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March 25, 2024

Market Volatility and the Triggers of Investor Behavior

In the world of investing, volatility is both a constant companion and a formidable adversary. It ebbs and flows like the tide, shaping market sentiment, influencing decision-making, and testing the resolve of even the most seasoned investors. According to the 2023 Ernst and Young Global Wealth Research report, younger investors are more likely to switch into active investments during volatility, with 50% of respondents increasing allocations compared to 22% of baby boomers. Another finding of the study was 40% of wealth management clients think that managing their wealth has become more complex over the last two years, and 57% of high-net-worth individuals (HNW) who feel unprepared to meet their financial goals cite market volatility as a primary reason.

Chart1: FRED-St. Louis Fed Equity Volatility Tracker

Source: FRED-St. Louis Fed Equity Volatility Tracker

Periods of high volatility are often associated with a sense of impending doom among investors. In all fairness, the evidence points in that direction as well. According to the St. Louis Fed’s equity volatility tracker, apart from the post-war recession in the early 90s, each period of elevated market volatility has been accompanied with a sustained period of economic downturn. Such history is a surefire way to spook investors.

As a result, understanding the psychology behind investor behavior during market volatility can help investors make better decisions and avoid common mistakes. In recent years, there has been a growing interest in understanding the role of behavioral finance in shaping market volatility. Behavioral finance examines how psychological biases and emotions impact financial decision-making, and when applied to market volatility, it provides valuable insights into the irrational behavior that can drive extreme price movements.

What is Market Volatility?

Market volatility refers to the frequency and magnitude of price movements in any direction for a security or market index over a specific period. Volatile stocks are generally considered riskier than less volatile stocks because their prices are less predictable. Implied volatility measures the expected volatility of the market, while historical volatility measures price changes over a predetermined period.

Volatility is an important variable in calculating option prices. The CBOE Volatility Index, also known as VIX or “Fear Index,” is a measure of investor sentiment. VIX tends to be inversely related to the S&P 500. This measures how much traders expect the price of the S&P 500 to rise or fall over the next month. A score below 20 generally indicates investor satisfaction, while a score above 30 indicates concern.

It is important to remember that even though market volatility makes the most seasoned investor think deeply about their choices, it is a normal characteristic of all financial markets.

Man about to get hit by wave in ocean. Photo by Kammeran Gonzalez-Keola

Notable Events of Heightened Market Volatility

There have been numerous instances in the past where market events have led to sustained periods of elevated market volatility. Some of the major events include:

Black Tuesday (1929) and the Great Depression
The stock market crash of 1929 signaled the beginning of the Great Depression. The sharp decline in stock prices led to panic selling as investors rushed to liquidate their holdings. This behavior was driven by a lack of trust in the market and fear of further losses. The lessons from this period highlight the importance of understanding the psychological factors that can trigger extreme market movements.

The Oil Crisis (1973-1974)
The Organization of Petroleum Exporting Countries (OPEC) imposed an oil embargo in response to U.S. support for Israel during the Yom Kippur War, leading to a sharp rise in oil prices and triggering a period of stagflation (high inflation and stagnant economic growth) in the U.S.
Dot-com Bubble (2000)
The rapid rise and subsequent collapse of technology stocks in the late 1990s and early 2000s became an example of a speculative bubble. Investor enthusiasm and irrational expectations have led to sharp corrections after stock price rises. The results highlight the risk of overestimation and the importance of performing careful fundamental analysis.
Global Financial Crisis (2008)
The global financial crisis was triggered by the bankruptcy of Lehman Brothers in 2008. Investor behavior during this period was characterized by widespread panic as financial institutions faced liquidity shortages and markets experienced extreme volatility. The crisis has highlighted the interconnectedness of global financial markets and the potential for systemic risks to amplify market volatility.
COVID-19 Pandemic (2019)
In early 2019, the COVID-19 pandemic led to a sharp and severe market downturn. Fear and uncertainty have led to massive selling across asset classes. However, central bank intervention and government stimulus have helped stabilize markets, demonstrating the impact policy decisions have on investor sentiment.

These historical examples demonstrate that investor behavior during stock market fluctuations is influenced by a combination of psychological factors, market conditions, and external events. Although it is difficult to predict the timing and severity of market fluctuations, understanding behavioral trends that may occur during these periods is important for investors seeking to make informed decisions.

The Traits and Behaviors of Investors During Times of Uncertainty

Stock market fluctuations, a subset of financial market volatility, have been a subject of extensive research due to their profound impact on investor behavior. Understanding the relationship between these fluctuations and investor behavior provides insights into market dynamics, risk management, and decision-making processes.

One prominent theory explaining stock market fluctuations is the Efficient Market Hypothesis (EMH), which posits that stock prices always reflect all available information. According to EMH, market participants process information rationally and adjust their investment decisions accordingly. However, this is clearly not applicable during times of high uncertainty. By virtue of the state of affairs, it is impossible to make efficient forecasts about the market. In a situation of high market volatility, EMH is not only inefficient, it could also feed into the false euphoria of investors stemming from an unfounded confidence in their knowledge base.

Prospect theory is another behavioral science theory that can help understand (not justify or predict) the behavior of investors during times of heightened volatility. Daniel Kahneman and Amos Tversky’s path breaking research tries to understand investor behavior during times of experiencing gains and losses. Loss aversion is one of the most salient features of this theory as the theory states that the feelings associated with loss are stronger than the positivity associated with a gain. In the context of the stock market, investors are prone to keep losing stocks, hoping they will rebound, and are more likely to sell gaining stocks, afraid of a potential downturn. The theory presents the potential rationale behind incongruous investor behavior and their emotionally driven probability association to different potential outcomes, based on the kind of losses or gains they have faced in the past.

Overall, investor behavior during periods of high market volatility can be largely characterized by certain patterns:

Disposition Effect:
As mentioned before in the discussion about Prospect Theory, investors tend to hold onto losing investments for too long while quickly selling winning investments. This behavior can be exacerbated during volatile periods when emotional reactions are heightened even further.
Flight to Safety:
During heightened volatility, investors might shift their investments from riskier assets to safer ones, such as government bonds or gold. This flight to safety reflects a desire to preserve capital in uncertain times.
Herding Behavior:
Investors may follow the actions of the majority, leading to herding behavior. This can amplify market movements, both up and down, as investors rush to mimic the actions of others. It can be said that the sudden increase in money market fund investments can be attributed to this kind of behavior.
Overreaction and Underreaction:
Behavioral biases can lead investors to overreact or underreact to market news. Overreaction occurs when investors exaggerate the impact of news, causing excessive price movements. Conversely, underreaction is observed when investors fail to fully incorporate new information into their decisions.
Selective Perception:
Investors might focus on information that confirms their existing beliefs while ignoring contradictory information. This can lead to misjudgments during periods of high uncertainty.

The impact of investor behavior on stock market fluctuations can also create a feedback loop. Investors’ reactions to market volatility can exacerbate price swings, causing further uncertainty and influencing subsequent behavior. Market sentiment, driven by investor behavior, can become a self-fulfilling prophecy, where widespread fear or exuberance influences trading decisions and subsequently impacts market prices.

The Rise and Fall of the Most Recent Period of Volatility

Markets often experience periods of increased volatility. Investors should typically expect volatility to be around 15% of the average return in a year. Market volatility was particularly quiet in 2023, a stark contrast to the prior year. With inflation declining and the Fed pausing interest rate hikes, the volatility of the S&P 500 in 2023 was less than two-thirds of its historical average over the 10 years from 2013 to 2022.

However, there were a few notable spikes. During the U.S. regional banking crisis in March, the VIX jumped above 30 amid heightened investor panic about bank profitability. Later in May, volatility spiked again after the Fed raised rates for the 10th time as it began speculating on a ‘higher for longer’ rate scenario.

The VIX fell to a four-year low in December 2023 after the Fed announced it would cut interest rates in 2024. Investors are closely watching how macroeconomic and geopolitical uncertainties will unfold during 2024. Moderating inflation, solid consumer spending, and labor market strength eased investor concerns in 2023, leading to lower volatility towards the end of the year. This is no guarantee that volatility will not return in 2024, as many geopolitical, trade and monetary policy decision could play tricks with investor’s thinking and decision-making once again.

Money-market fund assets are near all time high - fed hiking cycle

Source: Bloomberg

A telling sign of how investors still do not believe that there is no clear path to follow is their preference to hold cash and cash-like instruments, rather than invest in securities or bonds. Money market funds typically hold short-term assets including government debt, whose yields climb or fall rapidly depending on the central bank’s stance on monetary policy. Almost $1.19 trillion has flooded into U.S. money market funds through December 2023. That is a far cry from negligible inflows in 2022 and well above the average full-year net inflow figure of $179 billion for 2012-2022. As recently as March 6, 2024, U.S. money-market funds, bringing total assets to $6.08 trillion. These funds are considered safer in times of volatility and this is a clear sign that investors believe there is more uncertainty to come.

While some argue that volatility could remain subdued, others believe it could rise again in 2024 due to overheating markets and credit market pressures.

Hand holding a compass. Photo by Tobias Aeppli

Ways to Navigate a Volatile Market

To mitigate the impact of cognitive biases on market volatility, investors can employ several strategies. First, awareness is key. Recognizing and acknowledging the existence of biases can help investors take a more rational and objective approach to decision-making. Second, diversification can help reduce the impact of individual biases by spreading investments across various asset classes. Additionally, seeking out diverse sources of information and opinions can help counteract confirmation bias and provide a more balanced perspective.

