Whether you're bullish or bearish on the economy and the stock
market, I'm pretty sure you want unbiased information that either
confirms or refutes your investment thesis.
Those who are open-minded, curious, and willing to adapt to changing circumstances will likely perform well above average in the investing game. But if, on the other hand, you think you know what's going to happen in the future (overconfidence), you will probably not like this article, and your performance as an investor will likely be disappointing. In other words, you won't improve as an investor.
Bulls
There are three types of bulls operating in the markets today:
- Big Money Bulls
- Smart Money Bulls
- Dumb Money Bulls
Big Money Bulls have tons of money under their control. Sovereign Wealth Funds, Mutual Fund Families, State and Local Pension Funds, Foundations and Endowments to name a few. These financial behemoths can move markets when they are optimistic about the future.
But when they are concerned about the future they don't have the same sway over markets because they are constrained by the investment policy that comes from management. And who sits on the investment policy committees of these giant pools of money? In most cases it's Politicians, Technocrats, and Academic high-priests, few of whom have investment backgrounds.
As a result, the big money tends to move slowly, as changes in investment strategy moves from one bureaucratic committee to the next. The most important consideration for these bureaucrats is job security. And they are well aware of the dangers that come with turning bearish.
The Smart Money Bulls takes a different approach. They are intentionally agnostic about concepts like bull vs. bear, which political party is in power, or what the bureaucrats might be up to. They only care about one thing: what is the best way to position their portfolios to take maximum advantage of the conditions on the ground.
The Smart Money includes
- Top hedge funds,
- Proprietary traders on Wall Street,
- Fund managers who have winning records over decades
These are organizations that put performance above politics. They will happily take a short-term loss if they believe they will win in the long-term. And they will exit a losing position quickly if the investment thesis behind it has been compromised.
They don't have a committee of bureaucrats telling them how to position their portfolios. They have teams of analysts, portfolio managers, and traders who can speak freely and all participants are free to challenge a recommendation or a thesis that's presented. It's called the Socratic Method and I've seen it in action. It produces some of the best investment ideas ever conceived.
The Dumb Money bulls tend to believe that the market will always go up because it always has in the past. And they're right. The market goes up 67% of the time, and down 33% of the time.
This variety of bull will say that they aren't concerned with the 33% of down markets because eventually the market will come back and make a new high. This is true, but there is a serious cost to staying fully invested at all times, which I'll get to later.
A relatively new argument you hear from bulls is that the Fed will not allow the market to repeat the painful crash in 2008. Central banks all around the world learned from that near-collapse of the global financial system that if they wanted to prevent such a thing from happening again they would have to be proactive with their monetary policies. In other words, cut interest rates and flood the economy with money conjured out of thin air, long-term consequences be damned.
At the first sign of trouble in their economy, central banks quickly lower rates and pump money into the capital markets to fend off the intruders. This has worked since 2008, but one of the unintended consequences was a spike in global debt. Governments, corporations, students, and pension funds are now so top-heavy with debt that it wouldn't take much to start a repricing of that debt (bankruptcies, defaults, and the like).
But again, bulls don't seem to be concerned about this mountain of debt. What I hear from them is "with interest rates this low, debt isn't a problem." But what happens when the central banks begin to raise rates? Think about it.
Bears
There are three types of bears.
- Professional short sellers
- Congenital pessimists
- Informed and skillful DIY types
It takes a lot of guts to be a bear. First, you're swimming against the tide of history which shows that the bear playground is much smaller than the bull playground.
Bears are often portrayed as pariahs who are trying to bring the market down. There was even a time when Congress tried to outlaw short selling on the grounds that it was un-American. China banned short selling for a time in the 1990's but they later came to their senses.
But here's something that you may not know about bears. Bears have an Achilles Heel. When you short a stock, your maximum gain is 100% if the stock goes to zero. But your maximum loss is unlimited. If you make the wrong bet, you could be on the hook for losses on the order of 200%, or 300% or even more. It's tough to be a bear.
After 30 years on Wall Street, I've come to understand how the bear community operates. One of my first jobs as a trader was looking for stocks to short. I know some of the most skilled short-sellers in the market. And I can tell you that these folks are the most thorough and motivated researchers working today.
These short-selling shops hire the top graduates from the best schools. They pay them very well and they are rewarded by the ideas that these young math and physics savants bring to the table.
Evidence Based Investing
The new kid on the block is Evidence-Based Investing. What is it? It's primarily a marketing pitch. The idea is that the smartest people in academia have all agreed that the one and only best investment strategy for all investors is to buy and hold a portfolio of low-cost, diversified mutual funds and ETFs. But is that true?
For some investors, yes. Here are a few examples of investors who would be better off with a simple Evidence-Based Buy & Hold strategy:
- People who find the whole investing thing boring. (No judgement, just saying.)
