If I had a hammer, I’d hammer in the morning
I’d hammer in the evening, all over this land
I’d hammer out danger, I’d hammer out a warning
I’d hammer out love between my brothers
and my sisters all over this land.
“If I had a Hammer” - Pete Seeger and Lee Hayes, 1949.
“…if all you have is a hammer,
everything looks like a nail.”
- Abraham Maslow
I don’t know if American psychologist, Abraham Maslow, ever met Pete Seeger but they seem to agree about the use of a basic hand tool. Over the years, I have heard many variations of Maslow’s statement but the meaning
has remained the same – those good with a hammer tend to see every new challenge as a nail.
Unfortunately, many investors get caught up in Maslow’s limited tool selection by restricting their choice of investment strategies needed to reach their financial goals. In reality, investors would probably be better off if they could diversify their selection of investment strategies to add depth to their portfolios.
In today’s investment world, however, the “hammer” tends to be in the form of passive asset allocation strategies that distribute portfolios among various stock and bond asset classes. A typical allocation might be 60% stocks and 40% bonds, usually based on computerized proposals based on the concept of “Modern Portfolio Theory” developed in the 1950s by Dr. Harry Markowitz.
And what a hammer it is. Asset allocation strategies using low-cost index funds, and now ETFs, have become the 800 pound gorilla of the investment world.
Don’t get me wrong, I’m not saying that asset allocation strategies do not have a place in an investor’s portfolio. What I am saying is that asset allocation has its shortcomings and should not be the only strategy employed by investors who want to meet their financial goals. Using only asset allocation is like a toolbox containing only a hammer – useful in some applications but hardly a universal wrench.
Unfortunately, limited tool selection can affect the quality of your work. For example, risk management in a passive asset allocation portfolio is generally expected to come from low correlations among the asset classes chosen. The only problem is that actual experience during bear markets has shown that these low correlations can actually during down market cycles (remember 2008?). The result is that asset allocation’s tool to
manage risk can disappear just when you need it most.
The same goes for maximum portfolio drawdown, a statistic indicating the portfolio’s largest drop from a peak value to a subsequent valley. During the two bear markets that occurred in 2000 – 2002 and then again in 2007 – 2009, the S&P 500 Index dropped in value more than 40% and 50%, respectively. Since passive asset allocation was the only tool in many toolboxes, there was no way for portfolios to escape the carnage. What if you needed your money at the bottom of the drawdown? It would be your tough luck.
Asset allocation believers offer the standard line that the market will eventually regain its value, and for proof, they point to the fact that every drawdown has eventually been erased by the market. Well, every one except the Nasdaq Composite’s 75%+ drawdown which has still not been erased even after more than 14 years of market action. Buy-and-hold aficionados don’t talk much about that statistic.
But let’s appease the hammerheads and acknowledge that the stock market does usually regain its losses, eventually, but at what cost? Unfortunately, the price paid by many investors for following a passive investment strategy is often the most valuable commodity of all – time.
While the financial press continues to gloat about hitting new record highs, it conveniently ignores the fact that, since the year 2000, the stock market has spent much of the time either losing money or regaining lost ground. And when we talk about investors meeting their long-term financial goals, time is money.
Common sense tells us that time is an integral part of compounding’s ability to work its wonders. We’ve all seen the illustrations of how someone starting early with small contributions can end up with a larger nest egg than
someone starting later, even though the late-comer makes larger contributions. That’s why we always counsel investors to start saving as soon as they can, even if it’s not a lot of money. Yet periodic significant losses can render the time advantage impotent.
And it gets even worse: not only do losses require you to use valuable time to recoup portfolio losses after a drawdown, you have to earn a higher return to get there. As we all know, a 40% loss requires a 66% return just to get back to breakeven. That’s a double whammy if I ever saw one.
What’s needed is a way to sidestep losses during bear markets and major corrections, while remaining invested during up markets. Active investment strategies provide the potential to do just that.
The moral to this story is that investment professionals need to diversify their clients among different investment strategies, both passive and active – and not just a selection of various equity and bond holdings. Doing so could help portfolios weather the next storm (which some say is overdue) rather than getting hammered.
Having spent most of my career in the insurance and investment industries, I have seen more than my fair share of reports, studies and analyses seeking to explain investments and investor behavior. Most are mind-numbing in their complexity and are rarely worth an investor’s time. That’s why I prefer to explain financial concepts in common-sense terms, using everyday analogies where possible.
Most investors know a lot more about what goes on in the world around them than they do about the latest market analysis, so if we can explain financial concepts in terms they understand, then it might stick with them a while longer. This article will attempt to address why so many investors who lost money in 2008 (and some in 2002) still cling to passive investment portfolios. Here’s what I think.
I’m not much of a golfer, but the few times I have played taught me the need for a “mulligan.” According to my golfing buddies, a mulligan is essentially a do-over where your last shot doesn’t count against you. So how does this concept apply to investors who stubbornly hold on to passive investment strategies? Let me explain. I was recently talking to a neighbor and, knowing I’m in the investment business, she began discussing her own portfolio. She was bragging about how well her large wire house broker had been doing over the past few years and how pleased she was with his guidance. So I asked about how her broker managed risks and if she had lost money in 2008, during the height of the bear market. She admitted that she had lost money big-time in ‘08, but justified it saying that everyone did poorly during that period of time.
In other words, her broker got a mulligan for poor performance during the financial crisis.
As we all know, in 2008, almost every asset class not only lost money, but lost big. Between October 2007 and March of 2009, the S&P 500 Index lost more than 50% of its value. Since then, however, the Index has rebounded over 100% and reached new highs thanks to a large dose of easy money from the Federal Reserve Bank. The result? Investors remember the recent upward trend and give the market a mulligan for 2008.
There’s only one big problem. As my friends soon found out about my skill on the links, a lousy golfer seldom needs just one mulligan. The same is true of passive investment strategies. For proof, you need look no further back than the first decade of the new millennium, in which the major stock indexes needed . Do you really think those will be all it needs going forward? I doubt it.
That’s why it’s important for investors to compare where they are in relation to their investment goals, including mulligans, and where they should be to be on track with their original investment plan. Investors are often sidetracked by the financial media’s claims of “record highs” when all it really means is that they got back to breakeven. They should be paying more attention to risk management.
By focusing on the progress of an investment plan that includes actively managed strategies to reduce the effects of bear markets, investors can more clearly see how detrimental these do-overs can be.
After all, you won’t be able to get a mulligan if you miss retirement goals.
The National Association of Active Investment Managers (NAAIM) has released the agenda for the 2014 NAAIM Outlook Conference to be held November 10-11, 2014 at the Westin Ft. Worth/Dallas Airport, Irving, Texas. Join NAAIM and Active Investment Managers from around the country for the best Peer-to-Peer networking in the business. Register today now for one of the best Active Investment Management conferences this year!
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The “Shark Tank” Returns
Back by popular demand, NAAIM’s Outlook Conference will again feature its version of the Shark Tank, in which conference attendees share their strategies with Investment Advisors looking for third-party talent. The Outlook Shark Tank will be held as a preliminary event, with the winners being invited to present their strategies at NAAIM’s Uncommon Knowledge Conference in 2015. If you have a strategy, model or signal that you would like to present to companies looking to form strategic partnerships with top-notch investment managers, don’t miss this opportunity to participate in the NAAIM Shark Tank.
For more information on Shark Tank or the Outlook Conference, call NAAIM at 888.261.0787 or visit http://www.NAAIM.org.
After more than four years of riding the stock market wave with passive index-based strategies, some financial advisers and market watchers are starting to consider the potential for active management to navigate the next market cycle. Read more.