There are certain tenets that can help investors navigate such times of severe uncertainty. The effectiveness of these tenets, however, depend completely on how disciplined investors can be in their implementation. At Howard Capital Management (HCM), these tenets have helped to build the foundation for growth as well as downside mitigation over many decades. A non-emotional, math-based approach to investing and market analysis has formed the basis for the proprietary system called the HCM-BuyLine^®, which is the backbone of all investment strategies offered by HCM.

For the average investor, these tenets could help them avoid making novice mistakes and act while keeping in mind their final goal.

Seek to avoid major losses through risk management:
Overlaying investments with a risk management strategy can potentially help identify major market downturns to avoid portfolio devastation.
Seek to implement a math-based strategy:
The rise of computerized trading is consequently making investing more challenging. With a math-based and quantitative strategy, investors can seek to move in and out of the market faster, striving to minimize losses and maximize gains.
Move to cash/lower volatility investments during major market declines:
It could take months or even years to recover from devastating losses. Investors who avoid much of a significant drop by moving to safety not only attempt to preserve assets in major market declines, but positions themselves ready to capture major upturns (and potentially at attractive prices).
Seek to remove emotion from the equation:
Investors can be emotional with the swings of the market — holding a stock as it falls or selling it before it reaches its full potential can wreak havoc on a portfolio. An emotional approach to investing can hinder the ability to effectively manage investments.
Stay the course:
Commit to a strategy and risk level that not only could help one sleep soundly at night, but also with the objective of meeting current income needs and long-term financial goals.

Resources:

View The HCM Volatile Market Guide

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February 27, 2024

Wall Street Dilemma: How do you return those mega trillions in cash to the stock market?

In the past couple of years, investors across America have actively moved their investible income into money market funds and other cash-like investments to avoid the raucous caused by the rising interest rates. As of the third quarter of 2023, this corpus stood at $8.8 trillion. However, the bulls of Wall Street are hopeful that as the interest rates fall in 2024, this mega corpus will move back into the stock market.

The higher the Alpha, the higher the attraction

The main agenda of any investor is to earn returns that would help offset the effects of inflation. This has become even more relevant in recent times as inflation has been the main talking point for almost every person. The recent expectation of rate cuts has boosted markets towards the end of last year, touching record levels and leaving little room for further expansion. Many believe that the market has already priced in the ideal scenario where inflation falls without any job losses. However, as recent times have proven, the ideal scenario is seldom the case in real life and it usually takes more than wishful thinking.

For the Wall Street bulls, the hope is that the shift from cash instruments to the stock market will give the market the boost that it needs. As the safe haven instruments and low-interest money markets become less attractive to the average investor, the prospect of higher returns could be the stimulus they need to return to the stock market.

For the time being, stocks still face an uphill battle. With bond yields increasing and CDs offering attractive rates, the high prices of stocks could be off-putting for many. Even though stocks are proven long-term winners, the high prices can currently be a significant deterrent. The only thing working in favor of stocks is the duration of CDs and similar instruments. Younger, more aggressive investors may find the 12-month duration of CDs off-putting and not attuned to their risk appetite.

Money markets thrive for more than one reason

Even though stable times form the foundation for higher investment in the stock market, expectations that the market will boom once rates fall may prove overly optimistic. It’s important to remember that during previous cycles, even though money-market instruments have attracted investments during tightening periods, they didn’t hemorrhage when the central bank began to ease. During those years, assets across the board retreated from their peaks but still plateaued at much higher levels.

In addition, investors also tend to tap money markets during periods of market stress, not necessarily when yields are higher. Assets in money funds peaked at nearly half of the overall money supply in 2001 and 2008. There was a similar spike in 2001, the aftermath of the dot-com bubble.

The flexibility of money market instruments also makes it an attractive investment option for many, not just during times of stress. With no lock-in period, the market provides an easy, albeit less lucrative, escape during economic and personal uncertainty. While one’s money sits and earns minimal interest, the investor has the option of cashing in whenever they may like, which can make them more attractive than instruments like CDs with a minimum lock-in period. Proof of this is that total deposits at U.S. lenders have fallen to $17.4 trillion from a peak of $18.2 trillion since the Fed began tightening policy in early 2022.

Great expectations: Will they come to fruition?

Money market fund inflows in the US this year have far outpaced those in Europe, where retail investors have a much smaller presence in the asset class. But it remains to be seen if this is sustainable. While this has been a break-out year for the otherwise less attractive asset class, with rates beginning to return to normal, the Wall Street bulls may sway the interest of growth-oriented retail investors, luring them with higher returns and longer-term portfolio growth.

For 2024, the amount of cash that pours into money market funds depends on the pace of the easing cycle. In the past, rate cuts have often been large and rapid, aimed at stemming a crisis. Wall Street foresees a smoother glide path this time around, with rates ending up much higher than near zero, where they sat for years. Traders’ best case is for the federal funds rate to remain above 3% in the coming years. Fed officials expect the benchmark rate to decline to 2.9% by the end of 2026.

The Fed has suggested it intends to cut interest rates as many as three times this year, which could fuel the market throughout 2024.

HCM-022724-055

Sources:

Hot air balloon that looks like a globe flying in to stormy clouds

November 15, 2023

Global inflation, interest rates and where its all going

Inflation has become a prominent concern for investors in recent times, causing ripples across financial markets and prompting individuals and institutions alike to re-evaluate their investment strategies. This article delves into the current state of global inflation, providing essential insights and data to understand the evolving economic landscape. We will explore the causes and consequences of rising inflation and analyze how it is likely to influence investor behavior in the near future.

The Current State of Global Inflation

Before delving into the potential impact on investors, it’s vital to understand the current state of global inflation. The period following the 2008 financial crisis was characterized by low inflation rates across the world. Central banks in many developed countries struggled to reach their inflation targets, often below the desired 2% mark. However, since the outbreak of the COVID-19 pandemic in 2020, the global inflation landscape has undergone a significant shift.

In 2021, inflation rates started surging in many parts of the world, driven by a combination of factors:

Supply Chain Disruptions: The pandemic led to supply chain disruptions, causing shortages in various industries, which resulted in rising prices for goods and services.
Monetary Policy Response: Central banks, such as the Federal Reserve in the United States, implemented expansionary monetary policies, including low-interest rates and asset purchases, to combat the economic fallout of the pandemic. These measures injected a substantial amount of money into the economy, potentially fueling inflation.
Fiscal Stimulus: Governments around the world rolled out massive fiscal stimulus packages to support their economies. While necessary during the pandemic, these actions increased the overall money supply, further contributing to inflationary pressures.
Commodity Price Surge: The prices of essential commodities, like oil, copper, and agricultural products, experienced significant increases, leading to higher production costs for businesses and, ultimately, consumers.

The most recent data revealed some noteworthy figures:

The United States saw Consumer Price Index (CPI) increases at their highest level in decades, with the CPI reaching 7.7% in October 2022, the highest in more than 40 years.
Eurozone inflation reached 10.6% in October 2022, the highest level since the introduction of the euro.
China has experienced sustained higher producer prices, contributing to a global surge in raw material prices.

Investor Implications

The rising inflation environment has several important implications for investors, which will likely shape their strategies in the near future.

Asset Allocation: Inflation erodes the purchasing power of fixed-income assets, making them less attractive. Investors may shift their portfolios towards assets that historically perform well during inflationary periods, such as equities, real assets like real estate and commodities, and potentially cryptocurrencies.
Equities: Historically, stocks have been viewed as a hedge against inflation. Earnings of companies can increase with rising prices, allowing them to pass on higher costs to consumers. Nevertheless, investors must be cautious, as extreme inflation can lead to uncertainty and economic instability, which could impact stock markets negatively.
Bonds: Fixed-income investments become less appealing during times of inflation, as the real return diminishes. Investors might consider shorter-duration bonds or inflation-protected securities (TIPS) to mitigate this risk.
Real Assets: Real estate and commodities have traditionally performed well during inflationary periods. These assets can act as a store of value and may appreciate in value as inflation rises. Diversifying into real assets could help investors protect their portfolios against the erosive effects of inflation.
Cash and Fixed-Income Maturity Laddering: For those concerned about rising inflation, diversifying among different types of bonds and laddering maturities can help balance the need for income and preservation of capital.
Currency Exposure: Currencies can be significantly affected by inflation. Investors may consider allocating a portion of their portfolio to currencies that have historically acted as a hedge against inflation, like the Swiss Franc or Singapore Dollar.
Commodities and Inflation-Linked Securities: Investments in commodities or inflation-linked securities like TIPS can provide a direct hedge against inflation. Commodities, including precious metals like gold and silver, tend to appreciate when inflation is high.
Emerging Markets: Some emerging markets may offer opportunities for higher returns during inflationary periods. However, these investments also come with higher volatility and risks, so careful research and diversification are essential.
Staying Informed: Given the dynamic nature of inflation and the factors influencing it, staying informed about economic developments, central bank policies, and government actions is crucial. Being nimble and adaptive with your investment strategy can help protect your portfolio.

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The Role of Central Banks

Central banks play a pivotal role in managing inflation, and their policies have a significant impact on investor sentiment and asset prices. As inflation rates rise, central banks face a delicate balancing act. They must determine when and how to tighten monetary policy to curb inflation without jeopardizing economic growth.

