Monthly Archives: May 2015

Investing’s Hatfields & McCoys

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I recently had a conversation with a portfolio manager on the concept of active portfolio management, or as he put it, “market timing.” The particulars of our discussion covered benign topics such as risk tolerance and diversification. Nevertheless, a pleasant exchange on the merits of the FTSE Custom Multi-Asset Stock Hedge Index (MASH) quickly morphed into an argument. It became so ugly, in fact, that I found myself picturing a vengeful Ran’l McCoy, musket in hand, banging on my office door.

The lessons that he taught me? One, it is not possible to enlighten a steadfast “buy, hold-n-hoper” on the benefits of active portfolio management. And two, if you tactically allocate assets as a way to protect client portfolios, you’re the enemy of the “hold-n-hope” business model. (The more I think about it… his interest in how we manage money may have started with a client leaving him to join our family here at Pacific Park Financial, Inc.)

In any event, it is obvious that I do not have the persuasive powers to change the mind of a headstrong devotee. (For the sake of this story, let’s refer to him as Mr. McCoy.) So if you’re an intractable zealot of the “buy, hold-n-hope” investment faith, please stop reading now. What is the old saying? You can lead a horse to water?

I would like to summarize the conversation that I had with Mr. McCoy. But first, let’s be clear about something. Just because an investor or a money manager takes measures to protect a portfolio from catastrophic losses, it does not mean he/she is an evil “market timer.” I like to explain it in the context of a road trip. If you’re driving down a dark country road and an ominous fog suddenly rolls in, should you not become a bit more alert? Perhaps you might even ease off the accelerator pedal? That is what a responsible and seasoned driver would do. Active portfolio management is no different. You simply prepare for the possibility of danger.

Mr. McCoy’s response:

“Well, what happens when you take your foot off of the accelerator only to realize that there was nothing to worry about? You just wasted time and energy for no reason.”

Mr. McCoy was making a point about missing out on opportunity. Indeed, if you slow down or stop driving, you may not even reach your destination. Similarly, the downside in taking precautionary measures with your investments is the possibility that you might spend a bit more time and energy yielding to hazards that never materialize.

On the other hand, what is the downside in Mr. McCoy’s position? What if he doesn’t take his foot off of the accelerator and there just so happens to be a fallen tree around the bend? Now his road trip just turned into a nightmare. In fact, the damage may be so disastrous, Mr. McCoy may never be able to get in a vehicle ever again! In contrast, the worst thing that happened on my road trip is that I arrive at my destination a bit later than I originally anticipated. But I am still getting there!

Although my point made sense to him, Mr. McCoy debated the merits of comparing a road trip with the need to generate adequate investment returns. And I suppose no comparison is foolproof. Yet, I contend that there are a number of valid points that emanate from my example.

First, Mr. McCoy prefers keeping a portfolio on “cruise control” while completely ignoring the real possibility of adverse consequences in doing so. Granted, there may be a widely accepted speed limit for driving just as there is a widely accepted age-based allocation for investing. Then again, the posted speed limit is meant to be obeyed when road conditions are optimal. Unfortunately, road conditions can change drastically due to surface or weather conditions; the presence of unusually irresponsible drivers can alter the roadway as well. Investing carries the same risks of danger. Indeed, buy-n-hold — placing one’s future retirement on “cruise control” — offers little insurance against the real possibility that financial markets fall to unimaginable lows.

Also, investing is a function of the relationship between the risk of loss and the possibility of financial reward. A responsible investor should strive to keep that risk-reward relationship at an appropriate level at all times. If we fail to do so, we create emotional traps that hinder the pursuit of financial freedom. And since the markets don’t trade at a constant, the relationship between risk and reward is not constant either. Thus, sometimes it’s better to be invested in certain things in certain periods, and at other times, it is preferable if you are not invested in certain things. A portfolio on “cruise control?” Well, it does not even attempt to address the risk of loss, let alone the time-tested measures that point to extreme levels of risk in an investment arena.

Mr. McCoy chimes in at this juncture, attempting to explain that his auto-pilot approach does deal with risk. “That’s why we diversify with bonds.” Perhaps ironically, Mr. McCoy does not even know what diversification actually means, though his assumption is that it means a little bit of this and a little bit of that. This assumption is commonplace in Wall Street. So let me clear this up right now. Owning different asset classes such a stocks, bonds, currencies, commodities and real estate may mean you own a diverse group of assets, but it has nothing to do with diversification in the world of risk management. When it comes to the risk of loss, diversification means that you own assets that are not correlated to one another, or in mathematics, their correlation hovers around zero (0). If stocks, commodities, real estate and bonds begin moving in lock-step with one another — which at risky times they do — everything can fall apart simultaneously.