- People who are too busy with other things to spend any more than the bare minimum of their time on investing.
- People who don't have a clue about how the markets work, and aren't interested in taking the time to learn.
The Downside of Evidence-Based Buy & Hold Doctrine
Talk to any investor who is a bull and you'll probably hear Warren Buffet's name come up. There is a huge contingent of investors who consider the buy & hold strategy a religion. Google "Bogleheads" to see what I'm talking about.
Here's what I've learned about buy & hold and evidence-based investing. It works great during bull markets (67% of the time). But what happens to the buy & hold flock when a bear market comes along? Nothing good, that's for sure. Half of them panic and deviate from their investment plans. They find themselves lost in the wilderness, not knowing when to get back into the market.
Another 25% of them keep buying more risky assets as the market continues to fall. (Where they get the funds to do this has never been properly explained to me, given the claim that they are always fully invested.)
The last 25% of these sweet doomed angels simply give up the investing game altogether. They swear off stocks forever, like a gambler swears off betting after losing big in Vegas. Most of them will eventually come back to the game, but the damage is already done.
After the Great Crash of 1929 it took buy & hold investors 25 years to get back to even. That's an extreme case, but recent bears have cost buy & hold investors 5 years or more to get back to even. Is that acceptable to you? Wouldn't it make more sense to have a defensive strategy in place to deal with bear markets?
An illustration of the benefits of playing smart defense
In the final analysis, it doesn't really matter whether you self-identify as a bull or a bear. The way to make money during bull markets, and not get hammered during bear markets, is to have a defensive strategy in place. I call this the Plan B. I think every investor should have a Plan B.
Full disclosure: I help investors set up their Plan B because the advice and planning community doesn't. You don't need to hire me as a consultant to get this done. You can do it yourself with a moderate amount of effort.
If we put this in terms of a cost-benefit analysis, we can quantify the value of having a Plan B and following it faithfully. The chart below shows the difference in account values between a buy & hold strategy and a buy & play defense one. The difference in account values may not look very meaningful until you consider the following. (Continued after the chart.)
The defensive approach earns $5,000 more than the buy & hold approach. That's not chicken feed, especially when you consider that both accounts began with $10,000. In this chart, both strategies made a handy profit over the 16 year period. But the defensive strategy came away with an additional five grand. If you invested $10k, would you leave five grand on the table if you didn't have to? Think about it.
Let's consider the volatility of your account value. With buy & hold your account value will go up or down by 14% every year. Can you handle a 14% hit to your life savings? You may think you can, but maybe you can't. The defensive strategy smooths out this volatility to 9.3% per year. I think most investors can handle that kind of volatility.
The "risk-adjusted" returns for these strategies tell the full story. The buy & hold has a risk-adjusted return (the return after taking volatility into consideration) of 0.68. In comparison, the defensive strategy has a risk-adjusted return of 1.02. This means that buy & hold investors are only getting 68 cents on every dollar they have at risk, while defensive investors are getting $1.02 for every invested dollar. To win in the investing game you have to get fairly compensated for the amount of risk you're taking.
The rest of the story
The table below summarizes the details that I've laid out in this article. It shows the year-by year performance of both strategies.
The eye-opener is what happened in 2008. Buy & holders took a 37% hit to their nest egg, while the defensive folks only gave up 6.8%. That's pretty great, right? And it goes to the true value of having a Plan B. Bear markets don't come around very often - maybe every 7 or 8 years - but when they do show up, your Plan B will get you out of the way of the most damaging parts.
It worked in 2008. It worked in 2000. And it worked in 1974. It didn't work in 1987 but it only lagged the buy & hold strategy by 2.1%. 1987 was an aberration, and it could repeat again. But over the long haul I think it's just common sense to have a contingency plan in place. Don't you?
If you want to discuss setting up your Plan B, email me at info@zeninvestor.org
Erik,
You do a lot of really good analysis, but I have discovered over the years that it is the relationship between expected profits and interest rates that drives the market. If expected profits are higher then interest rates markets will rise. If interest rates are higher then expected profits markets will fall.
So the key to investing success, for me, is knowing what causes profits and interest rates to increase and decrease, recognizing when they are changing and invest accordingly.
Most of the time changes happen slowly so you can see it coming and have time to make adjustments. Some times change occurs over very short time and may not have time to make changes quick enough. This is the challenge in investing.
In the dot com boom you could see how few start up companies were able to make profits. There was time to know what was going to happen and get out of the way.
In the bad debt mortgage crises, could not see all the bad debt loans unless you were in the mortgage business. The bad debts showed up all of a sudden and there was little time to get out.
Learn and act on the items that affect expected profits and interest rates should do well in investing.
Howard Randall