taking emotion out of investing

7/29/2019 Taking Emotion Out of Investing

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Taking the Emotionout of Investing March 2013

In a volatile market, Julian Koski of Transparent Value seekssuccess by watching market signals, not going with his gut

Investors are not good market timers. Although the S&P 500

has doubled since its low on March 9, 2009, more than $280billion has been pulled out of stock mutual funds from the

beginning of 2009 through early 2013, according to the

Investment Company Institute. (In comparison, more than $1

trillion has been added to bond funds.) To be fair, the market

dropped so swiftly and deeply during the financial crisis that

many people could not afford further losses. But four years

later, the fear mentality has not gone away. Right now,

people want to manage the risk by staying out of the

market, says Julian Koski, co-founder of Transparent

Value, a subsidiary of Guggenheim Partners. Koski has

developed a patented method for valuing stocks that, he

says, takes the emotion out of investing. And today, his

model is indicating that suitable investors should consider

taking more risk. [I believe] you need to be exposed to

market risk if you are planning on retirement, he says.

Koski spoke about his investing strategy with Morgan

Stanleys Tara Kalwarski, explaining why he is bullish on

stocks. The following is an edited version of their

conversation.

TaraKalwarski: What are the biggest challenges facing

investors today?

J ulianKoski: The biggest challenge really lies in the fact

that investors are faced with situations that occurred in the

past but are dictating how [these investors] behave in the

future. We all know what happened in 2008, and I think that

investors often tailor their behavior in reaction to past

events.

A person who is looking at retirement and who is relying on

an equity product to [help] fund his retirement finds himselfin a position of having to accept continued future volatility

after already having endured volatility on an unprecedented

level. And it's something [investors] are not willing to

tolerate any longer. So thats a challenge, because you need

to be exposed to equity risk, but at the same time you dont

want to be exposed to the volatility.

[I think] the other challenge is that the baby boomer

generation, which controls more than 50% of mutual fund

assets, is risk adverse. But the drawdowns that occurred in

2008 require them to increase their allocations to risk.

The final challenge is that investors tend to want to time the

market, an inclination that hasnt served them well. *There

is a study [showing] that returns for the average investor

over the past 20 years have been somewhere around about

3.5%, while the S&P 500 returned close to 8.00% (7.81% to

be exact) over the same period. So, even if they think they

know when to get out of the market, [investors] don't know

when to get back in. And the market tends to outperform

without their being there.

Kalwarski: Are these challenges unique to the currentenvironment?

Koski: I don't think so. Generally speaking, investors don't

tolerate risk well. They tend to overvalue losses and

undervalue wins. So when things are bad, they see them as

really bad. And that doesn't bode well for their investment

decision-making processes.


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Investors like it when the markets are going up and are not

very tolerant when they're going down. But you have to be

willing to accept both and understand that this is all about

long-term investing. Risks occur at any point in time. It's just

really how you apply yourself to that risk.

Kalwarski: How does your strategy approach risk?

Koski: My father used to say to me: Don't manage risk like

a portfolio manager, manage it like an actuary. RBP,

which stands for required business performance, is

designed to view risk much as an actuary would. We're not

interested in trying to figure out if a stock is under- or

overvalued. It's irrelevant to us. We take the stock price and

try to figure out what management must do to support that

stock price.

In the case, for instance, of a technology company, we figure

out how many phones it will have to sell to support the

current stock price. Then we calculate what the probability is

that the company can do it again. We invest in the

companies that have a very high probability of delivering.

That probability is the underlying material that makes up our

strategy. The strategy is a platform that is made up of three

buckets: an aggressive, a market and a defensive bucket.

Essentially, the underlying difference among the three is the

betaor volatilityscreen that we use.

We begin with the large-cap universe and break that down to

high-beta stocks for aggressive, low-beta stocks fordefensive and betas of 1.0 for market. We then pick the

highest RBP probability and weight the strategy those

probabilitiesgiving an aggressive strategy, a defensive

strategy and a market-risk strategy.

