living with volatility

IT WORKS UNTIL IT DOESN’T

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We’re contrarians. We are not satisfied with conventional thinking that portfolio management requires plugging in the right numbers and then following the formula.

It’s not that simple—and it can actually lead investors astray.

Here’s the deal. Modern portfolio theory—one version of the conventional wisdom—uses rigorous statistical models that attempt to quantify volatility and risk in their many forms. The idea is that if you can measure and predict volatility then you can construct a portfolio that has only as much volatility as you desire.

We believe there are a lot of problems with this approach. These models all rely on the assumption that the market will continue to behave rationally. So when the market experiences irrational exuberance, statistical models quickly lose their meaning and begin producing nonsense.

For example, one measure of a stock’s volatility is called its “beta.” The more correlated a stock’s movement is to the broader market, the higher the beta. A high beta stock tends to be a big winner or big loser based on what the market is doing, while a low beta stock generally moves less than the market. A stock can even have a negative beta, where it tends to move the opposite way from the rest of the market!

Under normal circumstances, volatile stocks tend to have a high beta. But when a hot stock gets caught up in a speculative bubble, it can take on a life of its own. A stock on a hot streak that goes up even on days when the market is down will show a lower beta than stocks that follow the market but may still be volatile.

In cases like this, investment managers that are chasing “low beta” may end up with some very volatile holdings in a portfolio that claims to prioritize stability and low market correlation. And investors that are looking to avoid the roller coaster of the stock market may find themselves on an even bigger ride without realizing it.

We believe statistical analysis can be useful, but it cannot compete with timeless investment principles. Trying to quantify volatility exposure can lead to ugly surprises when the underlying models break down.

We think there’s another way. Instead of trying to mathematically capture and avoid it, we believe in living with volatility. If you are investing for the long haul and you know where your cash flow is coming from, you do not need to fret about day-to-day price action.

Clients, if you have questions about this or anything else, please give us a call.


Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All investing involves risk including loss of principal. No strategy assures success or protects against loss.

Up And Down Really Means Up And Down

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As long term investors we talk a lot about the need to weather short-term volatility in pursuit of long-term results. Our notion is that volatility is not risk, but an inherent feature of investing.

As years go by, many think of the market as having good years and bad years. This is based on the outcome for calendar years. The astonishing thing is how much movement there is during the course of the typical year.

“At least one year in four, roughly, the market declines.” We’ve said that about a billion times, to reiterate that our accounts are likely to also have good years and bad years, if one judges on annual returns. The object is to make a decent return over the whole course of the economic cycle, year by year and decade by decade.

But in those other three years out of four, the market also experiences declines during the course of the year. In an average year you may see a decline of 10 to 15% at some point during the year.

Our object is to leave long term money to work through the ups and downs, without selling out at a bad time. Three things help us do that:

1. A sense that everything will work out eventually, a mindset of optimism.

2. Awareness that downturns tend to be temporary, ultimately yielding to long term growth in the economy.

3. Knowing where our needed cash will come from, based on a sound cash flow plan.

Bottom line, even years that end up well can give us a rough ride. Knowing this can make it easier to deal with.

Clients, if you would like to talk about this or anything else, please email us or call.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

Stock investing involves risk including loss of principal.

All performance referenced is historical and is no guarantee of future results.

The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

 

Why Not Just Pull Back?

© Can Stock Photo / bthompson2001

The market has been rough lately! Seems like account values are shrinking month by month. In times like these, clients sometimes ask why we don’t just pull back when the market starts going down. It is a fair question.
We are thinking about a number of things in formulating investment strategy and tactics:

1. The average decline in the course of a calendar year in the major market averages is about 13%1. Basically, the market is always going down—and up.

2. A wag once noted that the market has predicted nine of the last five recessions. In other words, it may decline 10 or 20% without signifying anything about the health of the economy.

3. The times when it seems to make the most sense to sell out often turn out to be good times to be invested.

In short, the ups and downs are part of investing. We each face a choice between stability of values, and long term investment returns. There is no way to get both of these things on all of our money, although we may have some of each.

It is important to know where our money will come from, the funds we need in our pocket. For investors, it is also important to know our long-term portfolios will go up and down.

We mentioned above that the average stock market decline in the course of a year is 13%1. Let’s be clear about what that means: a $13,000 drop on a $100,000 portfolio; $65,000 on half a million; $130,000 on $1 million.

Here’s some solace: by the time you notice we’ve been skewered, we are closer to recovery than when the decline began. One year out of four, on average, the market (measured by the S&P 500) declines. Think about it—three years out of four, on average, it has gone up.

We don’t pull back because we do not want to miss the rebound. Our experience has been that we can live with the ups and downs. It isn’t always easy, but our experience has been that it works out over time.

Clients, if you would like to talk about this or anything else, please email us or call.

Notes and References

1. Standard & Poor’s 500 Index, S&P Dow Jones Indices. Retrieved November 5th, 2018.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

All investing, including stocks, involves risk including loss of principal. No strategy assures success or protects against loss.

All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

The economic forecasts set forth in this material may not develop as predicted.

This is a hypothetical example and is not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing.