Better to Dance with the Devil You Know Rather than the Devil You Don’t

Better to Dance with the Devil You Know Rather than the Devil You Don’t

There is a saying that it is better to dance with the devil you know rather than the devil you don’t.  

Nothing could be more true about that statement when applied to portfolio management today.  I have a feeling that many investors are discovering that they were dancing with a devil they did not know.

Or knew….but chose to ignore.  

I hold a strong conviction that risk-management should be part of EVERY investment strategy.  

The magic of compound growth can only occur when losses are kept small.

This is not my opinion but rather the irrefutable laws of mathematics.  Since every compound, period begins with the previous period’s ending balance, losses matter….a lot.  

Consider today, with the DJIA down about 32% from the recent market highs, it now requires a near 50% return to just getting back even.

In recent years, passive investors have scoffed at doing anything but  “buy the market”. 

Every decline has been met with “buy the dip”.

Investors lost patience with sound strategies that may have protected them in times like now…all because somewhere they were told that they must always perform as well as the market.

Be careful what you ask for.  ‘You want the market’s return on the upside?  Great. Here’s the downside that goes along with it.  

History books are filled with examples illustrating that there can be periods of time when the market has dealt investors with serious losses.  The fact that it has occurred in the past means it can happen again. And who is to say that the worst period is not behind us…but in front of us.

We do not know for the future is unknown. 

So for that reason, I chose the devil I know.  I choose to always engage with risk management because I would rather incur only a small loss than to be potentially exposed to large and catastrophic losses that I cannot control…and cannot recover from.

I would rather always put a predictable process before an unpredictable future.   

I will happily accept the fact that during strong bull markets lead by narrow leadership, my systematic diversified portfolio underperforms.  That is the devil I know.  

Better yet, I have my bear market protection in place automatically without having to think about it.

The reward is that my Balanced model is up 3.5% YTD.  Focus Four is up 1.0% Cornerstone is -2.3% and Keystone is -5.53%.  For those models with small losses, I can easily recover.

If a client is invested in them, it’s not a difficult conversation.

If you are an investor who has ignored risk…who has gambled on the future, you are now being given an expensive lesson.   

You are dancing with the devil you don’t know.

 

Six Blind Men, an Elephant, and Wall Street

Six Blind Men, an Elephant, and Wall Street

There is an ancient story of a group of blind men who were summoned to a palace where the prince had brought an elephant.   The prince then asked each of the blind men to feel the elephant and to then describe what an elephant was.

 In the case of the first person, whose hand landed on the trunk, he said “This being is like a thick snake”.

For another one whose hand reached its ear, it seemed like a kind of fan.

As for another person, whose hand was upon its leg, said, “the elephant is a pillar-like a tree-trunk”.

The blind man who placed his hand upon its side said, “the elephant is a wall”.

Another who felt its tail described it as a rope.

The last, who felt its tusk, stated the elephant is hard, smooth and like a spear.

While each of them was right based upon what they had experienced, none of them actually described an “elephant”.  In some versions of the story, they come to suspect that the other person is dishonest in their description and they come to blows. 

The moral of the parable is that humans have a tendency to project their partial experiences as the whole truth, ignoring other people’s partial experiences.  One should consider that one may be partially right and may have only partial information.

The elephant was the reality but each of the blind men used their own limited reality to define what an elephant was.

What does this have to do with investing?

Plenty.

In my three decades of professional investing, I have learned that the financial industry is very good at “partial truths”.  There are many things that are used to describe attributes to successful investing but each of those things may be only partially true, and thus, as in the example of the blind men, provide only a limiting view.

Unfortunately for investors, this can very costly.

Stay tuned for my upcoming series, “YES BUT…” as I expose Wall Street’s limiting truths one by one.   

You cannot afford to miss it.   

How to Invest Money. Why Investors That Learn to Play Defense Win at the Investing Game

How to Invest Money. Why Investors That Learn to Play Defense Win at the Investing Game

In learning how to invest money we can look to sports for useful metaphors to guide investors.

 

There are sayings in sports such as “Offense wins games and defense wins championships” or “A great offense is a great defense”.  In truth, every great team must have both a solid offense and defense but the importance of the defensive team cannot be understated.

 

In football, a good defense that can keep the opposing team from scoring makes it easier for the offensive team to win. A strong defense often leads to controlling the ball more often and having better field position.  And then there is the psychological advantage that a dominant defense can have when it shuts down the opposing team’s offense.

