When do you make money?
After every major market correction, we receive marketing materials that goes something like this: “If you miss the best 50 days, your return over the last 20 years would have been x%”. This is one of the rare times that Wall Street tells you the truth. Since it is rare to hear the truth from Wall Street, cherish it!
As I wrote in Chapter 27 of my book “Unveiling the Retirement Myth”, if you miss the best 2.5% months since 1900, your total index return over the last 109 years would have been a whopping 0%. These 2.5% best months not only make up for the huge losses in the other 2.5% of the time, but it also gives you and average return that the “stocks-for-the-long-run” people rave about.
Yes, you make good money in 2.5% of the time, and you lose big time in the other 2.5% of the time. In other words, this happens in extreme markets. The other 95% of the time markets are random. This has resounding implications: For example, the concept of efficient frontier is based on randomness. There, risk is defined as standard deviation of returns, a Gaussian concept. Modern Portfolio Theory (MPT), ditto. All portfolio managers, pension managers, money managers are indoctrinated –during their rigorous financial education – with the efficient frontier and other randomness-based theories. So, most of these misguided people who are looking after your investments, can be right only 95% of the time with randomness. However, money is made or lost in the other 5% of the time. They just dismiss it as “not normal times” or “new normal”. It does not matter how wonderful their “science” works 95% of the time, if it does not work the other 5% (non-normal, extreme markets) then they can’t make money for you. Neither “normal” nor “new normal” does make any difference. That is why, no more than 15% of mutual funds beat the index randomly (the lucky ones), and less than 1% of them beat the index consistently (the more-lucky and perhaps talented ones). During that 95% of the time, your pursuit of your dreams helps us create wealth, not necessarily for you but for us, the financial industry. Because the wrong science is being used, I predict – given enough time- most defined benefit pension funds will also fail or collapse.
This is also true for most individuals, even though many of them don’t know anything about the randomness. There are many studies that indicate that while markets made 10% during a certain 20-year time period, the average investor made half of that. In my opinion, that is because many of us make our investment decisions during or after such extreme events, and not before them. You need to protect yourself before extreme bad events occur, not after.
When you invest your money, there are five potential outcomes:
1. A large gain
2. A small gain
3. Breakeven
4. A small loss
5. A large loss
The large gain (#1) and the large loss (#5) usually happen in extreme markets. The other three outcomes (#2, #3, and #4) happen in normal markets. To protect your investments, you need to minimize large losses (#5). The success of your portfolio and your retirement depends on how successful you are avoiding such extreme losses. The bottom line is, if you can avoid #5, then markets can probably take care of your portfolio.
I use a technical analysis tool called the “simple moving average ” on a monthly chart. Here is how it can help you:
Draw the 5–month moving average, the blue line on the chart.
Draw the 12–month moving average, the red line on the chart.
When the blue line moves below the red line and the red line is declining, then markets may be going into a bearish trend. Go defensive with your equities.
When the blue line moves above the red line, the storm is mostly over, you can repopulate the equity portion of your portfolio.
If you are still in the accumulation stage, never hold more than 60% equities. If you are in the distribution stage, never hold more than 50% equities. The rest of your money should be allocated to fixed income.
For more information, see my book, pages 288 to 293, “Unveiling the Retirement Myth".
Disclaimers: Future performance of any charting system or technical analysis methods will not be the same as in the past. Technical analysis requires investment discipline and is not for everyone. With any technical analysis tool, it is unlikely to get the signals right at the market tops and bottoms, and, therefore slippages will occur. This particular set of moving averages can indicate the longer term trends and they do not apply to sector or stock trading, which require shorter time frames. Consult your financial advisor before engaging in any investment activity.