Tag Archives: david-merkel

Plan And Act, Don’t React

An investor can and should learn from the past. He should never react to the recent past. Why? The past can’t be changed, but it can be known. Reacting to the recent past leads investors into the valleys of greed and regret – good investments missed, bad investments incurred. We’ve been in a relatively volatile environment for the last two weeks or so. Markets are down, with a lot of noise over China, and slowing global growth. Boo! The markets were too complacent for too long, and valuations were/are higher than they should be, given current earnings, growth prospects and corporate bond yields. It’s not the best environment for stocks given those longer-term valuation factors, but guess what? The market often ignores those until a crisis hits. The FOMC is going to tighten monetary policy soon. Boo! The things that people are taking on as worries rarely produce large crises. They could mark stocks down 20-30% from the peak, producing a bear market, but they are unlikely of themselves to produce something similar to 2000-2 or 2008-9. Let’s think about a few things supporting valuations and suppressing yields at present. The overarching demographic trend in the market leads to a fairly consistent bid for risky assets. It would take a lot to derail that bid, though that has happened twice in the last 15 years. Ask yourself, do we face some significant imbalance where the banks could be impaired? I don’t see it at present. Is a major sector like information technology or healthcare dramatically overvalued? Maybe a little overvalued, but not a lot in relative terms. There are major elections coming up next year, and a group of politicians harmful to the market will be elected. This is a bad part of the Presidential Cycle. Boo! Take a step back, and ask how you would want your portfolio positioned for a moderate pullback, where you can’t predict how long it will take or last. Also ask how you would like to be positioned for the market to return to its recent highs over the next year. Come up with your own estimates of likelihood for these scenarios, and others that you might imagine. We work in a fog. We don’t know the future at all, but we can take actions to affect it, and our investing results. The trouble is, we can adjust our risk profile, but our ability to know when it is wise to take more or less risk is poor, except perhaps at market extremes. Even then, we don’t act, because we drink the Kool-aid in those ebullient or depressed environments. We often know what we should do at the extremes, but we don’t listen. There is a failure of the will. This is a bad season of the year. September and October are particularly bad months. Boo! I often say that there is always enough time to panic. Well, let me modify that: there’s also always enough time to plan. But what will you take as inputs to your plan? Look at your time horizon, and ask what investment factors will persistently change over that horizon. There are factors that will change, but can you see any that are significant enough for you to notice, and obscure enough that much of the rest of the market has missed it? Yeah, that’s tough to do. So perhaps be modest in your risk positioning, and invest with a margin of safety for the intermediate-to-long term, recognizing that in most cases, the worst-case scenario does not persist. The Great Depression ended. So did the 70s. Valuations are higher now than in 2007. (Tsst… Boo!) The crisis in 2008-9 did not persist. That doesn’t mean a crisis could not persist, just that it is unlikely. Capitalist systems are very good at dealing with economic volatility, even amid moderate socialism. Go ahead and ask, “Will we become like Greece? Argentina? Venezuela? Russia? Spain? Etc.?” Boo! It would take a lot to get us to the economic conditions of any of those places. Thus, I would say it is reasonable to take moderate risk in this environment if your time horizon and stomach/sleep allow for it. That doesn’t mean you won’t go through a bear market in the future, but it will be unlikely for that bear market to last beyond two years, and even less likely a decade. Disclosure: None.