 

In baseball, there is the example of the no-hitter –  a complete game in which a pitcher yields no hits to the opposing team.

 

In hockey, a team can win by only scoring one or two goals, but it is very rare that a team wins when the other team puts up four or five.  One has to look no further than the recent Stanley Cup series between the Blues and the Bruins for this example.

 

When it comes to investing, however, most investors are of the mindset to be constantly playing offense.  Yet, investment markets spend most of their time declining and recovering from those declines. A powerful fraction of time is spent creating new capital or making new money.  A study by Morningstar Direct for time period 1/1/1994 to 12/31/2018 revealed that U.S. stocks spent only 19% of that time creating new capital. The other 81% of the time was spent in decline and recovery.   

 

 

For international stocks, the time spent creating new capital was even less; only 11%

 

Given these facts, then why do so few investors have a defensive strategy?  Why do most investors only consider playing “offense”?

 

Without an effective risk management strategy, a portfolio may spend excess time in decline and recovery, rather than creating new wealth.

 

The math of losses

 

It’s also important to understand that any loss, requires a greater gain to recoup the loss.  As the following table illustrates, a 20% loss requires a 25% gain to get back to breakeven. For a 50% loss, similar to what investors witnessed in 2008-2009, it requires a 100% return to breakeven!

The other side of this coin is time.  While an investor may eventually recover financially from a market loss, what is never recovered and is forever lost, is the time that it takes for the portfolio to return to breakeven.  

 

And this assumes that (a) an investor has the mental resolve to stick it out and doesn’t panic and sell somewhere along the way, and (b) that the investor is not having to liquidate portfolio holdings in order to maintain living expenses.   

 

In the former example, I know of several investors who panicked and sold,  one after the dot.com crash in 2002 and others after the credit bubble crash in 2008,  and they NEVER got back in the market! One can not overestimate the psychological scar that large market losses can inflict.  

 

In the latter example, market losses can compound as a result of investors being forced to sell holdings at lower prices often resulting in a permanent loss of capital.

 

I have previously discussed the importance that sequence of return risk plays in retirement portfolios.

 

For retirees especially, having a defensive strategy should be considered a top priority since both resources and time are diminishing and market losses may increase the chance of running out of money.

 

For younger investors, market losses will have an impact on the sum of money that they can accumulate.  It sounds silly to say “you can’t compound your losses”, yet few investors understand the importance of keeping losses small.  

 

A quick lesson in math

 

In school, we are taught that an arithmetic average is calculated by taking the sum of the units being measured and then dividing by the number of units.

 

For example, if we wanted to know the “average” height of the students in a classroom, we would simply add up the height of all of the students and then divide by the number of students.

 

The arithmetic average is effective in situations where each of the items being measured is independent of one another. The height of one student does not have any impact on the heights of the other students.

 

By contrast, in the world of investment returns, the results of one year are related to the results of the next, because both are being compounded on a dollar amount that grows in year 1 (by the returns of that year) before being reinvested (or continuing to be held for investment) in year 2. As a result, a simple arithmetic return fails to capture the compounding effects that occur from a sequence of investment returns.

 

In other words, the fact that each year’s return carries over to impact the balance being invested into the subsequent year means it’s not enough to merely add up the returns of each year and divide by how many there are, to determine the average rate of growth the portfolio actually experienced. Instead, the actual average return is somewhat lower, to account for the fact that there were both higher and lower returns that compounded along the way. This is known as the geometric mean or the geometric average return.

 

The following table illustrates this:

The difference created between arithmetic average returns versus the actual results experienced by the investor is also referred to as “volatility drag”.  The greater the volatility in the return stream, the greater the variance will be between the “average” return and the actual portfolio’s measured return.  

Subtract taxes and fees and it becomes easy to see why many investors fail to achieve their desired wealth goals.

 

Lessons for investors

 

The lessons for investors from all of this are:

 

  • Investors need to think in terms of playing both offense (being in the market) and defense (protecting capital).
  • Aside from cash, CDs and the like, no investment strategy is without the potential for losses.  Given that the geometric return will ultimately determine the amount of spendable money accumulated, investors should strive for achieving consistent returns.  Investment strategies that provide low drawdowns and more consistent returns will likely outperform strategies where there is a wide dispersion between annual returns.
  • Investors should seek out strategies that are dynamic and that can rotate between offense and defense as necessary.  The goal should be to maximize gains during optimal market periods and to protect capital during suboptimal periods.

 

Popular, traditional investment approaches that keep investors fully invested at all times fail to recognize both the nature of the markets and the mathematics of growing wealth.   

