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.

 

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.    

 

Systems are everywhere…so why aren’t they in your portfolio.

Systems are everywhere…so why aren’t they in your portfolio.

Why systems should be part of your investment process.

Systems exist everywhere. In nature, we find almost an infinite number of hierarchical, interconnecting ecosystems that play key roles by which energy is transported and transformed. These natural systems can have a profound impact on our activities. Consider how the weather and climate systems affect our daily lives.  

Even our bodies are collections of intricate systems each performing a function critical to our survival.  

There are legal and political systems designed to create order and keep the peace.

Many systems operate in concert with our daily lives.

In society, we find that systems can provide for organization and guidance for human interactions. Take for instance how we drive. We follow a precise system.  

Here in the U.S., we drive on the right. We stop on red. We accelerate on a green.  And by everyone following this system, we are able to transport ourselves safely from one destination to another.

Or think about how when we arrive home at night and turn on the lights, we take for granted the electrical system that allows for energy to be converted to light.  These systems are so common we never once question their existence.

We have formed legal systems so as to provide a systematic, orderly and predictable system by which we can resolve conflict and provide for our general safety.

We have formed political systems so as to organize around various ideologies and to allow an orderly process to govern.

Without systems, we would live in a state of anarchy.

And systems are designed to provide a certain degree of predictability.

Yes, systems exist everywhere we look — except in most investors’ approach to investing.  

Why not have systems for investing?

When we examine the typical approach of many investors, we often find that it is completely random. Tips, newsletters, sound bites from financial media, advisor recommendations, friends and family, and the Internet all are the typical sources of investor “information.”

Pure entropy.

Without systems, there can be no order.

Without systems, there can be no degree of predictability.

Imagine if every time we flipped on the light switch we had to hope that it worked — that the outcome was completely random. How frustrating would that be?

Yet, that is exactly how most investors invest.  

The future is unknown.  That is one certainty about life in general, investing is no exception.

But imagine if we invest using rules and systems that are designed to be more predictable in their application. And imagine that the rules never deviate. Now, no matter what the markets provide investors, we are suddenly in control because of the structure provided by a systematic approach.

Systems provide a more predictable process to unpredictable information.

So what kinds of systems might an investor want to consider and how does an investor go about implementing a systematic approach?

These are the topics of much deeper explorations in future posts, but for now, consider the following:

What if we had a systematic way to determine the best asset-classes that deserve the attention of our funds based on current information and just as importantly, we knew where not to be placing our hard earned money?

In a similar fashion, we can use systems to determine the best industry and sectors and equally important to avoid those sectors and industries performing poorly.  

Through the use of systematic screening and ranking processes that are 100% definable and data-driven, we can quickly sift and sort through thousands of stocks to find the very best ones that meet our criteria.   

Systems can also be used to gauge the general health of the financial markets. Just as we use instruments to define weather conditions, we too can use the systematic application of measuring tools to define the general health of the market.  

Know your expected outcome before you trade.

Perhaps one of the most important benefits of applying systems to money management is the idea of expectancy — how an investor can practically know the expected outcome of a trade.   

That is the power of using systems and why every investor should consider using them.

But before we get to that, we need to understand perhaps the most important reason to use systems and that is this: Most investors are hard-wired to fail.  

Systems help us overcome this by providing a means for investors to minimize the involvement of their emotions.  We’ll dive into this deeper into how this works in future posts, but for now, we’re simply highlighting what you already intuitively know: Systems are everywhere, and without them, we’re left with chaos.

Taking a lesson from poker. Some thoughts on 2018 performance.

Taking a lesson from poker. Some thoughts on 2018 performance.

Why disappointing results doesn’t necessarily mean your approach is broken.

For many investors, 2018 was a challenging year. Diversification failed to help investors as most asset-classes finished with losses, more so than any other time in history.

In listening to both investors and their advisors, I have noticed an attitude that professional money management has failed them. Despite the sea of red returns, investors expected more and anything less was unacceptable. After all, it had only been a year ago that the S&P 500 had finished 22%, with international stocks doing even better.

When you go fishing in a lake with no fish, your probability of catching one is zero. And last year, there were very few places to fish for returns and expect a positive number as the following table demonstrates.

Be willing to acknowledge the role of luck.

In the book, Thinking in Bets, Annie Duke, a former professional poker player, talks about luck. She explains that people do not like the idea that luck can play a big role in our lives. While we know luck exists, we often resist the idea that even though we work hard and put forth our best efforts, things don’t always turn out the way we want or plan them to.

