So now what? The bailouts are in place and a new president is now inaugurated. I’ve been reflecting on the state of the market for this past year. It seems that most people always ride the rollercoaster all the way down and back up again. The “back up” part usually takes much longer than the down part, however.
This year has been the “perfect storm” in that every asset class or sector has gone down. With the greed on Wall Street and the over leverage in financial firms, the market has been like a train wreck.
Why did so many managers miss risk management? No matter what asset class or alternative class you invested in when the market went south, even fixed-income could find a safe haven. In past corrections, there was usually an alternative that was safer than equities.
Modern Portfolio Theory, MPT, has a long academic history and has much published research. The problem is that unless you have an infinite investment time horizon, such as an endowment, it doesn’t work. How many people have a 50-year time horizon, or even 20 years? Most baby boomers are at the point now where they will need income within 10 years. The discipline of managing risk in a portfolio goes far beyond the scope of what MPT allows for in a real life application.
If we look at market history, every time the market goes south, nothing seems to work. MPT rarely works in a down market, but it seems to work reasonably well in up markets. However, it usually misses the asset classes that outperform. MPT looks backward and uses statistical analysis to try to predict where you should invest. Historical data is useless in short-term down markets and is totally lost in severe down markets, as in 2008.
Every down market provides new lessons and changes to a game plan. The challenge is to recognize when the market has turned around so we can invest again. It is important to note that MPT uses past results to suggest which asset classes to over weight.
Dynamic and Systemic Relative Strength asset allocation would have given you a different result. The advantage of a Dynamic Relative Strength calculation is that you will know which asset class changes to outperform in order to take advantage of the upswing before – not after – the upswing has occurred. This process also provides a strong indicator as to when to shift asset classes or to go into cash in the portfolio versus equities or any other asset class. In down markets, cash is king.
The most important characteristic of a good investor is discipline with a game plan. “Outliers,” by Malcolm Gladwell, speaks of having 10,000 hours of experience before expecting significant success. It also sites examples of the Beatles – after having played clubs in the Netherlands for 8 hours per day with few breaks, they were in perfect position to come to America and become famous.
An investor or asset manager should have the same requirements. In interviewing a manager, it’s important to know his/her detailed game plan and how long he/she has been using the process. If you divide 10,000 by 40 hours per week, you will get 250 weeks, which equates to more than five years. How much time do most managers really spend studying the market and managing? They usually turn management over to other managers who must maintain a specific asset class and must be 100 percent invested at all times.
Investing was easy in bull markets, from 1982-2000. Research suggests that bull markets tend to last around 12 years and bear markets 18 years, based on research by Rydex Funds. Money can be made in a bear market, but one must be eminently more cautious in investing a portfolio.
To summarize, one must have a game plan that is dynamic and lets the market tell you when to be invested and in what asset class, or when to be partially or totally out of the market, as was important in 2008. It is important to know when and how to hedge with the market in these significant down turns. Make the hard decisions that will give you long-term staying power.
Only the minority of strong-willed, tough-minded investors or managers willing to tolerate discomfort will be positioned for good long-term results. The first thing you should ask yourself is not how much can I make, but how much can I lose? This will provide a focus for your portfolio game plan. Basically, Modern Portfolio Theory is great for academics but not in reality.
As for now, look for a tough-minded professional adviser who can help you heal your portfolio and 401(k) plan.
•••
Charles J. Root Jr., CFP, is managing director of Double Eagle Financial in Santa Rosa and is a registered investment adviser. He can be reached at 707-576-1313 or chuck@double-eaglefinancial.com.
