Hero

Well Meaning Misinformation

October 2016 Market Update

“If we insist on a degree of defensiveness that turns out to be excessive, the worst consequence should be that your profits will be a little lower than they otherwise might have been. I don't think that's the worst thing in the world.” –Howard Marks


A Twitter-Worthy Executive Summary

Missing the best 20 market days over the last 20 years turns a $100,000 portfolio value into $103,331, missing the worst 20 days, $1,213,054. Defense wins championships.


Once again, after a multi-year market rally since 2009, buy and hold investing is back in vogue with investors. When a rising tide lifts all ships, risk mitigation becomes a lessor concern next to just making sure you participate in the market action. This results in the creation of marketing pieces like the graphic below.


Source: Compelling Wealth Management Conversations. (2016). Oppenheimer Funds.

The implication of the above graphic is that a person shouldn’t even try and trade the market because missing even a few of the best days will devastate the long-term outcome of their portfolio. While the outcomes shown above are factual, the implied meaning is far from the truth.

Here is the why:  What is not readily apparent in the above data is that the calculations make the massive assumption that by making model changes an investor would not ONLY miss the best 10, 20… 60 days, but also suffer ALL of the bad days. This is a significant discrepancy and misleading in our opinion, as it is unlikely an investing experience would have all of one and none of the other. In order to dispel this misinformation, your CWM team has taken it upon itself to recreate the above data for the entire timeframe of 12/29/1995 through 12/31/15. As you can see below, simply buying and holding the S&P 500 index with a starting portfolio value of $100,000, does produce the growth in portfolio value similar to that shown in the chart above. 

→Buy & Hold: $331,846
→Best 20 Days Removed: $103,331

(Note: Outcomes differ just slightly from the above graphic due to our using a different data source than the study for the S&P500 closing values1)

However, here is how much the end portfolio value would be if, instead of missing the best 20 days, the investor misses the worst 20 days instead:

→Worst 20 Days Removed: $1,213,054

Or the worst 60 days:

→Worst 60 Days Removed: $5,547,941

If a person could miss only the bad days, their outcomes would be massively superior to buy and hold. This demonstrates why your CWM team believes mitigating risk is much more important than getting every single positive market day, even the best ones, which is why a core CWM investment tenet is “defense wins championships.”  Again, it is very unlikely that an investor would miss just the bad days or just the good days. The more likely outcome is an investor would get a mixture of both since the best and worst market days have a tendency to group together. For example, the best seven individual market days occurred during the Great Recession market crash in the fall/spring of 2008-2009 as did the four worst market days.  Here is what happens if you remove both the worst/best 20 days and 60 days:

→Worst/Best 20 Days Removed:  $377,725
→Worst/Best 60 Days Removed:  $386,745

Either scenario above is a better outcome than a simple buy and hold model. The example portfolio in this scenario also wouldn’t have suffered the scariest of the scary market days, which is worth noting from a behavioral finance standpoint, with the tradeoff being the best days were also missed. Missing a few more bad days than good days can create a significant positive difference for long term market results with less volatility and risk. Buy and hold cannot accomplish that.

The point is, risk management is obviously a worthy goal since avoiding the worst market days is significantly more important than missing the best. The way to do this is through disciplined process like CWM’s Performance Targeting System (PTS™) that aims to participate in less of the bad market days and capture more of the good.

The above is not meant to completely disparage the idea of buy and hold entirely. That strategy can be a very suitable investment methodology in certain timeframes or for certain investors who lack patience or the discipline to control their own behavioral decision making.  Poor decision making has been shown to lead to significant underperformance of average investors, a group that has been shown to routinely buy after market prices have gone up and sell after they have gone down. The graphic below demonstrates how the average investor (orange bar) has fared against just owning the S&P500 index (green bar) since 1996. 


Source: Kelly, D. et. al. (4Q 2016). Guide to the Markets. J.P.Morgan Asset Management.

The Stock Market Continues to Be Slightly Expensive

What helps us gauge when it is time to limit client stock market exposure is overall market valuation. When valuation is high, like it is today, the probability of having significantly negative market days is greater. The chart below displays some measures of the current S&P 500 valuation level, which is elevated by many historic standards. We believe current valuation levels reflect a point where prudent investors take measures to mitigate risk.

 


Source: Kelly, D. et. al. (4Q 2016). Guide to the Markets. J.P.Morgan Asset Management.

For now, caution is still warranted as risks seem elevated. CWM PTS™ models continue to be invested very conservatively, as they have been all year, with no sign that positioning will change at any point in the near future. The CWM team will continue to be disciplined in our efforts to provide the best risk adjusted returns possible for clients; a goal we have achieved so far during this year’s bout of volatility.

Please pass this article on to any one you know who may be interested in or might benefit from the information. We are always looking for more great clients just like you and would welcome any opportunity to assist them.

If you have questions or comments about the above subjects or other investment topics, I would love to have a conversation with you! Feel free to email me at MorganA@CWMnw.com or if you are interested in more regular financial tidbits, follow me on Twitter.

Morgan Arford
Chief Investment Officer, Principal
MorganA@CWMnw.com

P.S. My favorite presidential candidate, Giant Meteor, is gaining in the polls! About 1 in 4 people between the ages 18-35 prefer a giant meteor hitting the earth to either major political candidate.

1S&P500 closing data was pulled from Yahoo Finance for the timeframe 12/29/1995 through 12/31/2015. The S&P 500 Index is a market-capitalization-weighted index of the 500 largest domestic U.S. stocks. Indices are unmanaged and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict the performance of any investment. Past performance does not guarantee future results.

This article has been prepared and distributed for informational purposes only and is not a solicitation or an offer to buy any security or investment or to participate in any trading strategy. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice as individual situations will vary. For specific advice about your situation, please consult with a financial professional. Past performance is no guarantee of future results.

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