fun; Next week I

want things that are good for me’

In research conducted by Loewenstein &

Kalyanaraman (1999), a group of people were

asked to pick one movie (out of 24 titles) for

the same night, one week later and two weeks

later. These movies were broadly classified into

two segments:

Highbrow (e.g. Schindler’s List)

Lowbrow (e.g. Four Weddings and a

Funeral)

About 66% of the group picked a lowbrow

movie title to watch on the same night. While

choosing a movie for next week, only 34%

picked a lowbrow movie. When they were

asked to pick a movie to watch two weeks later,

29% of the group chose from the lowbrow

titles.

The results indicate that people appear to have

a preference towards immediate rewards and

discount the value of all delayed benefits.

To get a clearer understanding of how the

increase or decrease in time affects the utility

of a choice, let’s take a look at another

experiment by McClure, Ericson, Laibson,

Loewenstein and Cohen, 2007.


The Effect of Time Delay on Decision

Making:

In this experiment a group of extremely thirsty

people, were presented with the choice of two

options:

One cup of orange juice immediately.

Two cups of orange juice after 5 minutes.

Although the common notion may be that a

greater quantity is preferable, the results

strikingly differed from this expectation.. About

60% of the group chose to immediately have

just one cup of orange juice. In this situation,

the 5 minute time gap played a huge role in

diminishing the utility of two cups of orange

juice relative to just one cup--even though the

quantity possible was plainly greater in the

second option. In another round of a similar

experiment, the thirsty subjects were given a

different set of options:

One cup of orange juice after 20 minutes

Two cups of orange juice after 25 minutes.

When given the above set of choices,

approximately 70% of the people chose the

second option. In this scenario the utility of

higher quantity of juice was not diminished by a

5 minute difference. Remarkable! Isn’t it? This

experiment helped establish the relationship

between the delay in the reward and

discounting of its utility. There were two

important observations from this experiment:

a) The first observation was that the human

brain discounts the utility of a delayed

reward.

b) The second observation was that short term

discounting was greater than long term

discounting. In other words, a delay of 5

minutes between now and receiving actual

benefit was a bigger factor in deteriorating

the utility of a choice than the same

difference 20 minutes into the future.*

c) A choice that appears to be rewarding to

the brain may not necessarily be a result of

analytical thinking. It could also be a result

of emotions. For example, the decision to

have a slice of chocolate cake instead of

fruit salad, when following a low calorie diet

is not a logical decision but is based on

feelings of temptation.

Another experiment quoted in research by

Choi, Laibson, Madrian, Metrick (2002)

demonstrates a similar behavior where the

subjects of the experiment do not make logical

choices even when it concerns their own

savings. In a survey that was conducted

amongst 590 employees of a company, each

employee was asked the following two

questions:

Do they feel they are saving too little?

If yes, then would they raise their savings

rate in the next 2 months?

68% of all the 590 employees thought that they

were saving too little. Despite this initial

answer, of 590 people surveyed, only 24%

planned to raise their savings rate. After two

months, administrative data on their savings

was collected to find out how many people

actually increased their savings. Surprisingly,

only 3 percent of all those who were surveyed,

actually followed through on their thoughts.


The result defied logic. Even though 68% of the

group felt their savings were low, only 3% took

measures to increase their savings.

This behavioral phenomenon suggests that

decision making by a human mind is affected

by many other factors and not just for

analytical reasons.

*Ramsey (1930s), Strotz (1950s), & Herrnstein (1960s) were the

first to understand that discount rates are higher in the short

run than in the long run.

Decisions: Products of Analytical &

Emotional Brains

Researchers are beginning to measure how

people perceive time and discount value with

fMRI scans. In a scientific study of human brain

activity (McClure, Laibson, Loewenstein, and

Cohen Science, 2004), it was found that there

are two separate neural systems in the brain,

the Mesolimbic dopamine (M-D) system and

the Fronto-parietal (F-P) system.

The M-D neural system was found to be

involved with emotional activities and was

more active when the subjects chose smaller

and immediate rewards.

The F-P neural system was more active when larger, delayed rewards were chosen which required analytical thinking. These two systems operate in conflict with each other. The brain then makes a decision based on the combined effect of the activity in these two systems For 14 female thirsty test subjects presented with delayed juice and water rewards, McClure, et al. observed neural activity which implied that brain areas produced a discount factor of 0.96/minute. Referring to our earlier example then, a discount rate of 0.9625 = 0.36; 0.9620 = 0.44; and 0.9605 = 0.82. (An 18% loss from the zero to 5th minute, versus a am 8% loss from the 20th to the 25th minute.) Perceived value declines steeply in the near term, but soon levels off to an analytical value. Or, in simpler words, all decisions, choices and

actions are affected by both of these neural

systems.


A question that may come to the mind at this

point is: How does all that scientific jazz relate

to financial decision making?

Well, at BFM, we want our clients to be very

careful, patient, analytical and logical when it

comes to making important investment

decisions.

The recent times of economic slowdown and

highly volatile market activities have tested

investors’ patience to a great extent. But a

majority of those investors who believe in

principles like mean reversion, long term

investing and market efficiency have either

benefitted from such market movements or

have been able to avoid major losses to their

investments.

Our Advice

We can point to some general practices that can help investors improve their investment decision

making:

Thinking more analytically when making important financial decisions.

Being pro-active, curious and non-assumptive at

all times and spending time to evaluate

investments, possible risks and benefits.

Continuously striving towards improving self-

control and avoiding hastiness.

Avoiding making any important investment

decision while being in a passive state of mind.

Creating a balance between being patient and

being dynamic about investment choices.

Weigh your choices carefully!

“In the short run, the market is a

voting machine. In the long run,

it’s a weighing machine.” –

Benjamin Graham


Challenges in Financial Advising From the Scope of Behavioral Finance July, 2011

Dear Friends,

In today’s world, especially after the recent

financial meltdown, understanding the human

emotions and sentiments before investing

money is capturing interests of researchers and

advisers. We too continue our long love with

Behavioral Finance and present you some

interesting findings by researchers in this area.

Before we discuss the topics in detail here is a

brief introduction on Behavioral Finance.

‘Behavioral Finance combines the

psychological characteristics with traditional

finance principles in evaluating an investment.

Behavioral finance focuses on the cognitive

and emotional aspects of the investment

decision-making process.’

At the start we discuss Intuitive and Reflective

minds. Following up are discussions on Investor

Paralysis, Lack of Investor Discipline and Loss of

Trust by Shlomo Benartzi, Ph.D, UCLA Anderson

School of Management and some other

researchers. We conclude by providing some

interesting solutions to overcome the 3

mentioned behavioral finance challenges and

why they should be understood by financial

advisers and clients.

