JP Morgan becomes the latest Wall Street bank to offer empirical evidence of my belief: Conventional wisdom has risk wrong: how it's defined, measured, and managed.
Below are links to the story, but none of it is useful without understanding the issue.
JP Morgan's $2 Billion Blunder - Wall Street Journal
JP Morgan Reveals Significant Trading Loss; Shares Plummet -Fox Business
J.P. Morgan's losses reveal market chaos - MarketWatch
In addition to bullish investor sentiment, another counter-trend warning indicator has recently achieved a level that normally precedes a trend reversal. The Bullish Percent Indexes such as the NYSE Bullish Percent are at historically high levels. I'm not suggesting a reversal will occur tomorrow, but instead that we wouldn't be surprised if it does.
Source: Stockcharts.com / Shell Capital Management, LLC
The NYSE Bullish Percent is a breadth indicator derived from the percentage of stocks on Point & Figure buy signals. It may be used as a counter-trend warning signal. After 70% or more of the stocks trading on the New York Stock Exchange are already in a positive trend, at some point the demand runs out. The actual signal is when the NYSE Bullish Percent reverses down. That is, when 6% of the NYSE stocks decline enough to a sell signal. It's important to understand that Bullish Percent Indexes are in conflict with trend-following methods. If we aim to follow directional trends, a wide breadth of stocks going up is a good thing. But, it's a better thing when that breadth is rising, not so good when it is peaking, stalling, and reversing. Counter-trend measures may indicate when over-reaction may have occurred at the end of an advancing trend or after a waterfall decline. But it's important to know that advances and declines can go much farther than you think. That, in fact, is a key concept in asymmetric distribution profiles that include gains and losses beyond a 'normal' bell curve. To learn more about the Bullish Percent Indexes click: NYSE Bullish Percent.
A hat tip to Steve G. for pointing out a great quote from Bill Miller that supports my point in What we can learn from Bill Miller and the Legg Mason Value Trust. Jason Zweig wrote in the the Wall Street Journal the following in his Intelligent Investor article The Long Climb and Steep Descent of Legg Mason's Top Stock Picker:
Yet Mr. Miller was blindsided by the financial crisis. The more his financial stocks went down, the more shares he bought. Mr. Miller once quipped that the only time he would stop buying more when a stock's price fell was "when we can no longer get a quote."
As I say, everyone has an exit point: you can predefine your exit based on a logical method, tap out at your uncle point when you can't take any more pain, or ride it to zero. Each of those have very different levels of risk and all of them are your choice in advance. If you hold it to the point you can no longer get a quote, that becomes costly when you get too many of them at once...
Asset allocators use the so-called Modern Portfolio Theory in attempt to measure risk. But linear equations like standard deviation try to simplify the data to the point it grossly fails to capture the true potential for loss. Equations like standard deviation, in fact, aren't very useful in understanding market data. A good way to understand the problem is the flaw of averages: a 7 foot tall guy can drown in a pond that averages only 3 feet deep. If you don't consider the maximum drawdown (historical decline), in this case the maximum depth, you will greatly underestimate the risk.
Source: http://www.flawofaverages.com/
Market trends move far higher and lower from its average to fit nicely into a bell shaped curve. The bell curve for market data is asymmetric, not a picture of symmetry. It’s people who use such an equation that have outlier losses that are much larger than they expected.
The conventional wisdom of stock picking is the “value investing” methods popularized by Ben Graham in his first edition of Security Analysis in 1934. Ben Graham actually argued against measures of risk based upon past prices (such as volatility), saying that price declines can be temporary and not reflective of a company’s true value. He argued that risk comes from paying too high a price for a security, relative to its value and that investors should maintain a “margin of safety” by buying securities for less than the true worth.
I completely disagree with this part of the Graham “margin of safety”. His margin of safety assumes that you can actually buy securities for less than they are worth. In other words, you need to know that in advance and others don’t. It assumes the outcome is determined by the point of entry. I believe just the opposite. I believe the outcome is controlled by the exit – we don’t know the outcome in advance, so the results are determined by what point you sell. Graham’s “margin of safety” assumes you are right to begin with. so your risk management is achieved from paying a price so much lower than true value that you have room (a margin for error). That may have been more possible prior to 1934. Anyone who believes they are so right at the point of entry because they are paying such a low price, then, certainly won’t exit the position if it goes a lot lower. If you have no predefined exit on the way down to protect against large losses, I guess your exit is $0, and your risk is "all of it".
That’s what’s happened in nearly every major blowup in history. If you walk into a pond that is an average of 3 feet deep and you start walking faster as it gets deeper and deeper, you are increasing the chance you may drown. Starting out deeper in the water isn't going to change that.
Long Term Capital Management, one of the biggest blowups in history, assumed the markets they traded wouldn’t trend agsinst them any further, so they kept betting against the trend buying lower and lower until they couldn’t anymore. With a few Nobel Prize winning PhD’s on staff, they certainly believed they were right and got caught tight in the loss trap. They lost billions.
