Investment Behaviors & Beliefs

Traditional Risk Spectrum

The traditional risk spectrum (pictured above) provides many core principles which allow for the construction of a proper asset allocation for every investor. In fact, the Securities and Exchange Commission (SEC) enforces laws that are deeply rooted in asset allocation-based principles. Yet, where most investors and financial professionals (and yes, even the SEC) go wrong is they give little consideration to the reality that the risk spectrum can, from time to time, be turned on its head.

For a historical perspective, look no further than Senior Income Funds in 2008. As the name implies, these assets were meant to provide a high level of price stability as well as a steady stream of income for older folks. And for 30 years they did just that. Sounds like a pretty safe investment for a 75-year old widow, right?

Unfortunately, 2008 was not kind to many investments… especially the mortgage-backed securities in Senior Income Funds. They were some of the worst performing assets during the financial crisis. Highly risk-averse investors holding Senior Income Funds watched their investments drop by as much as 80% in value. Traditionally appropriate or not, should 75-year old widows hold assets in their portfolios that have the potential to drop 80%? Of course not.

No matter where an investment falls on the risk spectrum, we believe that no investor is safe from catastrophe without a sufficient strategy to minimize losses.

Yield Hunting

Do not confuse the need to generate income with a perception that one should go “yield hunting.” This is a foolhardy approach when trying to increase your portfolio’s ability to produce cash flow… especially when an interest rate environment is already low.

Capital appreciation is a critical component that often gets overlooked in the hunt for yield. Even if you are a conservative investor, there are benefits to moving up the risk spectrum with a portion of your portfolio. As long as a sell discipline is in place to limit the downside risk, there are times when growth stocks can supplement your portfolio’s yield with price gains.

For starters, growth stocks can offset the negative effects that rising interest rates and inflation might have on an income-oriented portfolio. Second, the tax rates on long-term capital gains are lower than those of ordinary income. Thus, it often makes more sense (tax wise) to cash in on the appreciation of your shares of growth stock (that you have owned for at least a year) to generate cash flow than it does to receive those dividends and interest payments coming from your bonds, preferred shares and other income producers.

Third, depending on the market environment, there are inherent risks associated with portfolios that are “over allocated” to a particular asset class. Keeping your portfolio concentrated at the low end of the risk spectrum carries risks much the same as concentrating at the high end does. Diversification across income and growth can provide a hedge against some of those risks.

Buy & Hold

Traditionally, asset allocation aims to balance risk and reward by apportioning a portfolio across the three main asset themes – growth (“stocks”), income (“bonds”), and preservation of capital (“cash” or cash equivalents.) If one allocates assets according to Modern Portfolio Theory (MPT), each component of a portfolio should have different levels of risk and return. These differences will cause each component to behave differently over time; hopefully, one is creating efficiency where risk is minimized and return is maximized.

Although this theory is indeed just that – a theory – it does have some well-reasoned assumptions. Obviously, investors prefer to maximize return while minimizing risk. Duh, right? Yet, there are a couple of indirect assumptions that MPT makes which are less obvious. In fact, those indirect assumptions may be downright counterintuitive to logic.

By definition, MPT relies on the fact that a proper asset allocation will, and should, be made up of both winning and losing investments. This is how volatility is theoretically minimized. The indirect assumption here is that an investor will ignore the “dead weight” in a portfolio and focus solely on the longer-term, bigger picture. However, our experience shows that the average investor will dwell on a portfolio’s losers. In a matter of months, no matter how much they try to distance themselves, investors become agitated by underperforming “losers.”

Another indirect assumption is that there is no need to sell a position in a portfolio, other than rebalancing assets back to original targets. Come hell or high water, an investment which has been chosen using fundamentally sound judgment, does not need to be sold. Yet this is precisely how a 75 year-old widow can be persuaded to hang onto an investment long enough to see her money fall 80% in value! (And then, she may feel forced to sell, leave the proceeds in cash, and never invest again!)

In our opinion, people like “buy & hold” until they don’t. They pile into assets that they believe will be good for the long-term. When the road gets tough enough, though, they eventually succumb to fear – or even worse, despondency. This usually equates to selling near the lows. Unfortunately, they then remain gun-shy sitting on the sidelines. Once their anxiety subsides, they may join an up-trending market when the waters seem calm. In essence, people tend to sell low, and then when they return, they buy near the highs.

Asset allocation is a great place to start with an investment strategy. However, we feel it does little to address the biggest threat to investment success… greed and fear. How do you manage greed and fear? You need to understand under what circumstances you would buy and under what circumstances you would sell.

The Emotions of Investing

Even before we buy our very first investment, we find ourselves riding the rails of an emotional roller coaster. Hope, anxiety, relief, denial, optimism, despair, euphoria, panic – these are the feelings that every investor experiences in a lifetime.


Emotions can generally be grouped into one of two categories: fear-based emotions and greed-based emotions. Fear-based emotions are most prevalent when markets trend downward. Complacency turns to anxiety, shifts toward denial, moves into despair and culminates in panic. Typically, it is near this point when investors take huge losses… when hope no longer springs eternal and despondency sets in.

As markets begin an inevitable rebound, greed-based emotions take hold of an investor’s psyche. Despondency turns to hope, swings to relief, moves toward optimism and cruises straight for euphoria. The hopeless memories have faded and the false comfort of complacency establishes a home. Alas, investors feel they can invest safely again, though it ends up being an exceptionally ill-timed decision.

What can one do about the emotional roller coaster? How can you avoid becoming your own worst enemy?

The first step is to recognize where your investment decisions begin. If you are like most investors, you envision, even fantasize, about how much money you are going to make. Any distant thought of selling your position hinges on how much money you’ve already pocketed before you would ever think about ringing the cash register.

But what if your investment doesn’t make it far enough into the black? What if it falls into the red? Heck… what if it never makes it out of the red? Do you have a plan to protect yourself in the event things don’t pan out? How bad must it get before you finally do something?

The problem most investors have is that they are extremely biased when considering both positive and negative outcomes with their investments. After all, if you had an equal likelihood of losing money on an investment, you might not purchase it in the first place, correct? Few consider a 50/50 gamble to be an advantageous endeavor.

A giant step in the right direction is realizing that successful investing has little to do with the odds of being right or wrong. Rather, it’s how bad you allow those wrongs to be.

Consider the following example:

There are two money managers that have been in the business for over a decade. You are looking to hire one of them. John, runs a decent-sized hedge fund where he has made a total of 10 equally-weighted investments over the past year. Of those 10 investments, there are only 2 that have not been profitable. With his 80% success rate, John seems to have the ability to deliver excellent odds for moving your portfolio forward.

Jane, on the other hand, runs a small advisory firm. Jane made a total of 8 equally-weighted investments over the past year. Of those 8 investments, 4 of them were not profitable. With only a 50% success rate, Jane does not seem to offer any more value than a monkey throwing darts, right?

So who is the better money manager? Well, it depends.

In the example below, John may have only had 2 losing trades, but they were doozies. By letting just a couple of his investments get away from him, John’s overall performance was drastically affected. Jane, on the other hand, was far less successful than John at being able to “pick winners.” However, unlike John, she did not let any of her investments get away from her. When Jane was wrong on her selections, she sold them for small losses before they could negatively affect the larger portfolio. By doing so, she was able to significantly outperform John.

The main lesson here is that avoiding the big loss is the key to overall performance. The best money managers understand that, when they are wrong, they must make certain they are only a little bit wrong. You cannot afford to be married to any of your positions. Pride, ego, product devotion, taxes, media hype – these are just excuses. Jane sees the big picture; John does not.

John may actually be a bona fide genius. In fact, his reasons for initially choosing those two big losers in the portfolio may have been nothing short of brilliant… so much so, that only an imbecile would fail to see his rationale. Unfortunately for John (and every investor), the stock market does not have to behave logically. Even a “guru” like John needs a discipline for selling.

Investors like Jane realize that the only bad investments are the ones you let get away from you. Establishing unemotional plans to limit your losses are just as important as the research you do to choose your investments.

Stock Market Gurus

We can all agree that one correct assessment does not a genius make. Likewise, making an incorrect assessment does not seal one’s fate as an imbecile. Intelligent people are just as capable of making bad decisions as foolish people are. It follows that a person with a less-than-average IQ can still have very bright ideas.

When it comes to the peculiar world of investing, some people may provide the perfect analysis and still come up on the wrong side of a trade. Others may get it right in spite of extremely faulty reasoning. Random chance and fickle timing can sometimes explain a lot. And yet, the outcome (not the reasoning) is how the financial news media as well as the investment public determine whether an investor should be served a slice of warm accolade pie or a cold crow sandwich.

Should you really care who the “best” portfolio manager was last year? It depends on what you actually do with that information.


The tale of the “Tortoise and the Hare” has been taught at a very early age to many a generation of students. Still, the majority of investors forget the lessons from childhood, often opting for flashier paths that they believe will bring them enormous fortune.

Are we compelled to behave in an irrational manner when it comes to our money? Maybe. Are the negative influences from peers and the financial news media too great? Possibly.

We are constantly bombarded with “get rich” publications, TV shows about making “mad” amounts of money, as well as industry profiles that crown individuals with seemingly mystical skills. Sadly, though, the quest for a quick and easy path to wealth typically ends in disappointment, if not disaster.

Magical formulas in the stock market do not exist. Stock market gurus do not exist either.

Not convinced? Let’s take a look at a number of “hot-to-not” individuals. The goal is not to chastise one-time heroes of the investment universe; rather, investors should be more aware of the pitfalls of performance chasing and bandwagon boarding. In a nut shell, placing blind faith in a stock market guru is hazardous to one’s investment well-being.

Bill Miller

Bill Miller co-managed Legg Mason Capital Management’s Value Trust Fund (LMVTX) from its inception in 1982. Over the years, Mr. Miller and his team received numerous honors for their performance record and distinct investment style, which focused on a detailed understanding of businesses and their intrinsic value.

Mr. Miller was ranked among the top 30 most influential people in investing when he was named a member of the “Power 30” by Smart Money. He was also named by Money Magazine as “The Greatest Money Manager of the 1990’s” and named Morningstar’s 1998 “Domestic Equity Manager of the Year.” In 1999, he was selected as the “Fund Manager of the Decade” by In 1999, Barron’s named him to its All-Century Investment Team, while BusinessWeek called him one of the “heroes of value investing.”

In 2007, LMVTX became the largest stock mutual fund in the world. With 15 consecutive years of beating the S&P 500, it seemed that Mr. Miller could do no wrong. In June of 2007, LMVTX was hitting fresh all-time highs, just as scores of hopefuls piled in. After all, why wouldn’t you want a stock market guru with awards galore at the helm of your portfolio? It’s a no brainer, right?

With a recession beginning to take shape in the 2nd half of 2007, not everyone believed that it would lead to an epic meltdown in the financial system. In fact, Bill Miller decided to invest even more heavily in banks and other financial services firms. The “stock market guru” was not able to predict the financial collapse nor the depth of declines in the shares of major financial institutions.

