A Better Approach To Investment Risk Management

Investment risk management is significantly improved using a Market Risk Model and ETF baskets constructed for Favorable and Unfavorable market conditions.

Missing 10 Best Days versus 10 Worst

The Financial Services industry heavily promotes the concept of buy and hold using Modern Portfolio Theory (aka Strategic Asset Allocation). It sagely informs investors that “market timing” is utter nonsense and we hear a good deal about the dire consequences of missing the best 10 days of market gains. Not so well promoted are the consequences of missing the worst 10 days of market gains.

We’re going to assume we had $10,000 to invest in the stock market on January 1, 1995 which was to be invested for the next 20 years through 12/31/2015. Here is how the numbers stack up (data courtesy of IFA: Missing the Best and Worst Days):

  • Remain fully invested for 5,038 trading days = 7.68% annual return
  • Miss the 10 best days of market = 4.0% annual return
  • Miss the 10 worst days of market = 14.13% annual return

You read that right … returns nearly doubled by missing just the 10 worst days. I’m often accused of harping on the “Maximum Drawdown” message but I think these statistics make the point that drawdowns are far more deleterious to portfolios than commonly appreciated.

"The next time that your stockbroker, financial advisor, or portfolio manager sagely informs you that any form of “market timing” is utter nonsense, consider whether that person is utilizing the best available tools to manage your investments."

Clearly, we should require a better approach to investment risk management than simply "buy and hold".

Can We Forecast The 10 Best and Worst Days?

No we can not!

But that does not mean that we can not identify market conditions which are conducive to better days and conducive to worse days. And market conditions which are conducive to better and worse days are far more likely to include the best days and the worst days. That does not mean that some of the best days won’t be mingled in with some of the worst and vice-versa. It does mean that we can stack the overall probabilities in our favor to improve our investment risk management.

Market Risk Model

I have studied market history for over three decades while developing and honing my market analysis skills. Somewhere along the path, my focus shifted from attempts to forecast market direction to measuring the health of the market. Lessons learned about market behavior and psychology under different conditions provided the foundation for developing the Market Risk Model. I established a simple objective … divide the market into two buckets: “Favorable” (healthy) and “Unfavorable” (unhealthy).

I’ve been building models of one kind or another for decades and one of my rules is that models must be simple and straightforward without a bunch of conditions designed to handle “exceptions”. I concluded that direction of the market, investor psychology, and market valuations were among the key criteria to be included in the Market Risk Model. I did a great deal of testing before I hit upon measures which worked consistently well across multiple full market cycles.

Beating the Market

The S&P 500 seems to be the benchmark everyone wants to beat and it is notoriously difficult to model. So my early challenge was to test the Market Risk Model against the S&P 500. What follows is an updated version of the testing I performed several years ago using the S&P 500, including dividends, with a starting investment of $100,000:

  • Case #1: Buy and Hold the S&P 500
  • Case #2: Hold the S&P 500 during “Favorable” markets and hold cash during “Unfavorable” markets

S&P 500 Buy and Hold:

  • Spent 205 months long the S&P 500 during a 17 year period
  • Earned $118,024 in dividends and gains
  • Endured two Bear Markets
  • Incurred Maximum Drawdown of 51%

Market Risk Model:

  • Identified 4 Favorable markets (82 months) and 5 Unfavorable markets (123 months)  during 17 years
  • Spent 82 months long the S&P 500
  • Earned $166,340 in dividends and gains (41% higher)
  • Skipped two Bear Markets
  • Incurred Maximum Drawdown of 8%

Custom Fund Baskets

I have a strong preference for large, liquid, low-cost Exchange Traded Funds (ETFs) which are passively indexed. The logical next step was to build custom ETF fund baskets suitable for each type of market.

An  “Unfavorable” market is characterized by higher volatility and greater risk of sharp declines. While we want to participate in positive trends within Unfavorable markets, we want to dampen volatility and go to cash under the most adverse conditions. A basket designed for Unfavorable market conditions is constructed to target low volatility and hedge risk. I refer to this basket as “Core”. Such a basket may also be as an “all weather” strategy where the investor wishes to moderate volatility under all market conditions.

A “Favorable” market is characterized by strong trends and low valuations. Such markets may incur short, sharp declines but tend to recover quickly. A basket designed for Favorable market conditions is constructed to participate in those parts of the market which have rapid growth and strong multiple expansion. I refer to this basket as “Satellite”.

Finishing Touches

The final step in our improved investment risk management methodology is to combine the Market Risk Model with the two baskets. The rules are simple:

  • Risk Model says market is “Unfavorable”: 100% of investment remains in the Core basket
  • Risk Model says market is “Favorable”: 100% of investment moves to the Satellite basket (Aggressive version) or 50% of investment remains in the Core basket and 50% moves to the Satellite basket (Conservative version)

S&P 500 Buy and Hold:

  • Spent 116 months long the S&P 500
  • Earned $97,853 in dividends and gains
  • Endured one Bear Market
  • Incurred Maximum Drawdown of 51%

Market Risk Model with Core & Satellite baskets (Aggressive)

  • Identified 3 Favorable markets (54 months) and 4 Unfavorable markets (62 months)
  • Spent 54 months long the Satellite basket and 62 months long the Core basket
  • Earned $295,031 in dividends and gains (302% higher)
  • Skipped one Bear Market
  • Incurred Maximum Drawdown of 8%

The next time that your stockbroker, financial advisor, or portfolio manager sagely informs you that any form of “market timing” is utter nonsense, consider whether that person is utilizing the best available tools to manage your investments.

Earl Adamy

 

Ready to learn More about the Strategies?

Learn how our Subscribers use our Tactical Asset Allocation Global Strategy to lower risk and improve returns.

Not ready to subscribe but want to stay in the loop?

Sign up for Earl's Tactical Asset Allocation Strategies newsletter and receive his featured articles and performance updates.