“Drawdown” has become the most feared word in the 401k vocabulary, just as “Total Return” has become the most worshipped phrase. OMG, how will plan participants be able to retire if their portfolio market values stop rising!
“Well, yeah,” you might say, “isn’t that what investing is all about. If you’re in the right sectors and the right funds, your drawdown will be minimized.” Well , yeah, that could be a viable drawdown minimization scenario if we had a crystal ball that could identify the “right” vehicles.
We don’t, and a litany of supportive sector correlation statistics just doesn’t change the basic facts of investment life that still are referred to respectfully by some as the “Market Cycle”.
Can you remember how easy portfolio management once was, simply by applying basic “QDI” principles to portfolio content selection and profit taking disciplines? It was a time when navigating an investment portfolio through the unpredictable, cyclical, undulations was indeed, a labor of love and respect for economic fundamentals… with strategies based on cyclical realities.
MPT charlatans, with “Frankensteinian” creativity, have transformed text-book-defined speculation into a passive sector-timing process based on probabilities… games of chance yet to be tested through any form of market correction.
In a program with no promise of income and no concern for fundamentals, is it any wonder market value drawdown is so feared.
Place today’s ETF and Mutual Fund equity content into the three Major Meltdowns of the past 30 years, and it’s likely that you’ll see the very same drawdown numbers… or worse, because of the artificial demand for a finite supply of real securities.
Drawdown happens; corrections are inevitable. The same MPT hocus pocus that, theoretically, is placing 401k dollars in the right sectors is, perversely, exacerbating the problem by blowing up the highest security price balloon ever, even higher.
Keep in mind as well, advisors and fiduciaries all, while we wonder at the brilliance of those who have created this ethereal (surreal), market fantasy land, that it is they (not you and I) that wield the fatal “pin”.
When the bubble bursts, remember these thoughts:
Drawdown minimization is accomplished by: investing only in “investment grade”, high quality, securities (fundamentally speaking); then diversifying among them sensibly within two “purpose delimited” security buckets; and regarding realized “base income” as the primary purpose of the income allocation and the secondary purpose of the equities.
With strict buy, hold, and reasonable profit-taking disciplines governing portfolio operations, drawdown minimization, continual income growth, and rapid recovery is virtually a sure thing… a sure thing that isn’t possible in a 401k environment that has kicked fundamental quality and income growth principles to the curb.
Decades ago, the academic community and financial services industry, in an effort to better understand what causes good versus bad rates of return in stock markets, began studying differing styles of investment management. There isn’t a hope of my staying awake long enough to cover even a sampling of the variety of styles that are out there, so I’ll keep it simple. Two styles in particular get plenty of attention: growth and value.
With the growth style, portfolio managers use their ingenuity to identify companies that are growing most rapidly. Since I carried around a BlackBerry (aka CrackBerry) for many years, I’ll use its creator Research in Motion(RIM) as an example. When the company was first getting its legs, it offered me and other research analysts a free trial of a little device with a monochrome screen that allowed you to send and receive text messages. We became addicted to them overnight and believed that this kind of service would catch on. Early movers can grow businesses very quickly with sufficient research depth, management expertise, and capital. We professional money managers provided the capital to RIM and the rest is history.
Early on, RIM was a growth company because even though they weren’t profitable and wouldn’t be making money for many years, the company kept selling more and more units. Revenues grew like crazy and, with some occasional disruptions (a market crisis, the technology bubble bursting), so did the stock price.
Portfolio managers who specialize in companies such as RIM are commonly called growth managers. The funds they manage are “growth funds.” The portfolio will usually have many stocks in various industries. They can be fast growing companies in slow growth industries or companies benefitting from an industry that is suddenly growing. Growth stocks can be very expensive. Investors expect the company to grow fast and so are willing to pay a higher price. However, you’ll have to buy a book explaining price/earnings (P/E) ratios, P/E to growth rate ratios, price/sales (P/S) ratios if you really want to get into security analysis yourself.
A value manager is more interested in buying and owning cheap stocks. Some companies grow slowly but pay their shareowners high dividends as compensation. A stock can be in an industry that is out of favour with the investment herd, or an industry can be out of favour entirely, making all the stocks in the sector cheaper. There are measures such as price/book ratios (P/B) and price to net asset value ratios that analysts use to gauge whether a stock is cheap or not.
Growth funds are considered riskier or more volatile than value funds. For instance, if the market is going higher because of a particularly strong economy, then the growth fund should go even higher still. A value manager might not perform as well as a growth manager in a bull market but won’t do as poorly in a bear market. A value manager is therefore considered more conservative.
A strategist friend of mine of TD Newcrest Research allows me to use his charts on occasion. One of the most telling charts compares growth stocks in the S&P 500 Index to Value stocks. The adjacent chart is an older one. When the line is rising, growth stocks are significantly outperforming value stocks. You can see vividly the technology bubble – growth stocks skyrocketing relative to value stocks – prior to the bubble bursting in the year 2000.
The shaded areas are periods of economic stimulation (US Federal Bank monetary easing). During these periods it’s not unusual for growth funds to perform much more strongly than value-oriented funds.
Conventional wisdom says that conservative investors who can’t stomach as much volatility should use value funds and that investors who don’t mind a wild ride should use growth funds. Alternatively, you can invest most of your money into a value fund while also putting some into a growth fund so that you might occasionally get more returns in a buoyant market with at least a portion of your savings.