To survive, our brains are wired to quickly create order out of that chaos. I have written and spoken extensively on the importance of understanding sequence of return risk.  By understanding sequence risk, an investor learns how the year in which they are born will play a significant role in their future investing success or failure. Buy and hold worked for an investor who retired in the early 1980’s but the approach was a total failure for the first decade of the 2000s. That is just “luck” as it played out against a specific investment style within a window of time that the investor had no control over.

Ideally, as investors, we want to use robust systems that work well the majority of the time and that minimize the element of “luck”.  I favor rules-based (read emotionless, data-driven) strategies with built in downside risk protection supported by real-world evidence.

Professional poker players have a demanding job. They must make up to 20 decisions within two minutes and win or lose a sum of money that would buy most of us a new home. There is always an element of luck that can dictate the outcome of a hand. How does a professional poker player know the difference between skill and luck?

Don’t be guilty of “resulting”.

Ms. Duke first has us imagine the best and worst decisions we made last year. We generally consider decisions that worked out well as “good” and the decisions that didn’t work well as “bad.” We naturally link the outcome of a decision with its quality. Professional poker players call this “resulting” and they rigorously strive to avoid it.

To improve, great players strive to evaluate their decision-making processes irrespective of the outcome. One could make a great decision given all of what was known and bad luck could enter into a situation to produce a bad outcome. With good luck, a poor decision-making process can still produce a winning hand. Even the best poker player can make all the “right” decisions —based upon years of training and playing —and still lose because of bad luck. In a similar vein,

I think it is important for investors to separate results from their investing process. In the financial markets, uncertainty is the rule and all that we have are probabilities. Past is prologue and the best we can do to increase our probability of future success is to find robust investment frameworks in past data and constantly apply them to current markets.

What this means is that any rule or investing approach will at times be subject to luck. No outcome is ever certain.  In reviewing last year, I discovered that many investors focused almost exclusively on the S&P 500 as it was the only asset class positive for much of last year. (the result) Call this a selective bias, made more evident in hindsight, that made some investors question diversification (the process) itself. But just a poker player must evaluate the decision-making process, so should an investor. What investor, striving for long-term success, would purposely pick only one asset class going forward?

Every poker player has had bad luck, but the great ones continually ask: “What could have been improved in how I played that hand? Where did my decision-making process fall apart?” Sorting out the difference is the key to becoming a great poker player.

Successful investing is about seeking known processes that provide an “edge”.

Likewise, finding the right investing process in the face of randomness in the markets may seem challenging. The many factors that influence public companies and their stock prices are not predictable; they impact our investment outcomes in the short term. Factors rotate. Nothing is ever constant.

But over the long term, investors who understand how to use probabilities to their advantage are more likely to succeed. Robust, dynamic systems supported by data over a variety of economic regimes will likely continue to perform better than strategies geared to specific market conditions.

In reviewing our own models last year I can say that while I didn’t necessarily like the outcome in every case, the results were not necessarily due to a flaw in our process. Lady luck was not kind.

That said, it’s important that investors understand that there are no free lunches. A buy and hold approach assumes market risk. A tactical strategy, rules-based or otherwise, assumes process risk. But like successful poker players, investors who understand these concepts, do make money in the markets. They understand that good process does not always mean a winning hand with each deal of the cards but the consistent application of a proven process that tilts the “edge” in their favor will reap long term rewards.

Process Trumps Product

Process Trumps Product

If you have been in the investment industry longer than 5 minutes you have come to realize that investors, i.e. your clients are not rational beings.  When times are good, they want it all and then some.  When times are bad, they forget what they told you during the good times, and suddenly expect you to have read their mind and taken a different approach.

What I have come to realize in my nearly three decades of working in the investment industry is that clients only want one thing:  They want to know and believe that they are on the path to get them where they want to be financially.

Notice I said to believe.  Along the way, there will be things that shake their belief.  The greatest skill you can learn and the greatest value you can deliver as a financial professional is keeping your clients on their path and from sabotaging their success with harmful human behavior.

Focus on using a predictable process to manage an unpredictable future.

We cannot predict what the financial markets will do. The future is uncertain.  We do however have control over the processes and systems we use to manage our client portfolios.