Intuitive and Reflective Minds:

Intuitive mind is the one which forms quick

judgment with great ease, less effort and with

no conscious input. Often it can lead to wise

decisions but it could also lead to irrational or

poor decisions, which could be a big issue if

these are financial decisions.

Reflective mind is the one which is slow,

analytical and requires conscious effort. It leads

to more thoughtful and rational decisions.

Financial Adviser’s role is to understand the

reflective mind of clients and help them to

reduce the mistakes caused by intuitive mind.

Investor Paralysis:

The psychological fallout of the ‘08-‘09 financial

crisis was very profound. Huge amounts of cash

were left idle for a long time as investors

thought that the market was still bearish.

Financial Advisers themselves can become a

subject to this behavior known as Investor

Paralysis.

A solution to Investor Paralysis is ‘Invest More

Tomorrow’ program which relies on

overcoming loss aversion and procrastination.


Lack of Investor Discipline:

From years it has been noted that investors buy

high and sell low. They also often buy the

wrong stocks, sell the wrong stocks and, in

normal times, do far too much buying and

selling. A winning stock offers the opportunity

to sell, and lock in a gain and hence the

investors do so to experience the pleasure of

that gain. This is a positive investing episode. A

losing stock involves the prospect of incurring a

loss. Investors hold on to such stocks in an

attempt to avoid a negative investing episode

(Source: Barberis, Xiong, 2010). This is not because

people are stupid, they are just humans.

A study of 66,465 individual investors over a

six-year period in the United States found that

the average investor turned over 75 percent of

his/her portfolio each year. Due to transaction

costs associated net performance was reduced

by 3.7%. (Source: Barber and Odean, 2000; Daniel et al.,

1998).

People buy stocks on a simple rule of thumb, or

heuristic: Follow the news i.e. Buy the stocks if

the company is in news. This is the intuitive

mind taking the easy way to making a choice,

but the reflective mind might reject the choice

wanting a more rational decision. Stock

markets often move in response to many

factors unrelated to true value. For example a

soccer mania country’s stock market gets

affected if the national team loses a big trophy

(Source:Edmans et al., 2007) .

Thus we see that investors lack discipline in

making sound investment choices and have

their emotions, peers and intuitive mind take

decisions. The challenge for behavioral finance

is to find ways to help people not go with the

crowd, and not be susceptible to the errors of

the intuitive mind. We discuss later the Ulysses

Strategy as a recommended solution.

Regaining and Maintaining Trust:

Apart from Investor Paralysis, the recent

financial meltdown has also had a huge impact

on the bond of trust between financial advisers

and their clients. According to a survey by

Chicago Booth/Kellogg School Financial Trust

Index, at the beginning of 2009 only 34 percent

of Americans expressed trust in financial

institutions. Thus rebuilding trust is of top

priority for financial advisors & institutions,

even if their strategies did not lead directly to

clients’ losses (Gounaris and Prout, 2009).

The bruised psychological state of investors has

been likened to the feelings of betrayal

following the discovery of a partner’s affair.

Demonstrating empathy and competence is the

key to regain and maintain the trust.

© 2011 Bourbon Financial Management, LLC. All Rights Reserved. 7

Researchers’ advice and what we at BFM strive to practice!

1) A potential solution to Investor Paralysis can be solved using ‘Invest More Tomorrow’ Strategy. This

strategy works on the lines of ‘Save More Tomorrow (SMarT)’ program. There are two parts to the

Invest More Tomorrow strategy: first, overcoming the fear of seeing the value of the portfolio decline,

or loss aversion; and second, overcoming the strong tendency to put off until tomorrow what one

should be doing today, or procrastination.

Overcoming Loss Aversion: Instead of investing all the cash at one go in the market, the investor can

invest periodically. The advantage here is that if market falls, the investor sees an opportunity to buy

cheap with the next purchase. In other words we can say intuitive mind does not react negatively

because the reflective mind turns the downfall into an opportunity.

Overcoming Procrastination: ‘SMarT’ worked by asking people to commit to increase their

contribution/saving rate in advance. In a similar way, Invest More Tomorrow involves clients to pre-

commit going into the market in the future at a specific time chosen by the investor themselves. Pre-

commitment is the important psychological element here as it results into a question of what to buy at

that point rather than whether to buy at that point.

We can summarize the Invest More Tomorrow into the following 3 steps:

(Source: Shlomo Benartzi, Ph.D, Chief Behavioral Economist, Allianz Global Investors)

• Clients should pre-commit to invest at a certain future time and date.

1• Work with clients to

agree on the size & frequency of periodic investments.

2• Decide in advance

on nature of assets to be purchased.3


2) To overcome Lack of investor discipline one solution is The Ulysses Strategy. The phrase “Ulysses

contract” refers to a decision made in the present to bind oneself to a particular course of action in the

future.

In this strategy the clients are advised to engage their reflective mind to pre-commit to a rational

investment strategy. Pre-commitment to a rational investment plan is important; otherwise the

intuitive mind might trigger irrational investment responses later when market conditions tempt them

to follow the herd. Also a memorandum is signed. This memorandum is not binding, in the sense of a

legal contract but it helps clients to stick with the plan when changes in market conditions tempt them

to go with the herd.

(Source: Shlomo Benartzi, Ph.D, Chief Behavioral Economist, Allianz Global Investors)

3) A 2010 Golin/Harris survey revealed that the most effective action to restore broken trust is to be

“open and honest.” To regain or maintain trust demonstrating competence and empathy is important.

When performance exceeds expectations, it is human tendency to proclaim full credit but during

downfall the tendency is to blame luck and other external factors. However, this is unwise to do.

Admitting luck at the good times portrays honesty to the shareholders. Warren Buffet himself is a

student of this belief.

• Help clients understand the impulsive nature of investment decisions.

1• Discuss what action

would be taken when, for example: index 30% down.

2• Sign a commitment

memorandum, with both client and advisors.

3


Talk about the downside before presenting the upside. By talking about the downside first, the

financial advisor is displaying honesty that generates a greater willingness in the listener to trust what

is then said about the upside.

Apart from making investment decisions for clients putting value on the human side of business has

been described as “relational intelligence”.

Clients portray embarrassment i.e. even if they do not understand a strategy perfectly they will not

admit it openly. So instead of asking questions like: “Is there anything about our strategy you don’t

understand one should ask “Is there anything about our strategy that I can clarify?

