Thursday, November 29, 2012

Are the Odds in Your Favor?

One of the biggest problems with traditional buy and hold investment strategies is that markets are not static.  During uptrends the odds of making money are largely in the investors favor while the odds of losing money are low.  However, during downtrends the odds of losing money are high and the odds of making money are low.  That doesn't mean that an investor can't make money when the odds are against him and it doesn't mean that an investor can't lose money when the odds are with him.  In any uptrend there will be plenty of down days, weeks, and months.  In any downtrend there will be plenty of up days, weeks, and months.  So, in an uptrend a buy and hold investor won't make money all the time, but if they stick with their strategy they will make money overall.  If we only had uptrends in markets then buy and hold would be a valid strategy but that is not how markets work.  In a downtrend a buy and hold investor won't lose money all the time, but if they stick with their strategy they will lose overall.  During the days, weeks, or months when they can make money they assume they are following a smart investment strategy, but this is not the case as it is never smart to invest in such a way that stacks the odds against you.  Over time this is why most investors end up going nowhere.

A good analogy to this is in Blackjack.  Blackjack has a certain set of "rules" (when to hit, when to stay, when to double down, etc) that if you abide by them give the card player pretty much equal odds with the house.  Anyone who has played Blackjack before knows there is always someone at the table who doesn't play by the rules, they hit when they aren't supposed to or stay when they should hit.  Every once in a while this person wins.  Does that make what they are doing smart?  Not at all.  Over time if they follow this strategy it puts the odds substantially in the house's favor. 

The key to investment success if reallly quite simple, always keep the odds in your favor.  Take the most risk when the odds are in your favor and reduce or eliminate risk when they are not.  You won't win all the time.  Sometimes it will be emotionally difficult to stay on the sidelines during an upside correction in an overall down market.  If you keep the odds in your favor over time you will end up much better off than the traditional buy and hold investor who sometimes has the odds on his side and often doesn't.

Tuesday, November 13, 2012

Monday, November 12, 2012

The Fiscal Cliff: Much Ado About Nothing?

Elections have consequences and this one will have consequences for what happens with the Fiscal Cliff.  Wall Street immediately sold off after  election results that looked like more of the same gridlock but this election might actually have been a pretty good scenario for avoiding the Fiscal Cliff.  While the Republicans maintained their majority in the House they lost seats and were expecting a much better outcome across the board in many winnable elections.  While the Democrats kept the White House and the Senate, and picked up seats, this was far from a landslide or a mandate.   In their post election rhetoric both sides look willing to deal.  Republicans seem to understand that some sort of tax increase, no matter how it is ultimately packaged, is inevitable.  Democrats seem to understand that they need to compromise with the other side and may not get everything they want.  What type of agreement we ultimately get is anyone's guess, here are a couple of ideas:

1. No "tax increase" on the wealthy but a phasing out of loopholes that is expected to generate somewhere near the same amount of revenue.  This would allow the Republicans to stick to their no tax increase pledge while basically being the same as a tax increase.

2. A smaller tax increase on the wealthy than the Democrats want.  This would allow Republicans to say they held the line somewhat.  This could also be sweetened with some sort of agreement to tackle the tax code and/or entitlements.

3. We could actually go off the Fiscal Cliff at year end, then in January have a retro-active deal.  Any deal in January could be spun as a "tax cut" as rates would have risen and a deal would bring them back down (even though they would still be higher than December).

At the end of the day the stakes are too high and the public has spoken.  Both sides will figure out some agreement that allows them to save face with their base and claim some sort of victory.  Whether this turns out good for the economy longer term is anyone's guess.  We still have a lot of problems that need solving and it is doubtful they will be addressed. 

Of course I could be wrong and there could be no agreement, what happens then?  That is the beauty of being tactical.  We don't move based on predictions, we follow market trends.  If the Fiscal Cliff is not solved we will just move to Treasuries, Gold, bonds, and/or cash and wait out the turmoil.  If it does get solved we will participate in any rally that ensues.  Either way we are prepared.

Monday, November 5, 2012

Is Tactical Practical?

There was an interesting article in the Wall Street Journal this weekend questioning whether tactical asset allocation has merit anymore (after a ton of articles following 2008 questioning buy and hold).  The author points out that a buy and hold portfolio of 60% stocks and 40% bonds would have outperformed tactically managed portfolios over the past three years so maybe tactical isn't practical.  

We have talked about this in other posts but to reiterate, you have markets that are in an uptrend, markets that are in a downtrend, and markets that are choppy.  Buy and hold rides the market up and rides the market down.  Tactical asset allocation stays in harmony with market trends.  When stocks are going up it will invest in them, when they start to go down it will get out of them and into cash or whatever else is going up.  In an uptrend a tactical portfolio and a buy and hold portfolio will look pretty similar.  In a downtrend, the buy and hold portfolio will ride the market down while tactical will not.  Choppy markets are the worst kind of markets for tactical as there are no real trends to grab onto.  The end result could be an up market, like this year and 2010, or a basically flat year like 2011.  Buy and hold portfolios ride the market up and down and end up wherever the market ends up.  This is of course assuming the investor can stand the volatility---a buy and hold investor in the S&P 500 would have had to hold on through the following:

May 2010 down 7.99%
June 2010 down 5.23%
August 2011 down 5.43%
September 2011 down 7.03%
May 2012 down 6.01%

Source: Morningstar

Because tactical asset allocation does not try to predict markets (nobody can do that), choppy markets with large up months and large down months are very difficult to navigate as there is no real trend to grab onto.  So is tactical practical?  If every year going forward the market was going to be choppy and we would never have another 1973-4, 2000-2, or 2008 again then maybe not.  Of course that is not how markets work, we will always have up markets, down markets, and choppy markets.  A buy and hold portfolio may make money in up and choppy markets but it will give it back in the down markets.  Tactical will not beat buy and hold every week, month, year, or three years.  But, over time, a good tactically managed portfolio will always blow away a buy and hold portfolio because it will hang onto most, if not all, gains during a down market.