In 2008 the Wall Street Journal printed The Stock Picker's Defeat about Bill Miller. Bill Miller’s Legg Mason Value fund has been criticized much since it’s large losses during the 2008-2009 period. Miller buys stocks he considers to be undervalued. That very worked well for about 15 years, but they learned how risky buying declining stocks can be. He was simply following his objective. It said nothing about any aim to manageme risk or capital preservation. If you keep buying what is falling, betting against the trend, you have to realize the fact that you are probably risking it all. A value investor believes a lower price is simply a higher “margin of safety” and that probably works until it doesn’t. When it doesn’t, you may be whipped out.
A more recent fund example is Bruce Berkowitz and his Fairholme Fund. A few weeks ago CNN Money wrote "Fairholme Fund loses half its value and its co-manager". It's another "value" fund that buys declining stocks hoping they go back up. They may turn out to be right, but in the meantime their losses are apparently too large for their investors. According to the article, they manage billions but billions have been withdrawn from the fund in addition to the capital loss.
Conventional wisdom seems to believe that "buying low, selling high" is some form of risk management. So, when some people hear something that sounds just the opposite, like my recent interview in Investor's Business Daily, they perceive it as more risky. Yet, it's just the opposite. Buying things that are rising and selling when they decline is a tactic of managing exposure to loss that is absolute. Defining risk as the difference between the price today and the price we'll exit if to goes down is an absolute form of risk management.
Another recent example is John Paulson, a hedge fund manager who become famous for profiting during the 2008 period crisis by betting that the strong housing market trend would reverse. It did... that time. Reuters recently wrote "Big losses for John Paulson". He apparently bet too big against the trend this time and took on huge losses. In this case, reportedly even he is losing sleep over the losses, according to "Losses mean sleepless nights for John Paulson". You can probably see how the more you believe you are right, the more that loss trap is likely to keep you awake at night. When your ego is tied to your opinions, it's hard to let it go and cut loose from the trap.
I was reminded of these things today when I read this in IBD about MF Global.
The brokerage bought up bonds of Italy, Portugal, Spain and Ireland last year, betting they would have bounced back by now. But the euro-zone debt crisis continued to fester, and MF Global started running out of cash.
The bold highlight is mine. You can probably see how conventional wisdom is the very tactics that lead to such blow-ups. Efficient Market Theorist point to such managers as examples of the problem with "active management", but it's really only an example of the problem of the most common approaches - the kind that get risk wrong.
I believe many people are emotional and they oscillate between the fear of losing money and the fear of missing out. After a series of big down days, they fear losing money if they're exposed. After a series of up days they fear missing out if they aren't fully exposed.
For example, a passive asset allocator is fully exposed all the time. So, passive asset allocators may be more likely to experience the fear of losing money after markets decline. That is, they fear losing more money after losses mount because their exposure to the possibility of loss is static, yet the magnitude of the possible loss is large. It seems a fixed allocation policy may have a difficult time with uncertainty because they depend on the direction of markets to create their results. I guess they may spend more time reading and watching the news trying to figure out what's going to happen next since what does happen next is what determines their outcome. However, they probably don't fear missing out as much. If you're fully exposed, you don't have to worry about missing out. So, it could be those who fear missing out (the up days) who are more attracted to a passive asset allocation strategy. While asset allocators risk losing a lot of their money, they don't miss any good (or bad) days. They get to experience it all. You may notice they say "we" in reference to the market. Instead of the market was up today, they say "we" were up today. Allocators like being "the market". That may work for them if they don't have that fear of losing money, or losing more money after they've already lost it.
Others prefer to rotate their exposure, but no one said it's easy. If they buy now, what if they're wrong? They risk entering just in time for the next leg down. If they don't enter, they may fear missing out. These emotions are especially present if their ego (sense of self worth) is closely tied to beating some index or benchmark. If their goals are instead their own, like "making as much money as I can without taking more risk than I can afford or handle" they may not feel the pain from the fear.
Like any kind of management, active risk management is a skill. Just as there are better managers of a football team, there are more or less skilled managers at most anything. Those who did exit early in the stage of falling prices and were able to avoid some of the recent declines now have to reenter. When prices are rising, those who don't really have a robust system start to fear missing out. Their system is their fear. Many people probably have more of a disposition between the fear of losing money or the fear of missing out. That is, I believe most people have the tendency to lean one way more than another. Those who mostly fear losing a lot of money may appreciate the potential of active risk management. Those who primarily fear missing out may be more likely a gunslinger who stays fully exposed.
Yet, some people may oscillate between the fear of losing money and the fear of missing out on a daily basis depending on what the market did that day. For them, they are in a constant state of fear due to the lack of control they have on the outcome and their feelings.
In my experience, wealthier people are more geared toward capital preservation than those who feel they need to take more risk to get ahead. Investor behavior is always what creates the outcome. In reality, avoiding large losses is the key. If you lose -30%, you need +43% to get it back. If you underestimate that fact and then panic after a large loss it will take a long time to get it back in a 1% savings account. Large losses are exponential; they compound against you. It's that power law that holds the key to good long term investment results. Beyond knowing the math, it's investor behavior that creates their results. To learn more, read Asymmetric and Exponential Nature of Losses
Trying to figure out what's going to happen next and oscillating between the fear of missing out and the fear of losing money seems like a tough way to go about it.