The Importance Of Your Time Horizon

I ran across two interesting articles today: Both articles are exercises in understanding the time horizon over which you invest. If you are older, you may not have the time to recover from market shortfalls, so advice to buy dips may sound hollow when you are nearer to drawing on your assets. Thus the idea that volatility, presumably negative, doesn’t hurt unless you sell. Some people don’t have much choice in the matter. They have retired, and they have a lump sum of money that they are managing for long-term income. No more money is going in, money is only going out. What can you do? You have to plan before volatility strikes. My equity only clients had 14% cash before the recent volatility hit. Over the past week I opportunistically brought that down to 10% in names that I would like to own even if the “crisis” deepened. That flexibility was built into my management. (If the market recovers enough, I will rebuild the buffer. Around 1300 on the S&P, I would put all cash to work, and move to the alternative portfolio management strategy where I sell the most marginal ideas one at a time to raise cash and reinvest into the best ideas.) If an older investor would be hurt by a drawdown in the stock market, he needs to invest less in stocks now, even if that means having a lower income on average over the longer-term. With a higher level of bonds in the portfolio, he could more than proportionately draw down on bonds during a crisis, which would rebalance his portfolio. If and when the stock market recovered, for a time, he could draw on has stock positions more than proportionately then. That also would rebalance the portfolio. Again, plans like that need to be made in advance. If you have no plans for defense, you will lose most wars. One more note: often when we talk about time horizon, it sounds like we are talking about a single future point in time. When the time for converting assets to cash is far distant, using a single point may be a decent approximation. When the time for converting assets to cash is near, it must be viewed as a stream of payments, and whatever scenario testing, (quasi) Monte Carlo simulations, and sensitivity analyses are done must reflect that. Many different scenarios may have the same average rate of return, but the ones with early losses and late gains are pure poison to the person trying to manage a lump sum in retirement. The same would apply to an early spike in inflation rates followed by deflation. The time to plan is now for all contingencies, and please realize that this is an art and not a science, so if someone comes to you with glitzy simulation analyses, ask them to run the following scenarios: run every 30-year period back as far as the data goes. If it doesn’t include the Great Depression, it is not realistic enough. Run them forwards, backwards, upside-down forwards, and upside-down backwards. (For the upside-down scenarios normalize the return levels to the right side up levels.) The idea here is to use real volatility levels in the analyses, because reality is almost always more volatile than models using normal distributions. History is meaner, much meaner than models, and will likely be meaner in the future… we just don’t know how it will be meaner. You will then be surprised at how much caution the models will indicate, and hopefully those who can will save more, run safer asset allocations, and plan to withdraw less over time. Reality is a lot more stingy than the models of most financial Dr. Feelgoods out there. One more note: and I know how to model this, but most won’t – in the Great Depression, the returns after 1931 weren’t bad. Trouble is, few were able to take advantage of them because they had already drawn down on their investments. The many bankruptcies meant there was a smaller market available to invest in, so the dollar-weighted returns in the Great Depression were lower than the buy-and-hold returns. They had to be lower, because many people could not hold their investments for the eventual recovery. Part of that was margin loans, part of it was liquidating assets to help tide over unemployment. It would be wonky, but simulation models would have to have an uptick in need for withdrawals at the very time that markets are low. That’s not all that much different than some had to do in the recent financial crisis. Now, who is willing to throw *that* into financial planning models? The simple answer is to be more conservative. Expect less from your investments, and maybe you will get positive surprises. Better that than being negatively surprised when older, when flexibility is limited. Disclosure: None

When To Deploy Capital

One of my clients asked me what I think is a hard question: When should I deploy capital? I’ll try to answer that here. There are three main things to consider in using cash to buy or sell assets: What is your time horizon? When will you likely need the money for spending purposes? How promising is the asset in question? What do you think it might return versus alternatives, including holding cash? How safe is the asset in question? Will it survive to the end of your time horizon under almost all circumstances, and at least preserve value while you wait? Other questions like “Should I dollar cost average, or invest the lump?” are lesser questions, because what will make the most difference in ultimate returns comes from the above three questions. Putting it another way, the results of dollar cost averaging depend on returns after you put in the last dollar of the lump, as does investing the lump sum all at once. Thinking about price momentum and mean reversion are also lesser matters, because if your time horizon is a long one, the initial results will have a modest effect on the ultimate results. Now, if you care about price momentum, you may as well ignore the rest of the piece and start trading in and out with the waves of the market – assuming you can do it. If you care about mean reversion, you can wait in cash until we get “the mother of all sell-offs” and then invest. That has its problems as well: What’s a big enough sell-off? There are a lot of bears waiting for rock-bottom valuations, but the promised bargain valuations don’t materialize, because others invest at higher prices than you would, and the prices never get as low as you would like. Ask John Hussman . Investing has to be done on a “good enough” basis. The optimal return in hindsight is never achieved. Thus, at least for value investors like me, we focus on what we can figure out: How long can I set aside this capital? Is this a promising investment at a relatively attractive price? Do I have a margin of safety buying this? Those are the same questions as the first three, just phrased differently. Now, I’m not saying that there is never a time to sit on cash, but decisions like that are typically limited to times where valuations are utterly nuts, like 1964-65, 1968, 1972, 1999-2000 – basically, parts of the go-go years and the dot-com bubble. Those situations don’t last more than a decade, and are typically much shorter. Beyond that, if you have the capital to spare, and the opportunity is safe and cheap, then deploy the capital. You’ll never get it perfect. The price may fall after you buy. Those are the breaks. If that really bothers you, then maybe do half of what you would ultimately do, but set a time limit for investment of the other half. Remember, the opposite can happen, and the price could run away from you. A better idea might show up later. If there is enough liquidity, trade into the new idea. Since perfection is not achievable, if you have something good enough, I recommend that you execute and deploy the capital. Over the long haul, given relative peace, the advantage belongs to the one who is invested. If you still wonder about this question you can read the following two articles: In the end, there is no perfect answer, so if the situation is good enough, give it your best shot. Disclosure: None.