In response to rising inflation, central banks have begun to adopt tighter monetary policies in various forms, such as increasing interest rates and tapering asset purchase programs. The U.S. Federal Reserve, for instance, began tapering its bond-buying program in 2021 and signaled its intention to raise interest rates in the future.

The actions of central banks will be closely monitored by investors, as any missteps could trigger market volatility. A premature or overly aggressive tightening of monetary policy could lead to a sharp correction in asset prices, while a delayed response may allow inflation to become entrenched.

Artist rendering of cryptocurrency, pile of gold coins

Cryptocurrencies as an Inflation Hedge

The rising popularity of cryptocurrencies, particularly Bitcoin, has been partly attributed to concerns about inflation and the erosion of fiat currency value. Bitcoin, often referred to as digital gold, is seen by some as a store of value and a potential hedge against inflation.

In 2021, Bitcoin experienced significant price appreciation, attracting both institutional and retail investors. The narrative of Bitcoin as a hedge against inflation, combined with its limited supply and decentralized nature, has made it an attractive asset for those seeking to protect their wealth in an inflationary environment.

However, it’s important to note that cryptocurrencies, including Bitcoin, are highly speculative and volatile assets. Their prices can be influenced by a multitude of factors, including regulatory changes and market sentiment. Investors considering cryptocurrencies should do so with caution and consider their risk tolerance.

man holding phone following maps directions

Where are we headed?

Global inflation is an economic force to be reckoned with, and it has already left its mark on financial markets and investor behavior. As central banks attempt to navigate this challenging terrain, investors must carefully evaluate their portfolios and adapt their strategies accordingly.

In a world of rising inflation, asset allocation becomes paramount. Diversifying into assets that historically perform well during inflationary periods, such as equities, real assets, and inflation-protected securities, can help mitigate the erosion of purchasing power. Additionally, keeping a close eye on central bank policies and staying informed about economic developments is essential.

Investors should also consider the role of cryptocurrencies, like Bitcoin, as potential hedges against inflation. However, they must approach these assets with caution and a clear understanding of their inherent risks.

In these uncertain times, prudent and informed decision-making will be the key to weathering the storm of global inflation and achieving financial goals.

Sources:

Disclosure

Howard Capital Management, Inc. (“HCM”) is an SEC-registered investment advisor with its principal place of business in the State of Georgia. SEC registration does not constitute an endorsement of HCM by the SEC, nor does it indicate that HCM has arraigned a particular level of skill or ability. HCM is not an accountant, or a tax accountant and this document is for information purposes only. Please consult a tax accountant for information pertaining to your account. HCM only transacts business where it is properly registered or is otherwise exempt from registration. LARL.GIArticle.121923 | HCM-121923-114

November 9, 2023

Revolutionizing Finance: How AI Will Transform the Financial Services Market

The world of finance has become a fertile hunting ground for exploring the potential of Artificial Intelligence (AI) because information processing is the backbone of the global financial markets. In the past as well, all kinds of financial institutions have invested heavily in technology and data in order to develop some kind of strategic or tactical advantage. However, the changing competitive dynamics over the last few years provide some hints about what could happen as AI becomes a real, scalable solution.

In recent years, it has become abundantly clear that AI can disrupt industry dynamics very quickly and decisively. With technology playing an increasingly important role in critical decision making, the rise of automated, passive investing solutions are already very common. In the hedge fund space, quantitative methodologies have become the norm for stock picks and entry/exit decisions. The finance industry is often an early adopter for any new technology that could give managers and investors an advantage such a competitive landscape.

Importance of AI InvestmentManagement chart

Source: EnY’s Report: AI and the Investment Management Industry

The financial services industry stands on the cusp of a profound transformation, driven by the steady march of AI. As AI technologies continue to evolve and mature, their impact on the financial sector is becoming increasingly significant. Even though change is always slow (and the financial services sector would be the first to testify to that), this ace of disruption in technological advancements is almost unprecedented and AI could be the tipping point for a quicker change in the industry than ever before.

Robot hand and Human hand touching fingertips

AI: A possible game changer?

Information is power, it has been since the dawn of time, and there will always be a race for it. Venetian merchants used Galileo’s telescopes not to study the stars, but rather to study the cargoes of approaching ships a few hours before their competitors. Unsurprisingly, the most vigorous application of AI for investment managers is attempting to generate the holy grail of new insights for the investment process to improve the investment outcomes for clients.

In today’s information age, AI is playing an increasingly important role in shaping economic and financial sector developments and is seen as an engine of productivity and economic growth through efficiency, improved decision-making processes, and the creation of new products and industries. Right now, the world is still in the early stages of that progression but there are already different applications of AI through the value chain, all generating business. If computing power and data generation keep growing at the current rate, then ML (machine learning) could be involved in almost all of investment management in the near future, affecting other industries and having a real long-term effect on investment returns.

Source: EnY’s Report: AI and the Investment Management Industry

AI also is rapidly changing the financial sector landscape by reshaping the nature of financial intermediation, risk management, compliance, and prudential oversight. Generative AI (GenAI) especially holds certain key implications for service-based industries. At the heart of GenAI are large language models, which are neural network–based models trained on massive amounts of data, including text and documents, and capable of producing understandable and meaningful text or human languages. LLMs (large language models) enable a wide range of applications across various domains with significant implications for the global economy and financial sector.

GenAI will most definitely accelerate AI adoption in the financial sector and investment management. Competitive pressures have fueled rapid adoption. This could further lead to gains in efficiency and cost savings, reshaping client interfaces, enhancing forecasting accuracy, and improving risk management and compliance. GenAI could also deliver to cybersecurity benefits ranging from implementing predictive models for faster threat detection to improved incident response. However, the deployment of GenAI in the financial sector has its own risks that need to be fully understood and mitigated by the industry and prudential oversight authorities.

Robot with a brain and stockmarket charts in the background

A.I.’s impact on financial services and investment management

The ways in which AI is set to revolutionize the financial services market are as follows:

Data-Driven Investment Strategies: AI’s ability to process enormous amounts of data in real-time gives investment managers a powerful tool for decision-making. Whether it’s analyzing financial reports, social media sentiment, or economic indicators, AI can quickly identify trends and correlations that may not be apparent to human analysts. This data-driven approach enables more informed investment strategies and better risk management.
Predictive Analytics: One of AI’s key strengths lies in its predictive capabilities. Machine learning algorithms can forecast market movements, asset price fluctuations, and even macroeconomic trends with a high degree of accuracy. Investment managers can leverage these insights to adjust portfolios, optimize asset allocation, and make timely decisions to capture investment opportunities.
Behavioral Insights: Understanding investor behavior is critical in investment management. AI can analyze investor sentiment, track behavioral patterns, and provide insights into market sentiment. This information can be used to fine-tune investment strategies and provide personalized recommendations to clients.
Customer-Centric Personalization: AI-powered algorithms are redefining customer interactions in the financial services sector. This hyper-personalization enables the creation of financial products and services tailored to individual needs. Chatbots and virtual assistants powered by natural language processing are also becoming integral parts of customer service, offering real-time assistance and information, enhancing customer satisfaction, and saving costs.
Algorithmic Trading: AI-powered algorithms are reshaping the landscape of trading and investment. Automated trading systems use AI to analyze market data, identify trends, and execute trades at lightning speeds. These algorithms can process vast amounts of information in real-time, enabling more informed and timely trading decisions. The result is increased efficiency, reduced risk, and the potential for higher returns.
Enhanced Fraud Detection: Machine learning models can detect unusual patterns in transactions, flagging potentially fraudulent activities in real-time. By continuously learning and adapting, AI systems become more adept at identifying new and sophisticated fraud schemes, thereby reducing financial losses and bolstering security.
Credit Risk Assessment: Traditional credit risk assessment models have limitations, often relying on historical data and fixed parameters. AI, on the other hand, can analyze a broader array of data sources to assess an individual’s creditworthiness. This allows financial institutions to make more accurate lending decisions and expand access to credit for individuals and businesses with limited credit histories.
Regulatory Compliance: The financial services sector is heavily regulated and adherence to these regulations is critical. AI can assist in compliance efforts by automating the monitoring and reporting of transactions, ensuring that all activities are in line with regulatory requirements. Machine learning models can also help identify and mitigate potential compliance risks.
Cost Reduction and Efficiency: AI can significantly reduce operational costs in the overall financial industry, but especially in investment management. Automation of routine tasks, such as data entry, document processing, and customer support, can free up human employees to focus on more complex and value-added activities. Additionally, AI-driven analytics can optimize resource allocation, leading to better cost management.

Risks of AI adoption

The AI life cycle can be broadly divided into three stages – proof of value, enablement, and ramp-up or go live. The proof of value stage solely aims at validating whether an idea is worth the additional investment and resources. The focus of the enablement stage is to quickly turnaround management support and resources to support technology development. An organization is ready to ramp-up or go live when a full product development plan and scope is in place, including the necessary technology assets and personnel. Throughout the entire process, it is important to keep in mind the principles of responsible and ethical AI to ensure that outputs are always fair and representative.

