Pressure to make big gains is much less if losses are minimized

December 21, 2009 — 3:06 AM UTC by Rob Isbitts, Guest Columnist

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2009 was a year when RIAs were able to take a good, long look at the way they approach equity investing. The sting of 2008 is still very much with them and their clients, but the historic rally since March has allowed some time to catch their collective breath.

Now, it is more important than ever for RIAs to have a well-thought-out philosophy about growing capital. It is equally important to be able to effectively communicate that to clients. The aim of this article is to help RIAs do that.

Consider the tale of two investors, Babe and Yogi. Lest you think that those references are to the baseball legends Ruth and Berra, they are not (though baseball references often make their way into my writing).

Bovine Approach

Babe is an investor who trusts the stock market to eventually come through for him. He would consider himself a generally “bullish” investor (Babe was the name of Paul Bunyon’s Blue Ox, and a Bull and an Ox are both bovines).

Thus, Babe keeps his portfolio invested in index mutual funds and exchange-traded funds (ETFs), with the objective of matching the return of the stock market in good times and bad. After all, he says, “the market will always bail me out.”

Yogi is an animated fellow (like Jellystone Park’s most famous resident). Yet he does not implicitly trust the stock market. After what he’s seen since last summer, his conviction is stronger than ever. He does not dislike equity investing; in fact it is the core of his portfolio. He likes the fact that he has daily liquidity in his investments, as equity mutual funds and ETFs provide.

However, he is neither a day-trader nor a buy-and-hold index investor. He is somewhere in between, and over the years he has sought out ways to use the stock market for what he wants out of it…a liquid, transparent way to grow his wealth over time.

Yogi is a “bearish” investor, but his friends tell him he’s “smarter than the average bear” in one important respect. He does not think the stock market will always go down, but he leaves room in his portfolio approach so that he can be very bearish when he wants to, and decidedly bullish when he concludes that the long-term outlook for stocks is positive.

You might say he is bullish on the ability for markets to recover from anything, but bearish on the philosophy of always staying fully invested in stocks. He refers to this conclusion as a desire to “rent the stock market” instead of owning it.

He believes that by incorporating hedging techniques such as long-short, arbitrage and other low-correlation strategies, as well as inverse equity funds that move in the opposite direction of a stock market index, he can squeeze out market-beating returns over time.

He also tells Babe that he uses cash as a “defensive weapon,” raising his cash position when he feels the market’s risk/reward is not in his favor. Furthermore, by using mutual funds and ETFs, he avoids individual stock risk and complex investment structures like limited partnerships.

The Upshot

Of much greater importance, Yogi feels that his approach to portfolio management gives him a higher likelihood of retiring to a lifestyle of his choosing, rather than one that is dictated by how the stock market happened to do during the period he was invested.

He has seen how retirees have lost so much in the past year, particularly those who had built enough wealth to retire in the style they dreamed of, only to see it taken away in a few months.

Yogi knows that his portfolio will often not be as “sexy” as Babe’s, as it will likely not jump the way Babe’s does when the market is bopping, such as in the rally since March of 2009. He does feel that in the best of times, he will get his fair share of the ups, and that playing good defense in tough times is far more important in increasing his chances of reaching his eventual goals.

He figures if he can get roughly two-thirds or more of the stock market’s gains over extended bull cycles, and keep losses to about one-third or less of the market’s decline in extended down cycles, that will be a winning combination.

Both Yogi and Babe have no idea when that lost wealth from 2008 will eventually be recovered, or even if it will be, but they ponder that from very different perspectives. For illustrative purposes only, here’s why (using hypothetical figures and returns for these hypothetical investors):

January 2008
Babe: $100
Yogi: $100

Babe and Yogi both had $100 when the frightening investment year of 2008 began. At year-end, here’s where they stood:

December 2008
Babe: $60
Yogi: $85

The market continued to fall in early 2009, leaving the two investors here:

March 2009
Babe: $45
Yogi: $80

The market rallies in March, and goes on a historical march higher. As of today, Babe’s portfolio is now at $70, and Babe is feeling very good again. His portfolio is up over 50% in just nine months! Yogi made money too, but at a far lower rate, about 25%. His portfolio, as it typically does, trails the market by a wide margin in these short, sharp rallies, though it tends to grab a much bigger share of the pie during more extended up moves. Here’s where they stand now:

December 2009
Babe: $70
Yogi: $105

Babe is celebrating what he feels is the beginning of much better things in his portfolio. Then he stops in for a latte and sees his buddy Yogi. Babe, who tends to think about his portfolio in dollars, not percentages, brags about the $25 he’s made in well under a year. Yogi congratulates him, and then explains that he too made $25 during that time.

Babe asks Yogi, “Did you finally see it my way and start investing in the market instead of that hedged growth thing you do?” Yogi thinks about it for a minute and states the conclusion and lesson from this story: “Babe old pal, I had $80 when the market started coming back, so I made $25 in real money by only making 30%.

Your portfolio had dropped so far in the tough times that you needed nearly more than a 50% gain to make the same $25 I just did with a 30% gain. It seems like your money has to work a lot harder than mine every time the market falls. In fact, I now have more money than I did at the end of 2007.

“Since you are still well below where you started, I’ll pick up the tab on the lattes today. It could still be awhile until you make another 25% to get back to where you were at the end of 2007. By then, I should still be way ahead of you, big guy.”

Change of Approach

Babe thinks about it, then realizes that it might be time to consider more seriously if he should replace his method with Yogi’s, or at least make some room for it alongside his traditional investing method. Babe and Yogi agree that given all that is going on in the world, this won’t be the last time the market swings up and down like this. Thinking about this makes Babe turn, well, blue.

Babe and Yogi finish their lattes, and Babe feels a lot better (and not because of the caffeine). He realizes that while his way worked for a long time, he now needs to consider the simple math behind gaining and losing in the stock market. Going forward, he wants to avoid making any more “boo-boos.” He commits to figuring out how “renting the stock market” can work in his favor, too.

Robert A. Isbitts, a 23-year industry veteran, is a newsletter writer, published author, and the Chief Investment Officer of Emerald Asset Advisors LLC, a South Florida RIA firm. He created and manages a series of separate accounts available to RIAs, and is the lead-manager of an asset allocation mutual fund. For more information on that mutual fund, visit www.easfunds.com. Rob can be reached directly at risbitts@emeraldasset.com.

The information herein has been obtained from sources believed to be reliable, but Emerald Asset Advisors, LLC (“Emerald”) does not warrant its completeness or accuracy. Prices, opinions and estimates reflect Emerald’s judgment on the date hereof and are subject to change at any time without notice. Any statements nonfactual in nature constitute current opinions, which are subject to change. Projections are not guaranteed and may vary significantly. Further information on the firm and its advisory fees may be obtained from the firm’s Form ADV Part II, which is available without charge upon request. Complete descriptions of all Emerald’s products and benchmarks are available upon request.



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