I have to admit: I probably have other life experiences that better prepared me to embrace uncertainty and fear more than others. I may not fear the unknown like others seem to, or have a strong desire to predict it right. I enjoy watching the movie unfold rather that trying to predict how it will. My sense of self worth is never tied to the outcome. Since I don't have those expectations and my results aren't defined by them, I don't have anything to fear.
I reader asked why I hadn't commented more during this "uncertain time". That's fair enough, and I like answering questions. Others have asked if I "watch it closely" when volatility rises.
My first objective is managing the portfolio. I believe every new moment is unique as it has never happened before, so it is always uncertain. Time evolves, it never goes back to where it was. I fully embrace that reality. In fact, it seems to be a source of my happiness. A good movie is spoiled if you already know the outcome. It can be a disappointment if you believe you do and are proven wrong. When others are excited and worried, I don't "watch it closely" any more than any other time. I am always aware of changes. I already know what I'll do next, so I don't need to worry about what may happen next. I already knew at what point I would quickly exit any positions I have that are falling to manage risk. I also know at what point I will re-enter them if they reverse back up. For me, volatile market conditions are both expected and normal. It neither affects my day nor how I feel. I just go with the flow knowing every new day will be unique and I like that about life.
If we are to do something worthwhile, we necessarily have to do it before, during, and early in the stage, not after the fact. Those who have read along my short missives the past several weeks may have picked up on the overall theme- active risk management. Specifically, that active risk management is something we do all the time, not just some of the time. I don't time active risk management- it's what I do. Active risk management is the predetermination of risk. It's something I do daily. I have a predefined risk level every day. It's an amount of decline we are willing to accept as we pursue a profit.
If you read the comments leading up to the recent decline of nearly 20% in the stock market, you may notice a theme.
June 02, 2011: The essence of investment management is the management of risks when I discussed that quote by Benjamin Graham and added some of my own thoughts.
June 08, 2011: What's going to happen next: Huge Losses? When I commented on some bearishly alarming newsletters being passed around. I suggested “ you know what you'll do if it does, but don't wait around looking for it.”
June 15, 2011: Know at what point you are wrong is quoted Dickson Watts, the author of the 1965 book “Speculation as a Fine Art and Thoughts on Life”. The quote was “Fools try to prove that they are right. Wise men try to find when they are wrong.”
On that same day, I went on to post Active risk management: don't leave it to chance.
June 28, 2011: High Net Worth Individuals and Hedge Funds I pointed out “Their top priority is preserving capital."´
July 07, 2011: Cash is a severely underappreciated tail risk hedge pointed out that statement as an interesting quote. That is, cash is an "asset class" too.
Later that day in The S&P 500 Stock Index no new high 44.9 months later I pointed out the wide swings in the stock market and my belief that “Clearly, the objective of avoiding such a waterfall event through active risk management may be considered valuable to some.´
July 16, 2011: High Net Worth Investors Want to Preserve Capital and Demand Effective Portfolio Management said “"capital preservation" doesn't mean parking money in low rate fixed income but instead actively managing risk to avoid much of the downside.
July 22, 2011: If you're talented, don't let the market determine your results points out a quote well known hedge fund manager. Not everyone is talented or skilled, but I believe those who are should use it, rather than taking what the market dishes out.
August 01, 2011: Directional price trends and volatility are not random, they cluster together I pointed out how price drifts unfold into price trends. That is, market prices tend to cluster together and evolve into directional price trends. Most of the volatility occurs in a negative trend, when prices are making lower lows and lower highs or trading below moving averages.
If you've read through these, you can probably see how there isn't much more to do when we are prepared. If you would like to get the updates via email, click HERE.
Mark Hubert at CBS MarketWatch wrote an interesting article titled "Using the VIX to spike August returns". He discussed a simple trading system using the CBOE Volatility Index to manage risk in a stock portfolio. Basically, as the volatility index spikes above 20, the system exits stocks to reduce exposure to the possibility of loss. It's not a complete system, but an example of how a scientific method of testing historical data can arrive at useful knowledge that can lead to a complete system.
But, more than the overall theme of the article, it reminded me of an important study of volatility clustering. He said:
..historically, the market’s most volatile days tend to be clustered together rather than occurring randomly. (This crucial finding traces to research conducted by New York University finance professor Robert Engle, for which he won the Nobel Prize in 2003.)
It reminded me of Risk and Volatility: Econometric Models and Financial Practice which is an important paper on volatility and volatility clustering. Rather than random, the market’s most volatile days tend to cluster together in the same time period. Engle won the Nobel Prize for his research. Efficient Market Hypothesis assumed market returns are random. Instead, market returns cluster – prices drift in a direction.
To read the Nobel Prize paper, click HERE.
The S&P 500 Stock Index remains about 13.5% below its prior high on October 9, 2007. Over a 17 month period it declined -56.8% and it has remained below the prior peak for 44.9 months. In addition, the chart shows the magnitude of the swings along the way. Clearly, the objective of avoiding such a waterfall event through active risk management may be considered valuable to some. Take a close look:
The S&P 500 Total Return Index is a broad-based, unmanaged measurement of changes in stock market conditions based on the average of 500 widely held common stocks. One cannot invest directly in an index.
