Carlos M. Sera has been managing money since the 1980s, and if there’s one thing he’s learned it’s that investors aren’t very good at predicting their tolerance for risk.
“Everyone wants to make money and never lose money, no matter what they say in client questionnaires. They could swear on a polygraph they will stick with the strategy in a 10%, 20% or 30% correction, but when it actually happens they want to sell everything near the bottom, and they won’t re-enter until the market goes to new highs,” said Sera, co-portfolio manager of the new Financial Tales Portfolio on Covestor.
Indeed, the growing field of behavioral finance has exposed common psychological mistakes that investors tend to make over and over again, such as buying at the top and selling at the bottom.
“I’ve seen this type of behavior so many times in my career,” Sera says. “I realized I had to develop a strategy that mitigates it and grows capital on a steadier basis so clients don’t shoot themselves in the foot.”
The Financial Tales moniker for the portfolio comes from Sera’s blog, which is designed to convey his market knowledge and experience through storytelling. He manages the portfolio with his son, Carl E. Sera, who holds a Chartered Market Technician (CMT) designation.
The elder Sera founded Sera Capital Management in 1990 with a focus on managing risk and quantitative analysis.
The Financial Tales Portfolio on Covestor invests in exchange traded products and attempts to outperform inflation by 5% a year over multiple cycles. Sera is quick to point out that the S&P 500 has only outperformed by 6.5% a year over multiple market cycles. The portfolio contains unleveraged ETFs and ETNs that have assets greater than $500 million – typically between 10 and 20 holdings, but it can hold as few as five securities.
The portfolio can invest in a wide range of asset classes, including U.S. and international stocks, bonds, real estate and master limited partnerships. Current holdings include iShares Core Total U.S. Bond Market ETF (AGG), iShares MSCI EAFE ETF (EFA), iShares U.S. Preferred Stock ETF (PFF) and iShares Mortgage REIT Capped ETF (REM).
Sera’s investment philosophy incorporates key principles of behavioral finance. It assumes investors are overly optimistic in bull markets and too cautious in bear markets.
“Our goal is to build up investors’ capital consistently. By not losing, they end up winning,” Sera notes, adding the portfolio focuses on absolute rather than relative returns.
“One of the biggest assumptions of Modern Portfolio Theory or MPT is that investors make rational decisions. That assumption is wrong and has nothing to do with reality. The behavior of investors is perhaps the most important aspect of portfolio returns and incredibly variable depending on market conditions,” he said.
Financial Tales Portfolio hunts for investments with high so-called MAR ratios, which are calculated by dividing the compounded annual growth rate of an investment over its history by the worst drawdown. For example, if an investment has a 5% compound annual return since inception, and its worst peak-to-trough drawdown is 15%, then the MAR ratio is about 0.33.
“We look for investments with higher MAR ratios because investors are less likely to bail on the strategy during tough times,” Sera said. “We spend a lot of time and effort trying to protect on the downside, to preserve capital for later investment. It’s all about the mathematics of recovering from a loss.”
For example, if an investment loses 50%, it needs to gain 100% just to get back to breakeven.
Sera says he doesn’t really pay attention to an investment’s volatility or standard deviation, which measures historical price fluctuations to the upside and downside. Instead he used the MAR ratio to measure volatility because it is the closest thing he’s found that reflects investor behavior.
“In the real world, volatility doesn’t equal. Risk is losing money,” he says. “Modern Portfolio Theory treats gains and losses the same and that simply isn’t true for investors.”
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DISCLAIMER: The investments discussed are held in client accounts as of December 31, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable. ETFs are subject to risk similar to those of stocks including those regarding short-selling and margin account maintenance. Past performance is no guarantee of future results.
