DR.CHENJIAZI ZHONG

While risk may be unavoidable, its definition is, at best, fluid.

• There is no such thing as a risk-free investment. Investors can mitigate risk but should recognize that every investment entails risk.
• Markets are always in the process of incorporating new fears, beliefs, and information; hence, there is the constant presence of a “wall of worry.”
• Bubbles represent an extreme expression of investor behavior. Investors should not be sanguine that spotting a bubble in real time is easy.
• The flipside of a bubble is a panic. However only in rare occasions does panic selling pay off.
• Risk and uncertainty are not the same thing. Financial markets generally do a decent job of pricing risk but are unable to capture the uncertainty inherent in an uncertain world.

Returns are transparent and highly publicized; finding a middle path between momentum and value within and across asset classes gives a better chance of returns.

• Investors should never forget that their goal is to generate real, after-tax returns and that inflation and taxes play key roles in our returns.
• Estimates of the equity risk premium have been coming down for some time. There are good arguments why we should contemplate and plan for a lower, even zero, equity risk premium.
• The market owes us nothing. Investors need to cont4emplate dealing with significant drawdowns in the equity and fixed income markets during their lifetime.
• Over the short and intermediate term, momentum rules markets. However, following a momentum strategy comes with significant psychological costs.
• Eventually momentum fizzles out and value wins out. The links between the financial markets and corporate finance ensure some balance between prices and reality.
• Investors have a better chance of earning balanced returns by combining strategies, like value and momentum, in their portfolios.

For better for worse, the stock market remains the investment choice; when people ask what the market did today, they usually mean the equity market.

• The stock market is not the economy. The two can diverge for extended periods of time. In short, Wall Street is not Main Street.
• In contrast with established theory, low-risk stocks have outperformed riskier stocks. Investors can now easily access these strategies but risk underperforming during bull markets.
• Dividends matter. The long history of the U.S. and foreign stock markets shows the importance of dividends. The increasing desire for yield may make dividends even more important in the future.
• Research indicates that the distribution of individual stock returns is not normal. A small fraction of stocks generate outsize returns. This phenomenon may become more pronounced over time.
• Short selling individual stocks is a hard way to generate returns. A number of obstacles prevent most investors from reliably profiting on the short side.

“In spite of promising lower returns than most other investment classes, bonds earn inclusion in portfolios by providing protection against the extraordinary circumstances of a financial crisis or economic deflation.”

• Bonds not only play an important role in investing, but bond yields also help link the financial markets and real economy.
• Current Fed policies aside, the slope of the yield curve has served as a better forecaster of recessions than the consensus opinion of economists has.
• Don’t fight the Fed is a well-worn cliché on Wall Street, but there is ample evidence that the Federal Reserve can impact investors’ willingness to take on risk.
• Cash is an asset but not an investment. Cash represents a means for investors to ride out periods of uncertainty, but relying on cash equivalents to meet long-term goals is a losing proposition.
• Bond funds are not bonds. Investors are well served by focusing on bond vehicles with definite maturities within the framework of an overall bond ladder strategy.
• There are modest benefits to taking on some credit and maturity risk, but investors need to be wary of diluting the insurancelike aspects of bonds in their overall portfolios.

Portfolio management is all about pulling together the threads of risk and return.

• Diversification works in theory and in practice. The problem is that investors often abandon diversification at the worst possible time.
• Asset allocation should be a deliberate process of portfolio construction rather than a haphazard collection of funds.
• Portfolio rebalancing through discipline and a contrarian approach works to lower portfolio volatility. There are a number of approaches to rebalancing, the only key being that it actually be done on a regular basis.
• Measuring portfolio performance is an important feedback mechanism, but the S&P 500  is likely not the appropriate benchmark.
• Portfolio leverage is the number one portfolio killer. Investors should avoid unwitting leverage.
• Illiquid investments impose a reduction in portfolio flexibility and higher costs. They are most often sold to investors rather than purchased.
• Investors should never purchase an investment they don’t understand. There is no such thing as a “must own” investment.

Generate abnormal returns stands to reason that becoming an accomplished investor or trader is an even tougher task.

