A Better Approach To Investment Risk Management

Updated July 25, 2019

Investment risk management is significantly improved using a Market Conditions 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 (see What Is A Market Conditions Model And How Does It Lower Risk?). I established a simple objective … divide the market into three buckets: Favorable, Balanced, and Hostile.

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 Conditions Model. I did a great deal of testing before I hit upon measures which worked consistently well across multiple full market cycles (see What Is A Full Market Cycle And Why Should I Care?).

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 Conditions 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 and the Vanguard Balanced Index Fund, including dividends, with a starting investment of $100,000. Here is what the chart shows:

  • Hold VBMFX (Vanguard Bond) when market conditions are Hostile, hold VTSMX (Vanguard Stocks) when market conditions are Favorable, and a 50/50 mix when market conditions are Balanced.
  • Buy and Hold the Standard & Poors 500 Index ETF
  • Buy and Hold the Vanguard Balanced Index Fund

Here are the statistics through June of 2019, a period of 19 years:

S&P 500 ETF Buy and Hold:

  • Spent 230 months long SPY
  • Earned $180,100 in dividends and gains
  • Endured two Bear Markets
  • Incurred Maximum Monthly Drawdown of 51%

Vanguard Balanced Index Fund Buy and Hold:

  • Spent 230 months long the VBINX
  • Earned $191.718 in dividends and gains
  • Endured two Bear Markets
  • Incurred Maximum Monthly Drawdown of 37%

Market Conditions Model with Vanguard Stock Fund and Vanguard Bond Fund

  • Spent 107 months long VTSMX
  • Spent 67 months long VBMFX
  • Spent 56 months long 50% VTSMX and 50% VBMFX
  • Earned $445,088 in dividends and gains
  • Endured two Bear Markets
  • Incurred Maximum Monthly Drawdown of 18%

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.

  • Favorable: A strongly trending market with little risk of major decline. Unexpected declines are likely to be temporary and relatively short-lived.
  • Balanced: Risks of market decline and opportunity for advance are roughly equal; however conditions are supportive of increased volatility and uncertainty.
  • Hostile: High risk of extended market Correction (10%+) and Bear Market (20%+) declines and large equity drawdowns.

Finishing Touches

The final step in our improved investment risk management methodology is to combine the Market Conditions Model using our three baskets with the Tactical Model making the fund selections. The test period is one full market cycle beginning October 2007:

Here are the statistics through June of 2019, a period of 12 years:

S&P 500 ETF Buy and Hold:

  • Spent 141 months long SPY
  • Earned $144,724 in dividends and gains
  • Endured one Bear Market
  • Incurred Maximum Monthly Drawdown of 51%

Vanguard Balanced Index Fund Buy and Hold:

  • Spent 141 months long the VBINX
  • Earned $115,119 in dividends and gains
  • Endured one Bear Market
  • Incurred Maximum Monthly Drawdown of 33%

Market Conditions Model and Tactical Model with Adaptive Global Strategy

  • Spent 141 months running the Models
  • Earned $446,816 in dividends and gains
  • Endured one Bear Markets
  • Incurred Maximum Monthly Drawdown of 9%

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

 

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A Caveat

A 35+ year secular bull market in both equities and bonds began in 1982. The last cyclical bull market in equities (and to a lesser extent, bonds) began 10 years ago. Returns during these periods have been historically exceptional. Market returns for the next 10 years are highly unlikely to approach those of the past 10. In fact, there is at least some evidence that market returns have a high probability of being significantly lower and that bonds and equities (which have risen together) may actually begin working at cross purposes.

Investors should not use the statistics shown for our strategies to establish expectations of specific levels of returns or drawdowns. Investors should, however, appreciate that we believe the principles which underlie the Tactical Adaptive Global, Tactical Adaptive Income, and Tactical Adaptive Innovation Strategies are enduring enough to significantly outperform the market in the future, both in lowering risk and in improving returns.

 

A Caveat

A 35+ year secular bull market in both equities and bonds began in 1982. The last cyclical bull market in equities (and to a lesser extent, bonds) began 10 years ago. Returns during these periods have been historically exceptional. Market returns for the next 10 years are highly unlikely to approach those of the past 10. In fact, there is at least some evidence that market returns have a high probability of being significantly lower and that bonds and equities (which have risen together) may actually begin working at cross purposes.

Investors should not use the statistics shown for our strategies to establish expectations of specific levels of returns or drawdowns. Investors should, however, appreciate that we believe the principles which underlie the Tactical Adaptive Global, Tactical Adaptive Income, and Tactical Adaptive Innovation Strategies are enduring enough to significantly outperform the market in the future, both in lowering risk and in improving returns.

A Caveat

A 35+ year secular bull market in both equities and bonds began in 1982. The last cyclical bull market in equities (and to a lesser extent, bonds) began 10 years ago. Returns during these periods have been historically exceptional. Market returns for the next 10 years are highly unlikely to approach those of the past 10. In fact, there is at least some evidence that market returns have a high probability of being significantly lower and that bonds and equities (which have risen together) may actually begin working at cross purposes.

Investors should not use the statistics shown for our strategies to establish expectations of specific levels of returns or drawdowns. Investors should, however, appreciate that we believe the principles which underlie the Tactical Adaptive Global, Tactical Adaptive Income, and Tactical Adaptive Innovation Strategies are enduring enough to significantly outperform the market in the future, both in lowering risk and in improving returns.