Consider the traditional approach that 99% of financial advisors take. “Mr. & Mrs. Jones, I want you to buy XYZ Product because…blah…blah blah”.  This conversation is product-focused.  Discussed are past returns and product features.

This approach puts you at an immediate disadvantage because (a) you have no control over the markets, (b) you have no control over how a given product will perform, and (c) the whole process leaves a great deal to chance.

Financial plans should not be left to chance.  Chance equates to gambling.

By being product focused, you sound like every other financial advisor.  You become lost in the noise.  A product is simply a means to an end rather than the end itself.

Understand the key emotions that drive most investors.

There are two emotional needs of all clients.  First, clients do not like losses.  Large losses are damaging both psychologically as well as mathematically to the success of a financial plan.  Large losses (>20%) should be avoided.  Many clients may jump ship after taking large losses and there will be no amount of convincing you can do to get them to ride the same ship again.

The second emotion of clients is the fear of missing out (FOMO).  Clients want to know they are on target.  They need to believe the path they are on is taking them there.   They don’t want to miss out.

Focusing on a product alone misses these emotional needs.  It does not connect to the emotional side of the brain.  Remember that with any type of purchase an emotional decision is made first.  Logic (the side that product/feature presentations are geared to) only comes into play after the emotional decision to buy has been made.

What if instead of focusing on product, you focus on the process you use to connect to their two emotional needs?

What if you show a process about how investments are selected?  How no matter what the market throws at us, your portfolio will automatically adapt?  What if you discuss how during wealth accumulation periods, the process automatically selected the top performing investments and avoided the worst?   What if you discuss a process designed to limit losses and become defensive during unfavorable market periods?

None of that discussion has anything to do with a product.  But it does communicate a process to address the two key investor emotions you need to be focusing on.

By focusing on the process, it allows you to fill in the blank with the product, as long as that product follows the process you outlined.

Maybe it’s a separately managed account, an ETF, or another investment structure. But the structure, i.e. the product, is secondary.  The focus should always be on the process…because that is THE ONLY thing you can control.

And that is why process trumps product and how successful financial professionals differentiate themselves.

What is Diversification?

What is Diversification?

The only free lunch?

Diversification has become an accepted, foundational principle for constructing investment portfolios. In many cases, the discussion around diversification centers on incorporating multiple asset classes into a portfolio to enhance the overall risk/return profile. This is the classic approach widely adopted by most financial planners.

In our view, strategy diversification is an additional, important investment tool for constructing portfolios. It is not just what securities are owned but also how and why. In using a rules-based system, these questions are answered very precisely.

Passive diversification derives return by accepting market risk.  A traditional diversified portfolio includes stocks and bonds, often at 60% and 40% allocation.  These investments are meant to be held during all market cycles with the understanding that when one asset class is down, the other is usually up.  But the risk of passive diversification is that there have been times when this theory wasn’t true.  A passive investor must be willing to hold an investment through sustained periods of losses and portfolio drawdowns.

Tactical portfolios derive return by accepting strategy or active risk.  It is often thought of as a risk management tool with the potential to reduce volatility and protect capital. It may also offer the potential to act as a portfolio growth engine by capturing unique investment returns, such as in sector and country rotation strategies.  Tactical management offers the potential to protect against downside market risk and capture upside market returns, but it is important to recognize it will not eliminate risk. Instead, risk has simply changed form, from market risk to strategy risk.

Benchmarking tactical strategies are often difficult.

One of the most common failings of the investment industry is the prevalence of poorly specified benchmarks.

By design, tactical management looks and behaves differently than strategic, passive investment allocations. These differences are sometimes misunderstood, and the ability to effectively extract returns through tactical management requires sustained commitment. Because tactical strategies behave differently than popular investment benchmarks, it is important to determine how long and by how much an investor will allow a tactical strategy to underperform against an appropriate benchmark. A significant risk for investors that utilize tactical strategies is not that the tactical strategy does not work, but rather that the tactical strategy is inappropriately benchmarked, leading to false comparisons or expectations.

Tactical strategies that reduce exposure to underperforming asset classes offer the potential to reduce volatility and protect against significant portfolio downside.  Downside protection is essential for investors with finite horizons, as the sequence of returns becomes particularly meaningful.  It may be impossible or difficult to avoid some drawdown or losses in investment portfolios, but the potential for tactical management to cushion drawdowns may make the difference as investors attempt to weather inevitable pullbacks and market volatility.