A proper risk management system is an active risk management system that increases and decreases exposure to the possibility of loss. It includes multiple parts. It includes an exit system that gets you out of losers, gets you out of laggards, and takes profits at some point. It’s also a system that monitors and controls how much risk you have at any moment in absolute terms.
For example, if I have 2,000 shares of a $50 security then I have $100,000 in that position. In a $1 million account, that’s a 10% total position. However, if I predefine and control my risk with an exit system that gets me out of a losing position, that exit point may be at $45. Thus, I have $5 at risk, or 2,000 shares x $5 which is $10,000, or 1% of the total portfolio value. If that position grew to $100 a share so my 2,000 shares is now worth $200,000 that position is now 20% of the total portfolio if we assume the rest of the capital hasn’t changed. However, that isn’t my risk. My risk is the distance between the current price and the point I’ll exit if it moves against me. If you haven’t rolled up the exit point as the price has advanced, and the exit remains at $45, then you’re risking $55 a share, or $110,000 which is about 11% of the account value! That is, if you started out predefining your risk at 1% of account value, it’s now grown to 11%. If it reverses back down to where you started you would lose about 11% of your total equity, not the original 1%. A proper risk management system rolls up the exit point by trailing the current price through the course of the position. In addition to trailing the price trend or volatility, it also accounts for the amount of open risk in the position. For example, I may predefine my risk and then limit it to 1%. In that case, the money management system would generate an exit price for this big winner. It’s a price that would only allow us to lose (or risk) 1% of our portfolio value in the position. In this example, the account would now be worth about $1,200,000, so the maximum risk allowed to be open in that position would be $12,000. Since we hold 2,000 shares, that’s a per share risk of about $6, which is only 3%. The position may trade in a range of 3% or more daily as its normal trading range. If so, an exit that tight would be too close and the position wouldn’t be allowed to grow. You can probably see why these systems require algorithms to design a robust method that considers multiple factors at once. And, our risk management systems require computer programs we’ve developed to do the work. I have at least shined some light on the concept, but doing it requires tremendous commitment, resources, and skill and that’s why most people don’t.
Active risk management allows us to increase exposure to potential for profit when conditions are in our favor and decrease exposure to the possibility of loss when prices are falling. A relative return focused, fully invested, passive buy and hold strategy, on the other hand, doesn’t provide such adaptation and flexibility.
Fools try to prove that they are right. Wise men try to find when they are wrong.
Watts, Dickson G. (1965). Speculation as a Fine Art and Thoughts on Life
I just received one of those alarming emails telling me of the coming Collapse of the U.S. Dollar and a stock market crash unlike ever seen before. It's a fine example of charlatan marketers using their knowledge of investor behavior to get our attention. You know, the ones that include statements intended to get us excited, like:
HUGE LOSSES!
It may be true that some people may once again take on heavy losses, should some of the alarming newsletter writers predictions come to pass. It doesn't seem to be working well so far, because the last one of these I got said to buy silver just days before its 30% decline. But, I can tell you I don't worry about things that haven't happened. A wise man once told me that people spend much of their lives worrying about things that don't ever occur. Because they worry, they experience those things over and over, even though it never happened. That is, you experience the things you fear the most over and over again by worrying about it.
Instead, I suggest you know what you'll do if it does, but don't wait around looking for it. For me, I'll just rotate out of those things that are falling into something that isn't. It's what I do. Predefine your risk by knowing at what exact point you'll exit if it's moving against you. Then, don't worry, be happy!
I take the active management of downside risk seriously as evidenced by my investment performance, and I'm telling you: that's exactly how I do it.
The essence of investment management is the management of risks, not the management of returns.
- Benjamin Graham
The problem is that many portoflio managers believe they manage risk through their investment selection. That is, they believe their rotation from one seemingly risky position to another they believe is less risk is a reduction of risk. But, risk is the exposure to the chance of a loss. The exposure is still there. Only the perception has changed: they now think their risk is less.
They don't know in advance if the position they rotate to will actually result in a lower possibility of loss. Prior to 2008, American International Group (AIG) carried the highest rating for an insurance company. What if you rotated to AIG? Or to any of the other banks. Many investors believed those banks were great values as their prices were falling. They just fell more. Just like tech and telecom stocks in 2000.
All risks cannot be hedged away if you pursue a gain. If you leave no chance at all for a potential profit, you earn nothing for that certainty. Risk is exposure to an unknown outcome that could be bad. If there is no exposure or uncertainty, there is no risk. The only way to manage risk is to increase and decrease the exposure to loss. That means buying and selling or hedging. When you hear sometime speaking otherwise, they are not speaking of active risk management. For example, asset allocation and Modern Portfolio Theory is not active risk management. The exposure remains.