From June of 2007 to March of 2009, Bill Miller’s fund plummeted 73%. In less than two years, LMVTX wiped out more than a decade’s worth of returns. Not only did LMVTX fail to beat the market in 2008, it underperformed the Lipper Average for Large-Cap Value funds over 1, 3, 5, 10 and 15 years. Worse yet, bear market math shows that while S&P 500 index funds fell roughly 55% in the time period, requiring 122% to get back to even, the 73% decimation LMVTX realized would require 270% just to recover. (Note: Bill Miller “parted ways” with Legg Mason Value in November of 2011.)

John Paulson

Mr. Paulson made a fortune from the collapse of the mortgage-backed securities market at the heart of the 2008-2009 credit crisis. His bet on short-selling subprime mortgages in 2007 has been called one of the greatest trades ever. At the time, there wasn’t a single financial news publication that wasn’t touting his seemingly clairvoyant portfolio management capabilities. The world of finance had a guru on the other side of Bill Miller, and his name was John Paulson.

The popularity associated with having made the “greatest trade ever” allowed Mr. Paulson to grow a miniscule, one-employee, $2 million hedge fund, Paulson & Co. Inc., into the fourth-largest hedge fund in the world; $2 million swelled to an astonishing $36 billion in investor assets under management.

Undoubtedly, Mr. Paulson’s 2007 bet against subprime was nothing short of a home run. Since then, however, Paulson’s performance is less like Hank Aaron and more like the infamy of the biggest strike-out artists. In 2011, John Paulson earned the dubious title of the worst performing fund manager. Popular stock market benchmarks may only have been flat to up a percentage point or two, yet Paulson’s Advantage Plus Fund lost a ridiculous -52.5%.

Surely the guru with the greatest trade ever could do better in 2012, right? Despite S&P 500 index funds earning more than 15%, Mr. Paulson’s flagship Advantage Plus was near the bottom in performance yet again, logging a pitiful -19%. The droves of investors who hopped on the John Paulson bandwagon suddenly found themselves down 62% from the top… in just two years! Buy-n-hold believers in Paulson began 2013 needing 163%… just to get back their initial investment!

So, I’ll ask you again… should you really care who the “best” portfolio manager was last year?

If you simply want to know so you can tip your hat to that individual, fine. If, however, you need to know so you can hang your hat on that individual, the answer is a resounding, NO!

Americans need their heroes. And some portfolio managers seem to have it all – media recognition, awards, past performance. But when a “guru” does not have a plan to minimize losses, it’s the buy-n-hold believers who lose.

The world is filled with very intelligent people like Bill Miller and John Paulson. Yet the smartest investors understand that they themselves, as well as their heroes, will be wrong simply because of random chance or fickle timing. It takes humbleness and a keen understanding of human nature to develop a plan to protect yourself from being wrong. In other words, you need a plan to protect yourself from yourself. Otherwise, things can get real ugly, real quick.

Smart Investing = Risk Management

Most investors believe that stock success is all about being able to “pick the winners.” Where did the buy side bias come from? Investment professionals want you to believe that they have unique talents and qualifications to put together a winning portfolio. Their ability to “pick” is their value proposition.

The problem with prophetic stock selection is twofold. First, on a risk-adjusted basis, you cannot find a single person who has outperformed the broader stock market (S&P 500) over a significant length of time. Bill Miller had a phenomenal run with Legg Mason. However, as described in the Stock Market Guru feature, performance came crashing down in epic fashion.

Investment costs also add to the underperformance of stock pickers. Whether it’s a mutual fund manager or an investment advisor or both, there is a cost for the service(s). And while do-it-yourself investors have a choice on whether or not to diversify, prudent professional investors are obligated to do so. It follows that most large-cap growth funds often have 90-95 percent of their portfolio invested in an index like the S&P 500.

As for the other 5 to 10 percent? That’s where the money managing stock picker reaches for a few “higher flyers” to edge out a benchmark like the S&P 500. In that fashion, he/she may justify the cost of his/her work.

So what happened to the goal to outperform? It’s more about keeping pace with the possibility of a modest edge to beat a benchmark. Why? So that ratings agencies give 4 or 5 stars for fund performance. Yet even if they fail to edge out the benchmark, the act of having 90%-95% of the stocks from the index itself means that the fund has less reason to worry about being a 1-star or 2-star fund that missed the party train.

Large mutual fund companies aren’t really interested in creating better funds than their competitors. They provide existing clients with enough fund options for those folks to stay where they are. Need proof? Check out the chart below on a dozen actively managed large-cap growth funds, all from different fund families. Do you see a big difference in the performance pattern? Or do all of the funds tend to offer the same stuff?

fund families

The second major issue with stock picking? A rising tide lifts all boats. In other words, it doesn’t take an Ivy League degree in finance to make money when the stock bulls are charging ahead. All it takes is a willingness to participate.

In contrast, when a stock picker focuses on the buy side alone, he/she is less prepared to preserve capital when the tide finally goes out. Many of these folks can’t even comprehend the “sell” word. Indeed, the outcome can be disastrous when the bear finally comes “a-mauling.”

So how can a professional money manager actually provide value? Risk management.

An investor in his/her 20s or 30s probably cannot appreciate the concept of risk management yet. Those who are very early in the wealth accumulation phase of life, a buy side bias is far more prevalent. After all, wages accumulate. 401(k) contributions go into accounts automatically. And the very notion of a need to protect capital from harm may seem foreign.

However, attitudes toward risk change. Those in their 40s or near-retirees in their 50s or 60s have already experienced horrific losses. They are more mindful of the time it can take to recover principal (not to mention inflation-adjusted purchasing power). Since the end of those future paychecks is in sight, the dollars cannot be easily replaced. This is where the importance of risk management comes to light.

Investing Using Insurance Principles

The simplest way to explain risk management is by comparing it to something we can all relate to, insurance. In fact, applying principles of insurance to one’s investing endeavors rests at the heart of the successful management of risk.

Southern Californians, for instance, have grown accustomed to frequent tremors and ground rumblings associated with living near active fault lines. Should they possess earthquake insurance on the homes that they own? Indeed, protecting the equity in one’s residence with earthquake coverage is an ideal metaphor for investment risk management.

There have only been two major seismic events in Southern California in my lifetime – Whittier Narrows in October of 1987 and Northridge in January of 1994. Both were memorable. And yet, neither of them were particularly troublesome for residents like myself here in Orange County.

I say “not particularly troublesome” with a curmudgeonly grin. Southern California homeowners like myself, who dutifully pay an earthquake premium each and every year, feel like they are throwing away hard-earned money. The deductibles are extremely high. And the “big one” never hits anyway.

In other words, nearly four decades have passed with little more distress than a smattering of phone conversations. (“Did you feel that?”) So why waste a single dollar, let alone the $350 cost to renew my earthquake policy. Yet, like most American homeowners, my house represents my largest asset.

So when my wife reminds me of the cost of our home, I relent. After all, even if insurance seems to feel more like a necessary evil that is making my wallet much thinner, why am I underestimating its importance? Because I have gone decades paying insurance premiums without ever needing to contact an agent? Of course, this is the mindset until we find ourselves with a home that has been overwhelmed by flooding due to a busted water pipe.

Insurance is one of those things that we usually only appreciate after we’ve experienced misfortune. What’s even more ironic? We purchase insurance with the hope that we will never actually need it. Whether it’s a home, car, pet or life insurance, the benefit of being insured comes from the peace of mind that the “unthinkable” will not come to fruition.

The premium of $350 represents a small loss that provides me with the peace of mind that my family’s home is protected against the possibility of a life-altering loss. And while I pray that I will never need the coverage, at least it’s there if I ever do. With home equity representing a big chunk of my net worth, then, I can’t write that premium check for earthquake coverage fast enough.

Just as your home needs protection from the risks that could severely damage or destroy it, so too does your investment portfolio. In fact, the necessity of portfolio risk management with your market-based securities may be even more important. Why? Because your investments represent your future. Thus, unlike a home, they represent time – an irreplaceable asset.

Working-aged investors usually have a relatively decent amount of time on their side. Their lifestyle today is determined by the amount of money they MAKE today, while their lifestyle tomorrow is determined by the amount of money they SAVE today.

In contrast, for nearly-retired or retired investors, folks need to be more wary of how the dynamic between time and money can affect their lifestyle. Their lifestyle today is determined by the amount of money they HAVE today. Their lifestyle tomorrow? Well, that’s determined by the amount of money they PROTECT today.

Very few investors have an actual risk management plan in place to protect their financial future. Yet, few would argue that insuring against investment misfortune is wasteful. On the contrary. When it comes to investing for your future…risk management is everything.

The Math of Investing

If you were asked to choose between two investments – Asset X, which has an average annual performance of 10% over the past 10 years, or Asset Y, which has an average annual performance of 6% over the past 10 years – which would you choose? It’s a “no-brainer,” right?

What if we also told you that within the last decade, Asset X experienced 3- and 5-year periods of phenomenal gains that included 296% and 128% respectively? Asset Y, on the other hand, topped out at 43% and 64% in its premier 3- and 5-year time frames. Pretty clear evidence that Asset X is superior, isn’t it?

It might surprise you to learn that, despite the amazing percentage gains for Asset X, a $500,000 initial investment in this fund dropped to $237,631 over the course of a decade. That’s correct… a 10% average annual return over a 10-year period resulted in a whopping 52% decline. You’ve lost more than HALF of your money!

Now let’s return to Asset Y – the fund that you didn’t think was worthy of your portfolio. The initial investment in Asset Y witnessed $500,000 grow to $872,599… a 75% increase during the same 10-year period. You nearly DOUBLED your money with a 6% average annual return.

Oh… it gets even better. Asset Y is sitting comfortably near all-time highs due to slow-and-steady progress. Yet Asset X is now 86% off of its record high. By choosing the flashier fund with the so-called better performance, one now requires roughly 610% to get back to an all-time peak.

Welcome to the wonderful world of investment math. (Please see below.)

This is no parlor trick; rather, it’s an exercise that demonstrates how performance numbers can be misunderstood. It’s a classic case of how perception can be confused with logic (e.g. a “no-brainer”), where we can easily be persuaded to make hasty, uninformed decisions.

Seeking out historical performance to discriminate between good and bad investment choices is commonplace advice. You’ll find this sort of guidance in most of the books and articles written to help the individual investor. Well, an investment that averages a particular percentage should no longer pass your “sniff test.” It’s not enough to just ask questions and get answers. You need to ask the right questions; you need to understand dollar growth over time, not get sucked into clever fund marketing. You need to sidestep emotional pitfalls, including those that tap into excessive greed.

Professionals in financial services industries are well-trained in appealing to human emotions like greed and fear. They understand the art of persuasion; the sales tactics used are time-tested winners. After all, it wasn’t an anomaly that mortgage-related investment products and real estate within self-directed IRAs spread like a plague from 2005 to 2007. It’s also no accident that “guaranteed” annuity product sales soared following 2008-2009. Both instances represent classic examples of hype that drives a herd of lambs to slaughter.

Without even realizing it, many investors may be relying on the wrong information and misguided emotional instinct when making investment decisions.

Bear Market Math

Bear market math is the term we use to describe a painful mathematic reality; that is, the more money you lose, the time (and magnitude of the return) needed to recover increases exponentially. But before we get into how bear market math can affect a portfolio, let’s first break down the formula for building wealth.