Investor Quiz

Investor Quiz

In 2015, the FINRA Investor Education Foundation conducted the National Financial Capability Study and a follow-up study to investors who invest outside of retirement accounts.  Part of the survey included a 10 question multiple choice quiz.  Only 10% of the respondents were able to answer 80% right and only 1% answered all 10 questions correctly.  

 

1. In general, investments that are riskier tend to provide higher returns over time than investments with less risk.

a.  True

b.  False

 

2.  If you buy a company’s stock…

a.  You own part of the company

b.  You have lent money to the company

c.  You are liable for the company’s debts

d.  The company will return your original investment to you with interest

e.  Don’t know

 

3.  If you buy a company’s bond…

a.  You own a part of the company

b.  You have lent money to the company

c.  You are liable for the company’s debts

d.  You can vote on shareholder resolutions

e.  Don’t know

 

4.  Over the last 20 years in the U.S., the best average returns have been generated by:

a.  Stocks

b.  Bonds

c.  CDs

d.  Money market accounts

e.  Precious metals

f.  Don’t know

 

5.  If a company files for bankruptcy, which of the following securities is most at risk of becoming virtually worthless?

a.  The company’s preferred stock

b.  The company’s common stock

c.  The company’s bonds

d.  Don’t know

 

6.  Which of the following best explains why many municipal bonds pay lower yields than other government bonds?

a.  Municipal bonds are lower risk

b.  There is a greater demand for municipal bonds

c.  Municipal bonds can be tax-free

d.  Don’t know

 

7.  What has been the approximate average annual return of the S&P stock index over the past 20 years (not adjusted for inflation)?

a.  -10%

b.  -5%

c.  5%

d.  10%

e.  15%

f.  20%

g.  Don’t know

 

8.  You invest $500 to buy $1,000 worth of stock on margin.  The value of the stock drops by 50%.  You sell it.  Approximately how much of your original $500 investment are you left with in the end?

a.  $500

b.  $250

c.  $0

d.  Don’t know

 

9.  Which is the best definition of “selling short?”

a.  Selling shares of a stock shortly after buying it

b.  Selling share of a stock before it has reached its peak

c.  Selling share of a stock at a loss

d.  Selling borrowed shares of a stock

e.  Don’t know

 

10.  Which of the following best explains the distinction between nominal returns and real returns?

a.  Nominal returns are pre-tax returns; real returns are after-tax returns

b.  Nominal returns are what an investment is expected to earn; real returns are what an investment actually earns

c.  Nominal returns are not adjusted for inflation; real returns are adjusted for inflation

d.  Nominal returns are not adjusted for fees and expenses; real returns are adjusted for fees and expenses

e.  Don’t know

 

 

 

Answers

1 – a

2 – a

3 – b

4 – a

5 – b

6 – c

7 – d

8 – c

9 – d

10 – c

What diets and investing have in common.

What diets and investing have in common.

Choose your investment plan carefully.

Type “diet” into Google and you will get over 1 billion pages.  There are popular diets like the Meditterian diet, Paleo diet, Keto diet, and the Atkins diet.  There are low-carb diets, low-fat diets, diets for weight loss, diets for weight gain and everything in between.   

Which diet is best for you is determined by many factors but probably the most important is:

What diet can you and will you stick to?  

Selecting an investment approach is really no different.  There are about as many approaches to investing as there diets.   Each has tradeoffs. But just as in selecting a diet, the best investment approach is the one that you can stick to.   

In the book, “Global Asset Allocation”, author Meb Faber outlines some of the most popular investment approaches used by investors today.  What is interesting is that while each of the approaches varies by allocation, in the end, the results are all quite similar.  

Recently Meb had this to say about the strategies:  

While in the long run, each of the strategies has provided investors with essentially similar results, the interim results of each strategy varied widely.  

How many investors would change approaches the minute they began to underperform the market or after suffering a 20% or more loss in portfolio value?

Pain or pleasure?

In the wealth of research by psychologists, Amos Tversky and Daniel Kahneman about decision-making heuristics, one of the better-known biases is loss aversion. Their studies in prospect theory found that the pain of a loss was approximately twice as strong as the pleasure from a gain.

Loss aversion may explain why people sell into a decline if their gains on holdings are dwindling toward zero. If a position is already in the red, the fear of larger losses might draw them into the stampede. It also inhibits buying back in even though the lower price has reduced valuation risk.