Can you be at risk for severe losses with 65% in stocks and 35% in bonds? You sure can. There are periods, usually in crises and breakdowns, when most assets in the financial markets “go to one (1).” That means they are all highly correlated or, undiversified. And the result? Monstrous loss of principal. In other words, many different asset classes could go down the toilet all at the same time. After all, they have in the past. When an investor faces this “nowhere to hide” scenario, a static asset allocation model won’t help you. An active management approach that seeks shelter in highly uncorrelated assets and/or cash equivalents can.

Lastly, just like with driving a car, investing always comes with the risk of loss. Yet, just because some risks are inherent, those risks are not necessarily unavoidable. We all have an ability to maneuver around obstacles, to slow down, to speed up, and so forth. So why wouldn’t we take advantage of those options so that our road trip is as safe as it can possibly be? Unless we have a crystal ball, or unless we enjoy the extreme highs and lows of the gambler’s “let it ride” mentality, there is no good reason.

Here is where Mr. McCoy believed that he arrived at a “gotcha moment.” Since nobody can predict what will and won’t ultimately happen in the markets, isn’t it smarter to rely on a static asset allocation rather than attempt to “guess” when bad stuff will transpire? He then proceeded to discuss historical data about missing out on the best days as well as other evidence on how “you can’t time the market.”

Well, I decided to go to actual historical data at this point. For instance, let’s say that you happened to invest in stocks for the very first time on October 9, 2007. After all, stocks were on a healthy run for quite some time. Surely it would make sense to put money to work during a healthy uptrend. If you’re unfamiliar with this particular date, it was the closing high that was set just prior to the start of what would be defined as the Financial Collapse of 2007-2008. It was also a few months prior to the beginning of the Great Recession.

From the closing high on October 9, 2007 to the closing low on March 9, 2009, the S&P 500 dropped 57%. Likewise, an investment in the SPDR S&P 500 ETF (SPY) would have garnered -55% thanks to dividend reinvestment. So, in this example, your very first experience with investing in stocks netted you -55% over the span of 17 months. And although the S&P 500 eventually recouped those losses four-plus years later, you spent more than five years of your life watching a substantial investment do absolutely nothing except cause you grief and anxiety!

That’s not all. You may think that it was normal for the S&P 500 to take just four years to reclaim that 123% for one to break even; however, it was anything but typical. The markets have historically taken roughly a decade to make an inflation-adjusted rebound from a 55% loss. You just so happened to catch a break from the U.S. Federal Reserve’s emergency stimulus measures of electronic money creation and zero percent overnight lending rates. Without the controversial policies that have forced savers to gamble in higher-yielding bonds and stocks, an investor could not have dreamed of recovering from the financial collapse this quickly, if ever!

Mr. McCoy argued that the ride would not have been that bad, since nobody would prudently be 100% invested in stocks. I explained that even if your stock allocation only represented 50% of your portfolio, which would be a conservative allocation by anybody’s measure, it still wouldn’t have been easy to stomach 30%, 35%, 40% losses. Remember, many correlations can go to 1, and many bondholders of higher yielding debt, even investment grade debt, lost 15%-30% in those holdings. Not everyone had shifted their allocation to U.S. treasury bonds alone, and certainly not static buy-n-holders who likely held subprime mortgage bonds, foreign bonds, convertible bonds, high yield junk bonds and a host of non-stock assets that also lost a ton of money.

When you’re living in the moment, not knowing what the future holds, and your only saving grace is that your investments may eventual recover, or “at least I didn’t own 100% stocks,” you’re not left with warm and fuzzy feelings. Why would someone want to stick with a strategy of doing nothing — simply holding-n-hoping — as one looks out into the future?

Mr. McCoy was becoming increasingly irate with me. He insisted that active allocators of assets could make even worse decisions, either “trading one’s self out of the market” and/or “giving into hazards that never come to pass.” Is he right? In part. Those types of instances are known as whipsaw trades, where you sell to protect against the risk of loss, only to buy back in the future with little gain or even a small loss for one’s efforts.

Consider the possibility that you have a series of negative trading events. You could find yourself with a number of trades that lost 5%. You could wind up with -5% every time the market boy cries wolf. According to Mr. McCoy, most of the time you will be better off not trading at all — simply holding onto your investment through the volatility. Trying to avoid some emotional hardship was, in his words, “pointless and futile.”