There are three basic components for securing your financial well-being: money (savings), growth (return), and time (years). It is impossible to build and maintain a nest egg for your long-term goals without each one of these items. Unless you are planning on a financial windfall, all three components are necessary.

However, not all three of these ingredients can be controlled. Money (what we earn and save) is one component where we have some measure of control. Education achievements, career paths, self-motivation, work ethic, budgeting, tax strategies, etc. – all have an effect on what we make and what we save.

We also have some measure of control over the growth, or the return on our money. Commodities, real estate, stocks, bonds, partnerships, trusts – there are literally tens of thousands of choices for investing our dollars. We even have choice with regard to how we access market-based securities, including individual issues, mutual funds, closed-end funds and ETFs. The size and accessibility of the investment menu alone assures us that there are opportunities to control portfolio outcomes. Whether we take advantage of those opportunities… that is a different issue altogether.

Finally, there is time; it is a constant and it is definitely out of our control. We cannot get it back once it has passed. And yet, investors regularly squander this precious resource.

Here is a short list of things people tell themselves as they are squandering time and money:

1. “This stock has treated me so well in the past.”

2. “It can’t possibly go any lower from here.”

3. “I’m just going to hang on until it gets back to break-even.”

The chart below shows the catastrophic effects of bear market math. The second column, “…GETS YOU BACK TO BREAK-EVEN” could just as easily be titled, “THE COST OF NOT TAKING A SMALL LOSS.” As you can see, the costs (including time, missed opportunity and emotional well-being) get exponentially larger as you buy-n-hold your way into the abyss.


We believe that by utilizing a sell discipline, you can keep portfolio losses small and minimize the bulk of bear markets. You will spend less time getting back to a break-even point and more time growing your money during a recovery.

The Investment Strategy Spectrum

A well-rounded investment strategy is as important to an investor as a flight plan is to a pilot. Without clear plans to deal with weather, traffic, instrument and mechanical failures, etc., a pilot has little to no control over the possible outcomes of a trip. The plane could arrive to its destination late, a little battered and bruised… or maybe it doesn’t make it there at all.

Similarly, investors need to have a clear plan to manage the outcomes of each investment as well as the portfolio as a whole. There are a variety of strategies you can use but, ultimately, each boils down to how appropriate it is given your specific goals, risk tolerances and lifestyle. For example, some strategies require very little time and energy to manage, but they may not offer a method for avoiding significant declines. Conversely, some strategies may do a great job at limiting exposure to market downturns, but they may also require more time, energy and discipline.

Below is a graphical representation of our interpretation of the investment strategy spectrum:


Static asset allocation (a.k.a. “buy & hold”) sits at the far left of the investment strategy spectrum. It is a commonplace approach because of its simplicity and laziness. In essence, all you have to do is select an “appropriate” mix of assets, choose the “best” investment options to fill those asset classes, and then relinquish control by placing blind faith in the markets. Other than rebalancing back to a target allocation regularly, you really do not need to give much consideration to anything else. In other words, just buy stuff, hold stuff, and then hope it turns out alright.

Well, unless you didn’t mind watching your money disappear in the 2000-2002 “New Economy” bubble (when the S&P 500 dropped 49%), and unless you slept like a baby in the 2007-2009 financial system collapse (when the S&P 500 dropped 57%), and unless you were quite content during the height of the Eurozone crisis in 2011 (when the S&P 500 dropped roughly 20%), buying-n-holding-n-hoping is not so easy. If you are like the vast majority of investors, sitting back and allowing the markets to harm your portfolio does not feel like you are maximizing profit nor lowering risk. Buy-n-hold may make theoretical sense; however, when catastrophe strikes, it will not make emotional nor financial sense.

On the other side of the investment strategy spectrum is “Day Trading.” Most of us recognize that day trading has the potential to be exciting; some of us even have “mad money” in small accounts to try out exotic ideas. Maybe the hot stock tip your cousin, Eddie, discussed at the dinner table on Christmas Eve is worthy of a shot in the dark. Yet, most people see this type of investing activity for what it truly is… gambling. This is why it does not warrant serious consideration when it comes to our serious money. After all, we all know it would be foolish to “bet the farm” on anything that comes out of cousin Eddie’s mouth.

Day trading and buy-n-hold each sit at opposite ends of the investment strategy spectrum. And yet, they may both share equally high levels of portfolio volatility in practice. Almost every investor can recount an example of how devastating it was to buy and then hold an investment as it went straight down the tubes. Many may have experienced spinning their wheels at buying and selling far too frequently, only to wind up like a gambler trying to hold onto a few final chips.

In truth, few things in life that exist at the furthest ends of a spectrum are appropriate. That’s why intelligent investors seek a happy medium. (It is also the reason why we feel that “tactical asset allocation” works better for most.)

In tactical asset allocation, one may begin with a static asset mix for a point of reference. For instance, many retirees have been told that they should have roughly 50% in growth (a la stocks) and 50% in fixed income (a la bonds). So one starts there… using the static mix as an optimal target in normal, uneventful times. You buy good stuff and hold that stuff for as long as it stays good… whether that’s 5 years, 5 months, 5 weeks or 5 days.

Eventually, as in life, things will change. They may change very quickly or a long period of time may pass in between. Either way, the intelligent investor already has a plan in place for change. If an investment or even an asset class is behaving erratically, one must be able to adapt to the shifting landscape. For example, if stocks have far exceeded typical volatility levels and they are dropping at an alarming rate, a tactical asset allocator would have the tools to lower the growth allocation in the portfolio; one might lower risk by downshifting to 25% growth, 50% income and 25% cash. Similarly, if bond yields are spiking at an alarming pace, employing one’s unemotional, mechanical plan might result in greater protection through a 50% growth, 25% income, 25% cash portfolio.

Markets will inevitably turn bad from time to time. It’s during those times that you need to retain – not relinquish – control over your investments. An active management component allows you to control outcomes by protecting against the volatility that comes from good investments breaking bad.

The Mechanics of “Active” Management

Achieving better performance does not necessarily mean you have to take on more risk. It simply means that you have to lose less on the downside. This mathematic fact is at the heart of what is known as a risk-adjusted return… and active management is a great way to improve your risk-adjusted return.

Below is a graphical representation of the mechanical differences of a “buy & hold” and an active management strategy:

As you can see, without an active management component, you are truly at the mercy of the markets. Squandering away precious time and money are extremely likely. Also, the emotional toll that comes with watching your investments fall is immeasurable; meanwhile, praying for recovery is not a particularly smart path toward achieving greater peace of mind.

In contrast, implementing a simple sell discipline (“Risk Off” Trade) can save you precious time and money. It will also help you avoid the emotional toll of riding markets down to the bottom. Additionally, one can achieve a higher risk-adjusted rate of return by simply avoiding the bulk of major market declines.

The Importance of a Small Loss

“Taking a small loss may look and feel like defeat… until you meet someone who has lost more than half of his net worth.” ~Gary Gordon

Again, just as was previously pointed out, the devastation that large losses can have on a portfolio cannot be overstated. Psychological effects aside, the size of returns required to recoup large losses is staggering. Likewise, the amount of time required to realize those staggering returns may not even be practical for most investors. Indeed, time does not favor those investors who have let their investments get cut by one-third, one-half or even greater.

Granted, it is very difficult for many investors to admit defeat in something that they had high hopes for. As human beings, pride and ego greatly influence our financial decisions; we may be prone to “rationalizing” our way out of doing what is necessary to protect our hard-earned money. This is why it is far more sensible to implement an approach that takes emotions out of the equation altogether. The use of mechanical, unemotional tools can help you make calculated investment decisions as well as protect you from significant declines.

The Average Investor: A Story of Investment Expectations & Outcomes

My oldest son’s journey from birth to six years old went by in the blink of an eye. It feels like, just a few days ago, I was pushing him in his bassinet around the maternity ward. Today I wake up to discover that he’s helping his little brother put on his shoes. A few minutes later, my firstborn is reminding me about his football practice.

When I share this perception with my parents, they nod knowingly at each other. Mom explains that I will be celebrating his tenth birthday before the weekend. “It goes by so fast,” she says.

In other aspects of our lives, though, a 10-year period may not bring back fond memories. This is especially true if we have lived through a decade in a dead-end job, a rocky marriage or a go-nowhere investment portfolio.

So imagine inheriting $500,000 leading into the year 2000. You weren’t really planning on this financial windfall, so you are comfortable putting it into stocks for 10 years to maximize your return. Believing that the S&P 500 has a history of doubling every six to seven years, you decide that an investment in large-cap U.S. stocks will suit you just fine. Surely after an entire decade, your basket would be worth a “cool mil,” if not more.

Additionally, let’s say you decided that you can do this investing thing on your own. You’ve heard the numbers – only 20% of mutual fund managers outperform the S&P 500. And that’s by taking on more risk than the market. So instead of bucking the odds by selecting a “professionally” managed mutual fund, you opt for the more cost effective route. You elect to put everything into an index fund, like the SPDR S&P 500 ETF (SPY).

Can you guess what your portfolio would have been worth after that long decade?

At the end of 10 years (2000-2009), you would have had $452,000. That’s right. Instead of doubling your money – which is what you may have expected given average historical returns – the S&P 500 (SPY) actually lost money over that decade. That’s not all. Twice during that 10-year period you would’ve watched your $500,000 investment get slashed in HALF – first in 2002 and then again in 2009. Talk about nerve-wracking days and agonizing, sleepless nights.

Now, what if by chance, your brother-in-law, a moderately conservative investment advisor, offers to rescue your $452,000 portfolio from the unnerving roller coaster? Would you be happy if after just four years (2010-2013) he provided you with a respectable 7.3% annualized compounded growth rate, turning your $452,000 into $600,000?

Probably not. If you had just left your money in SPY – if you had simply stuck with your original investment – your $452,000 would be worth about $813,000. Chances are, you would find yourself feeling frustrated for having abandoned SPY and for having listened to your brother-in-law in the first place. You might even have blamed him for the missed opportunity. Perhaps you would consider putting all of the dollars back into large-cap stocks. Or, just maybe, you’d find yourself battling anxiety like a deer on a dark country road.

All told, 14 years of your investment life have passed you by and you only have a 1.3% annualized compounded return to show for it. Since inflation averaged 2.4% annually from 2000 to 2013, your inflation-adjusted performance actually came in at -1.1% annually over the course of those 14 years. YIKES! How on earth did the value of your inheritance drop over nearly a decade-and-a-half?

If you think this story sounds highly unlikely, consider the chart below.

Researchers at J.P. Morgan and Dalbar Inc. analyzed a 20-year period in which they compared the annualized performance of the average investor (measured by taking the net of aggregate mutual fund sales, redemptions and exchanges each month) against the annualized performance of seven different asset classes – REITs (NAREIT Equity REIT Index), gold (USD/troy oz.), domestic large-cap stocks (S&P 500), oil (WTI Index), international stocks (MSCI EAFE), bonds (Barclays Capital U.S. Aggregate Index) and residential real estate (median sale price of existing single-family homes). Not surprisingly, the average investor drastically underperformed every asset class in the study. Worse yet, the average investor did not even keep pace with inflation (CPI).