Source: Shlomo Benartzi, Ph.D, Chief Behavioral Economist, Allianz Global Investors)

Overall we advice that pre-committing to a strategy reaps future benefits. A good analogy for the discussion can

be with someone who wants to start going to the gym but keeps delaying: “I’ll start that exercise program next

week, I promise! But it never happens. So do not make the same mistake with your investments!

We at BFM understand investors look beyond financial advice and we are here to give you a whole new

investment experience!

• Admit Luck.

• Discuss downside before upside.

Competence

• Have frequent contact with clients, especially in difficult times.

• Allay embarrassment.

• Seek feedback.

Empathy


Countries and Culture in Behavioral Finance A cumulative overview June, 2011

Dear Friends,

Recently, the subject of Behavioral Finance has been of intense research for finance professionals.

Contrary to the traditional principles of finance (risk and return), investors combine their psychological

characteristics with finance principles in evaluating an investment.

Every individual has his or her own opinions, interests, dislikes etc. But when researched deeply, it has

been understood that the surroundings and culture of the investor also play a decisive role in his or her

behavior.

Behavioral finance focuses on the cognitive and emotional aspects of the investment decision-making

process. Although we can say that people are built mentally and physically the same everywhere, the

collective set of common experiences that people of the same culture share have will influence their

investment decisions. Thus, different cultures and countries show different behavior towards

investment decisions.

We first discuss briefly different cultures with some real life incidents and surveys, and then we

describe the difference in propensity for risk tolerance among countries and cultures and how

individualistic-collectivistic line affects the risk tolerance. In the end we give a brief summary about

Islamic Finance which shows us how a culture affects investment decisions.

Difference in Cultures

Incident 1:

Meir Statman, Professor at Santa Clara University experienced this incident when he came to the US

from Israel to pursue a PhD at Columbia University. While sitting in a train Meir overheard a

conversation: “I told my daughter that I would support her through college but she is on her own

afterward.” Meir was astonished. The culture in Israel was one in which parents continue to support

their children even after college and sometimes also after marriage. (Source: Countries and Cultures in

Behavioral Finance, Meir Statman)

Incident 2:

A British National went to Saudi Arabia to work not aware of the cultural differences between the

countries. On his arrival the British Embassy handed him a guide which said “Sentences for alcohol

offences range from a few weeks or months imprisonment for consumption to several years for


smuggling, manufacturing or distributing alcohol. Lashes can also be part of the sentence”. Saudis

understand that the ways of non-Muslims are different from their own and they will not generally

interfere with what foreigners do. But foreigners who take advantage of this to break the law are

running serious risks. This surprised the British National but he had to follow the law to continue

working in Saudi Arabia.

Survey 1:

In their work, “Cultures of Corruption: Evidence from Diplomatic Parking Tickets,” Fisman and Miguel

(2006) examined whether diplomats took advantage of immunity from prosecution to park wherever

they wanted in New York City without paying parking fines.

The following results were observed:

Diplomats from Kuwait, for example, accumulated 246 tickets per diplomat during 1997–2002.

Diplomats from the UK, Holland, Australia, and Norway accumulated no parking tickets.

Even more interesting is that the number of parking tickets per diplomat was generally higher in

countries where corruption levels are higher.

Conclusion: People import norms from the culture they know into their new surroundings

Survey 2:

Propensity for Maximization:

Question: “I always want to have the best. Second best is not good enough for me.”

Propensity for Regret:

Question: “Whenever I make a choice, I try to get information about how the other alternatives turned

out and feel bad if another alternative has done better than the alternative I have chosen.” Score: (Strongly Disagree) 1 2 3 4 5 6 7 8 9 10 (Strongly Agree)

(Source: Countries and Cultures in Behavioral Finance, Meir Statman)


Different countries show different score for both tables. This shows cultures are not the same

everywhere since people react to the same situations in a distinct manner in each country.

Why do we have differences in risk tolerance in income among countries?

(Source: Countries and Cultures in Behavioral Finance, Meir Statman)

People in low-income countries have not “arrived” yet. They have high aspirations relative to

their current incomes and not as happy relative to higher-income countries.

People in low-income countries have a higher propensity for risk tolerance than people in high

income countries for the same reason that poor people spend more of their income on lottery

tickets than rich people.

Differences in risk tolerance in income among countries can be explained by the Individualism-

collectivism line. (Source: Countries and Cultures in Behavioral Finance, Meir Statman):

Individualism: Everyone is expected to look after himself and his/her immediate family.

Collectivism: People are integrated into strong, cohesive in-groups, often extended families (with

uncles, aunts, and grandparents).

When people are in groups, i.e. collectivism, they are provided downside protection.

Propensity for risk tolerance increases automatically when downside protection is provided.

Conclusion: Propensity for Risk tolerance is higher in collectivistic countries.

One other interesting fact resulted from this survey is “People are more happy in

individualistic countries than collectivistic countries” as seen in the figure above.

Out of 88 countries ranked by individualism: USA ranked as #1 while China ranked at #65.


Islamic Finance:

The main principles of Islamic finance include:

Prohibition of taking or receiving interest.

Capital must have a social and ethical purpose beyond pure, unfettered return.

Investments in businesses dealing with alcohol, gambling, drugs or anything else that Islamic

law considers unlawful are deemed undesirable and prohibited.

Prohibition on transactions involving speculation.

Prohibition on uncertainty about the subject-matter and terms of contracts – this includes a

prohibition on selling something that one does not own. (Source: ©Freshfields Bruckhaus Deringer

2006)

Our Advice

We can summarize some of the practices that should be followed:

Financial advisers need to probe their clients more about their culture. Also important is to

know the client obligations towards others. As we saw above, individualistic and collectivistic

groups have different styles of thinking. This reflected in their investment decisions.

Continuously strive to learn more about investing.

Understand the complexities in investing. The adviser will have to do more research and be

sure that he does not fail his fiduciary duty. For example, an Islamic Finance Client can sue his

adviser if his/her portfolio deviates from Islamic Principles.

Money and happiness do not go hand in hand. People who have big aspirations may have the

required health but may not be happy with it. On the other hand people with low aspirations

have the money that makes them happy.

Saving Rates depend a lot on culture. It is important to understand your culture before you

make investment decisions. Higher saving rates cultures are more risk tolerant that low saving

rate cultures.

Many times investors exhibit different abilities and willingness towards risk. Always honor the

willingness to risk because the investor feels comfortable if his risk level is under his/her

control.


Investment Decision Making Mayh, 2011

Dear Friends,

In the past, we have presented you with some educational materials associated with behavioral

economics and investment decision making. In this document, we try to sum up some research and we

explain a comprehensive approach to investment decision making from the perspective of behavioral

finance.

