Managing your money without a well-defined risk control system is a bit like Thanksgiving dinner without any of the trimmings. While the markets are exploding out to new highs again in near vertical fashion and investors again seem scared of nothing, it’s a great time to monitor the status of our various risk controls.
Performance Objectives versus Beating the Market
Last week, I spoke of the ills associated with trying to beat the market, or the S&P 500 index as so many have accepted as a proxy. Beating the market should never be your goal as an investor and I don’t say that defensively. The market is a fully invested, 100% stock only index in most people’s minds. Is that your allocation? Do you aspire only to outperform a 100% invested stock only index? Can you handle that type of risk when it goes down 2%/ week? Or losses 50% - twice since year 2000? Evidence suggests no one can because they all sell at the lows of every correction or the lows of every bear market. They all think they will know when to sell out at the highs, but they don’t and they never do. Investors need to become more mature frankly and begin thinking and acting on goals of performance objectives. Personally, I am trying to hit 8% average annual returns on my entire investment portfolio net of fees. My judgment period is generally a 5-7 year time frame on a rolling basis. What’s your performance objective for your age, your asset level, your income and your capital requirements either before or after retirement? Do you know? We have gone through this process with most of our wealth management clients and they know what they need to make, what their objectives are and we work hard to help them meet THOSE objectives. Now beating the market becomes something less important and we don’t fret about it.
It sounds easier than it is to just dial a return however. We often don’t have the environment in place to make money and sometimes our best value is simply not losing money. To hit a performance objective over time, we need consistency of returns and we accomplish this through our dynamic asset management style. Earning respectable returns with lower downside risk and volatility gives us the confidence to do things like buy low (because we aren’t screaming in panic) and sell high (because we don’t care if we beat the market every day or every week). But successful execution of such a system does not come from methods like passive indexing. Quite the opposite. It involves making adjustments regularly if necessary, to three critical dials. These are the trimmings of our system that keep us focused on hitting our performance objectives for our clients.
Trimming #1 – Net Exposure
Historically, we haven’t talked much about our investment process. Most don’t really want to know how the sausage is made right? But in recent months, I’ve found our new clients want to see it, all of it. Confidence in management skill and the ability to produce consistent returns in the future is really about having a well-defined, well-disciplined system. We do have the past returns based on real accounts (nothing hypothetical) to show with pride but they will always be past returns. Maybe we got lucky…. for the last 15 years. So let’s talk about our process starting with our first decision point – Net Exposure. The analysis here focuses on slow moving stuff measured on monthly and quarterly basis. We look at the primary trend of various asset classes. Is it going up (the stock market), going down (commodities) or going nowhere (the bond market). We look at valuations using market cap to GDP ratios. We look at things called the Tobin Q and historical 12-month P/E ratios for the S&P 500. We look at long range technical data like market breadth, summation indices, consumer sentiment, volume and leadership for confirmation of trend. We also look at the economic and fundamental environment including monetary policy, earnings and revenue growth. We also spend nearly $100,000/ year on expensive research from smart, lifetime investment shops that do an excellent job of summarizing lots of this data and helping us make critical decisions.
All of this goes into the hopper and we make monthly decisions as to how much investment capital we want exposed to the market and which asset classes we want to emphasize. Today, we have very little reason to be in bonds, commodities, internationals or cash. We have lots and lots of reasons to be almost fully invested in domestic stock and equities. With that said, valuations are becoming less attractive as we have clearly moved to the upper end of the historic spectrum. That means that our next significant moves will be defensive and our expectations for future returns from these levels are going to be muted. When we get our next deep stock market correction, then our opportunities will expand again. Net exposure is perhaps the most important dial any investor can touch and we only do so when we need to.
Trimming #2 – Selection
Once we decide how much exposure to have and which asset classes we’ll own, then we get selective. This is the faster moving stuff. Cash is always an option in this selection process and we measure relative strength of various sectors (financials, technology, healthcare), styles (Value or growth) and size (small caps, or large caps) on a rolling 30-day window. Doing so leads us into the leadership groups on all fronts and out of those things that are lagging. Believe it or not there is far more consistency here than you might think. Healthcare, biotech and pharma have been leading sectors for almost two years and these have been among our holdings for as long. Small caps have been out of favor for almost a full year but now they are surging again and possibly regaining leadership. We are taking early positions in small caps now after avoiding them for most of 2014. Energy has been in the dog house along with gold and silver for quite a while. They are trying to find a bottom but it’s still too early to jump in yet. You get the idea. Now let’s say that the market puts in a top today and the Dow opens down 200 points tomorrow and then loses another 2-3% over the next couple weeks. Cash, or money markets, would bubble to the top of our daily ranking in our selection system telling us to… buy cash (aka sell something). You can guess where cash is in the ranking now I bet. It’s right above energy, gold and silver
Trimming #3 – Position Sizing
Just like Thanksgiving dinner, we are always a bit conscious of our portion sizes – I hope. I’m a sucker of stuffing and garlic mash potatoes so I give those a bigger position size on my plate. When all things agree like the right sector in the right time of the business cycle and the right valuations with an attractive price pattern, we might find ourselves looking at this security or sector with a great deal of conviction. Healthcare and Pharma are great examples on all fronts except valuations, which are quite high now after recent years of out-performance. These sectors have the largest position sizes in our stock strategies. Berkshire Hathaway is up 24% this year and is the largest position in the All Season strategy. Some day BRKB will top out and start under-performing. We will first cut the position size down and then ultimately replace it entirely. I like position sizing as a tool to fine tune a strategy dialing into those things that have great odds of making money and dialing down those things that aren't quite as appealing. Putting it all on Garlic mashers might not be a great idea right?
And always have a safety net…
Beyond all three trimmings, we also put sell criteria on every position we own. It might be a moving average or a last low in price. It might be a certain spread to treasuries in the case of our income strategies or a momentum indicator for a fast moving speculative stock. When the sell criteria are hit, if we don’t trim a position away first, then the position is sold to cash and we find something else to own. The safety net is not at the portfolio level but assessed against each position every day.
Now, when we say we work hard at what we do, you get the idea. We work constantly with all of our trimmings to ensure that our client’s are hitting reasonable performance objectives over time. If we happen to beat the market over time, good for all of us.
Now I’m hungry – Have a safe and happy Thanksgiving surrounded by friends, family and smiling faces.