The point here is not to suggest that you should sock all of your cash into REITs, gold or the S&P 500. For one thing, you already tried that tactic – quite unsuccessfully – with the S&P 500 from 2000 to 2009. Rather, when it comes to investing, being average can be disastrous.

So, would you consider yourself to be an average investor? If you can relate to any part of the above-mentioned story, then you already know the answer.

Fortunately, there are things you can do to avoid being stuck in a rut with the “average investor.” Understanding the behaviors that are associated with being average is the first step. After all, being able to recognize the faults the typical person makes can help you avoid hardships going forward.

On the flip side, just like my son’s journey from birth to six years went by in a flash, time does not stand still for anybody. You cannot afford to waste time and energy being average… unless you don’t mind squandering your chance at financial freedom.

Behavioral Finance: Understanding How We Are Wired

Whether we like to admit it or not, at some point in life, we have all made investment decisions that epitomize what it means to be “average.” To understand why this is so, we must delve into what influences our misguided financial moves. And to do that, we must borrow some concepts from psychology, not economics.

Most economic theories erroneously assume that we are rational creatures – that emotions do not affect our financial decision-making. The ubiquitous assumption? People behave logically when seeking to improve their lifestyle. Perhaps this was the case when it used to take days, not milliseconds, to execute a trade; this may or may not have been true when one checked the Sunday paper for stock quotes.

Today, however, we live in a rapid-fire world of instantaneous information. Data is constantly streaming into “apps” on our smartphones. An errant tweet here or a fat finger there. In a matter of seconds, someone may be creating theoretical wealth whereas another may be going flat broke.

Our technologically advanced “global village” did not merely create new ways to trade market-based assets, it ushered in new schools of thought. Old school economists would have scoffed at the idea that emotions played a role in the investing process. Today, economics and behavioral psychology are joined at the hip. In fact, an entirely new field of study, behavioral finance, emanated from combining a wide range of disciplines – behavioral psychology, cognitive psychology, as well as conventional economics and finance.

Mental Shortcutting

In psychology, the technical term for mental shortcutting is heuristics. Heuristics simply describe how, given a vast and complex data set, the brain relies on emotions, impulses or simple rules of thumb, in lieu of strict logic. Why are heuristics so important? We regularly use them to navigate the complexities of a peculiar financial world. Quite frankly, there isn’t a more appropriate place for your brain to apply its mental shortcutting abilities. And, when it comes to your investments, those mental shortcuts might equate to extremely misguided instinct.

For example, let’s assume that I just provided you with every piece of timely information that is known on a particular company. I have given you fundamental statistics (e.g., P/E ratio, P/B ratio, DTI ratio, sales and revenue growth, inventory, etc.), technical data (e.g., trendlines, price patterns, MACB, RSI, etc.), corporate particulars (e.g., the CEO, board of directors, etc.), as well as all of the analyst opinions in existence. Indeed, I have put together hundreds, if not thousands, of facts for you to consider before you make a stock buying decision.

Studying every piece of data obviously turns the decision-making process into an arduous task. (And when it comes to the shelf life of financial data, arduous could be the difference between relevant or obsolete conclusions.) So, for the sake of discussion, let’s ignore the reality that it would be impossible to absorb every single detail.

Nevertheless, let’s assume that you have all of the pertinent specifics at your disposal. How do you go about reaching your well-reasoned decision on whether or not to purchase shares of stock?

Well, if you are like the vast majority of people – quite simply, you don’t. The amount of data alone would probably cause you to break into a nervous sweat. And your bout of anxiety would surely increase as the details begin to paint conflicting pictures.

The cognitive dissonance could go something like this:

According to these fundamentals, the stock is under-valued. However, this technical indicator supports the notion that the corporate shares are severely overbought. Yet, this analyst recently changed his opinion on the stock from a ‘hold to a buy.’ On the other hand, the CEO recently sold a large portion of her own shares, which suggests she believes her company’s stock price is too high.

In the end, most people wind up reaching into their subconscious toolbox without even realizing it. One naturally focuses on one or two bit parts of data that support an initial gut instinct.

“Well, the fundamentals surely don’t lie and that analyst who upgraded the stock to a ‘buy’ clearly sees the same bargain that I do.”

It’s a perfect example of how mental shortcutting employs our preconceived notions. And quite frankly, everybody is guilty of it. The markets are, for the most part, too dynamic for our instinctive minds to tackle without bias. Simply put, we are not wired to run regression analyses in our heads, nor are we equipped to ignore our basic impulses.

Overwhelmingly, “gut instinct” impacts most people’s investment choices. In fact, there is a technical term for the phenomenon called affect heuristic. This mental shortcut even fuels the engine of the greed/fear cycles in markets, where people tend to chase performance on the way up (greedily buying high) and run for the exits on the way down (fearfully selling low).

Another popular mental shortcut involves seeking comfort in the herd. This is known as the social proof heuristic. By witnessing others pour into an investment (think Apple or Tesla or Facebook), our minds easily build a compelling case. Indeed, we even take it a step further by recruiting others to join us on our investment quest. This bandwagon-like behavior was remarkably prevalent during the dot-com boom and subsequent bust in 2000; more recently, it set the stage for home-flipping and highly leveraged real estate purchases prior to the credit crisis in 2008. Indeed, in many circles, if you weren’t buying and owning multiple properties in the mid-2000s, you were seen as lacking the drive to be successful.

The last mental shortcut involves the biased assumption that when there are perceived similarities between a previous event and a current event, we expect the outcomes to be similar. This is known as the representativeness heuristic.

Earlier in this report, I discussed the expectation that many might make about the S&P 500 doubling over a 10-year time frame. Investors make this assumption based upon the history of the index since the 1950s. However, while some 10-year rolling returns might be 14%, others might be 2% or worse. As our conversation revealed, in fact, the S&P 500’s abysmal -1% rolling returns from 2000 to 2009 were a far cry from its historical norm.

Not surprisingly, the reliance on past performance as well as the misunderstood concept of annualized returns are just a few of the mathematical missteps that investors commit. These are common slip-ups that demonstrate all too well the ways that our subconscious speciously converts complex decisions into alleged “no brainers.”

Although this may be controversial to say, a huge chunk of investment success actually boils down to your ability to sidestep your natural tendencies. Thus, if you can develop strategies to avoid the pitfalls of mental shortcutting, you will be one step closer to avoiding the blunders of an “average investor.”


Framing is the psychological concept that our mental shortcuts are shaped (or “framed”) by outside influences. And when it comes to investing, framing explains how the circumstances that we perceive to exist get skewed by the things we see, hear and read. When our perspectives become clouded, we may unwittingly walk down a path which could have dreadfully negative consequences.

Unfortunately, when markets move closer to irrational territory, those outside influences become more pronounced. Whether it’s the frenzied craze to “BUY, BUY, BUY,” or the feverish panic to “SELL, SELL, SELL,” average investors face an uphill battle against the world around them.

For example, let’s go back to a time when the words “dot com” couldn’t be spoken without a cash register ringing in the background. It was a time when just about every day came with a new IPO doubling right out of the gate. It was the second half of the 1990s, and it was affectionately known as the “New Economy.”

If you have difficulty recalling this particular span, this was a period when the investing public enthusiastically rationalized the purchase of any and every technology stock. It did not matter what the company did to turn a profit, or even if the company earned a dime. In the situations when companies did have earnings to talk about, the price one paid was often 10 to 20 times more than the valuations for shares of establish brands like Exxon Mobil, Wal-Mart and Coca-Cola. Nevertheless, when professionals, pundits and gurus became wildly fanatical about the “New Economy,” it was pretty easy for the average investor to justify jumping onto the tech stock gravy train.

Think about some of the circumstances leading into 2000:

  • The historical 9%-10% average annualized growth rate of the S&P 500 had been dismissed as “old economy” returns. Many tech stocks had been doubling in a matter of months!
  • Fund managers loaded up on dot-com names to keep up with the wildly successful NASDAQ; it became nearly impossible for the so-called professionals to avoid being over-allocated to the technology sector.
  • Young guns ridiculed the stars from yesteryear, particularly Warren Buffett. Most regarded the 70s icon as a doddering old fool.

Now if you are human, which I’m 99.9% sure that you are, it’s easy to be swayed while living in the moment. Not only do we have our emotional influences (e.g., greed, fear, ego, etc.), but there are social influences that “frame” our perspectives. After all, if Jim Cramer, the all-knowing bulldog from CNBC and former hedge fund manager is buying it, why shouldn’t I, right?

Well, get a gander at the list of 10 stocks that the ever-popular Cramer dished up for “Cramerica” as the Winners of the New World in February of 2000:

  1. 724 Solutions
  2. Ariba
  3. Digital Island
  4. Exodus
  5. InfoSpace
  6. Inktomi
  7. Mercury Interactive
  8. Sonera
  9. Verisign
  10. Veritas Software

And… just in case CNBC had not persuaded you, the March 2000 issue of SmartMoney magazine had a way of cajoling and coaxing too. In it, readers could find out “what’s next for the market’s hottest sector – and how to profit from it.” Here is the list of those 15 Great Tech Stocks:

  1. ADC Telecommunications
  2. Applied Materials
  3. Ariba
  4. Cisco Systems
  5. Hyperion Solutions
  6. JDS Uniphase
  7. LSI Logic
  8. Lucent Technologies
  9. Parametric Technology
  10. PMC-Sierra
  11. Powerwave Technologies
  12. RF Micro Devices
  13. Sanmina Corp.
  14. Taiwan Semiconductor Mfg.
  15. Veritas Software

So, now that two highly touted and reliable sources have confirmed that tech stocks are where it’s at (well…three if you count your neighbor who cashed in his IPO shares of to buy a new Porsche), you probably felt confident enough to move forward. And just to be on the safe side, you decided to make some equally-weighted investments into those very stocks Mr. Cramer and SmartMoney recommended. After all, your neighbor might just have been lucky, but Jim Cramer and the experts at SmartMoney must have some kind of inside scoop.

It is critical to show the extent of the devastation when we fall “under the influence” of a crazed stock market environment. So hopefully, your memory serves you correctly with respect to just how poorly these tech stock portfolios fared.

The NASDAQ 100, a benchmark commonly employed to gauge the highs and lows of the technology sector, lost 50% of its value in 2000 alone. A loss of that size requires 100%… just to get back to break-even. What’s worse? Many investors still rationalized their way into holding onto their lofty dreams; others even convinced themselves to buy into the weakness.

The justification for “holding & hoping” usually goes something like this:

The experts aren’t wrong. The markets are just being panicky and you are supposed to buy when everyone else is selling. These are great companies. Surely their stock can’t go any lower. If I have to, I can just hold on until I get my money back.

Well, the NASDAQ 100 did not merely stop when it lost one-half of its value. From the high in March of 2000 to the low of 2002, the previously beloved NASDAQ 100 fell 83%. That requires an astounding 487% return just to be made whole!