It's required to accomplish what the family office Chief Investment Officer said in the post "What a family office looks for in a hedge fund portfolio manager" when he said:
I like analogies. And one of the analogies in 2008 brings to me it’s like a sailor setting his course on a sea. He’s got a great sonar system, he’s got great maps and charts and he’s perhaps got a great GPS so he knows exactly where he is. He knows what's ahead of him in the ocean but his heads down and he’s not seeing these awesomely black storm clouds building up on the horizon are about to come over top of him. Some of those managers we did not stay with. Managers who saw that, who changed course, trimmed their exposure, or sailed to safer territory. One, they survived; they truly preserved capital in difficult times and my benchmark for preserving capital is you had less than a double-digit loss in 08, you get to claim you preserved capital. I've heard people who've lost as much as 25% of investor capital argue that they preserved capital… but I don't believe you can claim that. Understanding how a manager managed and was nimble during a period of time it gives me great comfort, a higher level of comfort, on what a manager may do in the next difficult period. So again it's a it's a very qualitative sort of trying to come to an understanding of what happened… and then make our best guess what we anticipate may happen next time.
I made bold the relevant points.
The topic of selecting an investment manager is an important one. Many investors, including professional financial planners and advisors admit they have little skill at selecting asset managers. In fact, some admit they do such a poor job at it they don't even try. But if you understand the value in alternative investment strategies from private equity to absolute return focused investment programs, then you need to know what to look for in an investment manager. These alternative investment strategies are most often offered privately in a private hedge fund format and sometimes offered as a separate managed account (SMA). Whether you are a private individual investor, an allocator for a family office or institution, or a portfolio manager, the video below is an outstanding example of how a sophisticated investor analyzes a money manager. It’s an interview with the Chief Investment Officer of a family office. He explains why a family who sold a large business may be interested in alternative investments or alternative investment strategies rather than conventional public investments and investment programs like mutual funds. His family office has allocated 80% to alternative investment managers (like hedge funds and the Asymmetry Investment Program™). He offers some insight about:
Click below to view:
On how they select hedge funds: (begins around 4:07/9:57)
We are looking for opportunities with managers were we can get comfortable as to their strategy and what will generate returns for them and what the risks might be? We haven’t been very active with emerging or start-up managers. I think a lot of that has to do with where we are in terms of time.
2008 was an awesome and an awful market experience it's helpful to look at managers who actually were in existence during that period of time to gain some understanding of how they manage their portfolios are the most difficult. Someone doesn't have a 08 track record is much harder to get a sense of how they're going to do a difficult markets. 09 was a pretty easy market to make money if you were long.
How are you evaluating the 2008 period what are you looking at specifically, the drawdown?
We obviously start with performance but I also want to see exposure in the portfolio. How did the manager navigate those markets? Did he keep his portfolio fully invested in a market environment for his strategy was not allowing it to make money was actually causing losses? Did he trim exposure? When did he put exposure back into the market place? is something that we look at it. It's really it's a number of different factors we try and I can understand how the manager managed during that period of time and try to gain some insight on his style. Conviction doesn't automatically mean that you stay fully invested at all times. Although we certainly saw a number of managers who waited FAR too long to trim their exposure. So, it's a combination of all those factors we try and consider. But I would say one of the things that are most important to me is trying to follow a managers gross and net exposures during that period trying to understand. That leads to conversations of what the manager was thinking at the time.
He goes on to say:
I like analogies. And one of the analogies in 2008 brings to me it’s like a sailor setting his course on a sea. He’s got a great sonar system, he’s got great maps and charts and he’s perhaps got a great GPS so he knows exactly where he is. He knows what's ahead of him in the ocean but his heads down and he’s not seeing these awesomely black storm clouds building up on the horizon are about to come over top of him. Some of those managers we did not stay with. Managers who saw that, who changed course, trimmed their exposure, or sailed to safer territory. One, they survived; they truly preserved capital in difficult times and my benchmark for preserving capital is you had less than a double-digit loss in 08, you get to claim you preserved capital. I've heard people who've lost as much is 25% of investor capital argue that they preserved capital… but I don't believe you can claim that. Understanding how a manager managed and was nimble during a period of time it gives me great comfort, a higher level of comfort, on what a manager may do in the next difficult period. So again it's a it's a very qualitative sort of trying to come to an understanding of what happened… and then make our best guess what we anticipate may happen next time.
As a portfolio manager of an alternative investment program I can tell you he's spot on. Those whose jobs are that of the asset allocator, who allocates capital to investment programs, often rely too much on Modern Portfolio Theory statistics and not enough on looking very closely under the hood. As a quantitative trading system developer and operator, we are focusing on far different things and I can tell you: it's the things that matter. It's critical that the investor or allocator take a close look at the downside: how was their drawdown from peak to trough? What were the actual holdings during that time? Like he said: do they stay in the market even when it's not working for them? Or, do they reduce their exposure to the possibility of loss (risk management) by selling positions or dynamic hedging?
I also agree with his comments about experience. After such a radical waterfall occurred in 2008 - 2009, more investors and professionals have now figured out the state of the market. In a secular bear market, such waterfalls occur and it can happen again. After the fact, many investment professionals have scrambled to come up with solutions and naturally they'll be attracted to what actually worked in the past: like some forms of Global Tactical Asset Allocation, Trend Following, and other so-called "alternative" investment strategies like we run. We now have new people interested in active portfolio management that seek an absolute return, rather than a relative return. But like he said: they lack the actual experience. You really don't know how they'll react in the heat of the battle. But you can be assured of this: back-testing a system is one thing, executing is another.