We first briefly discuss each of the research topics that we have covered and we then present a viable

way to go about utilizing the conclusions of the research, to help you become a sound investor.

Myopic Loss Aversion

The first research we wish to mention is on the perception of loss. How the human mind models loss

and how people are impacted by losses more deeply than gains of the same value. We wish to discuss

an attribute called Myopic Loss Aversion (Richard H. Thaler, Amos Tversky, Daniel Kahneman, Alan Schwartz.1997)

Myopic Loss Aversion (MLA) is explained by two factors:

A. Loss Aversion: People tend to be more sensitive to decreases in their wealth than to increases.

B. Mental Accounting: Mental accounting determines both the framing of decisions and the

experience of the outcomes of these decisions.

The original paper has more details about the risk appetite of investors and how it is impacted by MLA.

However, we summarize the two conclusions related to an investor’s risk appetite in the

aforementioned research by the following:

1. If, in an investment, all payoffs are increased enough to eliminate possible losses, investors will

accept more risk.

2. An investor who monitors the investments in short intervals, appears to be more risk averse than

an investor who monitors the investments relatively infrequently.


Asset Allocation and Information Overload

Another viewpoint on how the structure of information about investment options impacts our thinking

is highlighted by a research on Information Overload. This research looks at the ways in which

investment options are structured and how this affects investment decisions. (e.g. options in a defined

contribution plan can confuse the investor). (Julie R. Agnew and Lisa R. Szykman, 2005)

A key observation mentioned in the research stated: “Consumers tend to reduce the amount of effort

they expend when decisions become more complex”. This tendency is highlighted in a study by Choi

et al. [2004]. The authors found that 80% of participants in plans with automatic enrollment initially

accepted the plan’s low default savings rate and the conservative default investment fund. Three years

later, over half these individuals maintained these ‘default elections’.

The research concludes that the tendency mentioned above is mostly triggered by Information

Overload. Information overload specifically refers to things that hamper a comprehensive evaluation

of an option.

For example, it could be the small font size of the information displayed or the number of choices or

complexity thereof. It becomes difficult for us to make certain difficult choices in the presence of a

simpler, less complex but expensive, ‘default option’.

In other research by Dan Ariely (covered in our past newsletter), it is shown that sometimes expensive

choices are presented in a more attractive manner than other more rational ones, thereby misleading

consumers.

Human beings have to make many decisions as part of daily life. Some of them are easy, some of them

are difficult. The question that can be asked here is what really makes these choices easy or difficult?

Well, we have pointed out some of the reasons, such as:

1. Large number of choices.

2. Complexity or less intelligible choices.

3. Presence of difficult choices along with simpler, less complex but expensive ones.

4. Presence of attractive but irrational choices along with unattractive but rational ones.

The above mentioned points are definitely factors at play, but research done by a professor Barry

Schwartz, who teaches social theory at Swarthmore College, adds more dimensions related to the

decision making process.


The Investor’s Paradox

In The Paradox of Choice, Schwartz observes that people often choose the options that, in their

opinion, will minimize the chance of experiencing regret in future. Investors may be tempted to hold

on to a losing investment or recognize sunk cost as expenditure that is yet to occur, in an attempt to

avoid acknowledging a misstep. (Schwartz, Barry. The Paradox of Choice. New York: Harper Perennial,

2005.)

Several studies cited in The Paradox of Choice have documented this bias involving sunk costs.

Respondents in one study were given a hypothetical situation wherein they

purchased nonrefundable lift tickets for two different ski resorts ($75), but later realized that both the

tickets were valid only for one day. Thus they had to choose between Ski Resort 1 and Ski Resort 2. Ski

Resort 1 costs $50, while the other costs $25. They were also told there is good reason to believe they

would have a better experience on the $25 trip. However, the majority of respondents choose to go on

the $50 trip because they had already paid the price of both tickets upfront. Thus, to offset their loss

they choose to go with costlier ticket even though 25$ ticket would give them a better experience.

Schwartz, using the example of stocks, points out: “what should matter in decisions about holding or

selling stocks is only your assessment of future performance and not (tax considerations aside) the

price at which the stocks were purchased.” Schwartz argues that sunk cost regret is greater when:

A person bears responsibility for the initial decision.

An individual can easily imagine or measure a better alternative.

Another challenge is the frequency with which we’re exposed to new information that may represent

an obstacle against maintaining a disciplined investment strategy. As we know from our earlier

discussion about risk aversion, the less often people re-evaluate their decisions the greater their risk

appetite and as per Schwartz, the less regret. However, with a barrage of new information, people get

motivated to re-evaluate decisions more frequently.

Some of that information may arrive as part of experience of other investor(s). People tend to give

more weight to anecdotal account of a single (or few) person(s) delivered to us directly, than to a

survey of a large group of people read in a magazine or newspaper.

Another thing that people do with reference to their prior decisions is that, they tend to compare them

with their past decisions or with decisions of other people. One valuable insight that Schwartz shares is

that comparisons may lead to high expectations, and result in changing investments at the wrong time

for the wrong reasons. So with all that information, how could you become a sound, mature and a

smart investor? Well, worry not. We outline few important points and recommend some practices that

would help you to become a better investor.


Our Advice

Well, we can summarize some of the practices that an investor should try to follow, such as:

Continuously striving to become more educated about investing.

Understanding personal objectives related to investment.

Determining one’s own risk appetite.

Exploring all the practically possible and logically sound alternatives related to investments.

Evaluating investment options carefully and comprehensively (without skipping the fine print).

We also recommend some things that an investor should try not to engage in. For example:

Evaluating decisions too frequently.

Comparing outcomes with past performance or outcomes of other people’s decisions without an

actual understanding of the real factors behind the outcome.

Becoming sensitive to short term devaluation of investments.

Schwartz observes an important attribute associated with decision making. We quote Schwartz:

“We seem to do our best thinking when we’re feeling good. Complex decisions, involving multiple

options… demand our best thinking. Yet those very decisions seem to induce in us emotional reactions

that impair our ability to do just the kind of thinking that is necessary.” We would like our investors to

focus on the first part. We need to feel good when we make important decisions. Not something easily

controllable but it is always worth the attempt.

We conclude with a hope that our recommendations would assist you to gain a more pragmatic and

cognizant approach to investing.


Markets Trends: Bullish, But How Long?

March, 2011

Dear friends,

Some of you have recently asked for our opinion on the financial markets and trends. Let me present here our

view.

Below is a chart that represents the historical bull market advancement periods with the y-axis

representing the percentage advance and the x-axis representing the length of period for

which, the advancement sustained.

Source: Strategas

As you can see on the chart above, the S&P 500 has almost doubled since its bottom on

March 9th, 2009.