The decision to move between these different exposures is

not driven by the RBP but by market signals. When should

we be aggressive? When should we be defensive? When

should we be all cash? We created a market overlay that

looks at market conditions and thatbased on those

conditions makes the allocation to any one of those three

strategies. It is not subject to decision making; its is all

rules-based. And those rules are then used to figure out

which allocation we should take. So we can go from 100%

aggressive to 100% cash at any point in time.

Kalwarski: What are the market signals?

Koski: We think there are three primary indicators of the

health of a marketplace. First, we look at consumer

sentiment, because consumers are a key piece of a healthy

economy. Another piece of a healthy economy is the

presence of willing buyers and sellers in a stock market

environment, and for that we look at market momentum. The

third, and probably the most important one, is the overall

health of the economy. For that, we look at the economic

indicators as defined by The Conference Board's Leading

Economic Index.

On a simple, basic level, we're looking at the moving

averages of those indicators. We want basically to see

whether all three are positive, two are positive, one is

positive, none are positive, or all are negativewhich would

be a very bad sign.

As of today, all three of those signals are still very positive.

So, right now, we're invested fully in the market fund, which

has a beta of 1.0.

Now, you're probably asking, If the indicators are all

positive, then why aren't you in the aggressive fund? Before

you make that decision whether to be 100% aggressive, you

want to see what the stock market is saying, because it could

be saying something completely different. The economy

could be a lagging indicator, but the stock market is

generally a forward indicator. So we conduct a secondary

check, in order to understand what the stock market is telling

us.

Kalwarski: How do broader macroeconomic or market

conditions affect exposure?

Koski: There are seven allocations in the strategy: 100%

aggressive; 50% aggressive, 50% market; 100% market;

50% market, 50% defensive; 100% defensive; 50%

defensive, 50% cash; or 100% cash. That's it. Right now, it

is 100% in the market.

Let me take you back to 2007. At the beginning of that year,

all three signals were positive. And in actual fact, the

allocation was to 50% aggressive and 50% market. So it had

high betas. Some 50% of the portfolio was in high-beta

stocks, and 50% were in betas of 1.0. By July, it had

switched to 50% market, 50% defensive. In other words,

something happened in the economy where two of those

primary signals had actually gone negative. Consumer

sentiment went negative and the leading economic index

went negative.

Now, what was going on in the economy at that point? In

July 2007, Bear Stearns began to announce that there might

be a problem with one of its hedge funds, and it was an

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indication that subprime would be a problem. By the end of

the year, all three indicators had gone negative, and we were

100% in cash. Throughout 2008, none of those indicators

recovered. And in fact, by March 2009, we were still in cash.

The first time the strategy rebalanced out of cash was in June

2009, when it went to 100% defensive. By the end of the

year of 2009, it was 50% aggressive again and 50% market.

So, we had stayed in cash for 18 months while these eventswere unfolding.

Now, what's really interesting is that the market was up in

2009. We were out of the market for six months of the year,

and yet we were able to catch up. The key difference with

our product is that we believe upside capture is as important

as downside capture. [When] the aggressive portfolio with

high-beta stocks signals a high-beta rebalance, it [can] act

like a jet engine; it [potentially] catches up very, very fast.

Kalwarski: How can this strategy potentially help investors

address the challenges you mentioned earlier?

Koski: Well, No. 1, it keeps you exposed to the market,

which is key. Timing the market is never a good thing. As

we've seen from this year, this market could be up. And if

you're not in it, you're not going to get exposure to it.

At the same time, you don't want to be subject to the

drawdowns of 2008 again. So [its helpful to have] some

kind of pressure valvea system that can automatically

expose you to the different betas. When its a bull market,

you want exposure to the aggressive strategy. But whenthings are bad, you want the pressure valve to kick in so that

you can go to 100% cash. So, it keeps you exposed but

manages the risk along the way.

Kalwarski: Is there any checf to make sure you're not

overly weighted in a given sector in the three indexes?

Koski: We don't manage to sectors. We're sector agnostic.

For the aggressive index, we essentially look for the highest

betas with the highest probabilities. For the defensive, [we

look for] the lowest betas with the highest probabilities and,

finally, [we look for] betas of 1.0 for market, with the

highest probabilities. Sector and sub-sector don't come into

account.