Staggering percentages aside, try to comprehend the amount of time that gets wasted when a “buy, hold & hope” strategy turns into a “gotta get it back” rescue mission. It has been more than 14 years and the NASDAQ 100 has yet to reach its former peak. (Now that’s one hell of a long rescue mission.)

And although 14 years may sound like a long time in and of itself, it’s nothing compared to the amount of time it would take to recoup the losses suffered from Jim Cramer’s stock advice. Of the 10 stocks he recommended, VeriSign is the only one with a stock certificate worth more than the paper it’s printed on. Yet, even VeriSign is still roughly 75% from its February 2000 peak (as of August 2014.)

As for the portfolio as a whole? At this point, Mr. Cramer’s “New World Winners” portfolio (or what’s left of it) would still need an inflation-adjusted rate of return of at least 5400% to recover from its 98% drubbing since February of 2000. Quite frankly, there isn’t enough time in several centuries to recoup losses of that magnitude.

Could you have fared better by running with the SmartMoney bulls? Don’t hold your breath. This turned out to be an exceptionally ill-timed list too. Just like Jim Cramer’s recommendations, these stocks would have eviscerated your principal, as well as your desire to invest in stocks ever again.

Ironically, even exceptional investors can get caught up in manias, bubbles and strange moments… just like the average investor. The difference? Exceptional investors know how to protect themselves from big losses. Unfortunately, the average investor is rarely prepared with a clear exit strategy to protect against big losses.

(And just in case SmartMoney didn’t hurt enough investors with their 15 Great Tech Stocks issue in March of 2000, they were calling for the abandonment of stocks altogether in their September 2002 issue. Their advice was less than one month prior to the lows of the bear market that began in March 2000. If bad timing were an award show talent, SmartMoney would win an Academy Award!)

Buy & Hold: An Unfeasible Investment Strategy

My first memory of investing occurred at the age of 15. It was my junior year of high school and I was in an economics class that was being taught by the varsity girls’ volleyball coach. Prior to attending, I assumed that I might easily purge the concepts from memory shortly after the posting of my grades. Still, my junior year economics teacher set off to change that. He had a different lesson plan in mind… and it would prove quite memorable.

On the first day, I remember seeing a large stack of haphazardly folded newspapers on the teacher’s desk. Once class began, he informed us that – for the next few months – we were going to work on a unique project that would cover the importance of investing. After all, the U.S. stock exchanges and free market system were the envy of the world.

If I look back on it now, I would guess that this particular teacher felt we needed to be “shown the ropes.” And since we were only a couple of years shy of legal adulthood, time was running out on receiving an education on one of the most important aspects of our adult lives – recognizing how our money makes money for future goals.

After handing each of us the business section of the Sunday newspaper, our teacher provided us with our instructions. Individually, each student would select two stocks to invest in. Then the class would compile all of the ticker symbols of the chosen stocks to create an imaginary fund. Each week for the next few months, we would calculate our fund’s net asset value (NAV) and jot it down on the large piece of butcher’s paper taped to the back of the room. At the end of the project, the class with the best performing fund would be crowned champion.

Obviously, our instructor’s goal was to teach us something about investing. Unfortunately, due to the nature of rebellious teenagers, the exercise morphed into a lesson on how to build a “vice” fund. Companies like Anheuser-Busch, Philip Morris, Smith & Wesson and Playboy Enterprises were popular components across the funds of every class. After all, with no real direction on how to choose investments, all one has is what seems familiar AND cool, right?

Each week, we eagerly scoured the business section to find out just how much money our stocks (and fund) had made, or lost. The end of the project was soon upon us and, alas, my class managed to pull out the win. And although we came out on top, the deciding factor boiled down to which class lost the least amount of money. The pay-off for our well-honed stock picking skills? We got to wear pirate hats made of newspaper for an entire day.

So why was this investment experience so memorable for me? I wondered how any class or team or person might be described as a winner based on having lost the least amount of money. If every class only managed to lose money, then why invest at all? I expressed my concern to the teacher. His answer? Although we all invested in “pretty good stuff,” he blamed the lack of performance on the stock market. Quite frankly, it just wasn’t a very good time to be invested in much of anything. “One needs to give the market more time to ensure the success of an investment portfolio,” he explained.

So if my teacher had been accurate in his portrayal of investing, I should simply buy “pretty good stuff” that seemed familiar to me and hold onto it for a long time. Is that the way to make money? Lesson learned… I guess.

Does this buy-hold-n-hope approach sound familiar? Here, once more, the “average investor” appears.

The Nature of Being Human

Most people still regard the advice of my high school economics teacher as both sensible and logical. The fact is, however, the average investor considers only the scenarios in which an investment works out. Few recognize the impact of losing, let alone the possibility of losing big. So once the decision to buy has been made, there is no clear plan to limit the damage from “good assets gone bad.”

Think about it. If the only consideration you give is to making a gain, you’re going to fall into the trap of telling yourself, “Well, I certainly can’t sell now. I have to at least get back to my purchase price.” This is the mindset until, of course, despondency fuels the voice inside of your head (or perhaps it’s your spouse’s voice), convincing you to throw in the towel.

For example, when someone experiences enough investing heartbreak and portfolio frustration, they usually follow up their misfortune with additional calamitous decisions: (1) They “double down” on risk and try to recoup losses quickly, (2) They walk away from investing for an extended period of time or, more tragically, (3) They quit forever.

In my earlier segment, Behavioral Finance: Understanding How We Are Wired, I detailed how our psychological makeup influences the financial choices that we make. The main take-away had been that the average investor is not wired to separate emotions from the investment experience.

It follows that without a disciplined investment approach, the average investor can find it very difficult to avoid the traps and significant errors associated with emotionally-charged decisions. So, if you agree that it is unfeasible to avoid being emotional (human), then you can agree that a more disciplined approach is required. One needs to minimize emotions that come from being human.

Understanding Math

Some would have you believe that investing is as basic as “buying good stuff and holding onto it until it makes money.” Maybe it was just that easy for my high school economics teacher. Indeed, so many tend to assume that – no matter how bad the losses – the markets will eventually recover. In truth, they often do. Yet, an important question remains. How long does it actually take to recover?

In my segment on the “Average Investor,” I demonstrated how an investment in the S&P 500 over the last decade would’ve resulted in roughly a 10% loss. Although 10% may not seem that bad on the surface, 10 years is a very long time to merely run in place, let alone walk backwards. What’s more, inflation exacerbates the underperformance. Thus, the natural erosion of purchasing power is like pouring salt on an open wound.

In order to gauge the ruthless nature of long periods of futility, we need to look at two of the critical variables: math and time. In fact, when it comes to the world of investing, math and time exist on the same side of the wealth equation… and they are not mutually exclusive.

First, let’s talk about the math. Although most investors say that they understand how it works, I still find many people astonished when I break it down into bite-sized concepts. Consider the chart below:


Many investors make the mistake of assuming that an investment which is down 1% one day merely needs 1% to get back. In actuality, though, that assumption is absolutely false. Although small losses can mislead us in our thinking – although the differences on smaller losses and recoveries may come down to decimal points – the relationship between gains and losses is woefully exponential.

For example, if you lost 25% last year but made 25% back this year, what would your 2-year performance be? If you assumed it was roughly flat (0%), you need to reference the above chart. The answer is negative six percent (-6%). You see, a 25% loss requires a 33% gain to get your money back. If you lost 50%? You need 100% to break even.

It gets worse.

Remember Jim Cramer’s Winners of the New World portfolio? It lost 98%, requiring an astounding 5400% gain just to get back to an inflation-adjusted breakeven point! So, the more you lose, the gains needed to get you back become exponentially greater. And when the gains you need to recoup losses require a lot of time to be realized, inflation is allowed to make a tough situation even worse.

Quantifying Time

I’m sure you’ve heard the phrase “Time is money.” The phrase is anything but cliché when it comes to your finances. Your mortality limits the amount of time that you have to accomplish your financial goals. Simply put, you must avoid going backwards because you will not be able to get that time back.

Everybody’s time is finite. It follows that allowing your portfolio to get hit by large losses is like allowing your health to get hit by the devastating effects of cigarettes. You are literally removing years, if not decades, from your portfolio’s life. Still, the average investor usually takes his or her investment time horizon for granted by failing to employ a discipline that keeps losses from getting out of hand.

Clearly, each person is different when it comes to defining a manageable time horizon. Teenagers picking stocks in an economics class obviously have much longer to invest than baby boomers nearing retirement have. So, time becomes an even more precious commodity as our years tick by.

Nevertheless, time is a constant no matter your age or risk profile. Whether you are the riskiest retiree or the most conservative 20-something investor, a year is a year and a decade is a decade. Moreover, since nobody knows how much time they will end up with, allowing investments the chance to waste away is nothing less than catastrophic.

Remember my high school economics teacher telling me that we needed to “give the investments more time?” Well, fortunately, history lends us data. Using the most widely referenced benchmark for U.S. stock returns, the S&P 500, I created the chart below to unequivocally define what that “time” equates to when one adjusts for inflation.  The data in the below chart reflects 80 years (1926-2013) of inflation-adjusted, large cap (S&P 500) total returns as reported by Morningstar.


At this point you recognize that one requires a 100% gain to recoup a 50% loss. Also, you may recall, the market has historically doubled every 6.5 years. However, when we adjust for inflation (i.e., purchasing power of our money), the historical average moves up to 9.1 years. It follows that a 50% loss will likely slice off 9 years from your investing life.

Even more unfortunate? The market’s average returns exist in a very wide range. So, perhaps a more appropriate statement regarding the 100% performance assumption would go something like this:

Historically speaking, the stock market takes an average of 9 years to realize an inflation-adjusted return of 100%; however, it has taken as little as 10 months and as long as 27 years to do so.

By simply adding the second part to that statement, we may have undoubtedly invoked new emotions. Perhaps one would feel less confident about the prospects of his/her portfolio doubling within the next decade. Perhaps one might recognize that a little more thought and planning is needed to account for the broad range of scenarios – as opposed to simply relying on the averages like “buy, hold-n-hope” does.

This brings us to the most important point that the previous chart makes. Consider the implications that the Maximum Years to Realize column has. Believe it or not, going back to 1926, there have been stock market periods just shy of 20 years that realized a 0% inflation-adjusted total return. Think about that… 20 years and nothing to show for it. That’s nothing short of tragic!

Do you need a modern-day example? Consider the world’s third largest economy, Japan. The Nikkei 225 Index (Japan) reached 38,957.44 on 12/31/1989.  Where is it 30 years later? It’s still down 50% from its late 1980’s heroics. And that’s not even adjusted for inflation!


The 2nd largest economy has a similar tale. China, via its Shanghai Composite, reached 6,124.04 on 10/16/2007. Nearly 13 years later, it is down close to 55%.

How long will it take to get back to 2007’s price? What about adjusted for inflation?


I can’t imagine that my high school economics teacher ever lived through a market period with lengthy periods of futility with his own portfolio. If he had, I’m sure his experience would have him thinking twice about his investment strategy AND his lesson plans. Or, maybe I’m wrong… maybe he was quite content with being average.