Also note that the average bull market lasts 57 months with a 164% average increase.


Here is another chart:

The chart below shows the 23-month Percentage Rate of Change (RoC) in the S&P500 index

across time (as of February 9th 2011).

Source:Sincereco

24 months ago, the SPX index bottomed on March 9th 2009, a closing basis at 676.53.

The S&P 500 index (SPX) has increased by over 90+% since.

The current rally represents the 3rd greatest percentage gain for any 23 month period in

the index’s history (as of 02/2011), with the gain standing at 90+%. It was preceded by the

2nd worst 23 month drawdown, only bettered by the 1929 – 1932 crash and the index is

still actually lower than it was 46 months ago (it closed at 1444.61 on April 9th 2007),

meaning that this drawdown is yet to be fully repaired, while both corporate earnings and

outlooks are much healthier at present.


Here are some thoughts:

Bull View:

The market should continue to rise in the next couple of years due to good

valuation vs. bonds/cash, the market has a free cash flow yield close to

7%, which is the highest in history and balance sheets and has never

been better.

Furthermore, confidence, consumer spending, hiring, and the availability

of credit are increasing and equity funds would see inflows.

Bear View:

Structural issues in our economy like debt, unemployment, real estate

prices would most likely persist. Rising oil and commodity prices may be

due in part by the additional liquidity provided by the quantitative easing 2

of the Federal Reserve.

Overall View:

As a believer in reversion to the mean, we think that the next decade

should be a positive one for stocks though return opportunities are not

what they were two years ago.

For the next three to five years, returns on an annualized basis may not be

as good as the last two years. There will be corrections which should

create opportunities to increase our equities exposure. So while we think

that returns will remain positive, volatility will be present.


Japan Disaster Thoughts

First, we offer our most heartfelt condolences to all those who lost their lives, to their families, and to all those now

in unbearable circumstances. Placing numerical values on the economic losses is an intolerable insult to all those

who lost their lives and to their families and relatives, and is morally indefensible.

- Uncertainty is the operative word in Japan, but as we take a step back and think about the broader economic

impact, it’s worth noting that this natural disaster is happening at a time when the U.S. data looks solid (good

valuation vs. bonds/cash, the market has a free cash flow yield close to 7%, among the highest in history, and

balance sheets have never been better, confidence, consumer spending, hiring, and the availability of credit are

increasing, and equity funds see inflows).

- Here is a summary table of the markets movement from last Friday March 11th to March 16

th:

Closing Price 11-Mar 16-Mar Variation

MSCI Japan 4,681.64 4,288.94 -8.39%

MSCI World 4,425.87 4,241.80 -4.16%

S&P 500 1,304.28 1,256.88 -3.63%

MSCI Europe 1,483.83 1,410.87 -4.92%

- The Yen at one point had strengthened to post WW II high but has started to weaken on speculation the G7 will

intervene.

- It is very difficult to quantify the long term impact of the Japanese disasters at this stage. Hence we should not

make any formal changes to portfolios at this point. The portfolio managers of the international funds you

may be invested in, are making changes in the funds if they believe they are necessary.

- We recognize that there may be extensive electricity supply disruptions that could lead to a 0.5 percentage point

fall in Japanese GDP this year, cutting growth from 1.4 per cent to 0.9 per cent (HSBC forecasts). In a bad

scenario, there may be a broader radiation contamination, affecting the Tokyo metropolitan area. This scenario

could cut GDP by 1 percentage point this year.

- Some fund managers are spotting buying opportunities. Chuck de Lardemelle says the roughly $9 billion in the

International Value Advisors Worldwide Fund he co-manages currently has a 14% exposure to Japanese equities.

"Parts of an already cheap market may have gotten cheaper," he says.


- Japan today accounts for a smaller share of the global economy than at any time since the 1970s – 5.8%,

compared to 7.5% a decade ago and more than 9% in the early 1990s (Source: IMF, WSJ).

- US send 7% of exported goods and services to Japan (one-fifth as much as European Union exports). The

entirety of American exports to Japan account for less than 1% of the total U.S. economy. (Source: U.S.

Department of Commerce, WSJ)

- Japan's stock market, which twenty years ago was the most valuable in the world, today accounts for a smaller

share of global equity values than at any time in decades. On the eve of the Kobe earthquake in 1995, it

accounted for nearly 30% of world stock market values. Today? Just 7.5%.

- It may be more of a human story than a big economic story (like 1929-1945-1973-1987-2001-2008…).

PS: Please find below a link for a video on the surprising truth about what motivates us

http://www.youtube.com/watch?v=u6XAPnuFjJc

http://www.youtube.com/watch?v=u6XAPnuFjJc


Update on US Tax (Are You Leaving Money on the Table at Tax Time?) + Why You Shouldn't Trust Wall Street's Top Stocks for 2011 February, 2011

Dear Friends,

On December 16, 2010, Congress passed the Tax Relief, Unemployment Insurance Reauthorization and Job

Creation Act of 2010. This legislation, negotiated by the White House and select members of the House and

Senate, provides for a short-term extension of tax cuts made in 2001. It also addresses the Alternative Minimum

Tax (AMT) and Estate, Gift and Generation-skipping Transfer taxes.

In Summary:

Two-year extension of all current tax rates through 2012 Temporary modification of Estate, Gift and Generation-Skipping Transfer Tax for 2010, 2011, 2012

AMT Patch for 2010 and 2011

Extension of “tax extenders” for 2010 and 2011

Temporary Employee Payroll Tax Cut More in the attached file!

You can also find a summary tax table on http://www.jetter.com/taxtables.pdf.

****

Warren Buffett, the chairman and CEO of Berkshire Hathaway Inc. and one of the smartest investors in the

world, knows all about broker conflicts. Buffett says he learned that "the broker is not your friend. He's more

like a doctor who charges patients on how often they change medicines. And he gets paid far more for the stuff

the house is promoting than the stuff that will make you better." I couldn't agree more. After 10 years close to

Wall Street, I saw the pressures and the abuses.

http://www.jetter.com/taxtables.pdf


You may wonder how good are Wall Street’s stocks recommendations. Please find attached an article that

may answer your question. In summary:

How would you do longer term if you followed Wall Street's top recommendations each year? The future, of

course, is unknowable. But I looked back over the past five years. I asked how you would have done if you

bought the analysts' top 10 favorite stocks at the start of each year, held on for 12 months, and then sold and spent

the money buying the new year's picks.

If you had started with $10,000 at the start of 2006, invested $1,000 in each stock and reinvested any

dividends, today you'd have $10,950. That's before trading costs and taxes.