The opposite of active is inactive, or passive. Some people pursue an active approach to earning investment returns. Others pursue a passive approach.
To fully understand the meaning of a word, it can be useful to study it's meaning.
The synonyms for passive are inert, unreceptive, submissive, flaccid. An antonym for passive is proactive.
I relate better to the synonyms for words like tactical: planned, calculated, deliberate, premeditated, considered, intentional. Tactical asset management is the intentional actions that are calculated, planned, and deliberate pursuit of investment objectives.
To decide between active and inactive, it may be useful to explore the words. The following are from Microsoft Word.
Which do you choose?
| Synonyms for Active | Synonyms for inactive | ||
| Lively | Motionless | ||
| Vigorous | Stationary | ||
| Energetic | Unmoving | ||
| Full of life | Immobile | ||
| On the go | Stopped | ||
| Full of zip | Still | ||
| Dynamic | Dormant | ||
| In force | Idle | ||
| Functioning | Out of action | ||
| Effective | Unused | ||
| In action | Inoperative | ||
| Operating | Sedentary | ||
| Operational | Lazy | ||
| Working | Slothful | ||
| Involved | Sluggish | ||
| Committed | Deskbound | ||
Over the weekend I was looking for something in my library when I came across an old book I've had for nearly two decades. In fact, it's been out of print for a while. Ned Davis wrote the book "Being Right or Making Money" in 1991. It's a story about the games people play trying to be right on their opinions rather than doing the things that actually create good results. Ned is the founder of the institutional research firm Ned Davis Research. I pulled it down and read it again. On the first few pages he writes;
Like nearly all novice investors and analysts coming into the investment business, I was convinced back in 1968 that all I had to do was discover the way the investment world worked, develop the best indicators available to forecast changes in the markets, and then have the conviction to shoot straight and gather my profits. And if I say so without much modesty, my record from 1968 to 1978 was so good at forecasting stock prices that during a “Wall $treet Week” broadcast in 1978, Louis Rukeyser said, “Ned Davis has had an outstanding record in recent years…and has been absolutely right about most the major ups and downs.…” The only problem was that at the end of each year, I would total up my capital gains and, unfortunately, I would not owe Uncle Sam much money. Before someone else could question me, I said to myself, “If you are so smart, why aren’t you rich?” It was at about that time (1978–1980) that I began to realize that smarts, hard work, and even a burning desire to “be right” were really not my problem, nor the solution to my problem. What I realized was that my real problems were a failure to cut losses short, an inability to be disciplined, difficulty admitting mistakes, fear and greed, and a lack of risk-management, none of which had much to do with being right in the stock market world. It was thus a lack of proper investment strategy, not forecasting that was holding me back. So I set out to get a computer and a good program, and started building timing models that I felt would give me the objectivity, discipline, flexibility, and risk management that I needed to make consistent profits. And since 1980, my company, Ned Davis Research, Inc. has been dedicated to building timing models that do not forecast, but simply are resigned to make money. I can tell you, it made a real change in my investment profits, and both Uncle Sam and myself are now much better off. As far as my forecasting of the market, if anything it suffered, because timing models that make money invariably are not nearly as cocky as a crystal ball guru, and they are so concerned with managing any disastrous risks that they try to hit singles and doubles rather than home runs. But I found that not being the top forecaster on Wall Street at any one time was not all that much of a liability. Again my financial well being improved significantly, and the humility and discipline that the timing models forced upon me actually relieved me of a lot of stressful anxiety. The game changed from winning or losing glory and prestige to a serious business designed to make money with less risk.…So being right is not really where it’s at, since at least as much of your focus should be on risk management tactics and a disciplined strategy.
All of that sounds very familiar with me. I couldn't agree more. The investment industry is made up of a lot of different peole with very different objectives. If you listen to people on TV, they are mostly making "calls" and trying to be right. If you want to make money, it's about portfolio management. I define portfolio management as all those things you do after you've entered a position. For example, predefining risk and controlling it by knowing at what point you'll exit if it goes against you. Most investors are novice; they've got real issues with uncertainty so the fear of not knowing drives them to spend all their resources trying to gather more information to support their opinion. But it doesn't matter how much information you gather - you still don't know. You can't be sure. It's always probablistic, never a sure thing.
On the next few pages Davis goes on to say he's known a lot of very good traders through his work and that:
The winners are very flexible and very disciplined, and they’re risk managers. While I am not trying to knock the importance of study, hard work, and being right in terms of investment success, the key is how to make money. I still believe that objectivity, flexibility, discipline, and risk management are the keys to making money
Amen, Ned. To be objective requires quantifying probabilities and expectancy so we have a mathematical basis behind a decision-making system. That is, making a "call" on the direction of something is subjective. You may notice it's mostly the salespeople like brokers who play that game. Observing that a signal earns on average $2 for every $1 it risks over the past 500 signals is objective.
