MathInvest and Risk
MathInvest’s approach to risk is different from that of most investment professionals. Every manager knows that there are times when it is either impossible or extremely difficult to make money in equities. The standard approach (Modern Portfolio Theory) tries to diversify away this risk by carefully choosing different assets, such as bonds which tend to move inversely to stocks. The pioneer work on MPT had been done by Harry M. Markowitz who advocated portfolios constructed with 60 percent in equities and 40 percent in debt. Unfortunately that simply means that in bad times 60 percent of one’s portfolio will experience a large decline while 40 percent has a modest increase. To us at MathInvest and our clients, better solutions are available.
As we said above, it is not difficult to determine the bad investment periods. One of the simplest approaches is that if an investment in Treasury bills is outperforming the Standard & Poor’s 500 Index, then you had best not invest in stocks. Even that naive approach leaves the Markowitz MPT in the dust, performance-wise.
If your life’s work is investments and you are experienced in the use of quantitative research techniques, before long you will have assembled a collection of tools for determining the more and less favorable times for investment. Any one of those tools can easily be wrong, early or late. But collectively, a “jury” of those tools, assembled over a lifetime, will provide you with better than average indications of when it is more advantageous to be either fully invested or not invested.
It is important to note that our tools provide us with indications as to when the investment climate will be difficult for us to profit. That could easily mean that the stock market is going down, but it could also mean a period of indecision. In either case it would be best to reside on the sidelines at those times. That is, the overlay decision to exit equities is not necessarily an indication of an upcoming declining stock market. If it were, we would consider a short strategy; but it is not.
We have thoroughly researched and tested these overlays, and we are always auditioning variants and possible additions to the “jury”. Our practical experience is that they work extremely well. A look at the stock markets over history reveals that equities rise about 70 percent and decline about 30 percent of the time. Our overlays reflect the same percentages. Furthermore, the overlays have provided protection against the occurrence of high-impact, hard-to-predict, and rare events that are beyond the realm of normal expectations, for example enabling us to successfully dodge the shocks of 2008.
During the period of 2003 through 2009, the S&P 500 Total Return Index experienced an overall gain of 36.76 percent, or a compounded annual rate of return of 3.85 percent, approximately half of which were dividends. To obtain that return, one had to risk a maximum drawdown of 55.53 percent of one’s capital. Using MathInvest’s overlays to exit the market and invest only in Treasury bills during the cautionary times would have resulted in an overall gain of 152.65 percent or 14.27 percent compounded annually. The maximum drawdown with the overlays was limited to 19.1 percent. In the illustrated case, the only active management was the use of the overlays. Thus, to best profit over time, avoid losses whenever you can. The chart below illustrates the effect of using the overlays.
When we are in our default scenario of owing a collection of stocks our approach also differs from standard risk practice. MPT would have one owning top-performing stocks in a diversified collection of industry sectors. MathInvest’s contention is that it makes absolutely no sense to own any stocks from sectors whose performance is at odds with the current business cycle. For example, if the widget sector is in a period of contraction, owning even the best performing widget stock solely to pay homage to the concept of sector-neutrality is asinine.
In conclusion, MathInvest’s method of dealing with risk can be summarized by avoiding stocks that have little upside potential. In the case of our overlays, we avoid all stocks when the prospects for all of them are poor. In the case of selecting individual stocks for our investment baskets, we also avoid those whose odds of success are decidedly not good. If you reduce the clunkers in a portfolio, then what remains will have better than average performance. It’s all simply common sense, something whose existence is regrettably uncommon.