But if you had just ignored Wall Street analysts, put that money in the SPDR S&P 500 exchange-

traded fund—which tracks the entire Standard & Poor's 500—and left it alone, you'd have $11,190:

slightly more. And you'd have saved a lot on trading costs and capital-gains taxes as well. Overall, you'd

have ended up considerably better off.

As for the unpopular stocks? Thanks to survivorship bias, we can't be completely certain. But if you'd

just bought the most-hated 10 stocks (in today's S&P) each year you'd have an astonishing $16,430

today.

That's in just five years.

Lehman Brothers? At the start of 2008, 17 analysts covered the stock. Of them nine had it as a "hold," five as a

"buy" and two—amazingly—had it as a "strong buy." Given that one of the smartest things anyone could have

done with their money, ever, was to sell Lehman stock at the start of 2008, how many analysts actually issued that

recommendation?

One. Out of 17. Source: WSJ.com

Investmentnews.com just reported that companies in the Standard & Poor's 500 Index that analysts loved the

most rose 73 percent on average since the benchmark for U.S. equity started to recover in March 2009, while

those with the fewest “buy” recommendations gained 165 percent, according to data compiled by Bloomberg.

When your broker calls to offer you his analysts' "top picks" for 2011, maybe you'd be better off asking him

which stocks his analyst hates. Or you could just let the phone ring.


Understanding Behavioral Finance- Rationality & Decision Making January, 2011

Dear friends,

Behavioral Economics explains how the process of decision making functions among common people.

It elaborates on the role of emotions and vision. Do you want to know how powerfully illusive our

vision is and how it dominates our decisions? Refer to “We are all Predictability Irrational - Dan Ariely”

on YouTube link:

http://www.youtube.com/watch?v=JhjUJTw2i1M&feature=related

Here, we present a short summary of the talk by Dan Ariely by extracting the important pieces of his

experiments from the video. Each experiment emphasizes on important aspects of our decision making

process. Please read through these pieces while answering the following questions and note the

difference between your answers and answers provided.

1. Visual Illusions

“Look at the two tables, try to figure out

which one is longer?”

You may think that it’s obviously the left

one, just based on your vision.

http://www.youtube.com/watch?v=JhjUJTw2i1M&feature=related


As Ariely points out in the video, it turns out that the tables are actually of the same length. It’s

our vision that causes the illusion and alters our judgment.

The Colored Cube:

“Have a look at the magic cube and the color

which are pointed out by the red arrows. What

are the colors of the two squares?”


When we cover the rest of the cube, here comes out the answer: they are the same!

We believe that they are different colors just because they look different with different

backgrounds. As what the picture on the right shows, when we put away the white background,

the illusion comes back.

The point is that we are dedicated to trust our vision, which we use more in a day out of all the senses

of our body (including common sense). We believe we are good at it, but the truth is different from our

belief when we take the case of two tables with the same length and the up and side centers of the

magic cube with the same color.

“If we make mistakes using our vision, which we think we are good at, what is the

chance we don’t make more mistakes in that we are not good at, ex. financial decision

making?”


The Difficult Decisions

Sometimes, as Ariely points out, it becomes difficult for us to make certain difficult choices in presence

of a simpler, less complex but expensive, ‘default option’. Ariely proves his point by mentioning the

Organ Donation example.

In the example he shows that the percentage population of drivers in a country, interested in donating

their organs after death has less to do with the intent of the people or their culture and more to do

with the default option made available to them by the person who designed the DMV form in their

country.

Organ Donation:

This is the chart shows the percentage

of drivers enrolled in organ donation

program in different countries.

The RHS countries (marked by the red

arrow) do much better than the LHS

ones (marked by the blue arrow) in

organ donation. Why?

It has nothing to do with culture or

religion, but the design of the format

DMV: Opt-in for LHS and Opt-out for

RHS.

Following pictures show how the design of the DMV form influences the decision of the drivers:


The LHS countries have the “Opt-in” box on their DMV forms and often people filling up the form

do not check the opt-in box.

Although the people in the RHS countries do not check the box as well, but in this case the box is

has an “opt-out” option. People find it hard to make a decision about something like organ

donation and end up going for the default option.

“Our decisions are not residing within us but the people who design the form! Could you believe

that one form would actually change your own behavior?”

The design of the form exploits the fact that humans would inadvertently choose the default option if

it eliminates the need of going through a complex decision making process. But is this phenomenon

limited to common people? What about people who are professionals in certain fields? Would they

make similar mistakes in their profession in a similar situation?

Professional Lapse of Judgment:

Ariely answers these questions through an experiment that deals with doctors and their decision

making process. He describes a scenario where, on the way to the surgery room the physician suddenly

remembers that his patient has not yet tried an alternative to surgery. Let’s take a look to find out

what happens to the “professionals”?


Scenario 1:

On the way to surgery room, the

physician suddenly remembered the

patient had not yet tried one medicine,

what will the physician do?

The Physician pulls back the patient

and tries the medicine

Scenario 2:

On the way to surgery room, the

physician suddenly remembered the

patient had not yet tried two different

types of medicine, what will the

physician do in this case?

Although it may seem obvious that

physician will pull back the patient, but

it turns out that physician will just let

his patient go through the surgery

instead of facing another problem of

trying to find out which medicine is the

right medicine for the patient.

Professionals have a huge impact on what others end up with. If you need help from

professionals make sure you find the right person!


2. Everything is Relative

Imagine that you are out of school and you are offered a job at a salary of $70,000 per year. It turns

out that you are the lowest paid employee in that company. Everybody else makes more you do.

Compare that to a situation where you are offered $65,000 in a company where you are the highest

paid employee. Which job will you take and be happy about it?

It is hard to choose the $65,000 job if it is being offered alongside the $70,000 job, however if $70,000

job was not offered at all then you would be much happier working for $65,000 a year where you

would be earning more than other employees in the company at same level. Your happiness is not

proportional to your salary but is proportional to your salary relative to other employees in the

company.

Ariely describes the practical implementation of this principle of relativity by discussing an old

subscription advertisement by The Economist.

The Subscription Trick:

The Economist has three subscription

terms:

A. $59 for only online access B. $125 for only print edition C. $125 for both print edition and

online edition.

The subscription forms were handed out

to a group of 100 students.


Following were the results of the

above experiment:

16% students chose option A

0% students chose option B

84% students chose option C

Then he deleted the option B and did the survey on another 100 students. The outcome changed as

show below:

Following were the results after the

deletion of Option B

68% students chose option A

32% students chose option C

The truth is that the second option is useless but it’s presence in the advertisement makes the third

option worthy and more appealing and people end up choosing option C.

