Risk-Reward: Why We Incrementally Raise Cash
A hypothetical question on our recent investment approach might be:
"Chris, you started redeploying cash on March 17 with the S&P trading near 1,256. Why did you begin to raise cash again on April 12? If we are in a bull market, shouldn't we just stay invested?"
Since a picture is worth a thousand words, we will begin our answer with a hypothetical example from history. The real world example below is similar to our current situation: (a) the market pulled back, (b) we invested some cash near the green box, (c) the market reversed, and (d) we began to implement the incremental approach by stepping away from risk as the market continued to drop. The hypothetical question above would apply to the situation below.
When the market became extended and peaked in October in the graph above, nobody knew how bad things would get over the next two years. Incrementally stepping away from risk as a bear market unfolds eventually leaves you with a 100% cash position. The graph above is "before" and the graph below is "after", or what happened next.
Currently, we are in a bull market and until proven otherwise the markets will most likely continue to make higher highs. However, regardless of what models you have or how much you study the markets and the economy, no one knows the day when (a) a new bear market is starting, or (b) when a significant and painful correction has kicked off (remember the "flash crash" correction of 2010?).
We can understand when the odds of a correction have increased or when a bull market becomes long in the tooth, but bull markets can go on much longer than rational analysis would forecast (think the NASDAQ between 1998 and March 2000). When the odds of a correction become elevated, as identified by the CCM Bull Market Sustainability Index (BMSI) and CCM 80-20 Correction Index, we do not know (a) how long a correction/bear market will last (three days, three weeks, three months, or three years), (b) the magnitude of the correction/bear market (3%, 13%, 23%, 33%, 53%), or (c) if a correction will morph into a full-blown bear market.
Possibly the biggest difference between seasoned professionals and the typical investor is the ability to raise cash at the proper times. You want to raise cash early in a corrective process and in the early stages of a bear market. Unfortunately, we all have heard too many stories from people who rode a bear market all the way to the bottom and sold out at close to the worst possible time.
If you are managing your own money or have a money manager, they better be able to answer this question in detail and without any hesitation:
If we head into the next crisis which leads to losses approaching 50% again, how would you protect capital?
If you manage your own money, and cannot answer the question above, it may be time to hire someone to manage it for you. If your money manager/financial advisor cannot answer the question above in a confident and convicting manner, maybe it is time to find a new manager/advisor.
Investing is not about great forecasting, protecting your ego, or being right - it is about making money and protecting capital. In order to do that effectively, you need to be extremely flexible, agile, open-minded, and willing to buy on a Tuesday and sell on a Friday if the situation has changed enough to warrant such action. That type of flexibility requires that you push your ego aside and be able to understand, in advance, that any buy or sell decision, taken in isolation, may turn out to be "wrong".
If you expect to make the proper decision in the markets 100% of the time, you will be very frustrated and lose large amounts of money. It is important to manage the so-called "wrong" decisions with an open mind and quickly be able to raise cash or buy back in when the market presents new information.
You can say it was easy to spot the problems and risks in October of 2007, something we agree with. However, no one knew the October 2007 peak was "the peak". Using the "it was easy to spot" rationale, you would have exited the NASDAQ in 1998 (way too early) and missed one of the greatest opportunities to profit in history.
For those who have worked very hard to build up their savings, protecting your assets from devastating bear markets is of uppermost importance. There is a difference between accepting normal "give backs" and short-term losses in order to profit from a bull market, and letting the losses run out of control to a point where you have significantly damaged your net worth.
Another good question - What is more important?
Capturing 100% of the market's upside 100% of the time, or even beating the market 100% of the time?
Capturing a respectable return when risks are higher, protecting your net worth when needed, and not having to live through losses in excess of 50% during the next bear market/crisis?
If you want to capture 100% of the market's upside 100% of the time, you must also be willing to accept 100% of the market's risk 100% of the time. That may be the right strategy for some people, but it is not our approach to growing and protecting capital. We might add that our approach allows for much better sleeping at night. This basic concept is known as risk-adjusted returns. A return must take into account the amount of risk you had to take to capture the return.
With the problems in Europe and QE2 due to end in June, we will continue to use the incremental approach until the market can find its footing again, which may occur today, in two weeks, two months, or in two years. If someone has a "today is the start of a new bear market" model, please email us when it is time to move to 100% cash.