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?


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 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





1 – a

2 – a

3 – b

4 – a

5 – b

6 – c

7 – d

8 – c

9 – d

10 – c