ORDER A PIE CHART FROM YOUR BROKER AND SOMEONE ELSE WILL EAT YOUR LUNCH. AND HAVE MONEY LEFT OVER FOR PIE

While the Author is in a “Thinking but not Concluding” mode, he will reprint from past posts. This one was from December 8th. If your broker or financial advisor is telling you to reallocate your portfolio as the pie chart says, pass this post along to her or him.

“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 December 8th[i], 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.[ii] 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.

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.[iii]

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.

CODA. 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] http://desertoftherealecononomicanalysis.blogspot.com/
2005_12_08_desertoftherealecononomicanalysis_archive.html
[ii] 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.
[iii] The market is in a current upswing, but this is at best a Cycle Bull Market within the longer Secular Bear Market. So traders and active investors can take large equity exposures right now, but with the understanding that when the Cyclical Bull ends, you must sell, take your gains, and move back to defense. Long term investors must pursue absolute return strategies. Posts in the Archive section address absolute, or real return, strategies.