It is not very difficult to find investment strategies that produce high returns, if you use Bloodhound’s search engine you can find over 4,000 investment strategies that have averaged more than 20% a year over the last 23 years using a portfolio of 20 stocks. The challenge for the investor is the volatility of the portfolio value, and trying to decide whether a fall in value is reason to sell (for fear of further loss), or buy more (because falling prices can be an indicator of bargains, and dollar cost averaging is a good way to let value climb). The industry refers to volatility as “risk” or “beta”‘, where risk is the standard deviation of portfolio value, and beta usually measures that in relation to the SP500 index. The problem is that standard deviations cannot tell the difference between a price that is fluctuating and one that is just going up (or down!).
To illustrate, here is a simple example. The two sets of data represent one that is trending upward, and one that is trending downward. If you look at the mean and standard deviation, you see they are exactly the same, so they, alone, tell you absolutely nothing about which you would rather have invested in!
There are several ways in which the investor can manage volatility (1) diversify the portfolio, because your portfolio is then averaging the gains from several stocks, and it is unlikely that all your stocks will go up or down at the same time. You can do even better if you diversify the stocks between sectors, or even to mix US and overseas stocks. All of these tend to mitigate volatility in the portfolio, but the downside is that you also average down the return! (2) select stocks for your portfolio that are less volatile. These tend to be the stocks of large companies, because their value changes at a slower pace. Large, in this context does not necessarily mean “large cap”, because some “large cap” companies are large cap because their price has been bid up; large, here, means revenue and profits. The disadvantage is that while these companies often pay dividends, the capital gain in their shares is not as high. (3) Use defensive strategies such as stop losses, protective Puts, hedge the portfolio by going partly or wholly to cash or adding short positions.
The trouble is that stocks go up and down in price all the time; if the investor is saving for an event several years in the future, he or she will know that long term strategies work out despite market fluctuations. There are scares every year and whether this year’s crisis is fear of a new President, or problems in a third world country, the result is the same; the market goes down, business carries on, and the market goes up again. If, on the other hand, you are going to need the money in the short term, you are less able to tolerate volatility because you do not want to sell low. Benjamin Graham said “an investor’s chief problem is himself” because emotion is hard to avoid.
At Bloodhound we have analyzed many investment strategies and concluded that the best way to protect long term gains is to stick with the same strategy. This is a method we think of as “time averaging”; its analogous to using a portfolio to average out the value of stocks; when we time average we average over good years and bad. The alternative is trying to time the market, and there is much evidence that nobody can. Read Graham!
The Bloodhound Model Strategies are good examples of investment strategies where excellent long term performance has resulted from applying the same strategy year after year. Let’s take two examples using a portfolio of 20 stocks: “Moderate2″ has averaged 14% for 23 years; it has only lost money 4 times (the SP500 index has lost 7 times). In the last 10 years, its biggest loss was 1.8% and it made money in 2008. “SuperAggressive4″ has only lost money twice, but one of those was 2008, when it lost 43% (SP500 lost 37%); despite that it has averaged 45% a year for 23 years.
Risk is a big subject and it’s difficult to manage. When we drew up the Bloodhound Model Strategies, we felt that traditional measurements like standard deviations were inadequate, so we specified volatility relative to the SP500 index, the number of times the portfolio has lost money in 23 years; and the number of times you might have seen the portfolio go down more than 5% in a year. All the rules, and the results, can be seen in our blogs. Notice that nearly all of our strategies are one year buy-and-hold; that means that they do not normally trade more often than once a year. That makes them unstressful to live with!