What is long term investing
Investors are often swayed and confused by 24/7 financial media (or shall we say ‘entertainment’). For many part time investors, it is very understandable that they will grasp with whatever told by professionals or ‘great’ investors. Some of these talks are plainly trash. Some of them, however, are actually correct, putting under the right context.
Investing is perhaps one of few fields where consumers or average Joe play with financial professionals in the same arena (well, not necessarily on the same level of playing field). You don’t see this in medical industry where average Joe is discouraged to cure himself without a doctor’s help. You don’t see this in engineering where you are required to at least take courses or get a certificate before you can operate an machine.
But the strange thing in investing is that you are encouraged and incentivized to go all in or do whatever you want because you are told that you are as good as or better than a professional. Brokerages devise many instruments for you to play with so that they can collect commissions or rake in the different spread between what you are paid in your cash and what they can get by lending your money to others such as U.S. Treasury. Fund companies want you to invest in their funds so that they can collect their management fees. Financial media want to attract your eyeballs or ears by putting out many ‘interesting’ shows (think CNBC), as sensational as possible.
However, one thing perhaps all of them have done right (albeit with very different motivations) is that you are repetitively told that you should be a long term investor. This is absolutely correct provided that you are ‘investing’ in the right way.
So what is long term investing? Or a better question is what is good long term investing because no one wants to have a bad one to lose money.
For us, the answer would be “invest using well defined strategies (or plans) for a long period of time”. It consists of two important components: “using well defined strategies (or plans)” and “for a long period of time”. Both are necessary, can’t have only one or none.
Well defined investment strategies
So what is a strategy?
Based on Oxford English dictionary, a strategy is “a plan of action or policy designed to achieve a major or overall aim”.
Based on Webster, a strategy is “a careful plan or method for achieving a particular goal usually over a long period of time”.
Examples of investment strategies include
- Strategic Asset Allocation: you invest in a diversified portfolio with proper allocations to major asset classes such as stocks and bonds. You then periodically rebalance your portfolios back to the target allocations.
- Tactical Asset Allocation: you also invest in a diversified portfolio with proper allocations but you can dynamically adjust your allocations so that you can achieve better returns or reduce loss or for both. The key here is that you need a disciplined well defined plan.
- “Experts” make their strategies ‘black box’. How many times you receive a fund literature that states a convoluted or vague description of investment strategies used in the fund? Do we know whether they are well defined or just a sketch? How do we know the fund manager will stick to the strategies (or is there even one at the first place)? No wonder many investors turn to ‘indexing’ that is much simpler and well defined to begin with.
- There are many systems or tools that use extensive data snooping or fudge parameters to make back testing results look good. For us, any parameter or algorithm change has to have a simple and intuitive reason behind it. If your strategy only works when a 73 day moving average is used, you’d better wonder why not 75 days, why not 180 days? etc.
The key here is that as an investor, you need to buy into the method you are using to invest. Because, as what we are about to explain, you’d better stick with it for a long time once you are committed. That means you need to use something you can understand and are comfortable with.
Long period of time
The second key factor for being a good long term investor is that, after you have chosen a strategy, you have to stick with it for a long period of time. Why?
As what we explained several times in this newsletter, investing is essentially playing with statistics or playing with random events. Financial markets behave randomly in a short term. In fact, we would claim that no one can predict well how a market will behave tomorrow. If you are looking for a sure thing, then investing is not for you. You might be better off by investing in U.S. Treasury bills, notes or bonds and hold them till their maturity. Even then, this is not a sure thing but that is a different story.
So recognizing our human limitation to predict the future is the first step in investing. That would mean a method can be only judged or evaluated when there are enough sample points (in statistical term) or in a long period of time. How long is a ‘long period of time’? Well no one has a precise answer. In general, mathematically, even 10 year time has very limited sample points (10 years would have only 2,520 daily sample points assuming on average 252 trading days per year). So you can see how challenging it is for a long term.
That also means investors have to endure under performance for a a period of time when a strategy under performs, compared with other strategies or just market indices. On the other hand, that could also mean this strategy and others will also reverse to mean: the ‘bad’ one might outperform again while the ‘good’ ones suffer.
We have written several newsletters on this before. See the following, for example:
- July 29, 2013: Strategic Asset Allocation: The Good, The Bad And The Ugly
- July 22, 2013: Tactical Asset Allocation: The Good, The Bad And The Ugly
- July 16, 2012: Understand The Behavior of Investment Strategies
- December 10, 2012: How Asset Allocation Strategies Performed In Secular Market Trends
- October 8, 2012: Asset Allocation Strategies Have Cycles Too
Consistency: your edge in long term investing
However it is hard to maintain the consistency in a strategy: a strategy has to be well defined and carefully planned. Many professional fund managers, for example, start out with something well defined but tweak the strategy along the way, either based on his own hunch or based on others. The problem is that, as what John Hussman stated, ‘a strategy is not a strategy if you keep changing it’. Rules or plans are meant to be executed in the future. If you change that along the way, you end up with a random trace, that is not a strategy (or may we say, that is a random strategy).
Very often, we have observed many investors behave exactly like this. For example, currently, buying US stocks has done well so he or she will say, ok, now I want to be a buy and hold forever investor. I change my strategy now to buy and hold.
The problem is that when stocks begin to lose value dramatically, till to a point this investor can no longer withstand, he will simply abandon it. That is what is called as ‘buy high and sell low’.
What is worse, investors are often told the risk of such a behavior or the risk of buy and hold. They might simply choose to ignore that because, as what they say, our memory is short. It is hard to imagine the pain in 2008 by looking at the good numbers right now. They say that they can withstand that risk again though when it really happens, they will bail out at the worst time.
So for example, how well can you do if you would stick to a strategy like P Relative Strength Trend Following Six Assets (a variation of our Tactical Asset Allocation that can invest up to 100% in stocks)?
We compare this portfolio with the large cap stock funds mentioned in Kiplinger’s 25 favorite no load mutual funds. We only compare the 3 funds that have 20 years history:
Portfolio Performance Comparison (as of 12/09/2013)
|AR since 12/9/1993 (20 years)
|P Relative Strength Trend Following Six Assets
|MPGFX (Mairs & Power Growth Inv)
|DODGX (Dodge & Cox Stock)
|FCNTX (Fidelity Contrafund)
|VFINX (Vanguard 500 Index Investor)
AR: Annualized Return (or CAGR — Compound Annual Growth Rate)
See more detailed year by year comparison >>
So not only this strategy has a return that is comparable to the 3 funds that have the best long term return records, it also does it with about 1/3 of maximum drawdown (17% compared with from 50% to 63% maximum drawdown of these funds)!
And that is the power to stay on course for a long period of time.
Portfolio Performance Review
The following are the performance of tactical portfolios in some representative 401k plans:
Portfolio Performance Comparison (as of 12/09/2013):
|The Bank of America 401(k) Plan Tactical Asset Allocation Moderate
|Exxon Mobil Savings Plan Tactical Asset Allocation Moderate
|Ford Motors 401K Tactical Asset Allocation Moderate
|Hewlett-Packard Company 401(k) Plan Tactical Asset Allocation Moderate
|The Goldman Sachs 401(k) Plan Tactical Asset Allocation Moderate
|AT&T Long Term Savings and Security Plan Tactical Asset Allocation Moderate
Nothing spectacular here untile you pay attention to their drawdowns and volatility, you can see these portfolios have done well for the purpose of ‘achieving reasonable returns with managed risk’, which is our motto.
We are in a holiday season and the markets have behaved as usual. US REITs and emerging market stocks are up and down across the zero ranking line in our asset trend score table. Others are consolidating. Bonds continue to be weak. Commodities have been at the bottom of the table almost all year round.
For more detailed asset trend scores, please refer to 360° Market Overview.
We would like to remind our readers that markets are more precarious now than other times in the last 5 years. It is a good time and imperative to adjust to a risk level you are comfortable with right now. However, recognizing our deficiency to predict the markets, we will stay on course.
We again copy our position statements (from previous newsletters):
Our position has not changed: We still maintain our cautious attitude to the recent stock market strength. Again, we have not seen any meaningful or substantial structural change in the U.S., European and emerging market economies. However, we will let markets sort this out and will try to take advantage over its irrational behavior if it is possible.
We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.
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