Actually, we don’t know our preferences that well, so we often accept all of the influences from the

external forces after doing a comparative analysis that may have been pre-designed in order to

influence our decision.

In the video Ariely mentions few more interesting examples, which you can see by visiting the link

mentioned above. The examples include an experiment related to Dating and another experiment

comparing a trip to Rome Vs. a trip to Paris. You may visit the link at your own convenience.


Our Advice

The point behind the discussion is that when we think about economics, we have this beautiful view of

human nature: “What a piece of work is a man!” We know our limitations in the physical world, and we

build our physical world around it step by step. However, sometimes when it comes to the mental

world, such as our desire for healthcare, retirement and stock market, we somehow forget our

limitations.

Before making any financial decision one must be sure of the kind of investment one is looking for.

Some homework should be done before making any major decision to make it a well thought out

decision.

Behavioral economics tells us where our limitations are in the mental world. It is always advised that

one should be aware of one’s emotions and should explore all the practically possible and logically

sound alternatives while investing.


Investors Fail to Capture the Returns they Expected + Chasing Performance May Lower your Returns November, 2010

Dear Friends,

Just wanted to share two interesting research reports.

1. Dalbar Research Institute shows that investor’s performance does not equal investment

performance. They found the following annualized returns for investors from 1987 to 2006

(similar results are found for different time period):

-The average equity-fund investor realized an annualized return of 4.30% ($100,000 became

$222,536).

-The market timer equity fund investor realized an annualized return of -1.80% ($100,000 became

$70,814).

-The market (S&P 500) realized an annualized return of 11.80% ($100,000 became $832,519).


2. Using another research report from Lipper and DALBAR, we can see, in the chart below, that

chasing performance may lower your returns. This research shows how mutual fund investors’

behavior affects the returns they actually earn.

Source: Lipper and DALBAR


Let's Be Positive!

October, 2010

Dear friends,

As some of you know, we started to be bullish on stocks in January 2009. The stock market had a great

rally between March 2009 and April 2010 (up 80+%).

Some clients have asked us what do we think today. Like Buffet, Ballmer and Immelt, we are positive!

Mid September, Warren Buffet, Microsoft’s Steve Ballmer, and GE’s Jeff Immelt provided their

perspective during a Conference in Montana.

Warren Buffett

• “I’m a huge bull on this country... we won't have a double-dip recession. I see our businesses coming

back almost across the board… It's night and day from a year ago.”

• “I’ve seen sentiment turn sour in the last three months or so, generally in the media. I don't see that in

our businesses. I see we're employing more people than a month ago, two months ago.”

• “The things that worked for the country through a century of two world wars, a depression and more--

all while increasing the standard of living--will work again.”


Steve Ballmer, Microsoft

• “There soon will be more technological advancement and invention than there was during the Internet

era, and that will help drive business growth.”

• “I am very enthusiastic what the future holds for our industry and what our industry will mean for

growth in other industries.”

• “We will see new technologies that move beyond the Internet to tie together computers, phones,

televisions, and data centers to create amazing new products. And the pace of innovation will increase as

technology makes workers more productive.”

Jeff Immelt, GE

• “Angry political rhetoric is not helpful, and headlines are too focused on finding negative indicators.”

• “Business at GE is improving. Signs across the world show growth improving, as evidenced by a rise

in GE's orders.”

• “GE is now finding it profitable to build manufacturing and service centers in the United States rather

than overseas, because it is more competitive to do so.


Videos on Behavioral Economics and Behavioral Finance (overconfidence...) September, 2010

Dear Friends,

Many of you know that I like behavioral economics. Here is a short video (with Dan Ariely from Duke

University) which explains what it is. http://www.youtube.com/watch?v=Fa-mIosWOK8

If you want to learn more about behavioral finance and the role of Psychology, here is a long and

popular video (viewed 28,000 times!) of a class of Robert Shiller, Professor of Economics at Yale

University.

http://www.youtube.com/watch?v=0ZLNbxWH8Lc

This video shows:

-The stock market and the random walk looks the same

-Some charts of the stock market since 1870, including

some comments about the great depression

-Human behavior and the role of overconfidence (for

men and women) with some experiments

-Prospect/Utility Theory-How people make choices…

http://www.youtube.com/watch?v=Fa-mIosWOK8

http://www.youtube.com/watch?v=0ZLNbxWH8Lc


Humans can't analyze all the information received September, 2010

Dear Friends,

Please find below a one-minute video.

http://viscog.beckman.illinois.edu/flashmovie/15.php

This video shows that human attention is limited and that we can’t analyze all the information we

receive.

We tend to pick the information that we need to prove that our thinking is correct. If we are bullish and

long the financial market, we tend to read bullish reports. Individuals have a tendency to simplify

decisions (good company -> good investment, momentum strategies -> chasing performance).

Furthermore, investors believe their information is correct and they are better at interpreting information

and making decisions. We have an inability to fully incorporate new information into risk and return

forecasts. The failure to recognize the true risk of an investment makes us trade more frequently than

can be justified by the information. Also, we tend to remember only the good decisions so our memories

don’t disagree with our opinion on our abilities.

http://viscog.beckman.illinois.edu/flashmovie/15.php


Cette vidéo démontre que les capacités attentionnelles de l'être humain sont limitées et que l'homme

ne peut pas traiter correctement toute l'information à disposition. En finance cela plaide en faveur de

l'hypothèse de rationalité limitée (limitée à cause des capacités cognitives limitées) à la différence de

l'hypothèse de la finance traditionnelle qui postule la rationalité parfaite des acteurs. Mais les capacités

attentionnelles limitées ne sont qu'une petite partie du problème car il se trouve qu'on sélectionne aussi

l'info qui nous arrange (par example si on est long/acheteur du marché, on ne va lire que les analyses

bullish et on interprète les infos dans le sens qui nous arrange...).

