Stick To Your Knitting

January 20, 2016

One of the hardest lessons for investors to learn is that losing less in the short term should lead to better long term performance. One of the facts that investors lose sight of involves basic math. Most investors think that if they lose 10% one year and make 10% the next year then they break even. That is just not true and it becomes less and less true as losses get larger. You can see from the chart below that the larger the loss, the harder it is to catch up. In an extreme case, if your portfolio goes down 50%, you need to recover 100% just to break even. Hopefully this shows that protecting on the downside is more important than shooting the lights out, or even keeping up, on the upside.


One of the best ways to protect your portfolio is through diversification. That diversification can be by asset class, country, investing style, market capitalization, etc. The trick is to know each holding’s “job” in the overall portfolio. Is the holding there for protection or growth? When adding a new position it is important to know if there is a correlation with the other holdings in the portfolio. One of the most common mistakes when investing is to forget each holding’s “job” and then make emotional decisions that are counter to the portfolio’s long term goals. For example, a holding intended to protect in down markets will likely underperform in strong markets and a position held for growth will likely hurt the portfolio when markets are weak. Investors need to understand why they hold each position and look at how it impacts the long term performance of the overall portfolio. Unfortunately, in this day of up-to-the-minute availability of portfolio returns, the science of investing is getting overlooked by short term speculating.

A study by Davis Advisors shows that in the 20 year period ending December 2010 the average stock fund return was 9.9% yet the average stock fund return of investors was 3.8%. It is human nature to chase performance and buy what did well last year but that goes counter to the entire concept of intelligent investing. If your portfolio is set up so that everything does well in a given year, that means that everything can do poorly in a given year. To be a successful investor over the long term involves diversifying your portfolio with investments designed for different market conditions.

Another example is a study conducted by Fidelity Magellan Fund on the performance of its flagship Magellan mutual fund during the tenure of its famous manager, Peter Lynch. Lynch ran the Fidelity Magellan fund from 1977-1990, delivering a 29% average annual return. Despite his strong performance while running the fund, Fidelity found that the average investor (based on weighted average buy/sell data) actually lost money during this 13 year period. How is this possible? According to Fidelity, investors would run for the doors during periods of poor performance and come rushing in after periods of success.

Looking at the chart below, you will see that different asset classes perform well at different times of the market cycle. To create a more consistent, lower volatility portfolio, investors need to diversify among many of these asset classes and not chase what did well the previous year.

 

(click to view image at full size. Opens in new window.)

Over the almost 16 year period, the S&P/TSX index’s return ranged from -33.0% to 35.1%. Similarly, the S&P 500’s returns ranged from -37.0% to 32.4%. The less volatile Market Neutral index return’s ranged from -1.1% to 12.6%.

If you only invested in the Market Neutral index in the 2013/2014 period, you would have been extremely disappointed as it returned only 13.6% compared to 24.9% and 50.5% for the S&P/TSX and S&P 500, respectively. Having said that, in the 2008/2009 time period, the Market Neutral index returned -1.4% compared to -9.5% and -20.3% for the S&P/TSX and S&P 500, respectively. The point is that any investing style can go through disappointing relative periods when compared to the rest of your portfolio but that same style will have its good times too. Understand why you own a product and do not second guess your decision without revisiting its “job” and why you bought it in the first place.

Investing your own money is a very difficult thing to do as you need to emotionally detach yourself and remember to look at the big picture. Investing based on panic or gut feelings will almost always lead to underperformance. Most investors are incapable of ignoring these reactions, which is why they hire professional advisors or money managers to look after their portfolios. Experienced advisors are trained to look at the longer term and the big picture. Unfortunately, advisors are often at the mercy of short term market volatility as investors’ second guess their long term plans based on short term performance (and what their friends and neighbours say their short term returns are). Investors often leave their advisors during or after market downturns and feel satisfied with their new advisor who benefits from the market recovery. Unfortunately, this process tends to repeat itself during the next market downturn. This type of investor behaviour makes it very difficult for individuals to meet their financial goals.

Many individuals spend more time shopping for a pair of shoes than picking a financial advisor to manage their retirement savings. Once you find the right advisor, sit down and set a long term financial plan. After that, the best thing you can do as an investor is to let your professional advisor run the portfolio to meet that financial plan without emotional and irrational reactions to short term events. Understand that each holding has a job and remain disciplined. Think of it as like you do your winter coat or an umbrella. You do not get rid of them in summer or when it is not raining; you continue to hold them for when they are needed.

 

For More Information:

Keith LeslieChief Risk Officer & Portfolio Manager

Keith Leslie is the Chief Risk Officer (CRO) and a Portfolio Manager at Norrep Investments. Keith leads two of the firm’s alternative investment strategies, with a focus on Canadian equities. He has over 17 years of investment management experience and…

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