Avoid Volatility and Preserve Emotional Capital

Avoid Volatility and Preserve Emotional Capital

Last week I came across a Better System Trader podcast featuring Gary Stone, founder of Share Wealth Systems.  Gary had a great post on his blog last November where he attacked Fidelity Investments for what he called “marketing misinformation”.

Fidelity distributed a document titled “Time in the market, not timing the market”.  The flyer pointed out that had an investor missed just the ten best days over an entire 10 year period, their returns would drop from a total of 68.9% to -4.64%.  The returns worsened if the best 20, 30, 40, etc. days are missed.  They concluded:

“But the longer you stay invested, the greater the probability that your investment will generate a positive return.”

Fidelity’s motives in making this point are two-fold.  The first is self-serving.  Fidelity collects fees from assets they manage so they have a financial interest in keeping you invested in their funds at all times.  Cynical point?  Yes…but true.

Fidelity’s second motive is likely a more noble one.  Average retail investors are horrible at timing the market.  They are notoriously emotional and tend to buy near the top and sell near the bottom.  Fidelity recognizes this and is encouraging investors to stay the course.  Stay invested and avoid the noise.

Staying the course and avoiding the noise is something I am onboard with.  This is the mantra of the asset allocators.  Historically, staying invested in markets through thick and thin has paid off.  When markets sell off, dollar cost average and buy more.  When markets are roaring higher, rebalance some gains and take advantage of lower prices in other asset classes.

This is sound advice to many but is not something I have ever been completely comfortable with.  I’m reminded of why traditional asset allocation strategies irk me so much every time I see the common disclaimer:

“past returns are not an indicator of future results”

Just because U.S. equities have done well over the past 40 years, does that mean they will do well over the next 40 years?  Bonds have been in a 30 year bull market.  Am I to believe that will continue going forward?  What if bonds aren’t necessarily a “safe” investment?  What if gold isn’t considered a flight to safety in the future?  Should I keep allocating money to it?

These are questions I can’t answer.  The optimist in me says the U.S. will continue to thrive and bonds will be safe, but I’m not paid to be an optimist.  Even for the brightest analysts, with decades of historical data at their fingertips, forecasting the behavior of an asset class based on historical norms is extremely challenging.  The butterfly effect is real, and weighs heavily on the global economy.  Making reliable, repeatable predictions is nearly impossible.

Markets aren’t efficient because market participants don’t always act rationally.  This is something I am sure of.  In referencing Ariadne’s behavioral investment philosophy I’ve said:

“I am more confident in the likelihood that past human behavior continues to repeat itself, than I am in the predictive value of any market fundamental or technical indicator.”

That is why I choose to base my strategies on behavioral phenomena (value & momentum).  While nothing is for certain, in my gut I firmly believe that human behavior is less likely to change than the historical performance of any particular asset class is likely to repeat itself.

Because I acknowledge the impact human emotion can have on asset prices and investment decisions, I try to mitigate that effect in portfolios I manage by avoiding environments prone to volatility.  My reasoning is best summed up in this entry from The Ivy Portfolio (emphasis my own):

“[A]s long as humans are involved in the financial markets, the markets will continue to be driven by the emotions of greed and fear. This aspect of the market is a simple example of an alpha generator that is “timeless and universal.” Our research has shown that returns are lower and volatility is higher when asset classes are below the 10-month moving average. This increase in volatility and its clustering is one of the simple reasons the timing model works – when markets are declining people become more fearful and use a different part of their brain than during periods when markets are going up.

Without focusing on the specific indicator referenced (many others would work similarly), the major takeaway is that markets in a downtrend have been more volatile and have had lower returns (exception being commodities).

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Source: Cambria Investments

So why does this matter and how does it relate to the point Gary Stone was trying to make?  Well what Fidelity didn’t tell you in their flyer, is that while missing some of the best days in the market will significantly hurt your returns, missing some of the WORST days will do even more to HELP your returns.

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Furthermore, missing both the best AND worst days would also greatly benefit returns.

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Gary also points out, unsurprisingly, that most of the best and worst market days happen in close proximity to each other (volatility clustering).  Both the majority of the market’s best and worst days come in downtrending markets.

Fidelity has their own motives for wanting to keep investors in markets at all times.  As an advisor, my motives differ.  While I acknowledge that it is impossible to “time the market” at exact tops and bottoms, I do believe that certain market environments, particularly markets in a downtrend, are not favorable conditions for generating returns in long-only portfolios.  I believe performance benefits from avoiding those situations.

A second major advantage I see in avoiding volatility is one often overlooked by many.  Dealing with less volatility can have big emotional benefits for both myself and clients. In volatile markets, I’d rather protect capital and wait for future opportunities than have my clients ride an emotional roller coaster of highs and lows.  Keeping emotions in check also makes sticking to a strategy much easier, which is critical.

I believe the most pertinent question to ask about any systematic/quantitative strategy is not “how hard would this be to replicate” but rather “how hard would this be to stick with.” 

– Patrick O’Shaughnessy, Investor Field Guide

I realize that to many advisors, sitting on the sidelines is a sin.  I’ve been told it is risking career suicide.

“You’re not being paid to sit in cash.”  

Agree to disagree.  While a big part of my job is investing money for clients, a bigger part of my job is providing VALUE to my clients.  I’m not a broker working on commissions.  I’m not trying to sell anything to my clients.  When conditions are ripe for prolonged market volatility, I see no benefit by keeping my clients involved.

So while there’s always the possibility that we might miss some upside by “timing the market”, if I can help preserve both physical and emotional capital for my clients, that’s the advice (and value) I will provide.


Tim Brennan

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