*The bold highlights are my mine.
A loss never bothers me after I take it. I forget it overnight. But being wrong – not taking the loss – that is what does damage to the pocketbook and to the soul.
Jesse Livermore - "Reminiscences of a Stock Operator"
The following chart is from my friend Ed Easterling at www.CrestmontResearch.com. I'm proud to say I was one of the very first to read and comment on Ed's book back in 2005: "Unexpected Returns". Prior to 2005, we had completed extensive research on historical Secular and Cyclical Bull and Bear Markets. Primarily, I had studied the trends going back over 100 years and tested tactical systems across those various trends. Our conclusion was that long term (Secular) Bull and Bear market's had occurred over and over throughout history. When Ed came out with his research in his book, we compared notes. His work was more focused on why Secular trends occur and under what circumstances. "Unexpected Returns" is a necessary study to understand the big picture. I can tell you that it was my understanding of market trends that motivated us to create the money management systems we benefited from the past five years. You can probably see how the timing of Secular situation correlates with our tactical asset management style - we built the Ark before the flood.
Though we studied and tested decision-making systems on much more detailed data, I thought I would show what these trends look like. Clearly, the U.S. stock market has been in a Secular Bear Market for a decade. Based on history, the current Secular Bear could last as long as another decade. Notice this chart goes back to 1900.
Below we show what the last Secular Bear Market looked like. This chart appeared in 5 of our quarterly portfolio commentaries before the waterfall in 2008. We continued to discuss these cycles so our investors were prepared for the possibilities. The last Secular Bear Market was about 16 years. We call the cycles oscillating up and down over time Cyclical Bull and Bear Markets. They typically last 1 - 4 years. At this point, the U.S. stock market has been in a defined Cyclical Bull Market since March 2009, however it is currently under pressure.
You can probably see the risk of a passive strategy and the potential value of actively managing risk and dynamically adapting to these systematic directional price trends. It doesn't require perfection.The average uptrend was 38%, the average decline was -25%. It was 343% cumulative peak to trough drifts, an average of 21% a year.
From this wisdom, we have some understanding of what is possible. Sadly, investors who do not actively control their risk may experience more waterfall losses and possibly panic selling before the current Secular Bear is over.Of course, just "being" tactical isn't enough. Portfolio management is a craft that requires wisdom, skill, and experience. Like any craft, it's learned over time.
"Those who cannot remember the past are condemned to repeat it"
- George Santayana
The following chart is from my friend Ed Easterling at www.CrestmontResearch.com. I'm proud to say I was one of the very first to read and comment on Ed's book back in 2005: "Unexpected Returns". Prior to 2005, we had completed extensive research on historical Secular and Cyclical Bull and Bear Markets. Primarily, I had studied the trends going back over 100 years and tested tactical systems across those various trends. Our conclusion was that long term (Secular) Bull and Bear market's had occurred over and over throughout history. When Ed came out with his research in his book, we compared notes. His work was more focused on why Secular trends occur and under what circumstances. "Unexpected Returns" is a necessary study to understand the big picture. I can tell you that it was my understanding of market trends that motivated us to create the money management systems we benefited from the past five years. You can probably see how the timing of Secular situation correlates with our tactical asset management style - we built the Ark before the flood.
Though we studied and tested decision-making systems on much more detailed data, I thought I would show what these trends look like. Clearly, the U.S. stock market has been in a Secular Bear Market for a decade. Based on history, the current Secular Bear could last as long as another decade. Notice this chart goes back to 1900.
Below we show what the last Secular Bear Market looked like. This chart appeared in 5 of our quarterly portfolio commentaries before the waterfall in 2008. We continued to discuss these cycles so our investors were prepared for the possibilities. The last Secular Bear Market was about 16 years. We call the cycles oscillating up and down over time Cyclical Bull and Bear Markets. They typically last 1 - 4 years. At this point, the U.S. stock market has been in a defined Cyclical Bull Market since March 2009, however it is currently under pressure.
You can probably see the risk of a passive strategy and the potential value of actively managing risk and dynamically adapting to these systematic directional price trends. It doesn't require perfection.The average uptrend was 38%, the average decline was -25%. It was 343% cumulative peak to trough drifts, an average of 21% a year.
From this wisdom, we have some understanding of what is possible. Sadly, investors who do not actively control their risk may experience more waterfall losses and possibly panic selling before the current Secular Bear is over.Of course, just "being" tactical isn't enough. Portfolio management is a craft that requires wisdom, skill, and experience. Like any craft, it's learned over time.
"Those who cannot remember the past are condemned to repeat it"
- George Santayana
We hear people talking a lot about stock indices like the S&P 500 stock index, referring to the index more than just a proxy for stocks, but also an investment. What you see below is a monthly chart of the past 10 years for the S&P 500 stock index. It is an index that many investment managers benchmark. I look at this chart, and I wonder; Who wants this?
Ten Year Chart of the S&P 500 Stock Index
Chart courtesy of eSignal
In August 2000 the S&P 500 index was as high as 1,525. On Friday, it closed at 1,064. This index is down -43% from were it was ten years ago. (1065 - 1525) / 1064 = -43%. We could say the same about its more recent high point in October 2007.