However, while following this process, there are many risks that an organization can face, especially in the financial services sector. With the algorithms making many decisions, it could be possible that the slightest oversight could have far reaching effects. It is important that companies remain cognizant of these and act accordingly. Some of the major risks of AI implementation are:

Data Privacy and Security: AI systems require access to vast amounts of data to function effectively, and any data breaches or misuse of this information could result in significant financial and reputational damage.
Bias and Fairness: AI algorithms can inherit biases present in the data they are trained on. In financial services, biased algorithms can lead to discriminatory lending practices or investment decisions, potentially violating regulations and harming customers.
Regulatory Compliance: The financial sector is heavily regulated, and the use of AI introduces complexities in terms of compliance with existing regulations. Institutions need to ensure that their AI systems adhere to regulatory requirements related to data protection, transparency, and fairness.
Ethical Concerns: AI raises ethical questions, especially in areas like robo-advisors. Decisions made solely by AI may lack human empathy or ethical judgment, and could potentially lead to undesirable outcomes for clients and breaking fiduciary responsibilities.
Model Explainability and Systematic Risks: Many AI algorithms, such as deep learning neural networks, are often viewed as “black boxes” because it can be challenging to explain how they arrive at their decisions. Lack of model transparency can hinder trust and regulatory compliance. In addition, as the widespread adoption of AI in financial markets occurs, it could lead to correlated trading decisions based on similar algorithms, potentially increasing the risk of market crashes or sudden volatility. This is a major risk that could culminate due to the combined efforts of all industry players and their over-reliance on AI.
Cybersecurity Threats: As AI evolves, so will the divergent uses of the technology. AI can be used by malicious actors to enhance cyberattacks. AI-driven attacks can be more sophisticated and difficult to detect, posing a significant cybersecurity threat to financial institutions and the information of those they serve.

To mitigate these risks, organizations must adopt a robust governance framework for AI, focusing on data governance, model transparency, and ethical considerations. Regular audits, ongoing monitoring, and collaboration between data scientists, compliance officers, and legal experts are essential for managing AI-related risks effectively. Additionally, staying informed about evolving regulations and industry best practices is crucial for navigating the growing AI landscape.

AI in Finance: A cautious revolution in the making

The impact of AI on financial services and investment management cannot be overstated. It is transforming the industry by providing investment professionals with advanced tools to make decision making easier and more comprehensive. However, it’s important to acknowledge that AI is not a silver bullet. Investment managers must combine AI’s capabilities with human expertise to create a winning formula.

However, the intrinsic risks could pose material risks for financial sector reputation and soundness—and, ultimately, could undermine public trust, if not handled with maturity. Enterprise-level applications could help mitigate some of the risks inherent in public-level application, but this option may not be cost efficient for smaller financial institutions. AI use needs close human supervision commensurate with the risks that could materialize from employing the technology in financial institutions’ operations. Prudential oversight authorities will strengthen their institutional capacity and intensify their monitoring and surveillance of the evolution of the technology, paying close attention to how it is applied in the financial sector. They will improve communication with public and private sector stakeholders as well as collaborations with jurisdictions at the regional and international levels.

As AI continues to evolve and mature, it will become an indispensable part of the investment management toolkit. To harness the full potential of AI in finance, institutions must invest in talent with AI expertise, build robust data infrastructure, and prioritize ethics and transparency. As AI continues to evolve, it will undoubtedly reshape the financial services landscape. The firms that embrace it, invest in the right talent, build robust data infrastructure, incorporate it into their strategies, and prioritize ethics and transparency will likely gain a competitive advantage in the dynamic and ever-evolving world of investments.

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Disclosure

March 30, 2023

Deep Impact: What really happens when banks fail?

The recent misfortunes of the Silicon Valley and Signature Banks are being identified as echoes from the financial crisis of 2008. Fears of a lasting economic downturn, impending stock market crashes, a debt crisis and government bailouts have investors worried whether the worst is still to come. Shareholders and depositors in the two banks in question have raised pertinent questions on the regulatory bodies like the FDIC and the auditory capabilities of the Federal Reserve. Not only has this sudden collapse affected a range of asset classes, but market leaders are suggesting that this could be the first of many more collapses in the months to come.

To fully understand how a collapse like this affects the economy and individual investors one must revisit the crisis of 2008 and draw lessons from that dark period.

The Great Financial Crisis of 2008

The crisis of 2008, which had far-reaching effects around the globe, was triggered by a combination of factors, including the housing bubble, the proliferation of subprime mortgages and the use of complex financial instruments, such as mortgage-backed securities, that were not well understood or regulated.

The overextension of credit by banks would be the first step in this crisis. Banks offered subprime mortgages to borrowers with poor credit histories, often with adjustable interest rates that could lead to payment shock when rates rose. As the housing market began to decline, many borrowers defaulted on their mortgages, leading to significant losses for banks and investors. The collapse of the subprime mortgage market triggered a broader financial crisis, as it undermined confidence in the banking sector and led to a credit crunch. The interconnectedness of the banking sector played a major role in the crisis, as the failure of one bank had a ripple effect throughout the system. The failure of Lehman Brothers was the significant event that sparked a global financial panic.

The fallout from that event led to an economic downturn that lasted for several years. The crisis caused a sharp decline in housing prices, a rise in foreclosures and bankruptcies, and a contraction in credit markets. Many businesses failed and unemployment rates increased in many countries. The years after 2008 were replete with stock market declines, banking system failures (including Lehman Brothers, Washington Mutual and Bear Stearns) and supremely controversial government bailouts. Finally, there were far-reaching sovereign debt crises in several countries, including Greece, Ireland and Spain. These crises had significant impacts on these countries’ economies, leading to major austerity measures and political unrest.

The banking sector’s excessive risk-taking and reliance on complex financial instruments played a pivotal role in the financial crisis of 2008. Opinion makers then stated that this crisis highlighted the need for better regulation of the banking sector to prevent similar events in the future.

Silicon Valley Bank: A brief history of prosperity and the sudden collapse

Silicon Valley Bank (SVB) is a commercial bank founded in 1986 and is based in Santa Clara, California. It primarily serves the technology, life science and venture capital industries. SVB operates across the United States, China, India, the United Kingdom and other countries. In addition, SVB has been recognized as one of the top banks in the United States and has received numerous awards for its banking services and commitment to innovation.

SVB’s collapse came all too suddenly as depositors sought to withdraw their deposits from the bank during a frantic 48 hours after learning the bank was in trouble after interest hikes by the Federal Reserve. Like many other banks, SVB had plowed billions into US government bonds during the era of near-zero interest rates. As the Federal Reserve hiked interest rates aggressively to tame inflation during 2022, the lagged impact of these hikes hit the startup-friendly bank really hard. When interest rates rise, bond prices fall. SVB’s portfolio yielded an average 1.79% return last week, far below the 10-year Treasury yield of around 3.9%.

With the Federal Reserve’s hiking spree seeing no end in the near term, tech startups had to channel more cash toward repaying debt. They were also struggling to raise new venture capital funding. This forced these companies to draw down on deposits held by SVB to fund their operations and growth. With this flurry of withdrawal requests, the bank quickly ran out of funds to service these requests. SVB’s stock plummeted 60% in one day and dragged other bank shares down with it, causing investors to panic.

SVB’s collapse could create systemic risks to the broader financial system, as the interconnectedness of the banking sector means that the failure of one bank can have ripple effects throughout the system. Some of these effects may include:

Lack of Access to Capital: SVB provides funding to early-stage and emerging technology and life sciences companies. The collapse of the bank would reduce the available capital for these companies and may limit their growth potential.
Slowdown in Innovation: The loss of funding and support from SVB could lead to a decrease in innovation and technological advancement.
Job Losses: The technology and life sciences sectors are significant employers in the United States. Job losses in these sectors could follow, which would have a ripple effect throughout the economy.
Economic Slowdown: The sectors that the bank supports are key drivers of economic growth. A decline in these sectors could lead to an economic slowdown or worse, a recession.
Disruption in the Banking Industry: The collapse could lead to a loss of confidence in the banking system. This could have negative impacts on other banks and financial institutions, leading to a broader economic impact.
Forced Bailout: The US government has previously bailed out large financial institutions, such as Citigroup and Bank of America, during the 2008 financial crisis. However, these bailouts were controversial, faced widespread criticism and decelerated overall growth. A bailout would only put more pressure on the tax system and invite the general public’s ire.

Note:SVB is not classified as a Systemically Important Financial Institution (SIFI) by the Financial Stability Oversight Council (FSOC), which means it is not subject to the same level of regulatory oversight and government support as SIFIs.

Finding a way back to prosperity

The need of the hour currently is to avoid a recession induced by this collapse. The Federal Reserve and Washington have a range of tools and policies at their disposal to help prevent another financial crisis like the one in 2008. Some tested ways to reduce the likelihood of another crisis include:

Transparent government intervention: The government took significant steps to stabilize the financial system by providing bailouts to major financial institutions such as AIG, Fannie Mae and Freddie Mac in 2008. The Troubled Asset Relief Program (TARP) provided financial support to banks, and the Federal Reserve implemented quantitative easing policies to increase liquidity in the markets. If things were to get worse and the banking sector reaches the brink of collapse, such intervention could help avoid the worst outcome just about in time.
Flexible fiscal policy: The government could take a flexible approach to fiscal policies to stimulate economic growth. The American Recovery and Reinvestment Act of 2009 provided funds for infrastructure projects, job creation and tax incentives for businesses that eventually helped get the economy back on track after a torrid year. However, in the current economic scenario, the large-scale spending bills (like the Inflation Reduction Act) already in place and inflation wreaking havoc on the economy, having a flexible approach might be more difficult.
Investing in building consumer confidence: Winning over consumers is the most assured way to create a sustained recovery path for any economy. If consumer confidence improves, so will their spending and investing habits. As consumers power the economic machinery, it could be the platform needed for further government spending to support the ailing sectors.
Seeking international support: The American financial and banking system does not operate in isolation from the rest of the world. Even now, the impact of SVB’s collapse has had far-reaching effects across geographic boundaries. Seeking international cooperation and support could help to stabilize the affected sectors and in turn, the economy. In 2008, the G20 countries worked together to implement policies that stimulated growth on a global level. Investing efforts in this route during dire circumstances wouldn’t be a bad idea.

