Humans are prone to hate losing money. Most of us value the same dollar amount of gains differently than we do losses. We are quick to realize a winning position in fear of losing gains, and slow to realize a loss in hopes that, ‘it will come back’. It’s how we are wired, to take the sure thing on the upside and to seek risk on the downside. This tendency works against us as investors as it’s the exact opposite of letting your winners run and cutting your losers. I’ll avoid the urge to elaborate on importance of win to loss ratio and get to the point of the post…
We believe this contributes to the behavior gap that plagues the investment world. One of our most read posts was this one: Buy and Hold – The Best Strategy You Can’t Follow. Large losses trigger emotional responses from investors. Making investment decisions out of emotion is not a great idea. We prefer to mitigate our cognitive issues, focus on probabilities, and advocate a rules based system to facilitate our behavior.
Our job as a firm is to deliver solutions that work in the real world for real investors. Many investment strategies or factor tilts or whatever you want to call it work on paper, but put investors at risk of large losses. The only strategies whose value will translate from the empirical world to the real world are ones that investors can stick to. You show me a strategy with a 50% drawdown and I’ll show you a behavior gap. A strategy’s return is less important than the investor’s return while exposed to the strategy. Developing a solution for the real world requires recognizing behavioral biases and doing something about them. There has to be some sort of release valve when the probability of large losses increases…enter market timing.
Yes, I said it, and yes we deploy what can be considered a form of market timing within our Behavioral Momentum strategy. First, let me be clear, nobody can time the market. Second, timing is the wrong description. Recognition is more appropriate. Timing the top or the bottom of a market move is not the objective. We are looking to avoid getting our faces ripped off. No system is perfect, we just need effectiveness and it’s extremely critical to keep it simple.
Without getting into our Behavioral Momentum strategy specifics, we use a combination of drawdown and trend measure in our system to recognize periods when reducing equity exposure makes sense. For a great primer on simple timing systems, EconomPic Data has a great post HERE illustrating the effectiveness of drawdown and Alpha Architect’s post HERE is a more in depth look at utilizing simple absolute and trending performance as indicators.
We want to help investors successfully utilize the stock market and avoiding large losses along the way is critical towards that end. Can we potentially get whipsawed, sure. But, we are willing and the evidence is compelling, that paying a potential whipsaw premium is worth the downside protection realized when the 10% drawdown turns into something much worse. Investors need a release valve.
Like the famous stock market quote says, “Everybody is a buy and hold investor until their faces get ripped off”…that’s actually not a famous quote but it should be.
One last link that’s relevant to this topic: Priority #1: Protect Your Capital