Devastating markets are not as uncommon as some may assume. Twice in the past 15 years alone the S&P 500 has dropped by approximately 50% in value: from March of 2000 to October of 2002, and then again from October of 2007 to March of 2009. What’s more, the recovery periods – if you can call them that – are not particularly impressive either. As of August of 2014, the S&P 500 is still 8% below its March of 2000 inflation-adjusted high based on price alone. If we wish to incorporate total return and the reinvested dividends that come with investing in the S&P 500, the real purchasing power of $10,000 after 14 1/2 years is approximately $12,220. Total annualized return is an anemic 1.3%. It is difficult to imagine someone advocating 15 years of buy-n-hold stock risk, only to have real money that barely grew at all.

Becoming a “Better Than Average” Investor

Neither your investments, nor the markets as a whole, will trade straight up, straight down, or absolutely sideways over time. This realization should lead to some compelling revelations by the “better than average” investor: (1) There are more appropriate times to be invested in risky assets, followed by, (2) There are times when it is better to have an exceptionally low allocation to riskier assets.

For example, remember the Time is Money chart in the Buy & Hold: An Unfeasible Investment Strategy section that showed there have been historical periods where the market realized an inflation-adjusted return of zero (0%) over the course of 19.9 years? Well, this period began at the onslaught of the Great Depression, beginning in September of 1929 and lasting through July of 1949. And as you’re probably more than aware of, the market did not move absolutely sideways from the beginning of that period until the end. In fact, the inflation-adjusted returns began with a precipitous drop of 79% that was then followed by a 575% gain off of the bottom, which was then followed up with another drop of about 30% off of the top. All tallied, it equated to a zero percent real return for the period.

Now, let’s consider the fact that you could have instituted a simple unemotional stop-loss strategy that limited your exposure to that volatile market period. For the sake of argument, let’s conservatively assume that you successfully avoided just 10% of that entire period. After all, an active investment strategy was somewhat new to you and you still couldn’t totally ignore your gut instincts. So, instead of a 79% drop, you experienced a 71% drop. Instead of the 575% gain that occurred off of the bottom, you experienced a 518% gain. And finally, with the bear market that ensued off of those highs, you experienced a 27% drop instead of 30%.

Can you guess what your overall return would be? Well, instead of the zero percent inflation-adjusted return which the buy-n-holder would’ve experienced, you realized a 30% inflation-adjusted total return. Yes, the roller coaster ride was still quite rough, but the ride was far more beneficial.

This time, let’s consider a more moderate assumption. Let’s say you have developed a more promising trendline discipline along with your stop-losses that together limited your exposure to the market by one-half. Instead of the initial 79% drop, you experienced a 40% drop. Instead of the 575% gain that occurred off of the bottom, you experienced a more modest 288% increase. And finally, with the bear market that ensued from those highs, you experienced just a 15% drop instead of the 30% that actually occurred.

Can you guess what your overall return would be then? Again, instead of the zero percent inflation-adjusted return for the buy, hold-n-hoper, you realized a 100% inflation-adjusted total return. You doubled your money… by avoiding half of the downside and by only garnering half of the upside. And again, while the amusement park ride may not have felt particularly amusing, the discipline was entirely helpful for protecting and growing wealth.

The point to take away is that the stock market offers opportunity even within periods that seem inopportune on the surface. However, this opportunity only presents itself to above-average investors who have the discipline that extends beyond “buying good stuff and holding onto it for as long as it takes to make money.”

Quite simply, a systematic discipline takes a lot of the guesswork out of the equation. Thus, you can avoid the pitfalls that come with being human as well as make your investment experience much less stressful. What’s more, by avoiding at least some of a market downturn, you can improve your overall return as opposed to wasting time recovering from big losses.

So Now What?

By this point, I have shown you the disappointments that inevitably occur with being average. By revealing the emotions, thoughts and actions of the average investor, I identified how to avoid those mistakes which lead folks to miss out on securing their financial freedom.

There are steps that every investor should take to increase their likelihood of succeeding with less risk. I will walk you through some of those steps which can get you on the right path. Here, then, are some questions designed to help you achieve your financial goals.

Can you distance yourself from your investments?

Successful investors are indifferent when it comes to their investments. The reason? There’s no point in falling in love with something that is totally indifferent to you. Love is best reserved for your spouse, your kids, your dog – heck, even your mother-in-law if there’s enough to go around. Yet falling in love with an investment is only a trait shared by the least capable.

I have been in the investment arena long enough to see the consequences that come with falling in love with a particular stock or particular mutual fund. I’ve seen everything from devoted employees losing a fortune in a 401(k) which shared an equally devoted allocation in the company stock, to grandparents losing half of their nest egg which was invested in a biotech company that produced a drug which happened to hit close to home.

Unfortunately, as humans, there are consequential flaws that come with investing in things that we feel connected to. One, we inherently feel that we have some sort of handle on the outcome of an investment once we profess to know the company and it’s potential. In our minds, we know what the company is capable of; thus, the stock price should eventually reflect what we think we know. Unfortunately, for every logical reason we feel an investment should climb to the moon, there are a hundred illogical reasons why it could fall below the whale poop at the bottom of the Mariana Trench.

Two, familiarity is often confused with the emotional baggage known as comfort. It explains how we can still love Apple Inc. (AAPL) and its wonderful products even though its stock dropped 50% in a matter of months for few reasons beyond tax issues and profit taking. It’s also how we can have utter disdain for Altria Group Inc. (MO) and everything it stands for even though its stock could have made us a small fortune since its inception.

Now I’m not telling you that it’s a bad idea to invest in things that you are familiar with, nor I am advocating that you should invest in things that you are unfamiliar with. What I am saying is that an investment strategy which involves you being joined in holy matrimony is a recipe for disaster. In fact, divorcing the idea that your familiarity has any implications at all on the outcome of your investment is a necessary step in becoming a successful investor.

Would hiring a professional adviser be advantageous?

Surely, the large banks and brokerage houses – with their armies of Ivy League statisticians and economists – have the resources to make highly informed decisions. You know…companies like Bear Stearns, Lehman Brothers, Merrill Lynch, Washington Mutual, Wachovia, Citigroup, or AIG.

Well, maybe not so much.

The tech bubble collapse in 2000 taught investors many lessons in chasing riches in overextended markets. Vast amounts of resources and knowledge were no match for the justification, nor willingness, to be highly leveraged in a speculative frenzy. In the late 90s, overexposure in tech was the disastrous norm.

The mid-2000s were equally unkind. The financial crisis that lasted from 2007 to 2009 not only decimated the value of market-based securities, it destroyed property values as well. Indeed, nearly all individuals, businesses and mega-multinationals would agree that the real estate market in the mid-2000s was a get-rich bubble with crazy valuations, as opposed to anything more practical. The same holds true with the dot-com-infused “New Economy” craze of the late 90s. Hindsight truly is 20/20.

Even the world’s largest central bank, the U.S. Federal Reserve, hadn’t a clue of the side effects its rate policies following the tech bubble pop would have on the real estate market, and eventually the world economy. What’s even more frightening? The Fed didn’t even acknowledge the recession that officially began in December 2007 until almost a year later in late 2008.

You should be experiencing some eye-opening revelations by now… if you haven’t already done so.

If you think access to knowledge and resources separates the professional investors from the average ones, you are sorely mistaken. What does separate the winners from the losers? It’s discipline that is void of emotional influence.

Unfortunately, most people end up spinning their wheels as they continue to give into their greed and their fear. Tapping into our core emotions is rarely the start of a sound investment decision. In contrast, taming them with a disciplined approach to money management is the best way to make progress, whether you do it yourself or hire a professional adviser.

So… have you ever pursued hot stocks, five-star funds or hot fund managers? Have you ever chased the riches of a “lucrative” segment of the market, like tech, real estate, oil or gold? Conversely, have you ever been so scared that you chose a “guaranteed” insurance product like an annuity? Or maybe you’ve decided to walk away from investing altogether, opting for a “money under the mattress” strategy instead?

If you answered “Yes” to any of these questions, you need to take the necessary steps to “right your ship.” You need to avoid repeating the same mistakes over and over again.

From the Fear of Loss to the Loss of Fear

Studies have found that the brain activity of a person whose investments are making money is indistinguishable from the brain activity of a person who is high on cocaine. Researchers have also found that trading stocks stimulates the same part of the brain as the area associated with sexual desire. Without a doubt, it feels very good to invest and make money.

On the flip side, words like “crash,” “collapse” and “crisis” are enough to terrify the most even-tempered individual. In fact, research has shown that when people lose money on their investments, the area of the brain linked to fear experiences immense arousal. Flashes of heat. Uncontrollable sweat. The sickening pit in your stomach. Your body is reacting to chemical changes that occur in response to its fear mechanism – a physical manifestation of watching money vanish before your eyes.

There is a reason why the devastation of loss is three times more intense – three times more unforgettable – than the joy of gain. When those chemical reactions in the body respond to fear, the brain creates an indelible memory of that event. It follows that people can recall frightful memories with greater ease long after they occur.

Not surprisingly, fearful recollections impact one’s future decisions. Perhaps this is why investors remain extremely apprehensive putting money back into financial markets long after they have been burned. What is the old saying, “Once bitten, twice shy?”

I often speak with people who abandoned stocks and bonds near the end of the Global Financial Crisis. I make no bones about my sentiments. Specifically, the bearish devastation ended in March of 2009, close to seven years ago. Missing out on the majority of a raging bull is just as foolish as holding onto investments that one ultimately sold for monstrous losses. The fear of loss instigated one bad decision followed by another.

Granted, it may be easier – emotionally speaking – to miss out on opportunity than it would be to watch your life’s savings disappear. That’s what occurred for so many folks between October of 2007 and March of 2009. People felt traumatized as 50% price depreciation eroded HALF of their account values.

Yet there is something to be said about the restorative power of market-based investing. Markets are cyclical. Booms follow busts.

Take a look at the table below. It contains the annualized performance data for a broad range of assets following the lows of the 21st century’s most gruesome bear.


Although it may feel like the stock market is riskier after an epic meltdown, data rarely support that fear. Again, booms follow busts.

Need more proof? If you could carve out the total returns of stocks during all of the bull markets that have occurred since 1925, you would find that large-company stocks offered a total return of 73% across an approximate span of two years. The mean annualized gain? 31%. Small-company stocks were even better. They provided a total return of 146% with a mean annual return of 55%.

Now let’s identify the bust side of the cycle. If you pull apart the total losses from all bear markets that have occurred since 1925, the average bear market length was just shy of one year. The total returns? Large-cap stocks averaged a total return of -27%, while small-cap stocks averaged a total return of -29%.

What do you get when you combine the booms with the busts? You get the results in the table below.


There is little doubt about it. When one evaluates 90 years of performance data, time in the markets matter. Time out of the market, across all asset classes, may lead to something worse than missed opportunity. It may lead to an inability to secure one’s financial freedom and well-being.

Indeed, the data above bolsters the case for Modern Portfolio Theory (MPT). In particular, MPT devotees insist that investors put aside their fears of loss to simply “buy-n-hold” asset classes through thin and thick.

