|The purpose of this quarterly report is to help guide our current and prospective clients specifically regarding the design, methodology, and process behind our investment strategies. We also work to offer a higher level of transparency into our investment strategies by showing unique perspectives on returns and risk profiles. Subjectively, this is a self-effacing report openly critical of areas in which we still need work and similarly patting ourselves on the back when appropriate. While we are proud of our historical returns, future returns are what really matters. We believe that investment success the direct result of excellent design, solid execution and regular self-critical evaluation. That’s what this report is all about.|
Relative Returns...To A Degree
I’m finishing up Dan Areily’s latest book called “Predictably Irrational” – The Hidden Forces That Shape Our Decisions. It is fascinating and I’ve highlighted practically every page. Dr. Areily is one of those special people with two brains, one with a Ph.D. in cognitive psychology and another with a Ph.D. in business administration. He is a professor of Psychology and Behavioral Economics at Duke University. The very first chapter is called “The Truth About Relativity” in which he offers several anecdotes regarding our flawed (irrational) choices using only the basis of comparison. The chapter confirmed what we might instinctually know applying this principle to our investing behavior for better or for worse.
Human nature is such that we have a constant need to compare. Dr. Areily states, “ most people don’t know what they want unless they see it in context”. We all compare everything in our lives to something outside of our lives, every day. How fit are we compared to our friends and family? How old or young do we look compared to our peers? How wealthy are we comparatively? What kind of car does my business partner drive? Do I live in a nicer house or neighborhood than you? Where do you vacation? Is this wine better than that wine? Comparisons typically come from personal observations and unfortunately, the media (false realities).
Rarely, do we rely on any sense of internal standards without having derived those standards from some early imprint, usually a parent’s values. Most of us are psychologically uncomfortable with any choice that stands alone or is offered to us in absolute terms because we don’t trust it. Take the new Apple watch, which is generally not selling as well as expected. Why? Well one could argue that it’s a stupid and unnecessary gadget (my opinion). Dr. Areily would argue that the new Apple watch really has no peers in terms of stated functionality, has nothing to compare to and thus, our simply human brains don’t trust the price tag of $399. Is that a good deal? Who knows when we have no other peer in the space. Apple has the added advantage of potentially setting the standard in pricing as the first to market. This is called the Anchor Price. But will that prove to be a “relatively” reasonable price? We simply won’t know until there is a viable competitor for that product. Consumers will continue to hold off until they have something to compare to. Now let’s bring this knowledge back to the investing world.
If you think about our primary human decision making process as derived from comparisons, you can easily see why it’s so easy for us to accept an investment approach that is based on indexing and benchmarking. John Bogle, the founder of the Vanguard funds, probably understood our human need for “relativity” more than investments. We grasp for easy to understand, objective comparisons to help guide us through important decisions and what better way than to lean on widely accepted market benchmarks. For instance, a typical question might be - How am I doing compared to the market? But we never ask questions like - How is my net worth compared to where I should be (want to be) at this stage of my life? Or more importantly, we might ask- Am I still recovering from losses from years ago, or making new highs? The answer to these would require some digging among difficult to find comparisons. As long as our money is doing relatively well compared to the market, we should feel some sense of success… we are told.
But like all things in life, seeking relative returns cannot be a pure objective in all situations, especially at extremes. If I saw a guy living on the street in a cardboard box, I would not feel good living in a slightly better cardboard box. Why then does Morningstar give a fund a 5 star rating to a fund that lost ONLY -46% compared to the stock market that lost -48% (2008 bear market)? Because that fund did relatively well so it gets five shiny stars and yet our wealth could be decimated! The world of relative index based investment objectives wants you to accept that outcome as a success. That’s absurd even for an individual position in your portfolio.
Now we need to set some expectations for the future. In the current market environment, there is a growing risk of both a protracted bear market in stocks and a new increased risk of a global economic recession as of September. At this stage of the cycle, we need to know and respect the reality that bear markets are to be avoided as they have a historical precedent of erasing 2/3 of the previous bull market cycle gains (Investech Research). Is the bull market over? No one can say with confidence yet but there are some cracks in the foundation. At the same time, we see evidence that we could still see another very strong thrust higher like one of those last gasp bull market runs in the late 90’s. Either way, the market is operating at a higher risk level than any time in the last five years and we may be angling toward some unappealing extremes. We should all be factoring this into our interest and pursuit of relative returns.
Seeking relative returns is a solid investment objective but not without some restraint. Our Explicit Investing Creed clearly defines Success as generating relative (Asymmetric) returns compared to our benchmarks. But we also add in the additional objective of limiting exposure to real “Risk” defined as an unrecoverable or semi-permanent loss of capital. In fact, all of our investment strategies are described in terms of their relative risk (Annualized Standard Deviation) and return (Compound Rate of Return) metrics. Here’s an example of that relative return comparison for our 15 year old Worldwide Sectors stock strategy. Remember the last 15 years included two bear markets of 50% each! The green dot represents our Worldwide strategy and the dark grey dot represents our easy to comprehend, comparative stock benchmark, the Dow Jones Global Stock Index. Worldwide has historically produced superior returns and lower “risk” compared to the benchmark.
Worldwide Sectors Stock Strategy
Our High Dividend Global Stock strategy has a similar looking plot relative to the same benchmark but with a shorter history. High Dividend continues to be our fastest growing program in Assets Under Management as well as one of our best performers on a 3 year basis.
High Dividend Global Stock strategy
Our long standing All Season flagship strategy looks similar with an additional benchmark of the Barclays Aggregate Bond index shown in light grey.
All Season Blended Asset Strategy
And one more example. Below is our New Power Stock Strategy also designed to produce strong relative returns compared to its benchmark, the Powershares Clean Energy ETF (PBW).
Here’s a look at the same New Power strategy graphically. The five year average annual returns net of all fees through today (10/12/15) have been +8.44% versus the benchmark which is showing an average annual loss of – 12.45%. This is an example of a relative return at its very best.
In all cases, our relative returns compared to our benchmarks are strong (moving to the upper left corner of the charts). So here’s the summary statement. Seeking relative returns as an investment objective is fine and consistent with our human need to compare. However, as in life, relativity cannot be held as the only standard for decision making especially when considering the potential for extremes. Every investment strategy must have the ability to unhook from the relative return objective when the risk of permanent unrecoverable capital loss increases. This is one of the primary value propositions inherent to our firm’s investment objectives across all strategies.
That’s it for this quarter’s Change of Seasons Report.
Please stay tuned to our regular Red Sky Report for a more detailed review of short term market conditions.