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A Year of Underperformance - The Horror! image

And so it goes. Now that the bull market is nearly six years old and has produced gains of more than 200 percent since March 9, 2009 (+213% to be exact), the popular press as well as a great many financial advisors appear to be climbing back aboard the buy-and-hold band wagon.

We're told that passive investing is the way to go and that no one can "beat the market." We're told that diversification is the key. And we're told that "active investing" is a waste of time, energy, and money.

To which, I would once again like to reply, "Hogwash!"

The buy-and-hope crowd points to 2014 as Exhibit A in their argument as to why their set-it-and-forget-it approach is superior. As you've no doubt heard by now, passive index investing has outperformed the actively managed mutual funds this year. Hedge funds are having a rough go. And active risk-managed strategies have struggled to keep pace in 2014.

S&P 500 - Weekly

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Maybe six years is enough to erase the pain the occurred from 2008 into the first quarter of 2009. Maybe the massive, QE-induced gains seen since 3/10/09 have convinced investors not to worry about bear markets. And maybe investors have grown to accept the idea that the "bumpy ride" is just part of the game now.

S&P 500 - Monthly

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For those that haven't drank the buy-and-hope Kool-Aid or haven't forgotten the "bumps" in the road that occurred in 2000-02 and 2008-09, the game remains all about managing risk. As Warren Buffett so famously says, rule #1 in investing is never lose big money.

And to be sure, the vast majority of investors did, in fact, lose "big money" at some point over the last fifteen years.

Doing the math here is paramount to understanding the point. Remember, if one loses 50 percent of their account value during a bear market, they must make 100 percent in the ensuing bull in order to come out even. And since the average bull market gain since 1900 has been something on the order of 81 percent, well, you can see the problem.

So, for those that believe in managing the risk of this game, not losing big money is the goal! And it is important to recognize that there are lots of ways to achieve this goal.

But Here's the Rub...

Trying to manage the bucking bronco that is the stock market these days is hard!

Make no mistake about it; trying to "win" at this game (by not losing) sometimes has a cost. The bottom line is that trying to "win" will, on occasion, cause you to underperform the market.

Here is an example of the point. The table below illustrates the returns of the S&P 500 and a purely hypothetical, sample management system from 1997 through last week.

     Exhibit A: Hypothetical Risk Management System

If you are like most people, your eyes immediately go to the bottom line. And with a purely hypothetical cumulative return of +1955% versus +181% for the S&P, the likely response is, "Wow - Give me that some of that, please!"

What's not to like, right? The cumulative return is more than ten times the market and the returns over the last 10, 5, and 3 years are far better than the buy-and-hope approach.

I know what you're thinking... What is that system and how do I get my hands on it?

For this missive, the answer is irrelevant. There are lots of systems out there can boast strong results. No, the key here is to understand the price one would have to pay in order to capture such a return.

The Price to be Paid

The problem here is a little something called behavioral finance. You see, investors are human and subject to emotions. And because of this, we humans oftentimes fall victim to acting on those emotions - usually at exactly the wrong time.

Take a look at the table below, it contains the exact same data as shown above. However, this table highlights "the price" (the red boxes) that must be paid in order for one to potentially capture the returns available from our fictitious system.

    "The Price" of a Hypothetical Risk Management System

First there is 1999. The stock market is enjoying a strong year. Technology is rockin'. And your system returns a mere 6.9%. Ouch.

Next is the 2004-2007 period. For FOUR LONG YEARS, the system provided what many would consider to be weak returns. Over the 4-year period, the S&P produced a gain of +32.05% while your genius-system only gained +14.19. The word you are probably looking for is, ughh.

The BIG QUESTION...

Here's the really big question you have to ask yourself. If you had started using this system at any time between 2003 and 2004, would you have stuck with it?

Hindsight shows us that for five of the next six years (the period immediately following the weak performance), the system kicked some serious butt. Sure, 2011 was disappointing. But given that the three years before had been stellar, sitting through 2011 probably wouldn't have been too difficult.

But, and be honest with yourself here, would you have been able to sit through the 2004-2006 period? Do you have the discipline and/or the commitment required to then enjoy the big-time benefits seen in 2008, 2009, and 2010?

Which brings us to 2014. As mentioned above, 2014 has NOT been a strong year for active risk managers. In short, the market declines have been short, sharp and were all followed by violent "V" bottoms. Thus, the character of the declines did not allow risk management strategies to benefit from the pullbacks.

But the key is that our hypothetical management system underperformed. Some might say the system underperformed BADLY. So, if you are using such a strategy, what are you going to do? Is it time to throw in the towel and give up?

Or... Should you recognize that periods of underperformance are simply part of the game and just keep on keepin' on?

Two Key Points

The first point here is simple. You have got to have patience and discipline in order to succeed at this game. As mentioned, it almost doesn't matter what strategy you implement as there are dozens of approaches that can help you succeed over the long term. The key here is that you've got to be able to stick to it when things don't go as you'd like.

The second key point to understand is that investors should NEVER, EVER put all of their portfolio's "eggs" in one basket!

If you had all of your portfolio invested in our hypothetical management system, you would likely be disappointed with the 2014 returns.

The answer is to diversify your portfolio. To be sure, active risk management SHOULD be part of every investor's portfolio - but definitely not ALL of the portfolio. One should consider diversifying by methodology. Diversifying by strategy. And diversifying by manager/management style.

In sum, using a diversified approach makes it much easier to deal with years like 2014. This year, active risk managers underperformed across the board. However, traditional asset allocation and longer-term approaches did very well. So, if an investor was diversified across the methodologies, they did just fine and it was likely easy to stick with the risk-managed approach. And that risk-managed approach might be helpful at some point - assuming the bears do return again.

Wishing you a safe, happy, and prosperous New Year!

Turning To This Morning

As a reminder, trading tends to be very thin during this holiday-shortened week. But for those traders manning their posts this morning, there are several stories to take note of. First, Greece is back in the news as PM Samaras failed to obtain the necessary votes to elect presidential candidate Stavros Dimas. Greek stocks have fallen precipitously as concerns about the country's economic future are on the rise. In Russia, the ruble is under pressure after last week's rally after the Finance Ministry said there were no plans to prop up the currency in the near-term. On the oil front, supply concerns in relation to Libya is providing a modest bid for crude futures. In Asia, China's growth rate is in focus and Japan's Abe approved a $29 billion stimulus package. Here at home, stock futures are following European markets lower at this time and point to a weaker open on Wall Street.

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

Major Foreign Markets:
    Japan: -0.50%
    Hong Kong: +1.81%
    Shanghai: +0.33%
    London: +0.03%
    Germany: -0.77%
    France: -0.58%
    Italy: -2.30%
    Spain: -2.07%

Crude Oil Futures: +$0.70 to $55.43

Gold: -$1.60 at $1193.50

Dollar: lower against the yen, euro and pound

10-Year Bond Yield: Currently trading at 2.222%

Stock Indices in U.S. (relative to fair value):
    S&P 500: -3.92
    Dow Jones Industrial Average: -27
    NASDAQ Composite: -9.41

Thought For The Day:

"How to make God laugh. Tell him your future plans." -Woody Allen

Positions in securities mentioned: None

Wishing you green screens and all the best for a great day,

David D. Moenning
President, Chief Investment Officer
Heritage Capital Research
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