Before I continue, there is an important point to discuss that Mr. McCoy unwittingly brought up here. He unintentionally made the connection between investing and emotions. Clearly, Mr. McCoy realizes that investing does not occur in a vacuum. We are all emotional creatures and our money is very important to us. It follows that our money affects our emotional well-being rather dramatically. In fact, there are actually studies that have shown an inverse relationship between stock market returns and hospital admissions. When stocks go down, hospital admissions go up, particularly for psychological conditions like anxiety and panic disorders, as well as depression.

So what is the point of investing at all if it’s just going to negatively affect other aspects of our life? Well, as with the preservation of our emotional well-being, investing happens to be a necessity for most folks to achieve financial freedom in retirement. Since we have to do it, we ought to find a happy medium that keeps our emotions and our investments in check.

This brings us back to the reduction of emotional hardship, which Mr. McCoy described as pointless and futile. Really? Even if you used the -5% whipsaw trades described earlier, and you used it as the basis for loss on one’s entire portfolio, you would need a series of occurrences that produced 16 losing events in a row on your portfolio. Luckily, I already know the statistical probability of such “streaks of bad luck.” After all, I’ve run literally hundreds of models with almost every, and any, variation of a trading rule you could possible imagine.

For example, one of the simplest active management techniques I’ve modeled is trading on the 200-day simple moving average (SMA) — where you buy when the price breaks above the 200-day SMA and you sell when the price drops below the 200-day SMA. Even making sure that the daily price execution is a worst-case scenario, where buys are executed at intraday highs and sells are executed at intraday lows, a streak of bad luck of such magnitude has not occurred at any time within the intraday price data that I have. And that’s going back more than 50 years! It has NEVER happened!

Heck, buy and holders have been mauled by four bear markets just in the last 15 years alone… and one of those was a -57% doozy! Even if you think the last 15 years were an anomaly, the long-run historical average still suggests that you should expect a bear market — with an average drop of about 30% — to occur, on average, about every three to four years. To me, that’s enough “fallen trees around the bend” to warrant some sensible action. This is especially true if you once believed that you could remain quite content on driving the posted speed limit no matter the road conditions.

We’ve probably all experienced at least one catastrophe with an investment in our lifetime. Do you really believe you will always have the earned income and days on the planet to make up for another disaster? If there’s one thing that defines our personal growth it’s the ability to learn from our mistakes. It follows that a fallen tree in our path should be enough for one to recognize that there is a better way.

Naturally, Mr. McCoy was not about to throw in the towel. He circled back to his contention that actively managing assets leads to missed opportunity. His argument is quite popular in the “buy, hold-n-hope” bag of rebuttals. The mantra? The reason buy-n-hold works so well is that you are guaranteed to participate in the best market days. Any active allocation of assets can make no such guarantee.

Does Mr. McCoy have a leg to stand on? Well, take any historical period of at least three to four years and calculate how your investment would’ve done had you missed the 10 best market days within that period. As you will see, the outperformance of a buy-n-hold would be dramatic. (SHOCKER! Miss the best 10 days or garner the best 10 days, and you see a difference.)

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Unfortunately for Mr. McCoy (and all buy-n-hold proponents), he did not consider another guarantee. You see, as a buy-n-hold-n-hoper, you are also guaranteed to participate in the 10 worst days. That’s not necessarily a guarantee for a tactical asset allocator. So, since Mr. McCoy was so willing to give me the benefit of the doubt on missing the 10 best days to be invested, I figured I’d provide him with the data that shows the importance of avoiding the 10 worst days. The below chart shows what actually matters the most.

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As you can see, psychological benefits aside, there is something to be said about the importance of missing the down days. The data summary (see the table below) also supports the notion that missing the down days is far more beneficial than participating in the up days. Average out the S&P 500’s 10 best and 10 worst trading days in the period covered by the above chart and you get a negative number (-0.14%). This negative number suggests that the 10 worst days were down more drastically than the 10 best days were up.

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Yet, as Mr. McCoy once again pointed out, it is next to impossible to predict when those good and bad days are going to occur. No person since the dawn of investing has been able to predict the direction of a market with any meaningful degree of certainty. This will never change. So, instead of possibly spinning your wheels at deciding whether you should be in or out, and instead of simply settling with a strategy that holds on through thin and thick, why not pursue an approach that represents a “happy medium?” Why not hedge your portfolio volatility by introducing a tool that is designed to be just that… a hedge against stock volatility? After all, limiting volatility can help you accomplish your financial goals, as well as make the journey less erratic — thereby preserving your emotional well-being.