Every investment strategy will have periods of loss and underperformance.   That is inevitable. There are no free lunches when it comes to investing. Everything you do is a tradeoff.

Further, a study by Charles Schwab showed the willingness of investors to invest has a very high correlation as to how well they are presently doing.  In the study, they demonstrate that fund flows match very closely with the rolling percent change in the markets.

Said another way, investors show a willingness to invest when times are good but reduce their investing during periods of weakness.  If the goal is to buy low and sell high, this is the exact opposite behavior required to achieve that goal!

If a sound strategy has been chosen and future success is determined by the total amount accumulated, then consistency in contributing to the investment account is important.

Remove emotions.

Because human behavior plays such a significant role in investing, anything that can be done to minimize emotional decision making works in your favor.    

And because loss aversion can have such a significant impact on investors’ behavior and long term success, it is my belief that the best approach for many investors is those approaches that attempt to minimize losses.  

In fact, one of the very first things I do when reviewing a strategy is to look at the maximum drawdown percentage and the Sharpe and Sortino ratios.  

The maximum drawdown reflects how much a given investment strategy has declined from a peak in equity to a low, before beginning to recover.  

I believe that the greatest emotional harm comes once this number begins to exceed -20%.  Further, remember that a 20% loss requires a 25% gain just to get back to even.

By looking at the Sharpe and Sortino ratios, we get a to see how well a strategy provides returns relative to the risk of the strategy.  The higher the number, the better the investor experience.

Enjoy the ride.

I believe that the experience along the way is just as important as arriving at the destination.   

The North Yungas Road is stretch of road in Bolivia also know as the “Death Road” where a combination of single track roads, 900m high cliffs, rainy weather, limited visibility, rockfalls, and lack of guardrails, has resulted in many motorists plummeting to their death.  

While you might be lucky enough to survive the travel experience, chances are you would never do it again.

Similarly, for investors who suffered 50-60% losses in the Tech Bubble of 2001-2002 or the Credit Crisis of 2008-2009, many chose not to continue investing.  The pain of the experience became greater than the reward of success which would have come by sticking to a plan.

Again, I want to stress that every investing approach has its pluses and minuses.  

The popular approach of passive indexing suits investors just fine if the goal is simply to do as well as the market.   It’s also a good approach to take if the desire is to keep expenses as lows as possible and to minimize taxes.

As Meb Faber detailed, the long-term results very little despite different asset-allocations.  

That said, this approach has some negatives:

  • It ignores valuations.  The results of this approach when investing when market valuations are high has resulted in decade long periods of little to no return.  
  • This approach leaves the future entirely to chance as the future is unknown.  An investor may or may not earn an adequate return to meet their financial goals.
  • The approach is prone to “sequence of return risk” where the order in which the returns come is just as important as the returns themselves.
  • Buy and hold subjects the investor to holding through periods of market declines which may be both emotionally difficult to withstand as well as mathematically difficult to recover from.
  • Large losses (drawdowns) often require prolonged periods of time to recover from.  While the money of market losses may eventually be recovered, the time it takes will never be.  Additionally, if the drawdown occurs during a period of required capital withdrawal, more of the portfolio must be liquidated or the distribution size reduced, each of which may have negative consequences.

Another approach is to use low-cost index funds but within the context of a rules-based process.  

The pros of such a strategy include:

  • Avoiding large drawdowns during periods of market weakness through the use of downside loss rules.  This keeps losses smaller which is easier on both the account and the emotions.
  • More consistent gains with smaller losses along the way make it easier to reach your financial goals because compounding is more consistent.  In the long run, this can lead to a greater cumulative return than a pure buy and hold approach.
  • Allocating to the sectors, industries and asset classes that are performing well and avoiding those that are not can help accumulate returns in excess of market returns.
  • Since the buy and sell rules are predetermined by the system, investors are less likely to let their emotions sabotage their own success.

While these are certainly positives, remember that there is no perfect approach.  Every investment approach has it’s positive and its negatives.

Risk never is completely eliminated but rather is transferred into another form.  

A purely passive index approach assumes market risk whereas the rules-based approach assumes process risk.  This may include:

  • An approach that actively mitigates risk may go through periods where it underperforms the market.   
  • More transactions increase transactions costs.
  • More transaction decreases the tax efficiency making them more suitable strategies for tax-qualified accounts such as IRAs and qualified plans.

Just as in selecting a diet, the key to selecting an investment approach should be based upon the desired outcome and the individual.   

In the end, what matters most is your ability to consistently stick to the plan.