Quelque soit la tâche financière en jeu, qu’il s’agisse d’une décision financière à prendre

(investissement, allocation d’actifs ou mode de financement à déterminer), d’une estimation à réaliser,

d’une analyse de risque à effectuer (scénarios futurs à probabiliser, aléas à chiffrer…) ou encore d’une

stratégie d’entreprise à planifier, que le décideur soit un particulier ou un professionnel (trader, gérant de

portefeuille, analyste de risque, dirigeant membre d’un comité de direction…), celui-ci est soumis à un

flot d’informations permanent qu’il doit trier, organiser et traiter. La tâche n’est pas simple. En effet, les

capacités attentionnelles ou mnésiques de l’être humain ne sont pas infinies. Il possède des

capacités cognitives limitées : citons par exemple Simons et Chabris (1999) qui ont effectué une

expérience très originale. Les participants de leur recherche devaient regarder à la vidéo des joueurs en

train de jouer au basket. Ils devaient compter le nombre de passes effectuées par les membres d’une des

deux équipes et notifier tout évènement anormal ou incongru se produisant éventuellement au cours du

jeu. Au milieu du match, la vidéo (truquée) montre soit un gorille qui passe pendant quelques secondes

devant la caméra et qui se frappe la poitrine, soit une femme avec un parapluie ouvert, ce qui constitue

plutôt un événement incongru au milieu d’un match de basket. Pourtant, près de la moitié des

participants ont indiqué ne rien avoir remarqué d’incongru (même quand on les interrogeait plus

précisément à propos du gorille ou de la femme au parapluie) ! Ce qui dénote un phénomène

« d’aveuglement cognitif ».

Dans les salles de marché, il n’est pas rare de constater empiriquement que des professionnels

« oublient » d’exercer des options dans la monnaie qui arrivent à échéance, alors qu’il leur suffirait

simplement d’y penser pour empocher une grosse mise. Longstaff et ses collègues (1999) dans un article

intitulé « jeter par la fenêtre un milliard de dollars » font ainsi état d’importantes erreurs réalisées par

les investisseurs dans leurs exercices d’options.

En amont de la décision financière, il y a donc la question centrale du traitement de

l’information : face au flot d’informations qui prévaut sur les marchés financiers comment le décideur

traite-t-il cette information ? Comment la structure-t-il ? Comment l’utilise-t-il pour analyser les risques

ou estimer les probabilités ?

Merci à mon amie et conseillère Caroline Attia, qui m’a aidé à comprendre.


Train Your Brain to Win Big August, 2010

When Playing the investing game, it’s easy to let your impulse make all the wrong moves. Learning to

trick yourself can help.

Why do smart people do such stupid things with their money? The answer often lies in neuroeconomics,

a hybrid of neuroscience, economics, and psychology that drills down to the biological bedrock of

decision-making.

Even when we think we are being rational, we are often driven by impetuous emotions of which we are

barely conscious. Therefore, the keys to investing success, whether it’s for retirement or just for fun, are

strategies and tricks to prevent the heat of the moment from melting your better judgment.

Ten Tricks for Better Investing:

Take the Global View

Hope for the Best-But Expect the Worst

Investigate Then Invest

N ever Say Always

Know What you Don’t Know

The Past Is Not a Prologue

Weigh What They Say

If it Sounds Too Good to Be True, It Probably Is

Costs are Killers

Eggs Go Splat


So That's Why Investors Can't Think for Themselves June, 2010

From February through May, the Dow Jones Industrial Average gained more than 1000 points in an

almost uninterrupted daily march upward. Then came the "flash crash" of May 6 and day after day of

losses through May. Now, in mid-June, the market has been up six of the past seven days.

Christophe Vorlet

What accounts for these sudden moves? Why do investors so often seem to resemble a school of fish,

all changing direction together?

Sometimes the most interesting answers to financial questions come from scientific labs. A study

published last week in the journal Current Biology found that the value you place on something is

likely to go up when other people tell you it is worth more than you thought, and down when others

say it is worth less. More strikingly, if your evaluation agrees with what others tell you, then a part of

your brain that specializes in processing rewards kicks into high gear.

In other words, investors often go along with the crowd because—at the most basic biological level—

conformity feels good. Moving in herds doesn't just give investors a sense of "safety in numbers." It

also gives them pleasure.

That may help explain why market sentiment can change so swiftly, why true contrarians are so hard

to find and why investors care so much about the "consensus view" on Wall Street.

In the experiment, researchers from University College London and Aarhus University in Denmark

asked 28 people to submit a list of songs they wanted to buy online and then to decide which they

would most like to own. Then the participants viewed the ratings of the same songs by two

professional music experts. Meanwhile, a magnetic resonance imaging machine recorded the patterns

http://www.cell.com/current-biology/abstract/S0960-9822(10)00595-6

http://www.cell.com/current-biology/abstract/S0960-9822(10)00595-6


of activity in their brains. Finally, as a way to measure the influence of the experts' views, the

participants had the chance to change their minds about which songs they wanted the most.

The brain scans showed that as soon as people learned they had chosen the same song as the experts,

cells in the ventral striatum—a reward center wired with dopamine neurons that respond to pleasures

like sugar and sex—fired intensely. "If someone agrees with your choice, it's intrinsically rewarding

in the same way food or money is rewarding," says one of the experimenters, Chris Frith of University

College London.

Why might other people's estimates of what something is worth lead you to change your own? Their

appraisal could make you unsure that yours is correct. You might become more popular once you

agree with others, or joining the experts may make you feel like one yourself. "We are very social

creatures," says Prof. Frith, "and we are desperately keen to be part of the group." "When someone

influences you, it happens very quickly, in under a second," says the lead researcher, Daniel

Campbell-Meiklejohn of Aarhus University. "That mechanism can travel quite quickly through a

population."

The experiment also showed that learning that the experts agree with one another—regardless of

whether you agree with them—triggers activity in the insula, a brain region associated with pain and

heightened body awareness. This suggests that the agreement of others may have a special ability to

grab our mental attention. No wonder a consensus opinion is almost impossible for many investors to

ignore.

Benjamin Graham, the founder of value investing, wrote that "the market is not a weighing machine,

on which the value of each issue is recorded by an exact and impersonal mechanism, in accordance

with its specific qualities." Rather, he added, "the market is a voting machine, whereon countless

individuals register choices which are the product partly of reason and partly of emotion." Herding,

Graham understood, is part of the human condition.

Thus, if you buy individual stocks, you should note which way the herd is moving—and go the other

way. You should get interested in a stock when its price gets trampled flat by investors stampeding out

of it. The list of new 52-week lows is a rough guide to what the voting machine has been trashing

lately. Then run your own weighing machine, studying the company's financial statements, products

and competitors to determine the value of its business—while ignoring the current price of its stock.

And make a permanent record that thoroughly details your rationale for making the investment. That

way, you set in stone exactly where you stood before the herd began trying to sweep you away.

(Source: WSJ-06/21/10)

http://books.google.com/books?id=-SVwCBG5ZiwC&pg=PA70&lpg=PA70&dq=


Sincerely,

Patrick Bourbon, CFA

Bourbon Financial Management, LLC

Excellence. Experience. Ethics.

616 W. Fulton St., Suite 411, Chicago, IL 60661

+1 312 - 909 - 6539 - [email protected]

www.bourbonfm.com

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Member of the Financial Planning Association and an Academic Affiliate of the National

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