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Building "Volatility Tolerance" Part 2

Saturday, February 21, 2015

– by Sheila & Rich Jamison -

The DJIA and the S&P 500 hit new all-time highs Friday while the NASDAQ inched even closer to its all-time March 2000 record. Yet they all started the day in negative territory with volatility spiking and, again, inspiring jitters among many investors. Could this be the end of the bull market?

The afternoon rally coincided with the announcement that the EU and Greece had come to a tentative agreement that may extend Greece’s bailout and EU membership for another 4 months. Fear abated and the markets rallied. Uncomfortable waiting from 9:30 until early afternoon though, wasn’t it?

Our prior InSights dealt with keeping your emotions out of your investment decisions. We examined several charts to see how/why emotions might be heightened and lead to poor decisions. More important, we saw how those same charts might also be used (albeit with some practice and internalizing) to damp down emotional responses (click here for a refresher).

We promised then to take a closer look at using objective criteria as the base for those decisions. That’s today’s subject.

Setting the Table

We’ve discussed relative strength (RS), sometimes called momentum or trend-following, before. It’s a tactic/strategy based prices, i.e., objective criteria. We can measure them. Still, some of you have told us that it is hard to get a firm grasp on this without a financial background. We intend to remedy that today.

Our goal is separating logic from financial knowledge. When making investment decisions,logic frequently stands opposed to emotion. Many bad decisions are caused by emotion overruling logic. Conversely, logic can almost invariably be the cure for bad decisions caused emotions.

Thinking in Pictures

We will tie the reasons and rationale for RS-based decisions* to the charts from the last InSights. This will make the benefit of using such criteria intuitively obvious. You don’t have to know how to use them; only to understand their value … even if and/or when they fly in the face of emotion.

Ideal vs. Real World Redux

The contrasts we deal with will be familiar. We showed them like this in the prior InSights (refresher here):

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Lessons of History

Building a diversified portfolio, rebalancing it periodically but otherwise being done with it (think Modern Portfolio Theory) simply wouldn’t have worked. Unless you happen to catch one (and unemotionally use) of the few exceptional run-ups since 1950, you waited decades for your growth. It didn’t lead to the ‘steady’ results and retirement goal attainment as it would in the Ideal World.

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Further, if you happened to catch one of those spikes, you’d have to resist the urge to bail out whenever they hit their snags and/or overcome reluctance to jump back in when theyturned up again. Same problem – success in even these periods only came if you kept your emotions in check.

Emotion’s Role

The appropriate asset mix for a static allocation approach is not clear. This immediately creates uncertainty by itself. Emotion, feeding on uncertainty, often leads to undisciplined (i.e., emotion-driven) allocation shifts in and out of the market, hopelessly trying tocapture all-of-the-up, but none-of-the-down.**

The Time-Caused Hoax

Looking at the average of 50 years’ worth of data, one might conclude that the static allocation should be 40% U.S. Equity, 20% International Equity, 30% Fixed Income, and 10% Commodity exposure. Taking out the finance, that’s like showing up 4 hours early for one flight and arriving at the airport just as your plane departs the next time you fly. You are 2 hours early for those flights on average. Still, you missed half of them!

Analogous to your flights above, appreciating how much variability there can be, decade to decade, in asset class returns, volatilities, and correlations can be an entirely different than using averages. If asset classes go through bull and bear markets – and they do – emotion frequently overrules patience and tolerance for losses. When that occurs, you’re not likely to stay the course.

Emotion & Time in Dollars

Remember this chart from part 1?

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Let’s put it and financial theory aside again and look at the consequences of putting money into the market at one particular date. If we had put $600,000 into the market in an S&P 500 Index emulating portfolio*** on March 24, 2000:

  • That $600,000 investment was below that value until July 6, 2007. But you better have grabbed your money quick! It dropped back below that again by July 19th, about 2 weeks later
  • Miss that window of opportunity? No problem. It recovered the original value again on September 19th … peaked on October 9th … then bounced around above and below that original investment value until December of 2007.
  • However, if you missed this opportunity, you had to wait until April of 2013 for your next chance to sell out at a profit.

