Fintech executive, writer, math geek, and investment systems developer. Founder and CEO of Altruist and Founder of FormulaFolios.

Investor Frustration, Market Timing, Bad Decisionitis...

Since I couldn't think of a really clever title for this weekend post I thought just rambling off the three things I'm writing about would suffice.  This will be a text and images post only, no video today.  It could be a bit of a geeky post too, but a very important one so please read carefully. Most of my readers know that I am what's referred to as a "quantitative asset manager" - which translates to: I use statistics to help make better, non-emotional investment decisions for my clients.

In many ways this is a great thing that has, over the long term, really helped a lot of people in protecting and growing their portfolios.  It is not, however, a perfect science.  So let the geekery begin...

Over the past couple of months I've shared the following chart and talked about a simple "risk management system" using the chart to help with exit (selling out of stocks) and entry (buying back into stocks) points:

It's a hair blurry but hopefully you can make out the red and green lines, which are the indicators of exit and entry (if you click on the images it will open a larger view of the image).  Since I've used this in videos I'm going to use this as a bit of a case study on whether or not quantitative systems should be used to help manage portfolios.

**UPDATE** I had a couple people wonder what the trigger points were for this system as well as ask if we use it in my practice.  The trigger points for a buy/sell signal are as follows:

When the short term moving average crosses the long term moving average, AS WELL as the MACD shows positive or negative divergence at month end only does the system trigger a buy or sell signal.  Also, this system is used for example only of long term trends in the S&P 500 and is NOT used for my clients.  We do have other systems in place that work very similar which is why it's been used for examples.  I don't publish our exact methodologies so as to not give away "trade secrets" per se'.

**Back to the Blog Post**

To cut to the chase it will prove:

  1. Yes, systems do help
  2. Systems can be wrong
  3. Systems can be frustrating
  4. Investors who abandon systems ultimately get hurt, sometimes badly

Now I'll dig into some of the details of what this particular system would have suggested over the past 15 years.  Technically I'm going back to January of 1996, so I suppose it's a bit longer than that, but mostly so readers can see the year-by-year results of both the good and bad of using systems to aid in smart money management.

What we're comparing is buy and hold investing versus the system, which I'll refer to as "Risk Managed" investing.

Since 1/1/1996 the system suggested 5 exit points from the market, the most recent being the end of last month (September 30, 2011).  Here's the exact dates:

August 31, 1996 - Exit December 31, 1996 - Entry

October 31, 2000 - Exit May 31, 2003 - Entry

July 31, 2006 - Exit October 31, 2006 - Entry

December 31, 2007 - Exit August 31, 2009 - Entry

September 30, 2011 - Exit Entry to be determined

Ok, so now that you know the dates here's what that translates to in returns had an investor gotten the exact return of the S&P 500 from January 1, 1996 until today (with all dividends re-invested), paid no fees and no commissions, and took no distributions.  Keep in mind that while there are S&P 500 index funds that track the S&P 500, you cannot actually invest directly into the S&P 500, which means with the index funds your returns would be slightly lower since they do have some costs.  I'll also put the hypothetical return of using the Risk Managed approach assuming the same criteria (dividends re-invested, etc.).

Buy and Hold: +95.4% Risk Managed : +182.9%

Translated into dollars, here's what a hypothetical $100,000 investment would look like with those returns:

Buy and Hold: $195,421.56 Risk Managed: $282,861.11

The standard deviation (risk) of the Risk Managed strategy is also approximately 1/2 of buy and hold, so in a nutshell the Risk Managed approach gets nearly double the return with 1/2 the risk.

So far, if you're following me, you can see that from a distance the Risk Managed looks to be far superior.  And why wouldn't an investor want to follow that versus Buy and Hold?

Ah, if only it were so simple.

Using a Risk Managed approach does have some pitfalls. And if an investor is not committed and patient they can get burned, frustrated, and maybe even call it quits before they get a chance to see the benefits.

Uh oh - Risk Managed Investing Still Can Lose Money

Sometimes we think that if we're using risk management we should be entirely protected, or at least mostly protected from market losses.  But it doesn't quite work out that way (at least not all the time).  Here's what the calendar year returns would look like comparing our two very different investment approaches:

[table id=4 /]

If you looked closely at the table, perhaps you saw some of the ugly.  In years like 1998, 2006, 2009, and this year (2011 YTD) the Risk Managed approach would have gotten trounced by the market.  If an investor started using this approach in 2009, boy would they be sour.  They'd have only made about 10% over the past 3 years while the S&P 500 has zoomed over 30%.

So is Market Timing (er, Risk Managed Investing) Worth it?

For the past 34 months an investor using a Risk Managed approach would be feeling more than uneasy about the supposed "risk management" going on.  They would have gotten only about 1/2 the markets upside of 2009 and 2010, and more than double the losses of 2011.  I can see how some would even question if it's broken - that the system doesn't work anymore.

In order to address those questions we need to delve a little deeper into the numbers and history of a Risk Managed Strategy.

