Welcome to a new year of the Gary Stone Journal.
2012 has come and gone and we can now look forward in the hope that 2013 will be a year of fruitful investment. To begin afresh, I thought that I would share with you my thoughts on an investment principle that is hardly the most exciting, but manage it correctly and it’s monetary rewards will pay off far more than the effort involved. I’m talking about the ability to, at times, move your trading capital and portfolio to ‘cash’.
Moving a portfolio to cash is an effective risk management strategy. It’s called managing systematic risk or market risk. It allows cash to sit on the sidelines until the probability increases that a rising market will ensue. The most important and critical ingredient as to ‘when to and when not to deploy funds’ comes down to timing. Timing of individual shares (the right time to close positions) and timing of the overall market. These two actions directly influence when capital leaves the market and heads for cash on the sidelines.
Timing the market can have the single biggest effect on a portfolio’s performance over time. When the market momentum is rising, your goal should be to expose your trading capital to the opportunity flow in the market. When the market is falling it becomes about protecting your trading capital. This is common sense and it sounds simple, right? But the reality is that everyday investors tend to get this very wrong. They suffer from fear, uncertainty, doubt and greed driven by all the ‘noise’ that surrounds the financial markets rather than objectively determining the right time to get in or out. They tend to add their own biases and form opinions based on information that they gather from reading newsletters, the paper or listening to the news.
I have just completed the better part of 21 months researching risk and money management measures and the evidence is overwhelming. Being able to deploy a strategy that can capitalise on the rise of the market and yet protects capital when the market momentum shifts down, can truly add 10’s of 1000’s, if not 100’s of 1000’s, of dollars to your end retirement whether you are long term investor with a focus on dividends or an active investor.
One such area heavily researched was the effect that volatility drag has on a portfolio. Volatility drag occurs on both individual trades and portfolios where for every loss a greater profit is required to retain equilibrium. For every percentage decrease in the portfolio value, a larger percentage increase must follow to just break even. Each time the portfolio fails to break even the probability of the portfolio recovering reduces because future gains must be larger than the past losses and more frequent.
A 10% fall requires an 11% gain to break even, a 30% fall requires an 42.86% gain to break even and a 50% fall requires a 100% gain to break even.
So it becomes essential that you not only have a goal to profit but also have a focus to protect. You have little control as to how much the portfolio will grow because it is largely dependent on how much the market rises but you do have significant control over how much loss and risk you experience.
All you need is a trigger point to react to the changing market
Rather than your trigger being gut feel, instinct, an economist’s or commentator’s point of view or reliant on somebody’s technical and / or fundamental prediction you need an unmistakeable, unambiguous and researched signal that calls you to the point of action and adds clarity, objectivity and consistency to your investment style. Opinion is subjective and mostly not research based.
Here’s how effective market timing works
Take the All Ordinaries Index below. The green signals on the chart are the beginning of a SPA3 Low Market Risk period and the red signals are the beginning of a SPA3 High Market Risk period. We are using SPA3 as an example but you can use any market timing approach that has an Edge, is objective and consistent.
Criteria embedded into SPA3 identify the falling or rising momentum of the index so that the trader can act according to the SPA3 rules. SPA3 traders engage the market while in a Low Risk market but remove 100% of their capital from the market during High Risk market periods. This critical risk management approach for systematic risk allows SPA3 traders to trade the market when the market is conducive to making profits yet protect capital by steping aside when it’s not.
The conflicting argument put up by the vast majority of investment managers and financial planners is that it’s about ‘time in the market’ rather than ‘timing the market.’ This is garbage and a complete disrespect to risk management and the existence of systematic risk. It’s actually about both, ‘time in the market’ and ‘timing the market.’
If you wish to understand the very essence of why our learned financial community continue to preach this nonsense, it’s because they are faced with an issue that is extremely difficult to solve. When managing many millions and sometimes billions of dollars it becomes difficult in the extreme and near impossible to remove capital from the market. Funds are not nifty and nimble like us self investors.
While we may consider investing $10,000 in a position, a fund could be investing many millions into a single position. They become so invested in individual stocks that liquidity and moving the market against themselves, let alone others, become serious issues and it forces them to have to ride out the up’s and down’s. In the meantime they ‘pitch’ to the uneducated that it’s ‘time in the market’ and that ‘timing the market’ is impossible, to justify the severe handbrake that they have on their investment processes and philosophies.
However, there are some fund managers, although very few and far between, that do use cash and ‘timing the market’ as part of their investment strategy. It appears that it is severely frowned upon in the industry. In an article entitled “A wizard with cash” published in the Weekend Financial Review on 5 – 6 January readers were introduced to Seth Klarman, head of the $22B Boston based hedge fund manager, Baupost, as the “the greatest investor you’ve never heard of.”
“Klarman is known to allocate 50% or more of client funds to cash at any given time. Holding cash and charging fees for it as a fund manager have long been taboo in the investment world. ‘If you don’t have anything better to do with it, give it back,’ is the standard retort of a mutual fund manager.”
“….he questioned why ‘the vast majority or our learned [and conflicted] financial community continue to preach the virtues of being, at all times, fully or substantially invested and being as transactionally hyperactive as possible.”
In coming weeks I will reveal some startling research that shows that Seth is right on the money!