I ask prospective clients the following two questions:
If the stock market was up 12% in a year what would you expect the return on your portfolio to be? If the stock market was down 12% in a year what would you expect the loss on your portfolio to be? The question is general enough to get them thinking.
The answers are often surprising.First, a disclaimer: There is a right answer. Yes, you read that correctly; I did not say that there is no right answer. There is no right answer in the fields of comparative literature, eastern spirituality, or modern art, but in the investment world there are right answers and wrong answers. I will give you the right answers and wrong answers.There are two possible responses to each question: you expect your portfolio return to be more than (>) 12%, or less than (<) 12% in an up market, and you expect your portfolio return to be more than (>) -12%, or less than (<) -12% in a down market. (I could have picked 10, 11, or 13%--nothing fixed about the 12% number, but I wanted it to be slightly higher than average returns to stimulate thinking). The four types of investors:
Speculator Dreamer Amateur Contrarian Speculator
Q: If the stock market was up 12% in a given year what would you expect the return on your portfolio to be?A: > 12%Q: If the stock market was down 12% in a given year what would you expect the loss on your portfolio to be?A: < -12%This is not an unrealistic response. Speculators expect more return when the market goes up and more loss when the market drops. Professional speculators, venture capital, private equity, might fit this category. However, the way that a professional speculator makes money is by having a strict sell discipline in a down market (or by being in so many deals that the rare supernova investment eclipses the numerous asteroids). A strict sell discipline, is what separates the professional from the accidental.I don’t think that the non-professional investor has the time, tools or skills to monitor the risk of his portfolio to be an effective speculator. Note that I said effective speculator. We all know the ineffective speculators who simply want to beat an up market but are completely uninformed about down markets—day traders, IPO buyers, penny stock buyers, etc. Maybe you have known this person. Maybe you once were this person.Paul Tudor Jones is one of the great speculators of our time. Jones is primarily a commodities investor originally from Memphis, TN. I met him in Atlanta years ago near the beginning of his career when he created a futures fund for Merrill Lynch. In 1987 he reportedly made between $80 and $100 million—more than anyone else on the street. He currently has a net worth over $4 billion. What philosophy guides him? “I'd say that my investment philosophy is that I don't take a lot of risk… at the end of the day, the most important thing is how good are you at risk control. Ninety-percent of any great trader is going to be the risk control.”[i] Dreamer
Q: If the stock market was up 12% in a given year what would you expect the return on your portfolio to be?A: > 12%Q: If the stock market was down 12% in a given year what would you expect the loss on your portfolio to be?A: > -12%This answer is illogical and is the most dangerous investment philosophy to hold. Investment strategies that short-term outperform the market on the upside tend to be aggressive in nature, or employ leveraging techniques such as buying on margin or options. Such strategies have the opposite effect in a down market and multiply losses. Now, a clever money manager might say that he employs aggressive strategies in up markets and conservative strategies in down markets, and that is how he plans on achieving superior returns in either market.The problem is that we never know in advance whether we are in a good market or a bad market. For example, the market debacle from 2007-2009 which befell sub-prime bond investors. They didn’t know that they were in a bad market until a few days before they folded their business and took multi-billion-dollar write downs. “On Oct. 1 the bank disclosed that it was writing down $3.4 billion in losses largely due to ill-considered bets on the U.S. subprime market…UBS held $19 billion in subprime residential mortgage-backed securities-90% or more of it rated AAA.”[ii] UBS, obviously, did not know what kind of a market they were in.The investor who expects to outperform in an up market and a down market will be disappointed and eventually divest. Even professional money managers who would describe themselves as aggressive would not expect these kinds of returns nor promise them. Of all of the choices this is the most highly suspicious. Amateur
Q: If the stock market was up 12% in a given year what would you expect the return on your portfolio to be?A: < 12%Q: If the stock market was down 12% in a given year what would you expect the loss on your portfolio to be?A: < -12%This investor expects lower than market returns in good years and bad years. Most studies (Dalbar, Inc. among the best resources) would indicate that this is what average investors accomplish. They don’t capture all of the upside but they lose more than the market in bad years. This was witnessed in the internet bubble and in any period of market excess when investors get into the market too late, thus never receiving any long-term benefit and exiting only after significant (I’m never going to do that again) losses. This is a wrong answer. If you really feel this way, you might be acting out of fear. If your fear is this great you may not be suitable to be a stock investor. Contrarian
Q: If the stock market was up 12% in a given year what would you expect the return on your portfolio to be?A: < 12%Q: If the stock market was down 12% in a given year what would you expect the losses on your portfolio to be?A: > -12%I believe this is the best answer for the non-professional long-term investor, and the most realistic route to positive returns. This investor realizes that the key to long-term wealth accumulation in the stock market is protection in down markets, thus he gives up some on the upside but protects on the downside.Hedge-fund managers, whom some consider the savviest of professional money managers, would fit in this category. Brian Portnoy, Ph.D., CFA wrote, “(M)ost hedge fund managers use hedging techniques, many of them will underperform in up markets and outperform in down markets. This speaks to a lower risk profile, not higher.”[iii] Why does this work? Math.
The numbers always work against you. How do the numbers work against you? Call it investment gravity. Remember, if you lose 50% in one year how much do you need to make in the next year to break even? 100%--twice as much. You need to absorb that and see how you can have investment gravity work for you. That is, realize that if you can only protect yourself during the down markets your total return will be higher than the person who did not protect himself.There actually is a fifth answer to the question. Whether the market goes up or down 12% you expect your returns to be neither greater than the market nor less than the market. You simply expect whatever the market returns. This answer would come from the committed index fund investor, and certainly a legitimate way to invest as over $2 trillion in exchange traded funds (ETF) and index funds attests. I hope that you can see the advantage of knowing your client in this very important way. It is also vital that you know yourself as an advisor. If you are a contrarian do you think it would be a good idea for you to manage speculative portfolios? [i] Ramin, Joel, “Interview with Paul Tudor Jones II (Abridged),” http://chinese-school.netfirms.com/Paul-Tudor-Jones-interview.html, 1/13/00.[ii] Reed, Stanley, “UBS Gets Whacked by Subprime Mess,” Business Week, http://www.businessweek.com/stories/2007-10-01/ubs-gets-whacked-by-subprime-messbusinessweek-business-news-stock-market-and-financial-advice.[iii] Portnoy, Ph.D., CFA, “The Investor's Paradox: The Power of Simplicity in a World of Overwhelming Choice,” New York: Palgrave Macmillan Trade, 2014. Kindle.
