ORDER A PIE CHART AND YOU WILL BUY SOMEONE ELSE LUNCH

"WAITER, I WILL HAVE A PIE-CHART WITH LUNCH.”
”HMM, SHE IS HAVING THE PIE CHART. WELL THEN I WILL HAVE HER LUNCH AND SHE CAN HAVE HER PIE CHART. AND SHE WILL PICK UP MY TAB.”

The Author’s post of yesterday, December 8th, was a smarmy dismissive of the “Buy and Hold”, pie chart asset allocation product that nearly all brokers and financial clients sell to their clients. The Author uses the word “product:” because that is what it is called in the investment industry. It is a semi-standardized investment methodology, along with “preferred” mutual funds, pre-selected stock portfolios, exchange traded funds or other packaged investments. The industry generally refers to these packages as “investment products”.

They are often marketed as “conservative”, “moderate”, or “aggressive”. This refers to the “risk” that each product takes in an attempt to generate a higher return. But as stated in earlier posts, risk is not a knob that can be turned to automatically generate a higher return.[i] Risk and expected return have a complex interplay, especially in a Bear Market. As the recent posts discussing Alpha have demonstrated, investments that appear to have less risk, like a value stock mutual fund, can have higher returns than aggressive, more risky, stock funds. (INCLUDE DATES OF ALPHA POSTS).

RISK AND REWARD, VOLATILITY AND CIRCUMSTANCE

Volatility was a big topic in the earlier posts on Alpha and Beta. Beta is a specific gauge of volatility that compares the volatility of a mutual fund or stock to the volatility of the S&P 500 index. Investments with a Beta of 1 move in unison with the S&P. Investments with Betas less than 1 swing less in value than the S&P. Investments with a Beta higher than 1 fluctuate more than the S&P.

Remember how it worked with the high Beta Afterburner Tech stock fund and the low Beta Slow and Steady Value stock fund? In a down-trending market, Slow and Steady beat the tech stock fund. If the trend of the market is down, and an investment is more volatile than the market, such volatility will amplify its moves to the downside because the investment will be going down more than up. This is the reason that a Bull Market style aggressive stock portfolio is a formula for financial disaster in a Bear Market. The next section of this post will show how such a disaster often plays out, using a hypothetical client and broker.

DISAPPOINTED WITH YOUR LOW OR NEGATIVE RETURNS? DON’T LET YOUR BROKER MAKE THINGS WORSE.

Let’s assume that an investor holds a pre-selected mutual fund portfolio with a “moderate” risk rating. The “moderate” portfolio was selected in 1998 and contains the client’s retirement savings portfolio. The investor turned 45 in 1998 and then had 22 years until her proposed retirement in 2020 at the age of 67. She did well in 1998 and 1999, but the 2000 stock plunge saw her portfolio fall by 1/3 between 2000 and 2002. Today, she is still a little below what she had in 2000. The investor is 15 years away from retirement and she is worried she will not have enough money for retirement. Sound familiar?

If she goes to her broker and shares her fears that her money may not grow enough to allow her to retire in 2020, what is her broker likely to do? If you guessed that her broker, a “buy and hold” pie chart devotee, may tell her to shift her funds into the “aggressive” portfolio to seek higher returns, you are right!

The broker will tell our investor that the stock market has been down the last few years and that her portfolio went down with the general stock market. But, the broker will go on to say the stock market has been up “lately”. And over time, the growth stocks in the “aggressive” portfolio should outperform the more conservative stocks the investor holds in the “moderate” portfolio.

The broker will probably make the obligatory disclaimer that “past performance is no guarantee of future results”. The broker and investor will ignore this statement, even though it is likely correct for the rest of this Secular Bear Market.

