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Lately, I’ve been fielding numerous calls and emails from people that have recently engaged in gut wrenching conversations with their investment advisors about their hemorrhaging portfolios. Apparently unsatisfied with the answers, they have asked me to provide a second opinion. The range of explanations follows a common theme as investment advisors attempt to justify why they chose to remain fully invested and took little action, if any, to mitigate their client’s losses. Since the comments follow such a common thread, I thought it might be an interesting topic to write about. Here are my thoughts.
Most of the excuses cited by these professionals fall along the lines of the typical group-think propaganda that now pervade the industry. I’ve heard comments like, “You can’t time the market,” “no one could predict this mess.” I have also heard attempts to fend off redemptions and preserve client confidence such as “It’s a mistake to lock these losses in,” “The government stimulus will save the day,” “stay the course,” “fight the good fight,” “the worst is already priced in the market,” and “Invest for the long haul.” Recite those cliches to a 60 year old who bought them in 1997 and whose portfolio has not earned a dime. Watch his reaction.
When I was rookie at a major Wallstreet firm, I was encouraged to recite the same shallow wisdom and sell the very investment programs that most advisors employ in their practices today. These programs rest their philosophy on some version of Modern Portfolio Theory (MPT). The key tenant to MPT is the assumption that investors are generally rational and rational investors diversify their holdings in the market and, therefore, the market is inherently efficient. The theory further suggests that, because the market is efficient, attempting to outperform the broad market can be regarded as an exercise in futility. Because the broad markets generally trend upward over long periods of time, MPT prescribes that investors simply commit their capital and remain fully invested in a diverse portfolio through all market cycles. Advocates of MPT preach that you must “stay the course” to achieve investment success.
This theory inherently discourages the use of cash and ignores the merits of alternative strategies (i.e. market neutral, short selling, hedging, non traditional asset classes, etc.) Of course, a traditional diversified portfolio will essentially mimic the market and, therefore, investors committed to this approach must be willing to endure difficult market cycles and resist “timing the market” in order to realize long-term gains. With some due credit, this philosophy advocates diversifying company, industry, size, and geographic specific risks. However, by nature, MPT leaves investors entirely exposed to “Systemic Market Risk” and ignores the fact that most asset classes are closely correlated. As evidenced by the facts outlined stated in my January 14 blog, you can see that modern portfolio theory is just a “theory” and bears, in my controversial opinion, several colossal shortcomings at least as it relates to practical money management for individual investors.
For one, it assumes that individual investors can wait long periods for their returns. But, if the average lifespan of an individual is 87, who can wait 10,20, or even 30 years for a return on their investments? Originally, MPT was used primarily by institutions (i.e. endowments, pensions), organizations that could afford to take a very long-term (30+ years) view. However, over time, MPT has been adopted in mass by the investment industry and applied to non-institutional investors (individuals). Today, the basic philosophy of MPT has become popular convention even among investors with very rudimentary understanding of investing and the capital markets.
In my view, investment professionals have taken this line of thinking much too far over the last 10 years. It has become the herd mentality of most investment advisors and investors. I believe it is one of the primary reasons why 99% of all funds and money managers posted huge losses last year. The herd was fully invested in a market that was systemically overpriced. The buy and hold mentality failed miserably in 2008 and has for a whole decade. Factually, the S&P index is little higher than it was in 1997.
Please don’t misconstrue my comments. I’m not suggesting that markets can be timed precisely, diversification is useless, or long-term investing is a farce. As I stated in my last blog, I don’t consider myself a market timer. Furthermore, I use reasonable diversification as an effective tool for managing risks, and I believe that investments are worth holding for long periods if bought and held at prices below intrinsic value and sold when above intrinsic value. But theoretical investment models should never replace common sense, critical thought, and/or fundamental analysis.
At the end of the day, a portfolio’s success rests on the investor’s skills and the time he or she devotes to it. Sometimes it is better to pick a small number of out-of-favor investments and wait for the market to turn in your favor than to rely on market averages alone. That is precisely what we are doing at Catamount Capital.
Investors need to do some soul searching. There have been several 15-20 year cycles in stock market history that were flat or down. So far the S&P has posted a full decade of 0% returns for “buy and hold” investors. Can you really afford to ride out an entire market cycle even if that means zero or even negative returns for another 5-10 years? Are you willing to endure further and potentially significant losses?
If your advisor promotes a narrow minded approach or lacks a robust analytical process, make a change. It may be imperative to your financial well being.