Here’s How to Get Better Investment Returns April 02, 2017
“Greedy, short-term orientated investors may lose sight of a sound mathematical reason for avoiding loss; the effects of compounding on even moderate returns over years are compelling, if not downright mind boggling.” Seth Klarman (17% annualized returns over more than 30 years)
Today I thought I’d take a break from Markets-in-Minutes and talk a little about loss management. There’s an old phrase that a bull market makes everyone a genius. And to some extent it’s true. It seems almost hard to lose money in a bull market, which is why so many investors get hurt so badly when the bear drives the bull out.
As a professional manager, I’ve been fired a couple times for not keeping up with the market in a given year. Investors that chase the market, and there are many of them, are failing to confront the mathematical reality of investing – it’s more important to protect capital than it is to maximize returns.
Here is a simple illustration.
The chart below tracks 2 investors in the S&P 500 since January 2000.
The red line is the result of an investor buying the S&P 500 and doing nothing but hold it through December 2016. In between were 2 gut wrenching recessionary bear markets, and years and years spent waiting for the account to make it back to break even. “Red” believes if you want ride the rallies you gotta endure the valleys. It’s a neat phrase he heard from his financial advisor.
The green line is an investor that buys the S&P 500, but whenever there is a recession this investor takes the simple precaution of reducing risk by 50%. When the recession goes away, the investor simply takes the cash set aside and buys back into the market. He’s isn’t worried about the gains – his eye is on the losses.
This investor misses the top and the bottom, but his initial investment isn’t any different than Red’s, nor are his initial gains. But in investing, as in football, it’s defense that wins championships.
Let’s compare the two:
Dotcom Crash Loss (initial investment to valley): -41.5%
Time to get back to initial investment: 5 years.
Time account stayed positive between recovery and next crash: 14 months.
Great Recession Loss (initial investment to valley): -47.3%
Time to get back to initial Jan 2000 investment 5 years.
Total gain after 1st 12 years (Aug 2012): 0.9%
Total gain for 16 years (Dec 2016): +60.6%
Dotcom Crash Loss (initial investment to valley): -23.8%
Time to get back to initial investment: 23 months
Time account stayed positive prior to next crash: 5 years
Great Recession Loss (initial investment to valley): -6.4%
Time to get back to initial Jan 2000 investment: 5 months
Total gain for 1st 12 years (Aug 2012): 44%
Total gain for 1st 16 years (Dec 2016): +229.2%
What happens if you play defense every month instead of just when a recession hits?
Below is the BXM Index (Green) vs. the S&P 500 Index (Blue) since 1989. The BXM is always partially hedged, meaning that it trades part of the potential upside gain each month to get some downside protection.
From 1989 to 2016 the BXM Index returned +1058.7% vs. the S&P 500 Index at 731.9%, and held gains far better during crashes.
Again, clearly its defense that wins championships.
What if you combined a BXM derived strategy with a recession risk reduction strategy?
If you are a current ACI investor, you are in luck. This is exactly what ACI’s Market Income portfolio does.
If you are not a current ACI investor and would like to learn more about how a solid defense might help you do better with your investments, you are also in luck. Just send an email to firstname.lastname@example.org that includes your first and last name, the city and state you live in, and “subscribe” in the subject line. Include your questions.
We’ll add you to the weekly updates newsletter, reserve 2 slots for you our online educational event “Winning on Wall Street in the New NOT Normal,” and answer whatever questions you have.
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ACI Wealth Advisors, LLC.
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And now for our bonus disclosures. Everyone thank the lawyers in DC. Neither the S&P 500 Index nor the BXM Index can be invested in directly. Past performance does not guarantee future results. The illustration assumes that the portfolio moved to 50% cash when the US moved into recession in 2000 and 2008. This assumption is based on hindsight and assumes that the investment manager both reduced investment as a result of the US entering recession and that the data used to determine the state of the US economy accurately signaled that the US had entered recession. The indicator used to determine the signal in the illustration is the Recession Probability Indicator developed by Stock Market Strategist Dak Hartsock. For additional information on the Recession Probability Indicator please visit: http://www.dakhartsock.com/monthly-features/recession-probability-indicator/
While the RPI has proved to be very accurate in the past, there is no guarantee it will prove to be correct in identifying recession in the future. There are inherent limitations in hypothetical or model results as the securities are not actually purchased or sold. They may not reflect the impact, if any, of material market conditions which could have has an impact on the manager’s decision making if the hypothetical portfolios were real. Historical performance does not take into account either transaction or management fees and is shown for illustrative purposes only – no illustrations contained in this article should be interpreted as an indication of performance of any ACI portfolio.The Chicago Board of Exchange S&P 500 Buy/Write Index or “BXM” has historically displayed less volatility than the S&P 500 and Market Income. There are no guarantees it will continue to do so in the future.