The broker will probably also show the investor the historical 5-year, 10-year, and 20-year performance figures of the “aggressive” portfolio and compare that to the “moderate” portfolio’s returns. The investor and broker will take comfort in the fact that the 10-year and 20-year returns for the “aggressive” portfolio are higher than the “moderate” portfolio. The broker and investor will not consider the fact that these returns were made during the Secular Bull Market of 1982-2000 and likely will not be repeated in the current Secular Bear Market.

“Remember,” the broker will then say, “You are investing for the long term, and over the long term, the aggressive fund should give you higher returns than the moderate portfolio. And look, this aggressive portfolio has a higher Beta than the moderate portfolio. That is good.” The conversation will end, the investor will shift portfolios, and she will set herself up for even lower returns for the next few years.

THE BROKER TOOK A BAD SITUATION AND PROBABLY MADE IT WORSE.

If the broker and/or the client understood that the market is in a Secular Bear cycle that began in 2000 and will not end for a number of years, the investment change from moderate to aggressive would not have been made. They would have understood that in a down-trending market, the greater volatility of the “aggressive portfolio” would tend to cause greater losses and lower gains than the more conservative portfolios.

WHY DID YOU BRING YOUR SNOW SKIS TO GO WATER SKIING?

Investors and their advisors must understand that the tools that worked in the Secular Bull Market of 1982 to 2000 will NOT work well in this Secular Bear Market. It must be considered that most of the brokers and many of the investment tools and methodologies were not operating in the Secular Bear Market of 1966 through 1982. So these strategies were not tested in a Secular Bear Market and should not be expected to work in a Secular Bear Market.

If the tone of the Author in criticizing the “Buy and Hold” methodology seems harsh and sarcastic, well, it sometimes is. The intent is not malicious. The intent is to help investors and investment advisors get better results. It is often difficult for people to turn away from the “tried and true”, what has always worked. What “got them to where they are today.” But too often the “today” people are looking at has long been yesterday. The recognition that yesterday’s methodology is today’s disaster dawns on most people far too late.


LIVE AND LEARN, LIVE AND RELEARN, IN THE DESERT OF THE REAL!


[i] This analogy of risk to a “Knob” or “Dial” is not the Author’s. Gary Easterling of Crestmont Research frequently uses it in his writings. www.crestmonresearch.com.

SOME SNARKY THOUGHTS ON THE “BUY AND HOLD”STRATEGY

BUY AND HOLD” STRATEGY WAS LAST CENTURY’S STRATEGY. WHEN THE FACTS CHANGE, WE MUST CHANGE.

The investment strategy that most investment advisors recommend is to buy and hold a diversified portfolio of investments. The diversification strategy is usually determined by the percentages set out in a computer-generated pie chart.

Many readers have seen these pie charts. The prior post contains a simplified, yet more “accurate” example of the pie charts most brokers and financial planners prepare for their clients. I am of course being snarky and sarcastic. But in Secular Bear Markets where investments are flat or lagging, this is not an inaccurate caricature.

The “Buy and Hold” diversification strategy had some financial and investment basis in the last Secular Bull Market, 1982-2000. Time, but not the industry, has passed it buy.

This "Buy and Hold" method combines three disparate strategies:

Modern Portfolio Theory. Modern Portfolio Theory, often abbreviated as MPT, has been around since the 1950s. Henry Markowitz first introduced it. MPT states that there are two types of risk in the market, systemic risk and non-systemic risk. The first risk, systemic risk, is the baseline risk of the investment market itself. So if you invest in the stock market, you are incurring the general risk that the market will rise or fall. You cannot eliminate this risk. It is systemic to the stock market. The second type of risk is non-systemic risk. This is risk above and beyond stock market risk. It is not risk from the stock market itself. It is the risk you take by owning a specific stock or mutual fund. Calculations like Beta, Alpha, and Standard Deviation can help you determine what that non-systemic risk might be.

