A long blog on frustration…

Reginald A.T. Armstrong •

Reginald A.T. Armstrong

This long blog will likely find you frustrated with your portfolio, with recent returns, and maybe with your financial advisor. Let me share a few thoughts on the state of the markets.

My friends, we have been since 2000 in what is known as a secular bear market. This is a market that has several cyclical bulls and bears, but in the end goes mostly sideways. For example, the Dow Jones Industrial Average was at almost 1000 in 1966 and it did not break much above that level until 1982—16 years later! Many believe the secular bear that began in 2000 was broken when we went to new highs in the past few years; others believe we have yet to complete the cycle and are still in a sideways market with more downside before the true bull begins.

As individuals, we tend to project into the future the recent past. It is what is known in behavioral finance as recency bias. So in 1999 I remember most investors clamoring for more US equities, especially the growth and tech stocks that were burning up the track at the time. I don’t remember many saying, “the market’s rate of return over the last 10 years is almost double the historical average; the price to earnings ratio of the market is at nosebleed levels, Regi let’s please diversify into other investments to help control the risk.” We did diversify, but few were happy we did until the bear bit. Similarly, I remember many saying in 2009 that a depression was at hand and that stock prices would not recover for many years. I don’t remember many saying, “the 10 year return of the market is now negative, maybe this is a good time to invest.”

As individuals, we want the upside of the stock market without the downside. We know that’s impossible, but we still want it. We want our portfolio to go up when the market goes up, but to not go down when the market goes into a panic. This is a recipe for frustration and for committing major errors. Typically, when an investor’s portfolio doesn’t go up with the market, he feels he is “missing out” and adds riskier investments—probably at a time when it isn’t wise. Or he figures his advisor is a dolt and hires another who is willing to take on more risk. Then when the inevitable crash comes, the investor panics and wants to sell as he fears losing it all.

Of course, some are more sanguine. They are willing to buy and hold. In my opinion, this is a fine choice depending on when you need your money. Keep in mind, the S&P Composite was essentially flat from 1900-1924, 1966-1982, and 2000-2012. The Nasdaq just this year broke even from its high 15 years ago, and the Japanese equity markets still haven’t recovered from their 1989 highs. So if you are young and building your portfolio through dollar cost averaging, buy and hold is likely an okay strategy. If your goals are under 10 years, this might turn out to be a riskier proposition than you think.

The losses of the 2007-2009 bear market caused us at our firm to review if there was a better way to manage downside risk. While diversification had worked really well from 1997 until 2007, both in up and down markets, portfolio losses during this bear market for even conservative portfolios we believed to be unacceptable. So we began a thorough review.

The result of our review was more extensive than I initially anticipated. I came to the conclusion that a portfolio needed to be robust, meaning all weather, because you never know the circumstances you will face. I defined a robust portfolio as one that aims to: 1) provides long-term growth of assets, 2) provides stable income if required, 3) keeps up with inflation, and 4) provides some protection from economic and market shocks.

This required two major shifts in how we manage assets. We already diversified our clients into various asset classes based on their risk tolerance. In the past, we had overweighted US stocks, especially large caps, and we tilted based on market expectations. Sometimes we were right; sometimes not. The first shift in our investment strategy was designed with the goal to remove the guesswork. It required more asset classes, and very importantly, a shifting to a simpler strategy. We shifted to an even equity allocation, versus tilting toward what we “felt” was best at the time. So if we had eight stock classes, we would invest evenly in all eight. Our studies showed this provided more robust portfolios in the long run, both during the accumulation phase and spending phase of life. The tradeoff was, like any diversified portfolio, you never do as well as the top asset class since it is only part of the portfolio.

The second major shift was the development of our WealthProtect System. Our research showed that a rules-based sell strategy that is based on selling an asset once it crossed its long term moving average could better manage the depth of a market loss. It also provided an opportunity to get back in at a potentially better price point. The major risk—whipsaws. This is when you get out and the market turns back around and you have to get back in.

So, let me make a few final points on our strategy and the markets today.

  1. Valuation matters. If you chase overvalued stocks, you will likely buy in a high price only to likely sell at a lower price. The current US market is the second most expensive in history after the 2000 top. We can wish it wasn’t so; we can hope it is different this time. That doesn’t change the reality of a frothy market. This doesn’t mean it will crash in the near term. It does mean that future returns will likely be muted. Foreign markets, on the other hand, are much more reasonable.

  2. Reversion to the mean is a powerful force. All equity asset classes have long-term returns ranging from about 8 to 11%* (past performance is no guarantee of future results). So when an asset has a particularly good or bad run that deviates from these historical long-term returns significantly, a good assumption is that eventually this will be reversed. So US stocks have had a good 3 and 5 year run way above their historical average, while foreign stocks, especially emerging markets, have been comparatively weak. Commodities have horrible 3, 5, and even 10 year returns compared to their historical averages. Reversions to the mean will eventually happen. Investors need to be careful piling into the hottest investment trend.

  3. Be careful of buy and hold. A buy and hold US stock strategy essentially has you buying into the second most expensive market that has had a great run. The odds of a reversion are very high. Maybe not now, or maybe not even in the next six months. But history says be careful. Buy and hold can be just fine if your time horizon is long enough, though.

  4. Diversification is prudent. It may not be sexy. It may not always be fun. In fact, it means that you always underperform the top investment. Diversification is the tortoise that aims to win the race because it is less likely to get thrown off course. It is prudent. An in an uncertain world, it provides clients with the flexibility they need.

  5. The Wealth_Protect_ System is frustrating. Our WealthProtect System will be frustrating when we get hit with whipsaws. It will appear as if we are idiots when you are in a conservative portfolio and the market rebounds quickly. Our system is designed with the goal to let winners run and getting out before experiencing deep losses. We believe protecting portfolios from deep losses is extremely important. The frustrating part is when the markets appear to be transitioning from bull to bear as they seem to be now. Also remember, that our system will also likely present us with opportunities to re-purchase investments at a much lower price point.

It is my opinion that the US equity markets are in a topping formation and that the likelihood of a significant drop is quite high. The internal action of the markets has been flashing a warning sign. With the markets severely overvalued, this means the downside could be more than most investors expect. Of course, we don’t know. This is why we stick to our strategy: broadly and deeply diversify your assets, based on a client’s risk tolerance and capacity, in order to increase potential return opportunities and potentially reduce risk, while using our WealthProtect System to limit the downside exposure. I sincerely believe this all-weather strategy gives us a better chance to pursue solid long-term returns without undue risk. And most importantly, help our clients work towards their financial goals.

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