The first thing we'll look for is to see if there were any other periods of under performance that may have caused similar doubts of the strategy.  In the data sample I'm using for this post we'd go back to 1998.  In 1998 alone the Risk Managed approach would have actually lost money even though the S&P 500 went up nearly 27%.  I can only imagine how investors would feel if the market was up 27% and their portfolio was down 1.4% - and my imagination tells me they'd be pretty upset.

1998 was only a calendar year though.  Using rolling 12 month periods (like a June to June, July to July, etc.) the Risk Managed approach would have at its worse fallen 30.5% behind the S&P 500 after the 12 months ending August 31, 1999.  Ouch!

On a positive note the Risk Managed approach did get back into the market in time to enjoy a nice 1999 and much better than market returns 2000 to 2002.  The problem is...how many investors would have stayed with it after how bad 1998 was for the Risk Managed strategy.  That one bad year alone would have made an investors 1, 3, and 5 year returns quite poor in contrast with the market.

In my experience even investors with long term time horizons have a hard time stomaching below average returns (especially with a negative year thrown into the mix when the market is up close to 30%).

When Risk Managed Shines

Risk Managed investing really shines in only the nastiest of bear markets and rewards only the truly committed investor.  When it warns of a potential major decline and then it happens.  In the period of 2000 to 2003 the S&P 500 dropped roughly 45% while Risk Managed would have lost only 2.7%.  In 2008 Risk Managed would have lost nothing while the S&P 500 lost 38.5%.

As I've shared in some of the videos on this topic, having a risk management approach is no guarantee of great results all the time.  In fact the system I'm discussing in this post would have given just 5 warnings in the past 15 years.  Two of them would have helped investors majorly, one would have caused a small missed rally, one a very large missed rally (the 1998 exit signal would have caused an investor to miss in over 25% gains the four months following), and the last we're in the midst of right now.  How this one plays out I do not know.

Bad Decisionitis

This is a condition that affects many investors.  It usually starts by analyzing a potential investment based on it's recent historical return without regard to why it either performed very well or very poorly.  Often times we as investors want to chase what's working best right now, which really is not accurate because it's the most recent history that we're analyzing.

It then can worsen significantly when our investment doesn't work out as we would have liked or hoped for.  We tend to look at time periods like one or two years to determine that our once shining investment is no longer a good one.  Eventually the investor throws in the towel and moves on.  Then the process is repeated over, and over, and over again.

So how do we avoid this?  What is the smart thing to do?

Using the Risk Managed approach I shared in this post we can learn a lot about how decisions should be made.  I think following just 3 simple steps would really help most investors avoid Bad Decisionitis.

First, is the investment approach good over the long term?  Second, what is the downside of the approach and am I comfortable with it?  Third, you've got to tell yourself (and then stick to it), "Unless I'm going to use all of my money in the next 5 years I AM NOT going to stress over my performance until 5 years has passed".

Here's why that decision making process works:

Remember when I covered the bad stretch for the Risk Managed strategy from this post back in 1998?  It would have been very easy for an investor to give up on the strategy.  After all, from January of 1996 to January of 2000 the strategy was up 75% while the S&P 500 was up 125%.  Plus the strategy has a negative year in a year the S&P 500 made 26.7%.  Even a patient investor could look at that stretch and convince them self quite easily that 4 years is more than enough time, and the strategy is broken.

Don't let that happen.

In the 4 years starting January of 2000 to January of 2004 the S&P 500 dropped 17.5% while the strategy was up 22.4%.  The Risk Managed strategy was able to not only recoup its lag against the market, but it zoomed out more than 30% ahead in total return.

The same thing happened in 2006.  The strategy had a hiccup and fell behind the market.  But after 2008 it had been more than made up and then some.

In Conclusion...

For number lovers that want to validate all the numbers I talked about in this post - here's a link to download the excel files with all the numbers.  What you'll find is the simple Risk Managed strategy that just told investors to get out of the market at the end of last month (causing them to "miss" the 5% gains of October) would have produced more than double the return of Buy and Hold investing and done so with less than 1/2 of the risk.  It wouldn't have worked every year, and even had some stretches of 3 to 5 years where investors could have grown very frustrated (maybe even giving up).

I tend to think we're in a situation not unlike the years past with this one, very simple strategy fell behind.  Many investors (myself included) that are actively trying to manage risk are looking rather foolish and may continue for a few months or even a couple years.  But in the end, the committed, patient, Risk Managed investor will end up well ahead (and with much less real risk) than those with Bad Decisionitis who just want to chase the most recent month, quarter, or even few years best investments only to get burned.

Always remember that no investment theory, process, or strategy is perfect.  In fact, it's perfectly normal and okay (though not fun and sometimes a little painful) for a investment method to lag the market and produce losses.  I know this well because the portfolios I manage go through their cycles of feast and famine.  Worrying about it doesn't make it better.  Switching things around all the time doesn't either.  Having a sound process and then staying committed even in times that are frustrating - Bingo, that works.

Be safe and have a great weekend.  If you have questions about this post just reply via email (if that's how you're notified of new blog posts) or use the comment box on the blog post.

Best,

Jason Wenk

Market Update - October 21, 2011

Quick video only update...