For many years, we have invited financial advisers to visit our home office. These visits let us get to know advisers better and allow advisers to meet the people who make good things happen behind the scenes when they engage us as a third-party money manager for their investor clients.

Last week our visitor shared that he grew up with a passion for aviation and had become a pilot at an early age. This led to a discussion about the checklist pilots use to help manage the risks associated with flying. I was once told, and our guest confirmed, that pilot checklists are composed of items that would have prevented accidents in the past if they had been checked.

He went on to point out that pilot checklists don’t change often because the engineered systems used by pilots haven’t altered much over the years. Yes, they have been updated and are more sophisticated, but they are functionally similar.

Our rules-based, systematic approach to investing is similar to following a pilot’s checklist. Each of the rules we have developed is there because following it would have helped manage portfolio risk or capture opportunity at some point in the past.

However, unlike the rarely changing systems pilots use, financial markets continually evolve through legislative action, technology advancements, or innovation of financial products. These changes influence the way investors behave and drive markets.

The world is always changing … and so is our approach to risk

In less than 50 years, we have deregulated commissions, allowed banks and brokerage firms to be affiliated, invented the internet, and introduced electronic trading. We have also created new financial instruments in the form of options, financial futures, and exchange-traded funds. And that is the short list.

This is another area where the checklists of pilots and rules-based portfolio managers differ. The pilot’s checklist is designed to provide the status of systems that monitor the physics of flying. The portfolio manager’s checklist (or rule set) is designed to drive prudent responses to market action that is propelled not by physics, but by investors and their emotion-driven behavior.

Investors respond rationally to economic, political, and market-related news and data most of the time. Likewise, the rules portfolio managers design to respond to such rational market behavior are effective at managing portfolio risk and opportunity most of the time.

Yet, unlike the laws of physics, which remain constant, human emotion and the resulting behavior can switch from rational to irrational with little notice. When such irrational investor behavior becomes the controlling power in the markets, rational rules may struggle to respond effectively. Fortunately, irrational investor behavior has historically been short-lived. Nonetheless, it is important to understand that it is often these periods of irrational investor behavior that drive sharp corrections (drawdowns) in markets and portfolios.

Without a rational approach, investors are vulnerable to “irrational” markets

It’s easy to identify market corrections driven by irrational investor behavior. The declines are usually very sharp and very short-lived and likely to reverse just as sharply and quickly. Examples of such corrections are highlighted in the following graph.

These market events can happen in the stock, bond, or alternative markets. Whichever asset class the sharp decline originates in, the effects are generally felt in the other asset classes. Often one or both of the other asset classes move in the opposite direction of the asset class experiencing the sharp decline. This is among the many reasons Flexible Plan’s strategic diversification includes allocations to multiple asset classes.

Unfortunately, these short-lived events often cause investors to want to change portfolio tactics and structure. Our experience and history strongly support the approach that well-designed portfolios often quickly recover from such short-lived declines despite being set back by them.

The key to investing success is to adapt

The checklist of a rules-based portfolio manager is constantly adapting in response to these perpetually changing markets, economic globalization, and the evolution of risk-management techniques available.

At Flexible Plan, we are particularly aware of this since we have been in business for 38 years and presently actively manage more than 150 strategies. Those who want to see how rule sets have worked within strategies over time can explore the historical (model) data we maintain and make available.

We believe it is important to continually learn from the behavior of our many strategies in the ever-changing markets and use that knowledge to improve them. Technology allows us to test incremental improvements over time to make our rule sets more effective at managing risk and taking advantage of market opportunities. This is an integral part of our responsibility to our financial adviser clients and their investor clients. The results of the latest rule sets are presented as hypothetical data so they can be used in the process of selecting strategies and creating portfolios.

When Jerry Wagner started Flexible Plan in 1981, he had the option of building the company’s investment process around the subjective group decision-making of an investment committee or around a systematic, rules-based decision-making process. He unhesitatingly chose the latter because rules were more reliable, able to be tested back over time, and not subject to emotions that can adversely influence decisions at critical times.

Today, 38 years later, Flexible Plan still has no investment committee and all investment decisions remain rules-based—rooted in statistical testing that demonstrates that each rule, as applied over time, plays a role in managing risks and opportunities.

FPI Research update

The S&P 500 was largely unchanged last week. Our bond-based strategies were some of the strongest performers of the week: Government Income Tactical gained approximately 1.2%, followed by Fixed Income Tactical, which gained more than 0.5% for the week.

The strategies that outperformed last week were dominated by equity trend-following strategies. QFC Self-adjusting Trend Following followed the NASDAQ 100’s move upward at 1X long last week.

Strategies that struggled last week include our Trivantage strategies, as gold fell slightly last week. Gold’s performance affected all of our strategies that use the asset class as a diversifier.

Among strategies that rotate between various market sectors and styles, Market Leaders outperformed, while our Evolution-based strategies lagged for the week.

PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS.  Inherent in any investment is the potential for loss as well as profit.  A list of all recommendations made within the immediately preceding twelve months is available upon written request.  Please read Flexible Plan Investments’ Brochure Form ADV Part 2A carefully before investing. View full disclosures.