Profits at the Peaks

If you withdrew your money:

  • At the July 19th peak, you had $610,062 (that’s 1.68% for your 7 years 4 months investing – for a 0.23% annualized return.)
  • At the October 9th peak, you had $614,805 (“skyrocketing” your return to 2.47% – or 0.35% annualized – for 7 years, 7 months “time in the market.”)

Otherwise, your portfolio wasn’t worth $600,000 again until April of 2013 (that’s 13 years, 1 month). Selling out then was a 0% return. Odd you wouldn’t have made anything, given you had over 13 years ‘time in the market’ by then.

Worse than Zero

Those were the positives you might have encountered. On the other hand, if you sold (perhaps you had to) between March ’00 and April ’13, your portfolio could have been as low as $261,690. That is, you might have had over 9 years “time in the market” and lost more than half your investment.

For the Very Patient

A few exceptional people will stay the course. Over the course of 30 to 50 years, we suspect that a percentage of extremely patient clients who have both that much time and the discipline to ignore emotional reactions will do okay.****

However, most investors can’t ignore emotion. They will make emotion-driven changes to their allocations.

They will swear off fixed income in 1982.

They will get bullish on commodities in June 2008.

They will give up on U.S. equities in March 2009.

They will give up on European equities in 2011.

They will … well, you get the picture

Notice that these dates are near the beginnings of bull runs in the asset classes named.Another emotional problem is one of the toughest things to do (especially if you stayed toolong before jumping ship) is getting back on board. By the time you recognize that the shi isn’t really sinking, it may be a long way toward its desired destination. Thus, even for the long term to work out, you must conquer emotion.

RS’s Answer

This is also simple. We’re speaking of a tactical allocation (TA) – meaning an allocation that can change with changing markets. Removing the financial terms and simplifying it toonly in or out of the market, it looks like this (see – red and green arrows for action, orange for stay alert, but no financial terms):

PLAY THIS:

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Like This

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There are two quick notes here:

1. Note that the arrows are not at the mountain peaks and valley bottoms. RS-based TA does not (nor is it designed to) get in at the bottom and out at the top. There is no financial theory or practice that can do that other than hitting a top or bottom occasionally (make that rarely) by luck. Tops and bottoms are like golf’s holes in one. Most golfers never get one!

2. Instead it is designed to capture the majority of a trend, and that generally beats static allocation methods by a more-than-significant margin. Applied to the S&P 500 from March 9, 2000, if you sold out when – and only when – the S&P dropped by 10% and bought back in when it rose 10% off the following low, you would have slightly over $1.9 million as of Friday’s close, well over the $829,000 you’d have if you had bought in and held on until now.****

We used 10% moves as our trigger points for ease of calculation in this example. Actual buy and sell points are not that cut-and-dried. Though RS is the dominant player, other market factors will impact the magnitude of change for market entry and exit. Thus the triggerpoints can vary. Repeating something we said earlier, you don’t have to know how to do this; just know that doing it has value.

A quick glance at the charts and pictures above reveals intuitively obvious points to get in and out. Looks like anyone should be able to tell these … but this is in retrospect.

At the time they begin, all the downturns – the little ones in the “caution” areas and the big drops marked at get out – look the same going in. All the turns start out as “cautions” and get their red or green arrows only when they exceed the trigger points.

An analogous situation exists for reversals back up. The trick is to use the big moves only after you’ve gathered sufficient objective evidence suggesting that they will be big moves. Just ride out the little ones so as to capture the trends. Easy to do in the rear-view mirror; not so easy in real time.