We typically have 50 names in the portfolio. And we

rebalance it four times a year, a fixed count on a fixed day.

So, it's automatic. Once the new probabilities come out after

a quarter, once the new financial information is in, we

rebalance the portfolio.

We do have pressure valves built into the system, because

waiting a whole quarter to rebalance to cash could be too

late. Our economic-conditions indicator, which is The

Conference Boards Leading Economic Index, comes up

monthly.

We look at that value monthly, and if we see it dropping

below the moving average, that forces what's called anunscheduled rebalance. We will act because we don't want to

wait three months before that particular signal acts. In 2007,

for instance, there were seven rebalances because the leading

economic index kept [dropping below the moving average],

and so we kept rebalancing. Had we waited, we would have

missed the opportunity to rebalance to cash.

Kalwarski: Do you foresee an unscheduled rebalance in the

near future?

Koski: You're never going to know the future. And the

RBP probability is based on the fact that you don't know

the future. But if an event does occur, if there's something in

those primary signals that is negative, then it will trigger the

rebalancing mechanism.

I look at the data daily to understand what is it saying and to

anticipate what a rebalance might look like. However, the

honest answer is that I don't know the future. I don't know

what's coming. And that's why we've designed this strategy.

*Unless otherwise noted, the source for all information is

J ulian Koski as of March 2013.


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Investors should carefully consider the investment objectives and risks as well as charges and expenses of a mutual fund

before investing. To obtain a prospectus, contact your F inancial Advisor or visit the fund companys website. Theprospectus contains this and other information about the mutual fund. Read the prospectus carefully before investing.

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment. Companiespaying dividends can reduce or cut payouts at any time.

International investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economicuncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, sincethese countries may have relatively unstable governments and less established markets and economics.

Rebalancing does not protect against a loss in declining financial markets. There may be a potential tax implication with a rebalancing strategy.Please consult your tax advisor before implementing such a strategy.

All indexes are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent theperformance of any specific investment.

Transparent Value, RBP, Required Business Performance, and the Transparent Value logo are registered trademarks of Transparent Value, LLC

or one of its subsidiaries. "See the market clearly" is a trademark of Transparent Value, LLC and its affiliates. Other featured words or symbols usedto identify the source of goods and services may be the trademarks of their respective owners. No claim is made that RBP can, in and of itself, beused to determine which securities to buy or sell, or when to buy or sell them. There is no assurance the RBPmethodology will successfullyidentify companies that will achieve their RBPor outperform the performance of other indexes. Transparent Value, LLC ("Transparent Value") is asubsidiary of Guggenheim Partners, LLC.

The views and opinions expressed herein do not necessarily reflect those of Morgan Stanley. The information and figures contained herein has beenobtained from sources outside of Morgan Stanley and Morgan Stanley makes no representations or guarantees as to the accuracy or completeness ofinformation or data from sources outside of Morgan Stanley. Morgan Stanley is not responsible for the information, data contained in this document.Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Past performance is noguarantee of future results.

The material has been prepared for informational or illustrative purposes only and is not an offer or recommendation to buy, hold or sell or asolicitation of any offer to buy or sell any security, sector or other financial instrument, or to participate in any trading strategy. It has been preparedwithout regard to the individual financial circumstances and objectives of individual investors. Any securities discussed in this report may not besuitable for all investors. The appropriateness of a particular investment or strategy will depend on an investor's individual circumstances and

objectives. There is no guarantee that the security transactions or holdings discussed will be profitable.This material is not a product of Morgan Stanley & Co. LLC, Morgan Stanley Smith Barney LLC or CitiGroup Global Markets Inc.'s ResearchDepartments or a research report, but it may refer to material from a research analyst or a research report. The material may also refer to the opinionsof independent third party sources who are neither employees nor affiliated with Morgan Stanley. Opinions expressed by a third party source aresolely his/her own and do not necessarily reflect those of Morgan Stanley. Furthermore, this material contains forward-looking statements and therecan be no guarantee that they will come to pass. They are current as of the date of content and are subject to change without notice.

Tracking No. 2013-PS-69 03/2013

2013 Morgan Stanley Smith Barney LLC. Member SIPC

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