What is Rules-Based Investing?
Making all investment decisions based on pre-established rules that clearly define the what, when, and why for buying and selling investments.
It’s an approach to investing that relies on observable and verifiable evidence between the data used to make decisions and the desired outcome. Before getting into the details, let’s talk about why this is so important for growing your wealth.
UNDERSTANDING RULES-BASED INVESTING
WHY INVESTORS PREDICTABLY UNDERPERFORM
Human emotion is the #1 reason investors underperform the market. DALBAR Inc, the leading independent financial research company, has been studying investor behavior since the late 1970s. Each year, DALBAR’s Annual Quantitative Analysis of Investor Behavior (QUAIB) has measured the gap between leading indicators of investment performance and what investors actually earn from mutual fund investing.
Their study measures the effects of an investor’s decision to buy, sell, and switch in and out of various mutual funds over different time frames. The results consistently show that the average investor earns less than the returns reported in the mutual fund’s performance report.
Their research proves that individual investors wait to buy until the market has gone up and then sell after it drops. Time and again that investors do the exact opposite of what is needed to be a successful investor.
In 2014, DALBAR reported that the 20-year annualized S&P return was 9.85% while the return for the average mutual fund investor during the same time period was only 5.19%, a gap of 4.66%.
When you look closer, no matter the time frame, individual investors still underperform. Take the period from 1985-2005. During this time, the average investor realized a 3.70% annual return while the average return for the S&P 500 was 11.90% – one of the highest in history.
To put this in perspective, if you invested $100,000 in the S&P 500 in 1985, it would have grown to $947,549 in those 10 years. But most investors would only manage to grow their accounts to $206,811.
$206,811 vs. $947,549
This underperformance is not limited only to stock mutual fund investors. In 2014, the average fixed-income mutual fund investor underperformed the Barclays Aggregate Bond Index by 4.81%. The broader bond market returned 5.97%, while individual bond mutual fund investors returned only 1.16%.
INVESTORS ARE THEIR OWN WORST ENEMY
Human emotion is the reason investors do so poorly. The emotions of fear and greed, and other behaviors like herding, are key drivers of investor behavior and irrational investment decisions.
Herding – individual investors acting collectively as a whole, without central direction
We believe investors are constantly in search of the “story” stock or for the latest “hot fund” and are willing to jump in with both feet when it feels right. Worse yet, when things go south, investors start to feel awful and they end up liquidating their investments at the worst possible time.
This has given rise to a field of study, Behavioral Finance. Without getting off-topic, you need to know that the effects of human emotion are so powerful, there are entire subsections of economic research devoted to trying to understand it. In short, behavioral finance attempts to provide an explanation for why people make irrational financial decisions. It tries to understand that when your money is on the line, riding the market’s peaks and valleys, we have a natural tendency to do the opposite of what we should be doing.
MY BRAIN MADE ME DO IT
The reason why we act so irrationally is primitive. It’s the way our brains are naturally wired. Research shows our brains have three distinctive parts: the primitive brain stem (fight or flight), the limbic system (human emotions), and the neocortex (reason).
As the brain develops in the womb, the first part to form is the primitive brain stem, followed by the limbic system, then the neocortex. When we are faced with a situation, the brain processes the information in the same order as to how it was formed. In other words, we must first go through our fight or flight response, then emotional response before we can reach the reasoning stage. There is a large amount of space between the limbic system and the neocortex. Which means it takes a lot of effort to move from emotion to reason.
In investing, it’s much harder emotionally to stick to your investment strategy when everyone at work, church, the family, and especially the media is screaming GET OUT!
BREAKING NEWS –
THE DOW JUST PLUNGED 100 POINTS
We believe the financial media is nothing more than a giant amplifier of the current mood of the crowd. The media perpetuates the hysteria of the investors by feeding on their emotions, which makes it harder for investors to stick with their investment strategy. The constant programming of financial experts, who often contradict each other, is designed to create sensationalism – to get investors excited, worried, and watching their shows.
This constant watching also feeds into the herding behavior. Investors hear the financial experts tell them what to do – to get out, to move into a particular investment to save themselves – and the investors want to follow their advice. They don’t want to be the only ones not doing what everyone else is doing.
Nobody wants to be picked last for the kickball game.
What we don’t hear from the financial media is that it is much smarter to invest in a systematic approach to investing designed for consistent, predictable returns. Why? Because it isn’t sexy and glamorous and won’t sell commercial space.
The good news is that much of the work on the rules has already been done. It can be found in hundreds of White Papers, books, and industry journals covering behavioral finance, investment systems, and decision-making theory.
The even better news is that out of the hundreds of resources available, we focus on the best of the best. Not only are these the best resources, in our opinion, for knowing and adhering to proven investment rules that work, they are the basis for every successful system I’ve built.