Why not growth when growth is performing and value at other times?
There are portfolio managers like me who hate being pigeonholed into either one of these styles. However, it is inevitable that one label or the other will be associated with a money manager because of the way consulting services are compensated and the way mutual funds are marketed (when growth is sexy, it only makes sense to promote the growth manager).
A maverick investor who understands the ebbs and flows of market sentiment will want to be invested in their favourite growth fund at the right time and to switch into a value fund at other times.
Whenever I’ve recommended a more active approach to selecting mutual funds in print or on television, such as using a growth fund and switching into a value fund when appropriate, I always get the same question: “How do you know when to switch?”
There is an easy answer, but nobody likes hearing it. The answer is: “You will know!” You should switch when your intuition or emotions tell you nottoo. It is that simple. If the fund you own has been doing extremely well and drifted up towards the top quartile or is now in the “best performing funds” category (rankings are available from a wide variety of publicly available services) and so you’ve begun to love it dearly, it’s time to switch into a different style of fund.
Here is a more current chart. In this case the shaded areas are periods of recession, and we are all aware that for the past few years monetary stimulus has been the norm. Not surprisingly then, growth stocks – avoided by most investors like the plague – have been outperforming value stocks.
As investors divest their income biased stocks (and bonds) they will naturally be tempted to move the money into the better performing growth style. However if history (and experience) is any guide, they’d be well advised to focus their attention on stocks and funds that have not yet participated in the recent market rally. In the event that government policy, encouraged by the rebound in the housing market, strong corporate earnings and slowly improving employment outlook, becomes less stimulative then value will in all likelihood become the place to be.
A perplexing phenomenon for money managers and academics alike is the so-called “January effect.” Also known as the small-cap effect it generally refers to the fact that January tends to be a pretty good month for the stocks of smaller companies. Despite efforts to come up with an explanation – window dressing by institutional investors, tax-loss selling and so forth – there seems to be no rational reason for the superior performance of these smaller company stocks early in every new year. Before devling into my own radical theory, is this a real or mythical phenomenon?
Personally, I’ve bet on this phenomenon over many years – loading up the mutual funds I’ve managed with smaller companies during December that I considered inexpensive (their share prices were beaten up for any number of reasons). The strong January investment performance would often put my portfolio in the top rankings for several months into the new year. Always good for business. I’d also encourage clients to buy our specialty fund that concentrated on smaller growth companies in early January, and hold it for a few months to capture the excess return. It simply worked.
Experiencing or just believing in the effect is one thing, but does the data support the myth? There are many studies confirming the anomaly. I found the adjacent chart illustrating that in in January the smallest publicly traded companies indeed do better than the bigger companies.
“From 1926 through 2002, the smallest 10% of all stocks (or “10th decile”) beat the 1st decile stocks by an average of 9.35 percentage points in the month of January.”
Despite repeated efforts to explain why there is a January Effect, everyone agrees that it still remains pretty much a mystery. Academics refer to such patterns as ‘anomalies.’ My own belief is that there are many instances when statistical observations are better explained by human behavior rather than analytics.
Ever notice that most babies are born in August and September? Biologically speaking, this would suggest that our species do tend to act somewhat differently nine months prior to these births every year. During the festive season there’s a whole lot of warm and fuzzy feelings that seem to influence our behavior. In some cultures there’s a surge in indulgences – food and wine for instance – and for a brief couple of months stress and fear are reduced signficantly. How do we respond?
Clearly we are inclined to be more intimate. Couples (if you’ve been married for awhile you’ll understand this) successfully avoid romantic activity for most of the year; bored with their partners or simply turned off by their annoying habits and personality flaws. Suddenly during the holidays we set aside our grievances and become more tolerant. Those quirks might even seem endearing for a brief period. Perhaps in the northern hemisphere humans are genetically engineered to seek warmth and comfort during the colder winter months?
Consider these cold hard facts:
We are more than willing to be intimate (hence the birthrate 9 months later) despite the risks – being asked to do more chores and the inevitable burden of an increased level of conversation.
During these months we spend recklessly on family and friends who don’t need the consumer items and in some cases don’t deserve them.
People drink more alcohol than they should and eat food that is bad for them.
Why wouldn’t the perennial change in our emotional makeup also have an impact on our investment decisions? My theory is that once a year risk aversion takes a brief backseat in our psyche – and while our hearts and wallets are open why not take some free-spirited risk in the stock market? Collectively hoping for a big score in those smaller company stocks that occasionally pay big, we all dive in together and cause their prices to rise.
The evidence of humanity’s willingness to take on more risk in the bedroom during the holidays becomes evident nine months later. And it should come as no surprise that the financial consequences of investment decisions made in a fit of euphoria during the holiday season also show up by September of most every year also. September is pretty much always the worst month for those stocks bought earlier in the year – small and large companies alike.
I certainly hope you had a good laugh reading my theory explaining the mysterious January effect. In my opinion it is certainly as good as the explanations you’ll read in the media. Truth is there is much we’ll never understand about so-called ‘anomalies’ whether they occur in financial markets or in human behavior. Simply knowing they do occur however can be a powerful tool when making one’s own investment decisions. Come to think about it, just knowing about some behavioral anomalies might also help when it comes to family planning.