When I used to play a lot of golf, one of my frequent playing partners had a phrase he used at least once per round: “At the end of the day, they don’t ask, ‘How?’ They ask, ‘How many?’” He would say that after he hit a bad shot but somehow got lucky and it worked out okay. To be fair, I said it a time or two as well!
That philosophy might work with golf, but it doesn’t work with investing. It isn’t just the results that matter. How you get those results matters, too.
More than numbers on a spreadsheet
I’ve mentioned in a couple of recent posts that before the last long bear market, which stretched from October 2007 to March 2009, 65% of U.S. adults had money in the stock market. But by the time it was over, just 55% had money in the market.
Equally noteworthy, after the ensuing bull market, an incredible 11-year run that saw the S&P 500 more than quintuple in value, the number of U.S. adults with money in the market was still just 55%.
Some investors have the stomach to ride out the market’s ups and downs, but a lot of investors don’t. While it’s true that bull markets have lasted longer than bear markets, and they’ve added more value than bear markets have taken away, it’s one thing to know that and to trust that it’ll continue to be the case; it’s quite another to stay with an aggressively invested portfolio through thick and thin.
That’s why it’s so important to choose a strategy you can continue to follow during the market’s toughest days. Such a strategy should protect your portfolio and your confidence.
The two sides of risk management
Usually, risk temperament questionnaires are described as being about protecting your portfolio. Of course, that’s important. The harsh math of the market is that a 50% loss requires more than a 50% gain to get back to even; it requires a 100% gain, and that usually takes time. So, as we get older — as we have less time to recover from market losses — it’s wise to decrease our equity allocation and increase our bond allocation.
But there’s an under-appreciated second aspect of risk management. It’s about protecting you. Market losses aren’t just numbers on a spreadsheet. As we’ve talked about many times, one of the most important findings from the field of behavioral psychology is that people usually feel the pain of loss to a much greater degree than they feel the pleasure of an equal gain.
A good game of defense
It’s a reasonable assumption that the investors who left the stock market after the 2007-2009 downturn did so for emotional reasons. That’s why using a strategy like SMI's Dynamic Asset Allocation can be so helpful. By providing strong downside protection, it guards against both financial loss and emotional pain.
At the end of April this year, the S&P 500 was down 9%. That’s bad enough, but that four-month period also included a stretch of 16 trading days when the market went from an all-time closing high on February 19 to a 34% decline at the close on March 23. Compare that to DAA’s path. At the end of April, it was up 1% for the year. Its results were much better than the market, and just as importantly, its ride was much smoother as well.
Of course, as I’m writing this, the market is soaring. Do you feel something different on days when the market is strong? Do you feel lighter, less stressed? Perhaps even less concerned about risk management?
When the market is up, it’s easy to forget how painful down days can be. Just a couple of months ago, every day seemed to bring more bad news, more fear. There was no telling how much worse it could get.
Even during times of relative calm, the market’s direction is unknowable. But today, I think you’ll agree that there are more questions than usual about what the future might hold for the economy and the market.
It all speaks to the importance of following a trustworthy investment strategy. While we say that a lot, its importance can’t be emphasized enough.
Here are the marks of such a strategy:
- It’s objective. We are all subject to many biases in our thinking — recency bias, confirmation bias, and more. It’s important that we counter our biased thinking by following a rules-based strategy that objectively tells us what to buy, if and when to sell, and what to buy next.
- It’s easy to understand. We should be able to explain to a 12-year-old what we’re invested in and why.
- It has a good track record. We should be able to see how our chosen strategy has performed under different market conditions. That doesn’t guarantee that it’ll perform exactly the same way in the future, but it should help manage our expectations. For example, DAA is designed to capture some of the gains of a growing market, but not all of them. And it is designed to provide strong protection in a declining market.
- It doesn’t require more of you than you're willing to do. As we like to say about DAA, it’s simple but not always easy. It tracks the momentum of just six asset classes, keeping you invested in the three with the highest momentum. However, depending on the size of your portfolio, when it comes time to make a change, that could mean moving a sizable amount of money.
Investing always involves an element of risk. During especially volatile times, that means there’s the potential not just for losses in your portfolio, it means there’s the potential for a loss of confidence so great that it could take you out of the market.
You can protect against both types of loss by following a trustworthy investment strategy — one that meets the criteria listed above. Doing so will be good for your portfolio (the results) and for your peace of mind (the ride).