The recent low volume surge in the market over the past week sparked the usual barrage of questions as to whether this was the beginning of the next bullish advance and should we reverse our recent cautionary allocation models. The answer is probably “No” as the weight of evidence, as we will discuss momentarily, is decidedly negative. However, it is also important to understand our investment strategy and mentality. Recently, we posted an article entitled “Markets Have Trapped Fed On QE3” which was picked up by The Pragmatic Capitalist website where one of the readers commented: “In his Street Advisor report of June 26, he stated: ‘The market currently remains on confirmed sell signals on multiple levels which further confirms our cautious stance.’ Undoubtedly a bear call will be successful if you persevere long enough but one could miss out on some nice rallies if you are always sitting on the sidelines, listening to the ‘experts’ and dithering.”
What is important about the comment is that as money managers, working primarily with retirement accounts, we are not interested in short term swing trading as we truly are managing money for the “long term.” While the commentator was correct about our newsletter statement – the comment was grossly taken out context and misconstrued. First, as our regular newsletter readers understand, is that we reduced our allocation models back in April and have been warning investors to remain cautious since that time. This is not a “bearish” call – it is simply a warning to reduce portfolio risk which has helped our clients, and readers, avoid the May decline. What the commentator failed to mention is thatwe wrote in early June that a rally in June was extremely likely and that, for those that had not yet reduced portfolio risk, this would likely be the opportunity to do so.
Secondly, and the most critical point, is that we do not sit on the “side lines” – we NEVER advocate going 100% to cash. We are currently holding higher levels of cash than normal, fully allocated to fixed income and are underweight equities. This is a temporary position until our “sell signals” reverse and overall market risk is outweighed by the potential for further reward. That is simply not the case at the current time but as we discussed in“Coming This Fall – The Best Time To Invest.”
As long term investment managers what is critical is not tracking short term market movements but outperforming the markets over the long term. Let me give you a mathematical example. Let’s assume that we want to maintain an annualized return of 10% over the next 5 years. Here are the hypothetical market returns: +10%, +10%, +10% -10%, +10%. Those returns look stellar on the surface. However, the impact on actual investment dollars is quite different.
While many individuals profess to regularly beat the market – the reality is that few do. Most investors tend to do well on the way up but fail to sell before the decline. However, for argument sake, we will assume that the average investor exactly matches market returns. The table shows an investment of $100,000 based on our hypothetical returns for the five-year period.
The important point is that it only takes one draw down over any one-year period to destroy compounded returns. In our example it would take an astounding 33% return in year 5 to return the portfolio to an annualized 10% return. This is why most investors real net returns since the turn of the century are far less than that of the actual market. Emotional mistakes of selling low, and buying high, have consistently put investors on the wrong side of their investment goals.
This is where our investment philosophy was derived from. By reducing portfolio risk through asset allocation modelling, and active management, the goal is to limit the damaging effects of market declines. Our philosophy is to capture 80% of the advance of the markets when they are rising and only 20% of the markets during declines. As you can see in the second chart in the short term our approach would leave us lagging the overall market, however, by avoiding the bulk of the market decline, and the destructive effects of that decline on the compounding effect, the portfolio would outgrow the market over time.
If we use actual S&P 500 returns and apply the strategy to a $100k portfolio since the turn of century the disparity is much greater. As Albert Einstein once stated: “The most powerful force in the universe is that of compounding.” However, compounding of returns only works with investments that have NO downside risk. Declines destroy the effect of compounding rapidly. This is why employing a more conservative approach to investing over the “long term” ALWAYS outperform indexed based returns.
This brings up some very important investment guidelines that I have learned over the last 30 years.
- Investing is not a competition. There are no prizes for winning but there are severe penalties for losing.
- Emotions have no place in investing. You are generally better off doing the opposite of what you “feel” you should be doing.
- The ONLY investments that you can “buy and hold” are those that provide an income stream with a return of principal function.
- Market valuations (except at extremes) are very poor market timing devices.
- Fundamentals and Economics drive long term investment decisions – “Greed and Fear” drive short term trading. Knowing what type of investor you are determines the basis of your strategy.
- “Market timing” is impossible – managing exposure to risk is both logical and possible.
- Investment is about discipline and patience. Lacking either one can be destructive to your investment goals.
- There is no value in daily media commentary – turn off the television and save yourself the mental capital.
- Investing is no different than gambling – both are “guesses” about future outcomes based on probabilities. The winner is the one who knows when to “fold” and when to go “all in”.
- No investment strategy works all the time. The trick is knowing the difference between a bad investment strategy and one that is temporarily out of favour.
As an investment manager I am neither bullish or bearish. I simply view the world through the lens of statistics and probabilities. My job is to manage the inherent risk to investment capital. If I protect the investment capital in the short term – the long term capital appreciation will take of itself.
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