Sources

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June 21, 2022

The Genesis and Failings of Market Predictions

In the year 1982, a leading global publication published a special dossier about what the world would be like in the year 2000. The publication invited a range of professional ‘futurists’ make their predictions. From a robotic revolution to the extinction of inflation to family experimentation practices, these predictions were published for all to read and gauge the future themselves. It’s not surprising that the most of the predictions remain unfulfilled till today. However, these futurists have not been completely discredited, nor have they become extinct. They live among us even today, with different roles and identities.

The practice of making predictions based on factual observations can be traced back to a time when markets didn’t even exist. From an instinctual perspective, making predictions is as much a part of human nature as is any other cognitive practice like rationalizing and reasoning. Over centuries, the art of making a prediction has undergone many-a transformation. This has been facilitated through philosophical, mathematical and even theological sciences. Even then, there still remains a strong element of uncertainty about the validity of making predictions. This is so because making predictions is essentially choosing one of two (or numerous) possible outcomes. There are some who will make the right choices and others who won’t. Those who make the right choice won’t be right all the time, and neither will the ones who made the wrong choice. However, the frequency or consistency in such a game of chance is anybody’s guess a.k.a. prediction.

For anyone who is looking to follow or disregard the plethora of predictions that are made every day, it is advisable to understand what governs such predictions and why they are so popular.

Five Famous Predictions That Never Happened

In the 80s, Nobel Prize-winning economist Paul Krugman predicted that the internet was just another fad and would have no discernible impact on investing.
Nobel Prize-winning economist Paul Samuelson was certain that the Soviet economy would surpass the American Economy by 1990.
Just before the 2008 economic meltdown, AIG had endorsed and promoted the Credit Default Swaps (CDS), which was a prominent cause of the market crash and led to the $85 billion bailout for them.
Economist Irving Fisher predicted the stock market was on the verge of a boom, 9 days before the great market crash of 1929 and lost most of his wealth in the process.
In 2007, former Fed Chair Alan Greenspan claimed that interest rates would be in double digits to control inflation, but a year later Fed fund rates were at historical lows.

Making a Prediction: An erroneous human tendency

The start of this practice is probably anyone’s guess. In recorded history though, the end goal guiding the making of predictions has generally been to attain a strategic advantage over the competition. Whether it is in financial markets, war or sports, predictions are a guesstimate that have a tendency of giving confidence to those who are hopeful of a positive outcome. On the contrary, people also have a general tendency to ignore the possible outcomes that are not so positive, even though it might be most probable.

When Nostradamus, the French polymath, wrote his predictions in the form of prose, he did not write any specific details. Yet, today, people attribute many historical events (including 9/11 attacks, the atomic bomb and the rise of Adolf Hitler) to the predictions made by him. It is also important to note that there are many predictions of his that have not manifested in any way or form. That doesn’t make his supporters and followers discredit his work though. They continue to look for patterns where none might exist. Similarly, there are many who came before and after Nostradamus, making claims about future events and the people involved who are revered in different walks of life, including business, politics and economics.

The truth is human beings are geared to widely accept certain visions of the future that suit their view of things, even if those visions improbable or impossible. It confirms how one analyzes the world one is familiar with and wants to believe that their view is correct. When that hypothesis fails, it is put down to chance or an anomalistic inconsistency in one’s analysis. In light of this, in today’s information age, it is not unusual to find a range of predictions on a daily basis about almost anything and everything happening in the world. Even though these predictions may border on being totally ridiculous, it can find its own stream of subscribers who believe that a particular outcome would suit their worldview.

The questionable foundation of general predictions

“Predictions fail because the world is too complicated to be predicted with accuracy.”

Dan Gardner, Author of Future Babble

Experts have been trying to forecast the price of oil since the inception of the industry in the 19th century and they continue their hot streak of being wrong till today. Modern futurists use retrospective quantitative methods to predict socio-political scenarios decades into the future (known as cliodynamics) yet all they have achieved is the creation of a broad, over-arching theme that captures only part of any future. For decades, there have been innumerable predictions of the Dow Jones Industrial Average index either soaring through the proverbial ceiling or crashing with devastating effects. Just like in the case of cliodynamics, only a miniscule part of the prediction has actually occurred, enough to be branded as an inaccurate prediction.

This further begs the question, how does one qualify to be an expert? What is the criteria that separates the ones who make consistently successful predictions from those who are much less accurate in doing so? As it turns out, there is no such criteria and those who are considered to be ‘investing gurus’ are barely ever absolutely right with their predictions. According to a study by CXO Advisory Group which collecting predictions from 68 different forecasters, after study 6,500 different predictions, it was found that, on average, a forecaster will be correct 46.9% of the time. In other words, if the example of a coin toss were considered where the chances are 50-50, an average person would likely beat the average ‘market guru.’

Dr. Tetlock, The Hedgehog and The Fox

From 1984 till 2003, Dr. Phillip E. Tetlock, a political science writer and revered author, conducted one of the most comprehensive studies of analyzing expert predictions. He assembled a group of 284 experts from a myriad of fields, including government officials, professors, and journalists. They had a diverse range of opinions, from Marxists to free-marketers. In this 20 year period, Dr. Tetlock collected over 28,000 forecasts about the future, including questions about inflation, economic growth, the price of oil, the stock market, elections and the global order of power.

As he validated and analyzed the data sets that he had collected over 2 decades, the final result that he arrived at was that ‘the average expert was as accurate as the famous symbol of random guessing – a dart throwing chimpanzee.’ Of course, some did better than others but they were all far from perfect when it came to making predictions. However, there was a critical pattern he identified while studying these predictions. The way these experts were making predictions had a strong correlation with their individual style of thinking.

In order to simplify this observation, Dr. Tetlock drew inspiration from an essay written by a political theorist and writer, Sir Isaiah Berlin. The essay was titled ‘The Hedgehog and The Fox’ which divided writers and thinkers into hedgehogs (who view the world through the lens of a single defining idea) and foxes (who draw on a wide variety of experiences and for whom the world cannot be boiled down to a single idea).

In Dr. Tetlock’s analysis, the hedgehogs were those who use one big idea (usually an analytical tool) to make forecasts. They preferred simplicity and clarity, so they preferred to keep information pared down to what they thought was the bare essentials. They like using words like ‘certain’ and ‘impossible’ and are usually the ones on television. The foxes, on the other hand, gathered information from many sources, looked at issues with more than one analytical lens, readily admitted mistakes, and were comfortable with complexity and uncertainty. They often said ‘maybe’ and they were humble about their ability to see into the future.

The study also showed an inverse relationship between fame and accuracy. The more famous the person, the less accurate their prediction would be. One would assume that this finding would keep the inaccurate hedgehogs out of the limelight and the focus should remain on the humble foxes. However, hedgehogs are brimming with confidence and make absolute declarations, something that dispels uncertainty. The fox talks about probabilities and possibilities. For the general viewing audience, it’s always more attractive to have their concerns and uncertainties absolutely dispelled, even if it is through a hedgehog analysis which is less accurate than a dart throwing chimpanzee.

The role of bias in analyzing predictions

“Everything makes sense in hindsight. We cannot suppress the powerful intuition that what makes sense in hindsight today was predictable yesterday.”

Daniel Kahneman, Behavioral Scientist, Nobel Prize winner

In the path breaking study called Prospect Theory by Daniel Kahneman and Amos Twersky, the study of human decision making under conditions of risk was thoroughly analyzed. The study’s findings run contrary to the normative implications inherent within classical subjective expected utility theories. This theory gave validation to the idea that risk taking and risk averse behavior occurs not in isolation, but in conjunction with individual behavioral dispositions. These dispositions are driven by the biases individuals may have.

