October 17, 2016: Investment Mistakes And Good Or Bad Investment Strategies

Re-balance Cycle Reminder All MyPlanIQ’s newsletters are archived here.

For regular SAA and TAA portfolios, the next re-balance will be on Monday, October 24, 2016. You can also find the re-balance calendar for 2016 on ‘Dashboard‘ page once you log in.

As a reminder to expert users: advanced portfolios are still re-balanced based on their original re-balance schedules and they are not the same as those used in Strategic and Tactical Asset Allocation (SAA and TAA) portfolios of a plan.

Please note that we now list the next re-balance date on every portfolio page.

Investment Mistakes and Good or Bad Investment Strategies

As markets are in a holding pattern, persistently in a high valuation level for stocks and extremely low interest rates for bonds, it’s a good time to ponder more on investment methodology or philosophy.

Often, when investors (fund managers, for example) had a loss, it’s very quick for them to do a soul searching, offering some sort of mea culpa on what went ‘wrong’. Human brains are mostly wired to adopt a binary right or wrong binary logic: if you invest in something that loses money or lags behind others in a period of time, you must have done something wrong.

However, in investing, it’s far more complicated than this. Understanding the non-binary (statistical) logic in this process is important.

We discussed this topic four years ago: July 23, 2012: The Difference Between Investment Loss & Investment Mistakes. In this newsletter, we want to look at this topic from some other angles.

The famous contract bridge playing example

In that newsletter, we brought up a contract bridge example. Let’s look at this again:

Ben Graham explains that playing bridge is like investing in that one must follow a discipline when investing or playing the card game bridge. An excerpt from the market comment:

Why bridge? Graham offers the following clue:

“I recall to those of you who are bridge players the emphasis that bridge experts place on playing a hand right rather than on playing it successfully. Because, as you know, if you play it right you are going to make money and if you play it wrong you lose money – in the long run. There is a beautiful little story about the man who was the weaker bridge player of the husband-and-wife team. It seems he bid a grand slam, and at the end he said very triumphantly to his wife ‘I saw you making faces at me all the time, but you notice I not only bid this grand slam but I made it. What can you say about that?’ And his wife replied very dourly, ‘If you had played it right you would have lost it.’“

Emphasis is ours.

In contract bridge card games, based on the distribution of the 52 cards, the bidding process (assuming players are rational to convey their holdings to their partners) and the cards played so far, one can infer probability of remaining cards in various hands, sometimes fairly accurately. Thus, rules are formulated for higher odds of winning.

In this example, the wife who followed the rules would have lost that particular game. However, if enough games are played, she would have done much better than the husband, who seemed to play based on his hunch (and “bravery”?). This is simply a statistical fact.

Investment strategies and mistakes

In investing, things are more complicated than contract bridge playing because there isn’t a known optimal strategy or set of rules that can be obtained up to now. This is due to the fact that numerous factors (underlying economy, underlying companies, investors’ behavior and sentiment, geopolitical factors etc.) can affect markets’ behavior. However, in the core of the process, investing is similar to bridge playing:

Even when you are following a good strategy (or a set of rules in the card game), you can still lose in a particular investment (or game).
However, if you stick to the strategy long enough (or enough games played), you will eventually make a good (expected) return that strategy is supposed to deliver.
But if you don’t follow the rules (or the strategy), all bets are off, and this becomes a lottery example (see, June 16, 2014: There Are Always Lottery Winners)

In investing, because of the impossibility to know the optimal strategy (let alone a sure fire, always win strategy), there are many good and bad strategies out there. Even among ‘good’ strategies, they often conflict with each other. For example, at a particular time, our Tactical Asset Allocation(TAA) might call for selling a fund while our Strategic Asset Allocation (SAA) might insist on holding that fund. It turns out, both of them are ‘correct’ in a long enough period of time. But in the short period of time, one of them is likely to lose out to the other.

For example, in the following chart, portfolio P SMA 200d VFINX Total Return Bond As Cash Monthly (listed on Advanced Strategies) bases on 200 days moving average of VFINX (Vanguard S&P 500) total return to decide to buy or sell VFINX:

The portfolio sold VFINX at the end of August 2015, only to buy it back at the end of October at a higher price. That was clearly a ‘mistake’ for many investors. However, from this strategy point of view, they were correct implementation. Anyone who adopts a dynamic strategy but based on a hunch to continue to hold VFINX at the end of August is more likely to underperform this portfolio in a long period of time, even though in the short term like in 2015, he/she might do better (notice here we are referring to someone who does buy/sell decision based on his gut call, not based on some other well thought out and proven strategies such as buy and hold a security for a long long time).

Of course, such a portfolio has been proven time and again that it can deliver comparable or better return with much lower risk than just holding VFINX, only in a long period of time:

Portfolio Performance Comparison (as of 10/17/2016)

Ticker/Portfolio Name	YTD Return**	1Yr AR	3Yr AR	5Yr AR	10Yr AR	15+ Yr since 2001
P SMA 200d VFINX Total Return Bond As Cash Monthly	6.7%	5.8%	7.7%	12.4%	11.7%	11.6%
VFINX (Vanguard 500 Index Investor)	5.7%	6.8%	9.4%	14.3%	6.7%	5.2%

**YTD: Year to Date

Unfortunately, since there is no sure agreement on what are ‘good’ strategies, investors often mix up ‘bad’ strategies with short term investment loss. All of them are simply called mistakes by popular financial media.

To us, the real mistakes in investing are two types: mistake to follow/select a bad strategy and mistake to not adhere to a good strategy (or simply no strategy at all).

In addition to the newsletter mentioned, we had more discussion on what’s a good or bad strategy in December 1, 2014: Two Key Issues of Investment Strategies. There are also many newsletters in Strategy & Portfolio Evaluation and Risk Management & Investor Behavior sections on our newsletter collection page that touched this topic.

We also encourage readers to read January 11, 2016: Review Of Trend Following Tactical Asset Allocation which reviews our TAA behavior in a long period of time. This is relevant as in a short period of time (well, as long as in the past seven years now), the tactical strategy has lagged behind S&P 500 index. But we are confident that when the current full market cycle (a bull and bear market) completes, the strategy will show its advantages in terms of risk reduction and reasonable or comparable overall returns.

Market Overview

Oil and energy commodities have recovered from their substantial low. REITs recovered a bit last week. Stocks underwent a correction last week, mostly due to the latest earnings news. At the moment, Factset again expects S&P 500 companies will report declining Q3 earnings, which would be the sixth consecutive quarter earnings decline. On the other hand, S&P 500 index is persistently near its record high. We believe caution is warranted, especially now that the Federal Reserve’s record low interest rate policy is near its end, which removes a strong psychological support or belief behind stocks’ high overvaluation.

For more detailed asset trend scores, please refer to 360° Market Overview.

The current nasty presidential election is a reflection to the long standing reality facing Americans and others: since the financial crisis in 2008-2009, not much substantial structural change in the U.S., European and emerging market economies has taken place. Economies have heavily relied on low interest debts. Capital might be misallocated to unproductive investments and consumption. In terms of investments, U.S. stock valuation is at a historically high level. It is thus not a good time to take excessive risk. However, we remain optimistic on U.S. economy in the long term and believe much better investment opportunities will arise in the future.

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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