At Shell Capital, we don't benchmark indexes. Our objective is to earn as much profit as we can with a specific amount of absolute risk. We call this "absolute return" rather than "relative return". We do not have benchmark-itis and we avoid relativity.
We hear people talking a lot about stock indices like the S&P 500 stock index, referring to the index more than just a proxy for stocks, but also an investment. What you see below is a monthly chart of the past 10 years for the S&P 500 stock index. It is an index that many investment managers benchmark. I look at this chart, and I wonder; Who wants this?
Ten Year Chart of the S&P 500 Stock Index
Chart courtesy of eSignal
In August 2000 the S&P 500 index was as high as 1,525. On Friday, it closed at 1,064. This index is down -43% from were it was ten years ago. (1065 - 1525) / 1064 = -43%. We could say the same about its more recent high point in October 2007.
At Shell Capital, we don't benchmark indexes. Our objective is to earn as much profit as we can with a specific amount of absolute risk. We call this "absolute return" rather than "relative return". We do not have benchmark-itis and we avoid relativity.
As a follow up with yesterday's comment "Drawing the Line in the Sand for the Stock Market: A Look at the S&P 500 Index Trend "... so far, so good. As you can see in the chart below, the February lows held today. The stock indexes were down 2-3% most of the day. But by the day's end, the selling pressure dried up. The index closed very close to yesterdays closing price. For those who are looking for a reversal up, you "may" be in luck soon. I say this because of today's price action.
If you look at the blue arrows, those are called a "Hammer" on a candlestick chart. The Hammer is a common bullish reversal pattern that forms after a decline. It's common enough that a Hammer marked the February low. In addition to a potential trend reversal, hammers can mark bottoms as it did in February. The height of the candle shows the wide high to low price range that traded today as sellers drove prices lower during the session but buyers stepped in at the end of the day and took over. Hammers are similar to selling climaxes. We'll want to see confirmation, which could be a gap up in the days ahead. For prices to reverse back up, the selling pressure that drove it down simply needs to be overwhelmed by buying demand. For that to occur, prices have got to get to a low enough level to attract buying interest.
Chart courtesy of eSignal Pro
Times like these can be very difficult for the passive investors who remain fully invested all the time. They are caught in a loss trap and don't know for sure how long it may last or how deep the losses may get. If the current price range does not hold support (the red highlighted area on the chart) and reverse up, the pressure will get stronger and stronger as their losses mount. There is also a possibility that stocks could reverse up for a few days or weeks and then reverse down to eventually break the February lows. From that point, it could keep going to the March 2009. Anything is possible. This is why, at Shell Capital Management we actively manage our risk by increasing and decreasing exposure to the possibility of loss... When prices are peaking out or start reversing down and volatility is rising, we exit weak positions systematically to reduce our exposure to loss. The market isn't the risk. The risk is the exposure. If we have no exposure, we have no risk. Our risk control system is a huge advantage for us. It allows us to control our risk to a maximum amount we're willing to take as we aim for capital gains. You see, we can't fully hedge or eliminate our risk all the time and expect to earn a profit. We aren't unwilling to take any risk at all. We must employ "some" risk in order to have profit potential. In order to earn a profit, we need exposure to some degree at some point. What we do differently is control the "degree of exposure" and the "point". We only want exposure when the odds are overwhelmingly in our favor. We do it by buying and selling things...
As it turns out, we have something in common with many of the most famous investors in the world. The following statement was written by Warren Buffett in a 2003 "Letter to the Shareholders of Berkshire Hathaway".
When we can’t find anything exciting in which to invest, our “default” position is U.S. Treasuries, ... Charlie and I detest taking even small risks unless we feel we are being adequately compensated for doing so. About as far as we will go down that path is to occasionally eat cottage cheese a day after the expiration date on the carton.*
It appears that Mr. Buffett, like us, has an objective of absolute returns ...
We like avoiding large losses on our portfolio (as defined by -15% or more). We like not having to "worry" if this Hammer is indeed a setup for a reversal, or not. We reduce our exposure to loss to an acceptable level and then go with the flow...
*Source: http://www.berkshirehathaway.com/letters/2003ltr.pdf
Last Thursday I commented:
"Crowd Sentiment is Optimistic: No Surprise to See at Least a Short Term Price Decline"
After the close that same day, I commented "Today’s Stock Market Decline is about Twice a “Normal” Move " when I concluded about the days market action "today we get at least a warning shot across the bow."
That post suggested that investor optimism had hit a extreme short term peak; a level that historically preceeds a correction (decline) in stock prices or at least low returns for a while. Indeed, it appears the former is underway. The chart below represents the S&P 500 Stock Index. It is a daily chart showing the price trend since December. As you can see, the most recent price action for this stock index shows a decline of -6% over the past 2 weeks. This same index declined about 9% in Jan - Feb before reversing back up to a higher high. As evidenced by the other posts I made last week , corrections of 5% - 10% are fairly common in a Cyclical Bull primary trend. With that said, we have reduced our exposure to loss over the last week.
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