MPT seeks to minimize non-systemic by investing in diversified portfolios of investment that either minimize risk or reduce non-systemic risk. Index funds, exchange-traded funds, broad baskets of category stocks would ways to achieve this diversification. Under MPT, we do not focus much on balancing risk/reward. We seek to minimize the risks through more sophisticated “buy and hold” pie-chart models. And we stick with this model until one of three things happen:

1. Our model fails and we must reallocate and try something else.

2. Our model succeeds and we “rebalance” the portfolio. This means that we sell our winners while they are still making money with them. We take the profits from our good performing holdings and reinvest this money into investments in our portfolio that are lagging and losing money. “We must,” will say the pie-chart broker, keep 10% of your portfolio in mid-cap value funds, no matter how much they have fallen in value. That is what the home-office pie chart says.”

3. We get older (like reach 35 or 55 or 65 and the portfolio must get more "conservative") and the broker’s home office tells us the pie chart must change, regardless of what was working or not-working the day before the pie-chart changes.


Efficient Market Hypothesis. (EMH). EMH comes in two flavors, flavors that a particle physicist might admire[i]. Strong EMH and Weak EMH. So what is EMH? The Efficient Market Hypothesis believes that the stock market is “informationally efficient”. This means that everything that is out there to be known about a stock is known and that the price of a stock reflects all of that information. And since everyone knows everything about the stocks and markets, it is impossible to “out know” a stock or a market. Let’s try an example:

One of our more maligned stocks, Hogsome-Darlington (HOG), is a manufacturer of obsolete American motorcycles. You are a stock analyst and your research determines that HOG motorcycle sales will fall precipitously when the US government outlaws the use of leather tassels on the end of motorcycle handlebars. Your research has revealed that people do not ride HOGs based upon their performance or reliability. In fact, HOGS grossly under perform other motorcycles and are notoriously unreliable. They are sold with a pre-printed “Lemon Law” complaint that the buyer can fill out ahead of time and send in with the registration documents.

No, your research reveals that people buy HOGs so they can let their leather tassels fly in the wind and look cool in the eyes of other HOG owners. Based upon this research, you sell HOG short and wait for it to fall.

The EMH, however, tells you that the market must already know the leather tassel story and the current price of HOG must reflect this knowledge. Even if HOG continues to rise in the face of certain bankruptcy. So why bother picking stocks? Since the market knows all of the information, like some giant lattice of magic wisdom, you cannot beat the market by speculating on HOG’s demise. Under EMH, all you can do is buy index investments and exchange-traded funds and hold them while the stock market (hopefully) rises. Sound familiar.

Above is the Strong Version of EMH. A newer theory, developed with the recognition that Strong EMH is baseless, is Weak EMH. Weak EMH argues that most everything about the market is known, and the market is generally informationally efficient. Could be. Or it could be the EMGH proponents finanly acknowledged their hypothesis was wrong and had to salvage their theory by diluting it.


Never Be Wrong Alone. Sir John Maynard Keynes once said (paraphrased) “If you are to be wrong, better be wrong with most everyone else”. So most brokers, financial advisors, portfolio advisors, like most other professions, all strive to be wrong together. If you are right and alone, you might get a bonus. Wrong and alone, a pink slip. This tendency among investment advisors to follow the dogma of the day, “Buy and Hold” like the pie-chart says, is safer. And it is a heck a lot of easier than developing investment models that actually help clients prosper in a Secular Bear Market.

SO HOW DO WE MAKE MONEY, YEAR IN AND YEAR OUT?

Prior posts have discussed Secular Bear Market strategies such as inverse funds, put purchases and lots of cash earning T-Note interest rates. A post of the last week talked about high Alpha mutual funds. In upcoming posts the Author will discuss some ways to value stocks and international investments as modest growth strategies.

WE KNOW MORE THAN THEY DO IN THE DESERT OF THE REAL!

[i] Okay, this is an inside joke for the physicists out there. There are two atomic forces, the “Strong” force, and the “Weak” force.

PORTFOLIO ASSET DIVERSIFICATION PIE

WHAT AN INVESTMENT ALLOCATION PIE CHART REALLY SAYS