• Most traders fail. The 90% of traders who fail will not only lose money but also experience the opportunity cost of time spent in the pursuit of trading success.
• Outperforming the market by large amounts over large periods of time is difficult. Don’t get fooled by those who claim otherwise.
• Trading is not fair. The best traders take full responsibility for their trades and treat their losses as tuition paid for a more complete market education.
• Every trader needs a trading plan. A checklist helps traders stay on track.
• Expectancy is an important framework for traders to understand. For traders, expectancy highlights the fact that being right is overrated and that there is a need to keep losses small.
• Markets are always changing, just as are the individuals who trade then. To thrive, traders need first to survive so that they can adapt to shifting market conditions.

All the evidence points to the fact that investors in the U.S. and elsewhere do not take full advantage of international diversification opportunities.

• Home bias prevents most investors from taking full advantage of the benefits of international diversification.
• An increasingly global economy and financial markets have reduced, but not eliminated, the benefits of global diversification.
• The greatest benefit of global diversification may come in the very long term in protecting investors from the existential risk of economic stagnation in their home market.
• Emerging markets are an important part of a globally diversified portfolio, but they no longer represent the easy diversification play they once did. Nor can, or should, investors count on their continued outperformance.
• Foreign currency exposure plays an important part of international diversification, but most individual investors should actively avoid forex trading.

It should not be surprising that investors are constantly on the lookout for novel investments that can provide a better risk-return trade-off than the old standbys; over the past decade, alternative investments have become increasingly important part of the portfolios of pension and endowment funds.

• Hedge funds play an important role in the financial markets, but their performance, weighed by high fees and increased competition, has deteriorated and become more marketlike over time.
• Private equity and venture capital play an important role in the economy, but the return picture for them is mixed. In any event, individual investors have at best limited access to these investment vehicles.
• Options strategies allow investors to express all manner of market views, including hedging risks. However, options strategies come with a steep learning curve, higher costs, and illiquidity.
• Managed futures have historically been good portfolio diversifiers generating returns in times of market stress.
• Hard assets represent another diversification opportunity for investors, especially in light of their ability to partially hedge inflation risk.
• Gold has been an object of desire for millennia but, like other alternative assets, fails the test of a perfect investment.

Nearly every study of forecasting in economics and finance shows that we human beings are poor predictors of the future. Given our collective inability to forecast the future, why do we all persist in doing so? It is because we hate randomness that many investors have a weakness for pundits with strongly held opinions about the future.

• Despite a poor track record we humans are addicted to forecasting. Investment strategies based on accurate forecasting are likely doomed to underperformance.
• Investing is an arena in which both skill and luck play a role. Investors should seek managers who are transparent about their strategies and humble in their approaches.
• Confirmation bias prevents us from finding disconfirming evidence. Investors need to work actively to expose themselves to a wide range of information.
• Male investors would do well to take some cues from female investors, who achieve equal returns with less risk and less trading.
• No individual can be competent in all areas of personal finance. We all need some help and counsel, especially when it comes to avoiding rash decisions.
• True financial planning is less about portfolio management and more about the major financial dilemmas we all face.

Market reports should not be an everyday staple of news coverage. Sometimes, occasionally, there are stories in the markets. But when there are not any stories, there is no point in trying to invent them.

• The state of financial literacy in the U.S. is abysal. The financial media does not help by emphasizing noise over information.
• The financial media sells noise because it is exciting. The fact is that the principles of personal finance and investing are pretty boring.
• Most investors would do better to think and act in longer time frames. Unplugging from the grid via a “media diet” can help free up time better used in research and analysis.
• The investment blogosphere is an imperfect meritocracy where investors should be careful to avoid confusing fact and opinion.
• Everybody talks his or her book. Just because a star fund manager gives out a stock pick does not mean it is right for everyone. Understanding a manager’s thought process is more important than the actual pick itself.
• The best investors take a “liberal arts” approach to investing, embracing insights from a wide range of fields. As markets have become more myopic, having a longer-term focus becomes more important for investors.

Reference:

Abnormal Returns by Tadas Viskanta (2012)