Why We Believe in Rules-Based Investing

Why We Believe in Rules-Based Investing

Why rules-based investing?

Investors have many choices in how to approach investing.  A common approach is to use a passive strategy that seeks only to replicate the results of the markets at the lowest possible costs. The key assumption being made with this approach is that the market returns will be adequate to fulfill the investor’s financial goals.

Unfortunately, such an approach leaves much to chance.  The future is after all, unknown.

Several factors come into play when choosing a passive investing approach.  Timing is one.  Institutions are less concerned about timing as they view their investment horizon as perpetual and ongoing. Additionally, institutions often benefit from a constant stream of new investment contributions.

The importance of timing.

For an individual, however, who must first save and then rely upon those savings to grow to meet their future financial goals, the importance of timing cannot be overstated enough.  An investor who had the misfortune to retire in 2000 had a much different experience than an investor who was fortunate to retire in 1982, right on the cusp of one of the greatest bull markets ever.  The first investor would have been in a battle for investment survival.  What the tech crash of 2001-2002 didn’t decimate, the credit crisis and market declines of 2008-2008 probably did.  After a decade, the average return for our unlucky investor would have been 0%…and if this investor was having to sell assets along the way to supplement their lifestyle, their results were likely to be worse.  Much worse.

Market results with and without 4% annual withdrawal at year-end for period 1980-1992.

Market results with and without 4% annual withdrawal at year-end for period 1980-1992.

Market results with and without 4% annual withdrawal at year-end for period 2000-2012.

Market results with and without 4% annual withdrawal at year-end for period 2000-2012.

For the investor who retired in 1982, they experienced nearly two decades where the average return was near twice the market long-term average. This investor would have enjoyed the ability to receive a rising distribution from their portfolio and have more than what they started with nearly two decades later.

Two different experiences where the only difference is created by where an investor is in the continuum of market returns.

Since investors don’t get to choose when they get to invest and retire as this is determined at birth, we prefer an active approach with the goal to minimize downside risks and maximize upside returns no matter when an investor is investing.

Our preferred approach is a rule-based method based on academic research and methodologies that are often used by institutions.   Such approach is also based upon data…the more the better.  And through the data, we can determine in advance of investing, whether the approach would have been supported by real-world historical data.

Fortunately, the foundation for rules-based investing can be readily found in the many white-papers and academic research published in finance journals and on websites like SSRN.  These papers serve the basis for further exploration.

Perhaps one of the greatest benefits for investors when using a rules-based approach is that it leaves less room for human emotions to sabotage their outcome.  Human’s are hardwired with survival skills and cognitive biases that impede their investing success.  And this is not just my opinion as studies consistently show that investors underperform the markets because of behavioral tendencies.

Thus, one of the easiest ways to improve performance is to simply reduce the interference caused by human emotions.

Rules-based investing does this.

We hold two important beliefs about investing that define our commitment to the rules-based process we use.

First, we believe that downside risk management is critical to an investor’s success.  This is based both on a mathematical truth and the potential impact on investor psychology.

We believe that the investor experience is just as important as the outcome.  While some may focus almost exclusively, on generating excess returns, we prioritize the downside risk management in an effort to achieve higher risk-adjusted returns.

Beware of volatility drag.

It should seem self-evident that one cannot compound their losses; that the only money available to spend in the future is from the compound growth within their portfolio.  Yet, evidence suggests that too few investors, financial professionals included, pay attention to downside risk management.

Given two portfolios, both with the same stated average return, but one with greater overall volatility, the portfolio with the lower volatility will earn more money as it suffers less from what is known as “volatility drag.”

The negative impact of volatility on compound growth.

Let’s consider two mutual funds. Each of them has had an average arithmetic rate of return of 8% over five years, so you would probably expect to have the same ending value. But it is a mathematical fact that the one with less volatility will have a higher compounded return.

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 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.  A portfolio in which downside risk has been mitigated will perform better over the long term.

In the example above, the geometric return (also known as Compound Average Growth Rate or CAGR) is lower than the arithmetic average return by 1.81%.  The arithmetic average return assumes the same return every year without considering volatility.  When compared to actual compounded returns, it overstates the ending value.  The CAGR, the amount of return required each year for an investment to grow from it’s beginning value to its ending value, is lower because it accounts for the volatility.  It is a more accurate measure of the impact of volatility.

Also, portfolios that are not managed on the downside often leave investors feeling anxious and prone to emotional decisions.  Why else did so many investors liquidate stock mutual funds in April 2009 right when the market was making a long-term bottom?

Our second belief is that our portfolio approach should be regime agnostic.  Investors do not get to choose the economic environment or the direction of the financial markets.  Yet, there is often the need for a portfolio to provide a required return regardless.  Portfolios that are adaptive to regime changes can be more consistent in achieving targeted returns and less dependent upon whether or not the investment climate is ideal.   Thus, we favor flexible, unrestrained portfolio policies whenever possible within the framework of a solid rules-based process.

Other benefits to rules-based investing approaches are that it reduces error and creates greater predictability.  Practicing a rules-based approach requires that an investor repeat the same process over and over.  The markets may change but the process does not.  The biggest challenge can be resisting the temptation to impose one’s personal opinion or investment views and second-guessing the system.  One word:  Don’t.

Focus on the process.

Lastly, adopting a rules-based approach forces the investor to focus on the process rather than the product.  We can benefit from the low-cost structure of passive index funds but not rely on the hope that the sequence of returns will be sufficient.  In other words, we can use a predictable, repeatable process to manage an uncertain future stream of information in order to navigate to the outcome desired.  I think most would agree that this is better than leaving one’s financial future to chance.

After practicing such an approach for nearly three decades, I know this approach works.

This is the approach I have used to build the Drawbridge Strategies investment models.