Find out how. Let's Talk

How the Market Works

Market Crash: Test Dummies

Posted by kdadmin on August 31st, 2015.

Market Crash: Test Dummies

One of the most INFURIATING things about being a highly credentialed, experienced, and successful investment advisor is watching the licensed amateurs in my field make us all look bad.

I just read an article over the weekend that was entitled something like, “What advice are the best financial advisors giving to their clients in the recent market crash?”

Guess what “the best” advice turned out to be?

“Stay the course and DO NOTHING.”

I’m not kidding! Somehow the fact that these “advisors” got caught with their pants down, while their clients accounts plummeted, doesn’t seem to register. It’s this sort “stay the course” feeblism that makes them all look like they care more about their bottom line than the clients’ bottom line.

Think about this. If you’re a client of a financial advisor, and, all of a sudden the market tanks, what do you hope to be true? You hope your fellow saw it coming, that he took a defensive position, a long time ago, because took a Roy Rogers approach to your money. In other words, as Roy would say, he is “more concerned about the return OF your money than the return ON your money.”

SO MANY AMATEUR ADVISORS hang their hat on modern portfolio theory alone. Let’s assume this is the result of being uneducated, and not lazy. Look, modern portfolio theory was a nice idea, in the 1970’s. Back then, Markowitz and Sharpe hung their hat on the notion that properly asset allocation could take much of the unsystematic risk off the table in a typical portfolio. But they made one assumptions that you need to know about. Namely, clients will be just as upset about an excess return to the positive, as they will be to the negative. By doing this, they were able to use statistical variance, operating essentially in an emotional vacuum, to prove their theory.

In reality: THIS. IS. FALSE.

Clients WILL NOT be upset about an excess positive return. No client will be upset if their account goes up too much.

Modern portfolio theory concerns itself with unsystematic risk, the kind of risk that can be reduced through diversification. In other words, if the you have a lot of stocks, and buy a lot of bonds, the fact that they are negatively correlated (one goes up, the other goes down) helps reduce your risk because a bad day in one will likely mean a good day in the other.

However, there is also something called systematic risk. Think of systematic risk as the tide. When the tide goes out, all boats go down. Last week was a perfect example of systematic risk. The market had a systematic correction of 15%. Stocks went down sharply and gold, bonds, and the like didn’t increase in a similarly opposite correction BECAUSE of concerns about how the Fed will change interest rates.

Look at the graph above. SPY (representing the S&P500), was down as much as 9% from the previous Thursday, finishingdown 2.32%. Notice how, on the day that SPY was down so severely, that GLD (gold), AGG (aggregate bond index) and TLT (20 year treasuries) ALSO WENT DOWN? And that EVERYTHING finished down for the week? According to unsystematic risk, this shouldn’t happen. But according to systematic risk, all the boats go down when the tide does out. In this case, the tide was “market sentiment.” Which means that there was no safe haven except cash, CMR, which held right at zero.

So, what’s the solution?Simply, post modern portfolio theory. Why? Because post modern portfolio theory assumes that clients will be happier with an excess positive return than an excess negative return. Technically speaking, it’s shifts the range of acceptable results in the statistical model. If a client is unhappy (read: scared), they are likely to sell at the bottom. Which creates a near certainty of loss. IN OTHER WORDS, ASSET ALLOCATION MUST BE DONE TO ASSUME THAT CLIENTS ARE HAPPIER WITH GAINS THAN LOSSES.

IN OTHER, OTHER WORDS, FOR A GIVEN LEVEL OF RISK, IF THERE IS A HIGHER CHANCE OF LOSS THAN OF GAIN, THE RISK SHOULD NOT BE TAKEN AS CLIENTS WILL BE UNHAPPY.

How hard is this to understand? Apparently, very.

There is a reason I have a page on my website dedicated to the geekery of post modern portfolio theory. There is also a reason that I sold out of the stock market in late May. When the first quarter GDP numbers were revised down into negative territory, this broke the upward trend of the GDP. Given the shrinking of corporate profits (via cost savings of mergers, consolidation, etc), the chance of upside gain simply wasn’t as strong as the risk of downside loss (give the stock market was at all time market highs). This is how the market works.

So, I could have been like every other ninny out there and “stayed the course.” But, instead, I sold my stocks to cash; and promptly watched the market tank, taking NONE of my clients’ money with it, while I giggled on the sidelines.

Which do YOU think was the best advice?

Which do YOU think gets you closer to being able to Live the Life You Love?

Meet

Minneapolis, MN | St. Croix, USVI
(763) 577-1900