Study: Stop Drinking the Kool-Aid and Manage Stock Market Risks

When you earn money, your thoughts travel to where and how you will allocate your newly acquired funds; interestingly, neurons are fired from the same region of the brain inspired by stimulants such as cocaine. On the contrary, when an individual loses any portion of his or her money, the brain processes this portfolio decrease and triggers a flight response—perhaps because now the question arises of how one can obtain his or her necessities and desires?

The fear of losing certainly has its place in investing. However, if one listens to the mutual fund industry, they will be told to put away their fears and simply buy-and-hold their funds forever.

Investors have been told time and again about the horrors of trying to “time” the market and that no one can effectively outperform the venerable S&P 500 by moving tactically in and out of the market (a claim we violently disagree with!). As proof, the buy-and-hope crowd dredges up an age-old research report that purportedly proves that if an investor should accidentally miss out on the top 1% of up days, their returns would suffer tremendously. (While it is true that returns do decline if an investor misses the 10 best up days in history, the story usually ends there and there is no mention of the benefits of missing the 10 worst down days in history or even the superior returns provided by missing both the 10 best and worst days!).

What the salesman leaves out is that the idea of trying to manage the risk in the market isn’t about capturing the best days, but rather avoiding the massive, portfolio-busting bear market declines. Thankfully, a new white paper by Mebane Faber, of Cambria Investment Management, publicly dispels this myth for all to see.

According to Cambria Investment Management Inc., S&P 500 data collected from 1928 through 2010 demonstrated that the average gain per year for the index was 4.86% per year. However, if an investor missed the worst 1% of down days in the stock market, his or her average annualized return would have been boosted to 19.01%!

Analysts have concluded that rare events, (coined ‘black swans,’ in the CIM study) such as major market swings are inevitable, yet unpredictable. So in following sage advice—buying and sticking with investments, standing by for the market to neutralize is the only logical thing to do.

Right?

Wrong!

Cambria argues this is perhaps one of the more misleading statistics in the field.

On August 11, the firm expressed their disagreement and displeasure with the standard argument that missing the 10 best days of stock market performance annually or over a longer stretch of time will damage or destroy shareholders’ portfolios. With this common misnomer in mind, it is customary for fearful followers to ‘buy-and-hold.’

“What (buy and holders) fail to realize is that, if you miss the worst days, your return is much, much better,” (+19% per year vs. +4.86% for buy and hold) says Mebane Faber, chief investment officer of Cambria. “And most of the best and worst days tend to cluster together.”

What is misunderstood about the “10 best and worst days” study is that typically, between 60 and 80% of the time, both the really good and really bad days occur when the market is in a tailspin, similar to that which has been experienced for the past two weeks. This is due to the fact that markets are simply more volatile when in decline.

Faber contends that staying strapped into the rollercoaster ride requires investors to reap the whirlwind of highs and gains on the upswings and losses on the worst days; and in fact, regularly, the dips are much deeper than the rises.

The paper boldly suggests that if you miss both the best and worst days, in either case, your compound return is still higher than in a buy-and-hold model (+5.48% vs. 4.86%). Thus, it is logical that attempting to miss the worst days in the stock market should be a major focus for investors.

Cambria asserts that despite popular opinion, market timing and risk management can be achieved and can be beneficial to the average investor.

Investors might come to the realization that normal market returns are in fact extreme. Individuals that continue to rely on a bell-shaped distribution, ignoring empirical results will inevitably continue to be surprised by future events

Editor’s Note… The bottom line here is very important. In short, all investors need to stop drinking the mutual fund “buy-and-hold” Kool-Aid. Instead of buying into the self-serving marketing pitches offered by the mutual fund salesman (ask yourself: Why do the mutual funds want you to never sell their funds?), investors need to learn to think for themselves.

In addition, investors need to be on the lookout for Black Swans at all times because history shows that they happen more frequently in the real world of investing than the academics writing books and lecturing to college students would have you believe.

Don’t forget that the folks running Long-Term Capital Management, which almost took down the financial markets in 1998, included Nobel Prize winners. They, just never thought a country would actually default on their sovereign debt (it was, after all, something like a 90-standard deviation event) – oops!

Oh, and lest we forget, the Crash of ’87 was caused by computers all trying to “insure” their portfolios against the same event at the same time. All those “smart” portfolio managers didn’t realize that they all couldn’t use “portfolio insurance” at the same time. As you will recall, that experiment didn’t end well.

And finally, the “quants” and their computer algorithms were largely responsible for the massive meltdown in 2008-09 as once again, the academically trained mathematicians didn’t factor in the risks of real world and the bubble that had formed. As a result, the hedge funds nearly took down Wall Street in its entirety.

It is for this reason that we believe in managing risk on a daily basis in ALL of our programs. We obviously won’t be right all the time (no one is), but we will be prepared to take action whenever a Black Swan event occurs.

As always, we would appreciate reading your comments on this topic.

 

  S&P 500 - Intraday

 

 

  S&P 500 - Last 12 Months

 

 

  S&P 500 - Last 5 Years

 

 

Remember, you are in control your email alerts! You can receive alerts for more than 25 free research report alerts including: The “10.0” Report, The Insiders Report, ETF Leaders Report, and The Focus List.