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Most wealth managers follow a buy and hold approach when it comes to asset allocation.
A key feature of this strategy is its static nature. Once asset weights have been determined, they tend to remain largely unchanged, regardless of what is happening in the markets. The unchanging nature of buy and hold portfolios means that investors must accept gut-wrenching losses in bear markets. During the financial crisis of 2008, it didn’t really matter which stocks you owned; if you owned stocks (or at least had a substantial weighting in them), you suffered severe losses.
Don’t Worry, Be Happy
When their buy and hold portfolios experience steep declines in bear markets, investors’ nerves can fray, and their willingness to stay the course is tested. At these junctures, advisors offer their clients comfort by assuring them that markets go up over the long-term, so they will eventually recover their losses.
If the Thunder Don’t Get You Then the Lightning Will
While we agree that buy and hold portfolios have, and most likely will continue to generate wealth over the long-term, this does not change the fact that large losses do severe and permanent damage to investors’ long-term compounding rates.
We often say that successful, long-term investing is principally about harnessing the magic of compounding. Importantly, there is no way to sugar coat the fact that large losses kill the magic. From a compounding perspective, losses are far more powerful than gains. If your portfolio suffers a 30% loss, then a subsequent 30% gain will not lead to a full recovery (a 42.9% gain is required to achieve this).
While it has historically been true that markets eventually recover from large losses, buy and hold portfolios are nonetheless incapable of protecting investors from large bear markets losses and the related destruction of their compounding rates.
T.I.N.A. (There is No Alternative): You Can’t Time the Markets
The most common defense of buy and hold investing is the TINA principle (there is no alternative). According to the TINA defense, timing the markets is impossible. Therefore, suffering periodic, large losses is an unavoidable part of investing.
If one defines market timing as the ability to consistently forecast exact market tops and bottoms, then we wholeheartedly agree that investors have, and always will fail to succeed in this endeavor. The forecasts of economists and market strategists have historically been no more accurate than a toss of a coin. This failure is best described by the famous economist John Kenneth Galbraith, who stated, “The only function of economic forecasting is to make astrology look respectable.”
You Don’t Need to be Perfect
Just because it is impossible to identify exact turning points in the markets does not mean that investors must passively accept large, bear market losses. You don’t need to be anywhere near perfect in terms of identifying precise market tops and bottoms to outperform a buy and hold portfolio over the long-term.
Rather, you merely need to be “imprecisely right” by capturing the majority of bull market gains and avoiding the majority of bear market losses. If your participation in rising markets is significantly greater than that in falling markets, this asymmetry will accelerate your compounding rate and result in higher long-term returns (not to mention spare you from the emotional taxation of gut-wrenching losses).
Let the Machine Learn, Then Learn from the Machine
At Outcome Wealth Management, we strongly believe that a superior long-term performance can be achieved through a rigorous, data-driven approach to playing the odds and managing risk.
We apply machine-learning algorithms to large sets of data to identify historical patterns and gain a probabilistic understanding of market behaviour. This allows our models to statistically evaluate market environments and adjust our portfolio accordingly.
In our Global Tactical Asset Allocation (GTAA) strategy, when our models indicate that gains are more probable than losses, we shift our portfolio into pro-cyclical assets such as equities, high yield bonds, etc. Conversely, when our models determine the opposite, we shift out of riskier assets and into safe havens such as investment grade bonds and Treasuries.
Since its inception in May 2017, the GTAA strategy has delivered on its stated objective of upside participation and downside protection. The latter was evident during the final quarter of 2018, when the strategy avoided losses as markets suffered a significant downturn.
We are confident that we will continue to achieve this combination of upside participation and downside protection in the future, thereby enabling our clients to more effectively compound their investments over the long-term.