There are a few main factors I use when building my models:
- Risk and Drawdown
Let’s start with relative strength price momentum. It is one of the most pervasive financial phenomena. Time and again, researchers have verified its value over multiple asset classes, and even across entire groups of assets. Even though the name sounds complicated, the concept is actually quite simple:
Every security (stock, bond ETF) within a universe of securities, is measured by its performance for some previous period of time. This is compared to the performance of its peers during that same time period. The resulting research says that securities with the best performance tend to continue performing well and those with the worst performance tend to continue their display of weak performance.
A body at rest tends to stay at rest, while a body in motion tends to stay in motion – Newton
Not only is momentum important to know what to own, it also tells you what not to own.
THE REAL SECRET TO EARNING MORE
IS TO RISK LESS
One of the myths of investing is that with greater risk, you get a greater reward. But it’s actually the opposite. All markets have volatility or fluctuations. In simple terms, volatility represents the uncertainty of investor expectations over time. Unfortunately, this uncertainty of expectations can be a double-edged sword. On one side, volatility creates massive opportunities for upside gains, but it also creates the same potential for financial tragedy under the wrong circumstances. Volatility creates a risk for investors.
We’ll talk more about volatility but first, we have to minimize risk.
Drawdown measures risk by how much money you’ve lost since your account reached its highest level.
If your account went straight up without losing a single penny, you would not have experienced any drawdown. This also means you didn’t incur any risk. Drawdown is a direct way of measuring risk.
For example, let’s say you start with an account at $10,000. Then the market has a big pull-back and now your account is only worth $8,000. Your current drawdown is $2,000 or 20%.
Then your account gains $3,000 over the next several weeks and is now worth $11,000. At that point, your drawdown goes back to zero.
After this, the market moves again and your account goes down by $1,000 to $10,000, back to where it started. But your drawdown is 9.1%. Why? Because we’re now comparing your current account balance of $10,000 to the highest value you achieved in the portfolio, $11,000 ($1,000/$11,000 = .091 or 9.1%).
Let’s take it a step further and talk about Maximum Drawdown or Max DD.
Maximum Drawdown is the largest drawdown ever recorded in your account or in a security. It measures the largest amount of money you would have lost from a portfolio or equity peak to a portfolio or equity trough.
Think about it like the maximum amount of money you would have lost had you bought an investment at the worst possible time and then sold it at the worst possible time.
As you can see, the drawdown is a very practical measure of risk. It is helpful when comparing particular strategies or investments.
BEWARE OF VOLATILITY
While managing volatility is important for any investor, it’s extremely important for investors near retirement or who are already depending on their portfolios to generate a sustainable income stream.
Over the last two decades, we’ve experienced two deep bear markets resulting from the Internet Bubble bursting, then the Subprime Mortgage crisis. Many investors lost significant wealth, and unfortunately, had to put their retirement plans on hold.
Much of this was due to traditional investment approaches, such as portfolio diversification, and buy and hold strategies. Both of which have often times proven inadequate in helping investors achieve their financial goals.
Take a look at this example. Let’s say you start with $1,000 invested over 3 years. You earn an average return of 5% per year but that average includes one year of negative 15% and one year of 25%.
Year 1 5% $1,050
Year 2 -15% $892.50
Year 3 25% $1,115.63
If you earned exactly 5% each year, your total would be $1,158. But the actual returns are only $1,116 – a difference of $42 or 1.3% The actual return, or the volatile sequence has a compound return of only 3.7% Where did that 1.3% go? The Volatility Gremlins!
Most investors don’t realize that volatility has a profound negative effect on returns because of its impact on compounding. This impact is known as variance drain or volatility drag. When two investments with the same average return are compared, the one with the greater volatility will have a lower compound return due to the negative effects of compounding.
A BETTER WAY TO INVEST
In the airline industry, air traffic controllers give pilots permission to take-off or land depending on weather conditions. They have rules against flying in unsafe weather conditions. Not surprisingly, airlines often cancel flights when they deem the weather is too hazardous to fly.
Investing should be no different. When market conditions are too risky, investors should avoid investing (keep their plane grounded). Yet the financial industry keeps telling investors to stay fully invested and ride out the storms.
We believe systematic rules-based models are no different than air traffic controllers monitoring the weather. A systematic model dynamically ranks asset classes, sectors, and even countries based on historical returns and volatility measures. If the models show volatility (risk) rising and returns diminishing, then a successful model will automatically rank asset classes, like short-term and intermediate-term bonds or cash, as the more favorable investment.
In turn, the model could protect your portfolio from exposure to more risky asset classes. But as skies clear, a systematic model should automatically give you the green light for wheels up as your portfolio moves to growth assets that can drive your returns higher.
No guesswork, no emotion.
At Drawbridge Strategies, we have designed several stock and ETF models that employ the rules of momentum, risk, and volatility. Our models are available to individual investors, investment advisors, financial publishers, institutions, and other financial professionals.
Don’t let your emotions interfere with your investment goals.