Unfortunately, investing success has never been as basic as buy, hold and hope for the best. There are scores of gaping holes in that approach, not the least of which is the ill-conceived belief that historical performance averages supersede historical valuations. In fact, as of November of 2015, U.S. stocks are near the highest levels of over-valuation ever recorded – on price-to-sales (P/S), price-to-earnings (P/E), market-cap-to-GDP.

It follows that it would be nothing short of amazing if we could assume, based on the previous table, that a 10.1% annual return on our stock positions could be banked every year going forward. However, we’re not talking about bank certificates of deposit (CDs). Stocks, bonds and nearly all asset types do not play by the same mathematical rules as a straight-line calculation of an annual CD return.

Here’s where it gets tricky. Take a look at the chart below:


As you can see, buy-n-holders may very well assume a 10.1% average return based on 90 years of performance data. However, even looking at a time horizon as long as 10 years, stock returns have rarely produced an average result. Instead, results more closely resemble an erratic roller coaster ride. The ability for a buy-n-holder to achieve decent returns simply boils down to being in the right place at the right time.

As for the real (inflation-adjusted) returns… things get even worse.


Not only does the average annual return of stocks drop to an inflation-adjusted 6.8%, but had you been an investor in the mid-1930s to 40s, 1970s to 80s, or in the 2000s, a 0% to -5% annualized real return over an entire decade was hardly inconceivable.

The truth is, an aggressive soul can talk night and day about his/her unshakeable faith in holding onto an investment forever. Even if bad returns are possible, there are a whole lot of positive outcomes too, right? Heck, even if you can get 5%, that’s better than nothing, right?

Yet the fear of loss always seems to trigger those chemical reactions that end with investors jumping off the emotionally charged roller coaster. Indeed, research conducted by Dalbar Inc. demonstrated how investors behaved over a 20-year period that included both the “tech wreck” (2000-2002) and the systemic banking/real estate disaster (2007-2009). Their findings showed that the average investor – realizing just a 2.3% annualized return – didn’t even keep pace with inflation (2.5%).

The Dalbar research becomes even more instructive when viewed from yet another perspective. Statistically speaking, based on history’s average business cycle of boom and bust, the average investor captured a little more than half (52%) of stock upside. And then when the inevitable bear came mauling? He/she experienced a vast majority (87%) of the downside destruction.

The graph below provides a visual representation of just how futile the average investor’s efforts can be.


As you can see, the tragedies for the typical investor are twofold. First, the idea that an investor will buy-n-hold is sheer folly. Fear of missing out leads to holding-n-hoping until the bitter end… where people eventually throw in the towel. Meanwhile, fear of additional loss keeps an investor sidelined during phenomenal stock recoveries.

Second, a 2.3% annualized return is extremely unlikely to get a person or his family to the goals that they have set. Not if they anticipated 6%. Not if they expected 7.5%. And the widely quoted average for stocks at 10.1%? Forget about it.

If your first thought in seeing the above chart is utter disbelief, join the club. Then again, I couldn’t help but recount all of those conversations I have had with investors since 2009. Those conversations shared a common theme: greed-induced, money-making desire late in the housing boom followed by panicky missteps at the tail end of the Financial Crisis.

Participating in most of the downside only to be frightened into missing much of the upside is dangerous for one’s financial health. Are we so hard-wired that we are doomed to repeat patterns that kill our progress? Or can we avoid making emotionally charged missteps? Can we tame the greed that is associated with trying to get ahead in late-stage cycles? Similarly, can we manage our investments more effectively so that fear of loss (and the losses themselves) are less nerve-wracking?

There are two rules that an investment discipline must adhere to if one intends to successfully navigate a portfolio through tumultuous markets and the emotional impulses. First, the discipline must neutralize emotional cues (i.e. greed and fear) when a decision is being made, and second, the discipline must foster emotional stability.

Sadly, many investors believe that buy-n-hold is a disciplined investment strategy. Their logic? One apportions a portfolio across an appropriate mix of assets where the initial effort to diversify keeps emotions in check forever more. Buy-n-hold capitalizes on the phrase, “we’re in this for the long-term.” It banks on theory – Modern Portfolio Theory (MPT) – that academics and journalists regularly trot out.

Can one argue that doing nothing as an investor – buying diversified assets, holding those assets, hoping they do well – is a disciplined approach that neutralizes greed and fear? Possibly. Of course, an investor would pretty much have to turn away from every financial show, report, friend, as well as the moment – since the discipline of doing nothing is a bit like meditation. You’d have to ignore external inputs entirely. (Judging from the Dalbar studies discussed earlier, it appears that most investors would not be capable of thinking happy thoughts and chanting a mantra, “I’m in this for the long-term.”)

And then, what about the second rule? In addition to neutralizing greed and fear, what about fostering emotional stability? In other words, it is one thing to banish negative inputs. It’s quite another to inspire emotional comfort. Buy-n-hold fails miserably in this regard because it assumes that people invest in a vacuum. They don’t.

Do monthly statement’s that show dramatically lower values foster good vibes? Does an angry spouse’s condemnation increase emotional steadiness? Do large-scale drops in account value – by themselves – promote unwavering confidence?

The fear involved in watching one’s life savings vanish eventually becomes too difficult to ignore. Ultimately, there comes a time when one’s faith in the buy-n-hold game wavers. It tends to occur as account values are falling to unimaginable lows.

In contrast, our investment discipline emanated from the reality that bad investment decisions start with greed and end with fear. Quite simply, allowing emotional cues to dictate investment choices is a recipe for a meat loaf made with SPAM. Not particularly appetizing.

It is critical to recognize that you are not likely to remain emotionally unaffected by your investments. Granting your portfolio leeway (either consciously or subconsciously)? Sure, you can do that. Still, leeway can turn into discomfort and then into outright agony.


Keep in mind, most things in life can be plotted along a spectrum. Our emotions are no different. Normally, you operate well within a generally acceptable range (or well within the “green,” as we like to say). Thus, we are capable of coping with life’s experiences. If, however, something pushes a person outside of a comfort zone, the experience causes a response to subdue the emotional impulse. Our mind forces us to do something to take us from the “red” or the “violet” back to the middle – back to the “green.”

When it comes to investing, these are the circumstances which can lead to extremely ill-advised moves. Sidestepping these circumstances is critical so that our emotions are kept in balance. If an investment strategy fails to take into consideration an investor’s need to stay within an emotionally beneficial range, the likelihood of making an ill-conceived decision rises dramatically.

Rather than relying on our gut instinct, which may or may not get it right, we prefer unemotional, mechanical guidance. The mechanical signals serve as a foundational backdrop for our active approach to asset management. The information-driven, non-emotional indications promote emotional stability by limiting exposure to harsh downtrends. Equally compelling, the same indicators also facilitate greater participation in uptrends.

For instance, we may put together an investment plan based on a generally accepted asset mix for a target allocation. For this example, let’s say that a retiree requires 50% in growth (via stocks) and 50% in fixed income (via bonds). We start there… using the target during favorable investing environments. Here is where we buy “good stuff” and hold the “good stuff” for as long as it remains “good stuff.”

That last sentence is key. Specifically, we understand that a day will come when a particular asset or a number of assets will cease being “good stuff” for a portfolio. Things change. They may change quickly. They may change over a long period of time. But they change.

Regardless, we have an unemotional, tactical plan in place to account for the dynamic environment. After all, when you employ an approach that recognizes the certainty of change, you can avoid the emotional roller coaster that threatens your financial freedom.

Static vs. Tactical Asset Allocation

My wife is a “reality show” junky. Our digital video recorder (DVR) is jam-packed with programs that I can barely tolerate in 15-second advertisements, let alone entire episodes. Although I have explained to my wife that the shows are every bit as scripted as the live-audience sitcoms of yesteryear, she still adores them. So, I make a chivalrous effort to show interest. (What else can I say? Happy wife, happy life.)

As fate would have it, we happened upon a series that we both enjoy. It is a documentary series called Project Greenlight on HBO. If you are unfamiliar with the program, I can tell you that it features an amateur writer/director who just won the chance to direct a feature film. The documentary showcases the trials and tribulations of the individual as he acclimates to a large-scale production. Viewers get a glimpse at the drama, personalities and moving parts involved in the filmmaking industry.

Recently, my wife and I watched an episode that revolved around the film script. The evolution of the script – from concept and rough draft, to rewrites and working drafts – was intriguing. And, being the investment advisor that often ponders the unimaginable, I began thinking…

What if you were approached by a screenwriter who wanted to create a feature film about your financial future? What would that script look like?

Pretend for a moment that Matt Damon or Charlize Theron or [insert your favorite actor/actress here] is playing the lead role. And that lead character is “You.” Depending on your current circumstances, of course, there would be a host of supporting cast members. Your school-aged children, destined for Ivy League educations, might have accompanying parts. Your favorite aunt who has moved to an expensive assisted living facility may require some film time. Additionally, if you had anyone looking over your nest egg, a “Financial Professional” might require quite a few lines.

Consider the excerpt below from the first draft of my imaginary script. It’s common dialog that is often shared between an investor (“You”) and an adviser (“Financial Professional”).

You: I’m getting older. Heck, I’m starting to think about retirement.
Financial Professional: Oh, come on now. 55 is the new 40!
You: I can tolerate some risk, but I do not know if I am as comfortable with so much in stocks as I was when I was 40.
Financial Professional: Well, remember. It’s time in the markets that matters the most. We will slowly lower your allocation to stocks and slowly increase your allocation to bonds as you get up there in years.
You: I also have a grandson now. I would like to put away a little something for his future.
Financial Professional: Congrats! You may have just pushed your retirement back a couple of years, but hey, earmarking a chunk of your portfolio to ensure little Johnny’s future is a nice gesture.
You: I was also thinking that I’ve been paying too much to Uncle Sam.
Financial Professional: Join the club! Let’s move a larger portion of your taxable dollars into municipal bonds to generate some tax-free income.

As I begin developing my imaginary screenplay, I realized that I left out a critical element. What about “Mr. Market?” Doesn’t Mr. Market have something to say about the lead character’s financial future? Is he an antagonist who makes things worse than hell on earth for “You,” the hero? Or is Mr. Market a generous, compassionate soul?

To answer that question, we have the good fortune of consulting with the screenwriter to determine his/her vision. Perhaps it’s a romantic comedy, where a handsome Matt Damon or a gorgeous Charlize Theron (playing the role of “You”) rides off into the sunset without a care in the world, thanks to the generosity of “Mr. Market.” Or maybe it’s a horror flick, where Mr. Market burns down your 3000 square foot McMansion, leaving you to sell keepsakes and family jewelry to pay for a rundown RV that you park on the bad side of town. One way or another, it seems, the final draft will determine whether Mr. Market is heinous or generous.

So what type of movie are we going to create? We don’t know yet. The first excerpt didn’t consider Mr. Market’s role, even though he may be rather vital in the grand picture.