Two Keys to Getting Comfortable

1. Recognize that though all dips feel the same on the way in, they are not all the same. Most pass without incident.

2. Accept that you will never know which will be which when they begin and that not knowing heightens emotion. Falling back on a discipline that relies on numbers rather than emotions makes a great set of training wheels. While kids on bikes with training wheels may still have accidents from time to time, overall they’ve done a lot better with them than without them.

Summing It Up

We believe tactical asset allocation is essential to creating superior portfolio performance. Look again at the dollar numbers presented earlier.

To be clear, we are in no way advocating an undisciplined allocation approach. TA is notan undisciplined, helter-skelter approach, the kind that many think of when they hear the term “market timing.” TA is highly disciplined. But it doesn’t accept that any allocation isalways the correct allocation. Hence, it adapts to be in the strong areas and out of the weak ones.

Moreover, an undisciplined approach is very likely to perform substantially worse that even the static approach over time. However, research shows that relative strength (RS) can be an effective method of building an adaptive approach to asset allocation.

Ignore the News

When you come to the next dip in the road, remember that another way to say ‘stay with the trend’ is “ignore the news.” Each day’s headlines can be loud, bold and sometimes uncomfortable. Comfort is an emotion.

Again we caution you that all dips feel bad as you start down into them. Some will be bad. Others will be only speed bumps. And it takes time to conquer the emotions triggered by all of them.

Listen to the Market

RS-based TA portfolios can depend upon the contribution of sometimes “uncomfortably” long leadership trends to provide the outlier returns. In other words, when emotions are screaming get in or get out, RS provides objective data to say “yes,” “no” or “not yet.” The more you listen to that data, the easier it is to tell that other little voice to get lost.

Remembering the 3 charts we studied in the previous InSights will help with that (see them here). We are here to help too … even if all you need is a bit of moral support from time to time. We’ve always got time for you.

*RS is an example of an objective criterion. It is not the only such measure … and none are perfect. A relative strength driven approach to asset allocation basically allows the investor the possibility of investing in multiple asset classes, but allows for great flexibility. When asset classes are relatively strong, they will receive exposure in the strategy. When they are relatively weak, they will receive little or no exposure. However, RS is the one we’ve found most useful.

**There are people who want to do just that. These are the same folks who want huge gains garnered by using only absolutely safe investments. We refer to this as “wanting to go toheaven without dying.” It cannot be done!

***It’s not possible to invest in the index itself. We use the index numbers for ease ofillustration.


References:
Charts derived from Yahoo Finance data and graphing at finance.yahoo.com on February 14 and February 21, 2015.
Asset allocation can be flexible without being erratic and undisciplined. The money managers. Dorseywright.com. January 30, 2015.
Tactical Asset Allocation Using Relative Strength. John Lewis. Dorsey Wright Money Management. March 2012.

The data above were taken from sources deemed reliable. However no guarantee can be made as to their completeness and accuracy.
Interpretations of the data, views and/or opinions expressed are those of the Jamison Financial Group based on market and economic conditions as of the date of publication and are subject to change. They do not necessarily reflect the opinions of any other individual, group or organization.
Nothing in the above is meant to be, nor should it be construed as, investment advice orrecommendations to buy or sell any security. Individual securities whenever mentioned are for illustrative purposes only and may not be relied upon as investment advice.
Tax and/or legal information contained herein is general in nature and for informationalpurposes only. It should not be relied upon as advice. Consult your tax professional or attorney regarding your unique situation.
All indices are unmanaged and are not illustrative of any particular investment. A direct investment cannot be made in any index.
The Dow Jones Industrial Average is a price-weighted index of 30 actively traded blue-chip stocks.
The NASDAQ Composite is a market-weighted index of all the over-the-counter common stocks traded on the NASDAQ system.
The S&P 500® is a market-capitalization-weighted index of common stocks.
Past performance is no guarantee of future results.

© 2015 Jamison Financial Group. Please feel free to distribute copies to individuals you feel may benefit from the information presented. Commercial use is prohibited.