I presented Mr. McCoy with my alternative. Perhaps we could work the MASH Index into the bigger picture? What might the chart look like if we invested in the MASH index during the 10 best AND 10 worst days? If the results demonstrated improvement beyond the hold-n-hope results, the MASH component would be beneficial as a means to ensuring that a hold-n-hoper did not miss out on the opportunity that Mr. McCoy was so adamant about.

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As the above chart shows, working the MASH index into a buy-n-hold strategy demonstrated improvement above buy-n-hold alone. Additionally, by providing a reduction in volatility, a concerted effort is being made to alleviate the emotional strain of being invested during hazardous periods of time. All else being equal, if the MASH index made the buy-n-hold ride much less bumpy, wouldn’t it be a worthy addition to any portfolio?

Mr. McCoy wasn’t convinced that a less volatile portfolio could outperform. Luckily, I had already run the numbers. Not only was the inclusion of the MASH index providing less volatility to a stock portfolio, but the MASH Index showed little to no correlation to stocks when they hit those “rough patches.” That is the essence of genuine diversification!

How exactly did the “stats” turn out? The MASH index provided a much smaller standard deviation than that of the S&P 500. Keep in mind, a “standard deviation (σ)” is a method for measuring the volatility of an investment. One standard deviation (1σ) represents a range in which the investment trades approximately 68% of the time, two standard deviations (2σ) represents a range in which an investment trades approximately 95% of the time, and three standard deviations (3σ) represents a range in which an investment trades approximately 99% of the time.

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As the table above shows, the day-to-day trading range for the S&P 500 was at least 2x that of the MASH index at each measurement. For example, the S&P 500’s three standard deviation (3σ) reading meant that it traded within an 11.39% day-to-day range 99% of the time from 7/1/2011 to 4/30/2015, as opposed to MASH trading in a narrower band of 4.49%. The larger the trading range, the more volatile the investment is.

That’s not all. Remember the previous table which summarized the S&P 500’s 10 best and 10 worst days? Well, that was only a piece of a much more compelling story regarding correlation between stocks (the S&P 500) and the MASH index.

I wanted to look at more than just the 10 best/10 worst days. So I decided to look at the 10 best/10 worst weeks, months and 3-month periods. I chose to investigate the same information for the MASH index. (See the table below.)

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If avoiding the down periods is a predominant attribute of successful investing, the “Worst Low” and the “Average” columns under the S&P 500 and the MASH sections should lead to some eye-opening revelations. First, the “Worst Lows” were much more stable and manageable with the MASH index, as compared to the S&P 500. Second, the “Average” of the 10 best/worst periods are positive across the board for MASH. This insinuates that MASH’s 10 best periods were up more drastically than the 10 worst periods were down. This is in stark contrast to the S&P 500.

Mr. McCoy was listening, of course, but he was becoming increasingly agitated. I couldn’t help myself. I still had more to show him.

You should recall that I presented the notion that the MASH index had little-to-no correlation to stocks when stocks hit those “rough patches.” So I defined those “rough patches” in the recent past for Mr. McCoy. Between 7/1/2011 and 4/30/2015, the S&P 500 has experienced four instances where it fell by more than -6.66%, which corresponds to the 10-worst trading days in the table above.

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As you can see, my data showed that by instituting a non-correlated, less volatile option like the MASH index, an investor could’ve improved the performance of his or her portfolio. Investors need not be relegated to holding-n-hoping stock assets without any type of parachute.

“So… in summary, Mr. McCoy, not only can a more proactive approach to investing reduce the emotional strain of watching your money disappear by 30%, 40% or 50%, you can minimize the financial stress as well. And since one’s overall return is directly related to one’s time as a participant, one can also save a bunch of years by avoiding the potential hazards in the roadway.”

[PHONE CLICK]

“Mr. McCoy…are you still there??? Mr. McCoy???”

If you are interested in learning more about the FTSE Custom Multi-Asset Stock Hedge (MASH) Index and whether it is appropriate for your portfolio, give us a call at 888-500-GARY (4279). Additionally, please click here to inquire about investing in the MASH index for FREE for the remainder of 2015.

 

Disclosure Statement: Pacific Park Financial, Inc. is a Registered Investment Adviser with the SEC. Pacific Park Financial, Inc. and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising on this website. StockHedgeIndex.com is created independently of any advertising relationship.