So let’s now add the new character in the rewrite:

You: I’m getting older. Heck, I’m starting to think about retirement.
Financial Professional: Oh, come on now. 55 is the new 40!
You: I can tolerate some risk, but I do not know if I am as comfortable with so much in stocks as I was when I was 40.
Financial Professional: Well, remember. It’s time in the markets that matters the most. We will slowly lower your allocation to stocks and slowly increase your allocation to bonds as you get up there in years.
Mr. Market: And when I move in to sink the bond market with a flurry of interest rate torpedoes near the end of your employed years, what then? Your bond allocation will get killed… along with your hopes of retirement! (Mr. Market laughs maniacally)
Financial Professional: Oh, don’t mind him. We will simply hold steady. Besides, a rising interest rate environment is usually conducive to a strong stock market. Your stock gains should help offset your bond losses.
Mr. Market: (More maniacal laughter)
You: I also have a grandson now. I would like to put away a little something for his future.
Financial Professional: Congrats! You may have just pushed your retirement back a couple of years, but hey, earmarking a chunk of your portfolio to ensure little Johnny’s future is a nice gesture.
Mr. Market: Just wait until I turn into a bear for little Johnny’s sweet sixteen and I fall -50% by his graduation. You better hope little Johnny can throw a football well enough to supplement those higher education costs. Or maybe he will like community college. (Still more barbarous laughter)
Financial Professional: Remember, we are in this for the long term. Besides, the market almost always makes money over long periods of time like 18 years.
Mr. Market: (Even more maniacal laughter)
You: I was also thinking that I’ve been paying too much to Uncle Sam.
Financial Professional: Join the club! Let’s move a larger portion of your taxable dollars into municipal bonds to generate some tax-free income.
Mr. Market: Ever hear of Detroit, Puerto Rico, Greece? Muni bonds are going to be what mortgage-backed securities were back in 2008 and 2009. (Devilish laughter continues)
You: My mom was invested in Senior Income funds in 2008 and 2009 and those things were chock-full of mortgage-backed securities! SHE LOST 80% IN THOSE DAMN FUNDS!
Financial Professional: Again, we are in this for the long haul. Don’t worry about what the market does over the course of a few months. It’s important to stay the course.

In this snippet of dialog, Mr. Market plays a diabolical role. Worse yet, the person you have hired to protect your portfolio has no real solutions for the villainous Mr. Market. If the script receives the go-ahead greenlight with “Financial Professional” performing so poorly, you might as well tell the screenwriter to start from scratch. This script will flop in the opening week.

On the other hand, perhaps this screenplay can receive a happier ending. If you were able to make sure of it, wouldn’t you? Of course you would. I think another rewrite is in order.

You: I’m getting older. Heck, I’m starting to think about retirement.
Financial Professional: Oh, come on now. 55 is the new 40!
You: I can tolerate some risk, but I do not know if I am as comfortable with so much in stocks as I was when I was 40.
Financial Professional: Okay. We can take a look at that. We’re not going to take more risk than you are comfortable with. Also, we do not have to leave every dollar exposed to stock or bond risk at all times. That said, it is possible that you would have more bond exposure as you grow older.
Mr. Market: And when I move in to sink the bond market with a flurry of interest rate torpedoes near the end of your employed years, what then? Your bond allocation will get killed… along with your hopes of retirement! (Mr. Market laughs maniacally)
Financial Professional: We can handle rising rates. I will simply reduce the bond allocation and raise more cash to drastically limit the damage. I may also elect to hedge some of those assets with an investment category that would directly benefit from a rising interest rate environment should the trend continue.
Mr. Market: (Grumbling)
You: I also have a grandson now. I would like to put away a little something for his future.
Financial Professional: Congrats! Earmarking a chunk of your portfolio to ensure Johnny’s future is a venerable goal.
Mr. Market: Just wait until I turn into a bear for little Johnny’s sweet sixteen and I fall -50% by his graduation. You better hope little Johnny can throw a football well enough to supplement those higher education costs. Or maybe he will like community college. (Barbarous laughter)
Financial Professional: Bears of that magnitude do not occur overnight. I will raise cash along the way, using unemotional stop-limit orders, trendlines, and other technical tools to ensure that the portfolio avoids a big loss and remains on target.
Mr. Market: (More grumbling)
You: I was also thinking that I’ve been paying too much to Uncle Sam.
Financial Professional: Join the club! Let’s move a larger portion of your taxable dollars into municipal bonds to generate some tax-free income.
Mr. Market: Ever hear of Detroit, Puerto Rico, Greece? Muni bonds are going to be what mortgage-backed securities were back in 2008 and 2009. (Devilish laughter)
You: My mom was invested in Senior Income funds in 2008 and 2009 and those things were chock-full of mortgage-backed securities! SHE LOST 80% IN THOSE DAMN FUNDS!
Financial Professional: Just like I would do with the rest of the portfolio…I would tactically shift your allocation – raising more cash – to drastically limit the damage.
Mr. Market: (Dead silence)
You: Wow… it really seems like I am in good hands.

This last script seems far more likely to end happily ever after. Although the market retains its villainous role, we now have a financial professional swooping in to save the day. This is in stark contrast to the previous iteration, which had a financial professional who had no solutions for the market’s madness.

Ironically, in real life, the average investor rarely has plans to deviate from a script where the market is playing nice. Most people do not plan for bad times by making tactical shifts; most do not “rewrite” the present ruinous path that they are currently traveling.

The fact is, you need to be able to adjust your investment allocation based on your life circumstances AS WELL AS the market environment. It is your responsibility – or your advisor’s responsibility – to actively mitigate the risks associated with an ever-changing landscape. Your portfolio, much like a screenplay, should evolve over time. That is the quintessential difference between static asset allocation and tactical asset allocation.

NYSE Rule 48 Leaves ETFs Exposed

On Monday, August 24, 2015, the S&P 500 opened the day down 0.3% from where it had closed on the previous Friday. It also happened to be down 6.5% from where it had closed exactly a week earlier. Unfortunately, the true downside story had yet to develop.

Within minutes after the opening bell, the S&P 500 index dropped nearly 100 points (and the Dow dropped more than 1,000 points), down 5% to session lows. Scores of so-called trading circuit breakers were tripped, halting many stocks in their tracks. The occurrence was wholly attributable to above normal volatility which, in turn, caused the New York Stock Exchange (NYSE) Rule 48 to go into effect.

NYSE Rule 48 is a little-used regulation that went into place in 2007 following its approval by the Securities and Exchange Commission (SEC). In a nutshell, it had been designed to pre-empt panicky traders from panicking. It was intended to ensure orderly trading amid extreme financial market volatility.

Up until that Monday in August, the rule had only been used about 70 times, with nearly half of those occurring during the financial crisis in 2008. And although all of those previous occurrences were rather uneventful for exchange traded funds (ETFs), this time was different.

The problem stemmed from the fact that stock ETFs represent a basket of underlying holdings. And when one of those stocks within that basket has been halted due to panic-fueled selling, a problem occurs within the ETF as well. You see, an ETF has no circuit breaking mechanism in place to protect it. The ETF still trades in spite of the fact that not all of its underlying stocks are actively pricing.

So how does one arrive at a fair valuation for the ETF when it is unknown what each and every underlying position is currently worth? You can’t really… nor did the scores of investors who were holding those ETFs affected by Rule 48. This fueled the panic to get out of those stock ETFs, driving their prices even lower.

The resulting consequence of the gap in ETF trading protection was alarming. Some very highly liquid ETFs were trading at discounts that were two, three, even four times that of their underlying stocks and/or tracking index. For example, iShares Core S&P 500 (IVV), an ETF that tracks the S&P 500 and has an average daily volume of nearly 5 million shares ($1 billion traded daily), was down 22% intraday on 8/24/2015. For those investors who sold into the panic, or had stop-loss orders on those affected ETFs like IVV, were harshly penalized for doing so.

Did August 24, 2015 teach us something we didn’t already know? Sort of… but it wasn’t a situation that we hadn’t already prepared for.

Yes, we were surprised to see highly liquid ETFs trading at drastic discounts that are more analogous to the wide bid/ask spreads of thinly traded investments. Nevertheless, we already had safeguards in place to protect our clients from those types of rare market events.

First, just as we do not focus a large percentage of our portfolio on one specific investment, we do not focus 100% of our portfolio on ETFs alone. We diversify our market access for the same reasons we diversify our investments across multiple asset classes. And what I mean by “market access” is that we often utilize multiple types of investment tools to gain exposure to a specific asset or asset class. We use individual securities, like individual stocks and bonds. We also use diversified investments, like closed-end funds (CEFs), mutual funds, and exchange traded funds and notes (ETFs/ETNs). This approach allows us to diversify our portfolio in more ways than one. Thus, the diversification of market access reduces the risk of holding one classification alone.

Second, we never use market orders when trading those investment tools that price throughout the day – which include individual stocks, ETFs/ETNs & CEFs. This protects us from the threat of our orders getting filled at the wrong end of an extreme trading range, where buy orders execute near intraday highs and sell orders execute near intraday lows. After all, placing a stop order on a position simply changes the stop order to a market order (which gets executed at the quickest available bid price) once the underlying investment breaches that “stop” price on the order ticket.

For example, those investors holding IVV may have had a stop order on the books at 185. On 8/24/2015, IVV opened at 188.51 and then quickly blew through 185 on the way down to intraday lows of 147.21. Once the stop price of 185 is breached, that same order becomes a market order which, again, is filled at the next quickest available bid price. Quite simply, that means the order could very well have been filled at a price as low as 147.21 – more than 20% below the stop order price. This scenario is even more tragic considering the fact that IVV eventually recovered all of its losses and closed up on the day, ending the trading session at 190.52.

Instead, using stop-limit orders is more advisable. For example, that same investor could have placed a stop-limit order at 185. Once that 185 stop level had been breached, the order becomes a limit order which can only execute at or above the limit price of 185. All of that intraday noise from 185 to 147.21 could have been avoided had a stop-limit order been in place instead of a stop or market order.

Lastly, we also stagger our orders such that we are not executing 100% of a particular buy or sell all at once. By staggering, or “time slicing” our orders, we can further reduce the risk of executing at the wrong end of an extreme intraday range. This can sometimes lead to trades executing over the average price span of multiple days instead of just one. It can also mean a better overall average execution price since calmer heads usually prevail following a panicky event.

For example, in the previously mentioned stop order example, I explained how an investor could’ve received an execution price of 147.21 even though he or she had a stop on the books at 185. Had that same investor simply stretched the trade out over the course of the trading session, he or she could’ve taken advantage of an execution closer to the average intraday price of 172. That’s almost 17% better than the single order at the day’s lows. Stretch the order over the course of two days and the average price gets better by an additional 6%. That’s an average execution price that is 24% better within a 24 hour period… simply by staggering the sell order.

In sum, there are no perfect investments just like there are no perfect investment strategies. And, as is the case with pretty much everything in life, you must find an appropriate balance between a give and a take, a weaknesses and a strength. The goal as an investor is to find what’s appropriate given your needs and desires, while also taking into consideration the ever-changing risk-reward landscape.

Although NYSE Rule 48 did expose a chink in the armor of some ETFs, one can already anticipate that the exchanges are working to identify a better solution. Even without that solution, though, there are multiple ways to mitigate the risk of ETF ownership within your portfolio. And you can be sure that mitigating the risk of a “flash crash” is better than eschewing ETFs altogether. Few investment structures offer as many benefits, from diversification to trade-ability to tax efficiency to ultra-low costs.