When it comes to making market predictions, such biases play an important role in influencing the final decision of an individual. Some of the prominent cognitive biases that affect predictions are as follows:

Overconfidence bias: Overconfidence is one of the cognitive biases that underlie the illusion of validity. Overconfidence bias can be defined as an unwarranted and often times illogical faith that an investor has in their ability to predict the market. This bias is remarkably prevalent in the investment community. James Montier, former co-head of global strategy at Société Générale, once conducted a study with over 300 professional fund managers to measure the scale of behavioral biases. He asked if they believe themselves to be above average in their ability. 74% of fund managers responded in the affirmative, believing they were above average at investing. And of the remaining 26%, most thought they were average. In short, virtually no one thought they were below average.
Confirmation bias: The illusion of validity persists because people fall prey to the confirmation bias; they focus on information that is consistent with their beliefs while neglecting inconsistent information. As physicist Robert Park once said, “People are awfully good at fooling themselves. They’re so sure they know the answer that they don’t want to confuse people with ugly-looking data.” This bias is more prevalent in market predictors with higher perceived knowledge about the market and higher strength of belief (i.e., sentiment). They will also have a negative interaction effect between the perceived knowledge and the strength of prior belief on confirmation bias.
Representative bias: Representative bias occurs when the similarity of objects or events confuses someone while thinking about the probability of an outcome. According to Kahneman and Tversky, representative bias badly affects people’s decisions during their opinions building and reasoning. This may mislead investors and forecasters to believe they have already processed the information correctly right before they make a decision. While making a judgment, they are likely to ignore other related factors which may affect the value of the investment. Because of the representative bias, forecasters may ignore the law of small numbers where they incorrectly consider a small sample size as being representative of the population. Even though these numbers may reflect the current trend, they cannot possibly describe the properties of a whole population.
Hindsight bias: Hindsight bias leads people to exaggerate the quality of their foresight. It is a behavioral trait where one becomes convinced they accurately predicted an event before it occurred. Based on this, they make predictions about the future. Once an event is part of history, there is a tendency to see the sequence that led to it as inevitable, as if uncertainty and chance were banished. Armed with such a bias, one can become overconfident of one’s foresight and make exaggerated predictions. Those who have hindsight bias, it is common to hear the phrase, “I knew it all along.”

The role of bias in analyzing predictions

It is easy to suffer the pitfalls of following the predictions of the numerous ‘hedgehogs’ that populate mass media nowadays. The markets, just like the future, will forever remain unpredictable. All the predictions that are made, whether scientific or instinctual, are essentially rooted in some form of cognitive bias and are probably driven by the possibility of making some personal gain. To base one’s investment decisions on ‘expert’ predictions is akin to sailing in a storm without a life jacket.

The advisable way to achieve one’s investment return goals is to have a clear objective and an innate ability to shut out the noise made by the so-called market gurus. Instead of listening and acting on the words of the ‘hedgehogs,’ it is more prudent to follow the analysis of the foxes who gear themselves for an uncertain future. These foxes will be advisors and managers who prefer diversification of risk and do not make claims about knowing what comes next. Instead of relying on instincts and emotions, an investor must trust those who take a calculated approach to mitigating possible losses and acting in time as the market moves.

While it might be considered a lot more amenable to do away with market gurus altogether, it is not possible in the current structure of information dissemination and market speculation. In certain markes, like Prediction markets where one trades the outcome of events and market prices indicate what all the investors think the probability of the event is, the role of the guru/expert is almost non-existent. There are many proponents for such markets but they remain a laggard to the popular markets where ‘crystal ball’ predictions still attract a majority of investors. These markets also have the largest market capitalizations and will always remain difficult to transform.

In order to facilitate diversification, there exists a broad range of assets and asset classes in the world now. It would be the rarest of rare occurrence for all of them to boom or go bust at the same time. By planning one’s investments wisely across these classes, based on a sound investment plan, would most likely achieve the long-term gains that any investor dreams of. While ignoring market predictions may not be easy, avoiding making knee-jerk investment decisions based on them can be easily avoided through discipline and consistency.

In Warren Buffet’s now famous article “The Superinvestors of Graham and Doddsville,” he presents indisputable data about how a specific number of asset managers who shared a common teacher have consistently managed to outperform the index over decades. None of them claim to have any supernatural prediction powers and neither do they boast of knowing something that others do not. They have followed their tested methods over a long time frame to achieve a goal they set for themselves. They dedicated their lives to achieving those goals and stayed true to the practices taught to them by Benjamin Graham. In the concluding paragraph of the article, Warren Buffett detailed an undeniable reality of the world which encapsulated the distracting and irrelevant nature of market predictions:

“There seems to be some perverse human characteristic that likes to make easy things difficult… It’s likely to continue that way. Ships will sail around the world but the Flat Earth Society will also continue to flourish.”

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June 17, 2022

Focus on the Data—Not the Drama. How Advisors Can Educate Clients on Today’s Turbulent Market

Stock market volatility has reached a fever pitch in recent months, as has investor anxiety. We don’t expect it to dissipate any time soon. The markets are not trading on fundamentals. Instead, they’re trading on investor sentiment and emotions fueled by outside noise.

How did we get here, and how should advisors work with their clients to focus on the data, not the drama?

Not Your Father’s Stock Market

There are a few things investors need to understand about this stock market that make it considerably different from 15 or 20 years ago. One thing we know is the markets don’t work and function the way they did before. The velocity with which stock markets move is much faster. The upward and downward swings are happening with much greater speed.

A significant part of that transformation over the last decade is the dominance of automated trading. As much as 85% of market trades today are executed by computerized trading or automated machine execution. That’s a far cry from just ten years ago when automated trading accounted for about 20% of trades. Automated trading not only contributes to the higher velocity of trading—but is also a primary contributor to the more significant market selloffs and runups we’ve been experiencing. Couple the increased velocity with the tens of millions of investors accessing hundreds of millions of pieces of data 24/7 at digital speed, and you have a market that can, and will, quickly react to new information or the instant investor sentiment changes.

The media has exacerbated the problem in its seemingly hyperbolic headlines and 24/7 new cycle. The thirst for advertising dollars often makes the media focus on bad news simply because it sells better than good news. Much of the information investors get from the media is centered on driving clicks or viewership, not necessarily on conveying optimal investment advice.

The Challenge for Advisors: Control Client Performance Expectations

Between the stock market volatility and the constant drumming from the media, investors have been pulled in many different directions, often causing them to change their expectations and become emotional about the market.

Emotions often lead to poor investment decisions, which then may lead to underperformance. Current investor losses may have little to do with asset allocation, diversification, or fund choices. Losses may have more to do with suboptimal buy and sell decisions driven by emotions.

Advisors have historically been challenged to meet client expectations. Past experiences or current circumstantial pressures can be driving forces behind shifting expectations. It’s much more of an issue when clients’ expectations whipsaw along with the market. You’re familiar with the concept: “Keeping up with the Joneses.” Applying this theme in a behavioral finance context, and you have what is referred to as “Anchoring Bias,” where investors errantly anchor portfolio return expectations to recent market highs, instead of taking a holistic view of their progress towards their long-term financial goals.

How are advisors supposed to manage that?

The key for advisors is to get control of client expectations through communication and education—and put current market events in perspective. Advisors can work to help their clients avoid common behavioral biases during periods of heightened market volatility by educating them on three critical points:

Volatility is not only normal, it also may be good for investment returns
Volatility and risk have separate meanings
Ignore the noise

Volatility Is Normal

Investors need to understand that market volatility is a normal part of markets. Market pullbacks between 5-10% are a common occurrence, and not unusual to see multiple market pullbacks within the same year. These recalibrations typically occur when the market is overbought or the release of new fundamental news. Investors should in fact consider welcoming market pullbacks because they often help the market reset proper valuation and present investors with a good buying opportunity.

Market Corrections (10-15% declines) are also normal, and while not as prominent as Market Pullbacks, can be viewed in a similar light, but with more caution. When clients are concerned about volatility, it helps to put it in perspective. Remind them that since 2000, the S&P 500 has gained, on average, more than 8% one month following a market correction bottom, going on to then gain more than 24% the following year. So, not only have corrections been short-lived, but they have also been a precursor to significant market gains in their aftermath.

Consider that, in each year since World War II, the market has experienced an average intra-year decline of roughly ~14%, with the market ending the year lower only every third year. As the graphic below shows, the market finished the year in the positive.

Source: Bloomberg

When looking at periods of volatility over a historical timeline of the stock market, it’s clear that stocks can be volatile for periods of time. But over the long-term they historically appear more stable, steadily producing positive returns over time.

The two charts below examine the relative volatility of stock market returns of 5-year rolling returns versus 30-year rolling returns.

A critical takeaway is to educate clients on the importance of following their financial plans and drive awareness of investor behaviors that lead to poor investment decisions during periods of normal market volatility. Reviewing and analyzing a client’s progress towards specific goals should be a primary benchmark for determining changes to an investors financial plan, not TV headlines.

Volatility And Risk Are Not the Same

Investors’ greatest fear is losing money; it’s natural to equate volatility with market risk. However, volatility and risk are not the same, and it’s critical to educate clients on the difference.

Market risk is the chance that by being in the market, you will lose money—though true losses are only realized when a security is sold for a loss. Investors suddenly spooked into bailing out of the market after it has already declined 10 or 15%, could be subjectively “sounding the horn” on a financial plan, still in the 2nd quarter.

Volatility on the other hand, is a range of expected returns or price changes for a particular security, relative to its average – also known as Standard Deviation. Securities with a larger range tend to be larger swings in price and returns, through changing market conditions.

Also, it’s important to remind your clients that volatility is a two-way street. There can be as much volatility to the upside as to the downside. However, investors tend to only focus on the latter, which is why their investment performance can suffer. According to DALBAR’s Investor Behavior Study, twenty years of investor data shows that those who abandoned the market to avoid its worst days almost invariably miss the market’s best days as well. That makes it difficult to overcome the losses incurred and hurts overall investment performance.

Consider this graphic, which shows how your returns would have been impacted on a $10,000 investment if you missed the market’s 5, 10, 30, and 50 best days. What makes it worse for investors is, typically, the market’s best days have occurred near some of its worst days, which is why it’s essential to stay the course during periods of extreme volatility.

Source: FactSet. Returns are based on the S&P 500 Total Return Index. Past performance is not indicative of future returns. An individual cannot invest directly in an index. Data is as of January 31, 2022.

