Pick a Valid Investment Strategy, Stick With It

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 Pick a Valid Investment Strategy, Stick With It

Photo Credit: BK

I’m not going to argue for any particular strategy here. My main point is this: every valid investment strategy is going to have some periods of underperformance. Don’t give up on your strategy because of that; you are likely to give up near the point of maximum pain, and miss the great returns in the bull phase of the investment strategy.

Here are three simple bits of advice that I hand out to average people regarding asset allocation:

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  1. Figure out what the maximum loss is that you are willing to take in a year, and then size your allocation to risky assets such that the likelihood of exceeding that loss level is remote.
  2. If you have any doubts on bit of advice #1, reduce the amount of risky assets a bit more. You’d be surprised how little you give up in performance from doing so. The loss from not allocating to risky assets that return better on average is partly mitigated by a bigger payoff from rebalancing from risky assets to safe, and back again.
  3. Use additional money slated for investing to rebalance the portfolio. Feed your losers.

The first rule is most important, because the most important thing here is avoiding panic, leading to selling risky assets when prices are depressed. That is the number one cause of underperformance for average investors. The second rule is important, because it is better to earn less and be able to avoid panic than to risk losing your nerve. Rule three just makes it easier to maintain your portfolio; it may not be applicable if you follow a momentum strategy.

Now, about momentum strategies — if you’re going to pursue strategies where you are always buying the assets that are presently behaving strong, well, keep doing it. Don’t give up during the periods where it doesn’t seem to work, or when it occasionally blows up. The best time for any investment strategy typically come after a lot of marginal players give up because losses exceed their pain point.

That brings me back to rule #1 above — even for a momentum strategy, maybe it would be nice to have some safe assets on the side to turn down the total level of risk. It would also give you some money to toss into the strategy after the bad times.

If you want to try a new strategy, consider doing it when your present investment strategy has been doing well for a while, and you see new players entering the strategy who think it is magic. No strategy is magic; none work all the time. But if you “harvest” your investment strategy when it is mature, that would be the time to do it. It would be similar to a bond manager reducing exposure to risky bonds when the additional yield over safe bonds is thin, and waiting for a better opportunity to take risk.

But if you do things like that, be disciplined in how you do it. I’ve seen people violate their strategies, and reinvest in the hot asset when the bull phase lasts too long, just in time for the cycle to turn. Greed got the better of them.

Markets are perverse. They deliver surprises to all, and you can be prepared to react to volatility by having some safe assets to tone things down, or, you can roll with the volatility fully invested and hopefully not panic. When too many unprepared people are fully invested in risky assets, there’s a nasty tendency for the market to have a significant decline. Similarly, when people swear off investing in risky assets, markets tend to perform really well.

It all looks like a conspiracy, and so you get a variety of wags in comment streams alleging that the markets are rigged. The markets aren’t rigged. If you are a soldier heading off for war, you have to mentally prepare for it. The same applies to investors, because investing isn’t perfectly easy, but a lot of players say that it is easy.

We can make investing easier by restricting the choices that you have to make to a few key ones. Index funds. Allocation funds that use index funds that give people a single fund to buy that are continually rebalanced. But you would still have to exercise discipline to avoid fear and greed — and thus my three example rules above.

If you need more confirmation on this, re-read my articles on dollar-weighted returns versus time-weighted returns. Most trading that average people do loses money versus buying and holding. As a result, the best thing to do with any investment strategy is to structure it so that you never take actions out of a sense of regret for past performance.

That’s easy to say, but hard to do. I’m subject to the same difficulties that everyone else is, but I worked to create rules to limit my behavior during times of investment pain.

Your personality, your strategy may differ from mine, but the successful meta-strategy is that you should be disciplined in your investing, and not give into greed or panic. Pursue that, whether you invest like me or not.

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.