One of the first basic rules I learned about investing was “Buy low and sell high.” Seems simple, right? In theory, yes. In practice, maybe not.
Buying low means putting more money on the table when the market is on the decline—a time when you may feel least like taking on more risk. Selling high means getting out of the market when all of your senses (not to mention the financial media) are telling you the sky’s the limit.
When emotions take over, bad things can happen
This past week, Flexible Plan Investments hosted a webinar with behavioral finance coach Jay Mooreland. The webinar, “The only forecast that matters,” is available on demand here. He did a great job of putting this investor behavior in perspective. He said that our brains are driven by confidence, not accuracy. He also cited a study by CXO Advisory that showed that only 47% of over 6,000 “expert predictions” between 2005 and 2012 were accurate. This is particularly significant because the media tends to promote bearish market experts at market lows and bullish market experts at market highs. Investors are inclined to have confidence in those deemed “market experts” whether they are right or not.
So how do investors’ emotions work to their detriment in these cases? When an investor is already experiencing anxiety during a bear market—a good time to buy low—bearish market experts may give that investor confidence that the anxiety he or she feels is appropriate. This may stop him or her from taking advantage of that “buyer’s market.” Conversely, when an investor is experiencing elation during a bull market that is hitting high after high—a good time to sell and capture gains—bullish market experts may reinforce that investor’s feeling that the good times are never going to stop. Based on this confidence, the investor may even throw more capital into the market (buy high) when he or she should be selling. Like investment analyst Benjamin Graham always says, “The investor’s chief problem—and even his worst enemy—is likely himself.”
This is a well-documented pattern of behavior for investors and one that does not serve their best interests. It is also the reason that we at Flexible Plan Investments rely on portfolios driven solely by strategies that are based on rules, not emotions. We have no investment committee debating what we might do on any one day. Instead, we objectively analyze real-time market data and draw investment conclusions based on market history.
We do not predict or forecast. We do not react emotionally to market action or economic developments. We do respond in a way history has shown is the most beneficial to investors.
Making sentiment work for you
Disciplined investors can make other people’s emotions work for them. In the field of technical analysis, there is an area of study known as sentiment, which explores the overall attitudes of investors toward a particular market. There are many sentiment indicators designed to signal when investors and market experts are at the extremes of bullish and bearish beliefs. When extremes in sentiment are reached, historically, going against the crowd has shown to deliver the best outcome for investors.
The following chart shows an example of an indicator based on the percentage of AAII (American Association of Individual Investors) members who responded to a weekly survey indicating they were bullish. High readings in this indicator are generally associated with market tops—selling opportunities. Low readings in this indicator are generally associated with market bottoms—buying opportunities. A disciplined, non-emotional investor could take great advantage of these swings in market sentiment.
Unfortunately, not all of us are disciplined investors. When acting on emotions, we typically make poor investment decisions. Many studies have shown that mutual fund investors often buy the most near market tops and sell the most near market bottoms. In doing so, they end up compromising their returns.
How to take emotions out of the investment equation
So what’s the solution? How can investors avoid letting emotions get in the way of reaching their financial goals? At Flexible Plan, we address this by taking emotions out of the investment decisions completely. We develop investment strategies that can respond objectively to trends and extremes in price action in all three of the asset classes in which we invest: stocks, bonds, and alternatives. Our risk-managed core strategies are designed to provide portfolios with objective, rules-based, exposure to all three asset classes. A well-designed core will generally provide a portfolio with approximately 80% or more of the desired portfolio return and risk reduction.
Our explore strategies complement our core strategies by allowing investors to target a specific asset class in order to “fine-tune” their risk management or enhance return. All of our core and explore strategies are rules-based. Every rule set is designed to objectively exploit some inefficiency in the market. The more inefficiencies that can be exploited within a market by a group of rule sets, the more opportunities a portfolio has for profit. While the rule sets built into each strategy are not designed to forecast or predict, they are designed to increase an investor’s probability of success.
Another way we help investors take emotions out of the investment equation is by allowing them and their financial advisers to “delegate” watching the market every day (another source of investor stress, according to Jay Mooreland) to us. Flexible Plan watches all of the markets in which we invest—all day, every day. We are continuously ready to take the action our many rule sets require. This takes the burden off both the adviser and the investor, giving them more time to identify and work toward those financial goals that allow investors to live their best lives.
Market update by FPI Research
Last week, equity markets continued the uptrend they began in early February, following the sell-off in late January. The NASDAQ finished the week up 2.21%, the S&P 500 gained 1.58%, and the Dow Jones Industrial Average rose 1.02%.
Financial news outlets continue to blame the coronavirus, which the World Health Organization has named COVID-19, for recent market down days. Because we are in the midst of the outbreak, the global economic impact of the illness is still unknown. As more data becomes available, economists and financial professionals are providing estimates that are more informed.
Almost two months into the outbreak, Bespoke Investment Group published an interesting piece. Rather than marking forward estimates, the article looks back at what the investor experience has been during this time. According to Bespoke, “The S&P 500 has given up early gains and is now trading modestly lower in what has become an all too familiar pattern ever since the coronavirus entered the world stage in January. In fact, of the now seven Fridays so far in 2020, the S&P 500 has traded lower on the day six times. The one exception was the Friday heading into MLK weekend back on 1/17. Ever since then there’s been a genuine skittishness on the part of investors to add equity exposure into a 65+ hour window where markets are closed and who knows what type of headlines regarding the coronavirus will come out.”
With the markets near their highs, examining two of our most-used trend-following strategies will help paint a picture of how the data dictates positioning at current levels. Our QFC Self-adjusting Trend Following strategy held 2X long exposure all of last week, ending with a weekly gain of 4.72% after fees. QFC Classic, one of our market beta strategies, continued to be fully exposed to equities and gained 2.56% after fees last week.
One advantage of investing in actively managed trend-following strategies is their participation in market uptrends when conditions seem favorable, as shown by the strategies discussed above. The primary benefit is the objective of capital protection via active risk management when conditions are unfavorable—in other words, having the ability to protect investors during non-trending and downward-trending environments. Preserving capital during bear markets leaves more capital for compounding during trending bull markets.
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.