Ignore The Noise

When it comes to investing, the media noise can be deafening. Helping clients understand, while all the significant news events of today may seem consequential, they often have little if any impact on reaching their long-term investment goals. A sudden 1,000-point drop in the market today can certainly be uncomfortable. But through full market cycles, they may barely register as an afterthought on a 5-, 10- or 20-year performance timeline.

It’s critical to have a component to your investment management process that keeps the negative news out of perspective. That will help replace the emotional buy and sell decisions that come with outside market noise, creating more explicit client expectations and potentially more consistent outcomes.

The Bottom Line

We have a phrase at Howard Capital Management, “Focus on the data, not the drama.” We want to make sure we’re making investment decisions on the information we know, not what we think is going to happen.

Right now, there are a lot of unknowns. We are looking for the trends; we concern ourselves with the data, the math, and probabilities.

We trade based on our proprietary HCM-BuyLine®, which is designed to identify clear market trends and seek optimal portfolio allocations through buy and sell decisions based on those trends. Emotions have no place in our process.

The HCM-BuyLine®

The HCM-BuyLine® has been identifying and confirming trends for three decades, enabling Howard Capital Management to sidestep catastrophic market declines in 2000, 2008, and 2020. To learn more about the HCM-BuyLine® and how it is used to tactically manage mutual funds and ETFs, please click here.

About Vance Howard

Vance Howard’s vision for HCM originated after seeing the devastating financial losses investors suffered during the stock market crash of 1987, an event precipitated by computer program trading and investor panic. In an effort to the help investors monitor changing market conditions, he developed the HCM-BuyLine®, a proprietary math-driven indicator, designed with the goal of reducing the impacts of emotional investment decisions.

About Howard Capital Management

Howard Capital Management, Inc. (HCM) is a SEC-Registered Investment Advisory Firm founded by Vance Howard, which offers professional money management services to private clients, financial advisors, and registered investment advisors through a suite of separately managed accounts, retirement tools, self-directed brokerage accounts, proprietary mutual funds, and ETFs. As of December 31, 2021, Howard had assets under management of $5 billion.

For more information, financial advisors should contact their wholesaler by contacting Howard Capital Management at howardcm.com or 770-642-4902.

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March 2, 2022

How to Respond to the Impact of Inflation on Today’s Stock Market

Look for the Silver Lining

The bears have current control of the market. Inflation will be with us for some time, and preservation of capital is critical.

The HCM-BuyLine®, Howard Capital’s proprietary math-based indicator, recently turned negative for the first time since the start of the pandemic in February 2020, which recommended our portfolios move a portion to cash and/or short-term bonds.

The inflation bear, too, is most definitely real, and it’s not transitory. During 2021, this higher bout of inflation has been felt at the grocery stores and gas pumps. Now it’s being felt by the markets. It was only a matter of time before the markets buckled under the weight of rising inflation and the prospects of higher interest rates.

Are we in a longer-term bear market or is this just a nasty correction? Only time will tell, of course, but for now the trend is down and fighting the trend can be expensive and painful. We will let the market find its base, and when the HCM-BuyLine® turns positive, we will re-enter.

How Did The Markets Get Here?

The Federal Reserve has put quantitative easing on steroids since the beginning of the pandemic, ballooning the federal balance sheet to nearly $9 trillion. This was done to increase the money supply and stimulate economic growth during the COVID pandemic. As the growth of production of goods and services slowed, the money supply growth eventually overtook it, causing the price of goods and services to be bid up. When too many dollars are facing too few goods, the result is inflation.

Then add in supply chain issues and increasing wages. Payroll has gone up as employers have had to pay more to get people to come to work. That has contributed heavily to inflationary pressures on the market. There are still four to five million people not working right now.

Often ignored in the inflation equation is the velocity of money—the rate at which money is exchanged in the economy. Following the financial crisis in 2008 and the COVID pandemic in 2020, consumers were more inclined to save their additional dollars out of caution. During COVID, savings increased because many services were no longer available for purchase, such as travel and restaurants.

Now, as many COVID restrictions have been lifted, consumer activity has reached pre-pandemic levels, increasing the velocity of money, but setting the stage for a more prolonged inflation, which we think could be with us for the next 12 to 18 months.

How Should Advisors and Their Clients Respond?

Whether we’re in for a repeat of the 1970s will depend on how the Federal Reserve responds to inflationary pressures. The Fed was a little late to the game and missed a rate hike opportunity in January. The Fed now has to walk a tightrope with future rate hikes later this year. Rising rates too quickly could potentially hurt markets, but not acting at all is only fueling the inflation problem, which is now at a 40-year high. The Fed is in a no-win situation of having to make some difficult decisions that may sting a bit. The latest indications are that it will hit the brakes on printing money in March.

The basic arrow left in the Fed’s quiver is to raise interest rates, which we expect them to do three or four times in 2022.

Some equities could hold up better than others. High-dividend-paying and big-value stocks have been performing relatively well so far. Look for value stocks and cyclicals to potentially outpace growth stocks, while an increase in interest rates later this year could mean a strong headwind for tech stocks. Energy stocks may also do well. But in a deep and sustained selloff, most stocks will likely get caught up in the contagion.

Advisors and their clients need to avoid making decisions based on emotions as it invariably leads to bad outcomes. Some specifics:

Know that the market fluctuations are normal. Declines of 5% have happened on average three times a year; declines of 10% on average have historically occurred every 16 months; and declines of 15% have happened every three years. Stay the course.
Aim to maintain enough investment power to get back in the market at lower prices when the market turns positive.
Seek to avoid going to long-duration bonds, especially those relying on their investment capital in retirement. Once interest rates start rising, bond prices may become an instant loser.
Consider short-duration bonds or even cash. Cash isn’t ideal because, at a 7% inflation rate, people would be losing 7% of their money. But it may be the best of the options.
Avoid interest rate-sensitive stocks like utilities.

The world is not going to end. It’s just going to be a bit more volatile than usual. It’s like being in an airplane. It doesn’t mean we don’t land safely, but advisors and their clients might want to tighten their seat belt along the way.

Reasons To Be Positive

There are several reasons to be optimistic right now. COVID may finally be waning, the economy has remained strong, and virtually anyone who wants a job can get one. Investors have had three excellent years in a row, so a downturn is to be expected. These market cycles run about three years, and they never last long, maybe six to twelve months at worst. This is completely normal market action.

Indeed, market selloffs may be healthy because they may allow for valuations to normalize. Note that volatility and risk are not the same. Risk refers to the permanent loss of capital. Volatility is simply the price fluctuation of a security. Firms with non-volatile stock prices may not generate a profit. Embracing volatility may lead to great buying opportunities for high conviction picks and how positive returns are generated. Advisors and their clients may want to welcome volatility—because it’s how positive returns are generated. For those reasons, embrace volatility and avoid letting emotions drive their investing decisions.

The HCM-BuyLine®

About Vance Howard

About Howard Capital Management

For more information, financial advisors should contact their wholesaler by contacting Howard Capital Management at howardcm.com or 770-642-4902.

Risks and Other Disclosures

Howard Capital Management, Inc. (“HCM”) is registered with the SEC and only transacts business where it is properly registered or is otherwise exempt from registration. SEC registration does not constitute an endorsement of the firm by the Commission, nor does it indicate that the advisor has attained a particular level of skill or ability. Changes in investment strategies, contributions or withdrawals, and economic conditions may materially alter the performance of your portfolio. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment or strategy will be suitable or profitable for an investor’s portfolio. Past performance may not be indicative of future results.

HCM Indicator. The HCM-BuyLine® (Indicator) our proprietary indicator is used to assist in determining when to buy and sell securities. When the Indicator identifies signs of a rising market, HCM then identifies the particular security(ies) that HCM believes have the best return potentials in the current market from the universe of assets available in each given model and signals to invest in them. When the Indicator identifies signs of a declining market, the Indicator signals to move clients’ investments to less risky alternatives. Not every signal generated by the Indicator will result in a profitable trade. There will be times when following the Indicators results in a loss. An important goal of the Indicator is to outperform the market on a long-term basis. The reason is the mathematics of gains and losses. A portfolio which suffers a 30% loss takes a 43% gain to return to the previous portfolio value. The Indicator is a reactive in nature, not proactive. They are not designed to catch the first 5–10% of a bull or bear market. Ideally, they will avoid most of the downtrends and catch the bulk of the uptrends. There may be times when the use of the Indicator will result in a loss when HCM re-enters the market. Other times there may be a modest positive impact. When severe downtrends occur, however, such as in 2000-2002 and 2007-2008, the Indicator has the potential to make a significant difference in portfolio performance. Naturally, there can be no guarantee that the Indicator will perform as anticipated. The Indicator does not generate stop-loss orders that automatically sell securities in the portfolio at a certain price. As a result, use of the Indicator will not necessarily limit your losses to the desired amounts due to the limitations of the Indicator, market conditions, and delays in executing orders.

Please remember to contact HCM, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you want to impose, add, or modify any reasonable restrictions to our investment advisory services. Please Note: Unless you advise, in writing, to the contrary, we will assume that there are no restrictions on our services, other than to manage the account in accordance with your designated investment objective. A copy of our current written disclosure Brochure discussing our advisory services and fees continues to remain available upon request. LARL.HCII.022822

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February 16, 2022

Bullish or Bearish on Equities in 2022? Buckle Up for a Bumpy Ride

How Advisors May Mitigate Potential Losses for Clients

To put the stock market’s performance of late in perspective, the S&P 500 index nearly doubled from 2019 through 2021, up more than 90% in just three years. That’s despite the S&P 500 Index suffering one of its steepest declines in history, erasing more than 30% from investors’ portfolios in just 22 trading days after February 20, 2020. But that historic COVID-related event was also followed by one of the sharpest and quickest market recoveries in history. From there, the market resumed its climb to record highs through 2021.

However, Howard Capital Management sees a strong likelihood for volatility and a possible correction or bear market during 2022.

In fact, a market correction may have already begun. Howard Capital Management’s proprietary math-based indicator, the HCM-BuyLine®, has turned negative for the first time since February 2020 at the start of the pandemic.

Let the Math of the Markets, not Emotions, Drive Investment Decisions.

Howard Capital Management’s HCM-BuyLine® enables the firm to mathematically determine what the market, a particular sector, or specific stock is doing and which way a trend is breaking.

For example, according to the HCM-BuyLine®, when the intermediate trend in the stock market is positive based on mathematical indicators (i.e., a 15-day to 20-day moving average crossover, a multitude of new 30-day and 52-week highs), there shouldn’t be any reason not to be 100% invested in equities.

Conversely, if indicators turn negative, with more 30-day and 52-week lows, advisors should likely know something is wrong, and the trend may be breaking. The key is to let the math of the markets, not emotions, dictate how to respond.

Risk mitigation starts with analyzing and quantifying the trend of the market—whether it’s up or down—before acting. Then, take an active approach to pinpoint the trends in different sectors. The stock market is comprised of many different sectors, each with its own patterns and technical indicators. If the trend turns negative in one sector, it may likely turn positive in another.

An investment strategy should be agile enough to identify those changing trends and act on them in a timely manner. An active management strategy is not just about capturing returns during upswings wherever they are occurring, it’s also about sidestepping market declines. How active management is implemented can potentially make a huge difference for investors.

Whether trading the market as a whole or a particular sector, it’s essential to trade what is happening now, not what advisors or their clients think will happen. Investment decisions and attempts to time the market are common pitfalls often influenced by human emotions and can be a far riskier approach to meeting their long-term goals.

What makes Howard Capital Management different is how we employ our active strategy. We make decisions based on quantitative, mathematical calculations to determine current probabilities of major market moves and the likelihood of a sustained trend in either direction. By following a disciplined rules-based process, we aim to help investors avoid making emotional investment decisions and keep them on track with their long-term goals.

What to Expect in 2022

Howard Capital Management anticipates volatility similar to the fourth quarter of 2021. Though volatility is never fun, it is a natural part of market behavior. It can also lead to great buying opportunities, which is what we saw in 2020 and has helped generate the outsized returns of the previous three years. Consequently, by using a tactical risk management approach, advisors may be able to make volatility work to a client’s advantage.

The equity market may see a few more years of double-digit positive returns, but it is likely to be a very bumpy ride, which is why technical analysis—understanding the price movements of securities—should be the backbone of an investment strategy.

Capturing gains and minimizing losses is important to many investors, however, many of these same investors do not have a strategy or system to achieve their goals efficiently and often try to time the market. Any pullbacks or corrections in a strong uptrend should be viewed as opportunities to find bargains along the way. Conversely, if the market turns bearish, moving assets into cash or short-term bonds may help preserve capital to then be deployed for the next upturn. Howard Capital Management is not afraid to make these decisions mathematically, following a strict system to remove such inefficiencies and complexities.

Inflation: A Negative Headwind

Today’s surging inflation is the likes of which Howard Capital Management has not seen for decades. Inflation is an incredibly negative headwind, and most money managers, advisors, and clients today have never had to factor it into their strategies.

Sustained inflation is going to impact different sectors in different ways, presenting opportunities with some. For example, while past is not prologue, banks and financials have historically performed well in inflationary environments, as have energy stocks. Utilities are another sector that have also previously held up well.

High-quality tech stocks have also historically tended to hedge against inflation. Many analysts believe that inflation-induced higher interest rates and costs hurt the valuations of tech stocks. But companies with a software-based business model, pricing power, low debt, and fair valuations may be an inflation hedge. Technology still drives this economy, and while they may have a bad month or a bad quarter, technology stocks have in the past seldom had bad long-term performance.

The greater risk in an inflationary environment is in the bond market. Long-term bonds have shown greater volatility than stocks like Microsoft or Apple. The 20-year Treasury has been nearly as volatile as the S&P 500. Imagine how they may perform when the Fed starts raising interest rates in 2022. If that happens, investors may not want to own 10-year or 20-year Treasury bonds or long-term corporate bonds.

There hasn’t been a bear market in bonds for over 30 years, so it’s long overdue. Then again, Howard Capital Management hasn’t seen inflation like this in more than three decades. Investors holding long-term bonds are likely to see their portfolios lose value in the coming years. A tactical risk management move for bond investors would be to move into short-term bonds and high dividend paying stocks.

Effective Risk Management does Matter for Returns

Risk management matters. It’s about how clients avoid the market’s worst days while seeking gains from its best days. It’s also about how clients preserve capital when the markets move downward, so it can then be deployed productively where the market is working best.

With the HCM-BuyLine®, it’s not about guessing which way the market is going to move—because no one can predict the market’s direction. Instead, it’s about applying a technical, non-emotional methodology that can follow market trends. One method of attempting to making money in any market environment is identifying the trends and following them with conviction.

The bottom line is investors should be tactical enough to act as trends break in any sector to sidestep declining performance and move money to sectors where the market is working best. Howard Capital Management does not know which sector at this time, but there will be sectors that may make a positive impact in 2022, either because of or despite higher inflation.

In summary, we believe advisors and their clients should trust in a system that removes emotion in a highly emotional market and let the market unfold as it will. No one knows what tomorrow brings but, Howard Capital Management will continue to trade our system and move in or out of equities when indicated.

About Vance Howard

About Howard Capital Management

Howard Capital Management, Inc. (“HCM”) is an SEC-registered investment advisor with its principal place of business in the State of Georgia. SEC registration does not constitute an endorsement of HCM by the SEC, nor does it indicate that HCM has arraigned a particular level of skill or ability. HCM only transacts business where it is properly registered or is otherwise exempt from registration. Howard Capital Management, Inc. (Howard CM) offers its investment methodology through multiple programs that may invest in exchange traded funds, variable annuities, Bonds and Mutual Funds. There is no certainty that any investment or strategy (including the investments and/or investment strategies recommended by the advisor), will be profitable or successful in achieving investment objectives.

When the HCM-BuyLine® indicates a bull market, HCM then identifies the particular mutual funds, ETFs or individual stocks that we believe have the best return potentials in the current market from the universe of assets available in each given program and invests in them. When the HCM-BuyLine® indicates a bear market, HCM moves clients’ investments to less risky alternatives. Howard CM’s performance results: 1) are presented net of advisory fees of 2.2% paid monthly in arrears, 2) are net of transaction fees and commissions, 3) are not net of custodial fees, and 4) reflect the reinvestment of dividends and capital gains. Past performance is not a guarantee or a reliable indicator of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy (including the investments and/or investment strategies recommended by the advisor), will be profitable or equal to past performance levels. LARL.020922

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Other HCM Sites

About Us

Overview

Meet the Team

Territory Map

Our Services

Individual Investors

Financial Advisors

Private Wealth Services

Investment Strategy

HCM-BuyLine®

HCM Portfolios

Self-Directed Brokerage Accounts

Retirement Tools & Services

Resources

Brochures

Insights

Wealth Watch

Global Outlook

In the News

What is Market Volatility?

Notable Events of Heightened Market Volatility

The Traits and Behaviors of Investors During Times of Uncertainty

The Rise and Fall of the Most Recent Period of Volatility

Ways to Navigate a Volatile Market

View The HCM Volatile Market Guide

The higher the Alpha, the higher the attraction

Money markets thrive for more than one reason

Great expectations: Will they come to fruition?

The Current State of Global Inflation

Investor Implications

The Role of Central Banks

Cryptocurrencies as an Inflation Hedge

Where are we headed?

Sources:

Disclosure

AI: A possible game changer?

A.I.’s impact on financial services and investment management

Risks of AI adoption

AI in Finance: A cautious revolution in the making

Sources:

The Great Financial Crisis of 2008

Silicon Valley Bank: A brief history of prosperity and the sudden collapse

Finding a way back to prosperity

Sources

Five Famous Predictions That Never Happened

Making a Prediction: An erroneous human tendency

The questionable foundation of general predictions

“Predictions fail because the world is too complicated to be predicted with accuracy.”

Dan Gardner, Author of Future Babble

Dr. Tetlock, The Hedgehog and The Fox

The role of bias in analyzing predictions

“Everything makes sense in hindsight. We cannot suppress the powerful intuition that what makes sense in hindsight today was predictable yesterday.”

Daniel Kahneman, Behavioral Scientist, Nobel Prize winner

The role of bias in analyzing predictions

“There seems to be some perverse human characteristic that likes to make easy things difficult… It’s likely to continue that way. Ships will sail around the world but the Flat Earth Society will also continue to flourish.”

Not Your Father’s Stock Market

The Challenge for Advisors: Control Client Performance Expectations

Volatility Is Normal

Volatility And Risk Are Not the Same

Ignore The Noise

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