Winning from Market Drops

Top line is our core portfolio performance for February 2018.
Straight line shows 4% annualized growth.
Dotted yellow line shows the S&P 500. Over 90% of professional money managers cannot equal this over the course of a decade.
Blue dashes line shows the Toronto Stock Exchange index.

 

How do highly effective investors (HEI’s) achieve the results shown in the chart above?

Improving on our basic, broadly based index ETF investment strategy comes with no guarantees but let us look at a technique that has a reliable and positive track record. First, we need to decide on our personal asset allocation. You could search the legitimate investment literature (ssrn.com, investopedia.com, wikipedia.com) or books on investing by respected authors such as Benjamin Graham, Burton Malkiel, John Bogle and others for greater detail, but what we will look at below is as simple as it is effective.

Our portfolio should consist of a balance between a low-cost, broadly-based index exchange-traded fund and cash. Earlier in life, aggressive investors might keep a larger percentage in the broadly-based index ETF. Investors later in life, or cautious investors, might keep a larger percentage in cash. A balance of 50 percent broadly based index ETF and 50 percent cash, with slight variations, is effective. In a sideways market, you need not do anything. But if the broadly-based index ETF drops sharply and the cash percentage of the portfolio increases, then buy some broadly based index ETF shares to get back to the 50-50 allocation. You will be buying low — the ideal way to buy.

Now, here is a variation on the above theme used by HEI’s to get the results shown in the chart above.

When the broad-based index ETF drops by 10 percent, move a third of your cash into your broad-based index ETF. When it drops by a total of 20 percent, move the rest of your cash over. When it drops by a total of 30 percent, borrow all that your margin limit allows and move it into your broad-based index ETF. If you don’t have the nerves of steel required for borrowing on margin, a bad idea most of the time, then stop at the point where you have moved all your cash over into this index fund. Borrowing on margin is often dangerous, producing many sleepless nights. You can get impressive results without it.

Every time the index goes up by 10 percent, sell enough to rebalance your portfolio to half cash and half broadly based index ETF.

How often do these market corrections happen?

History shows that 5 percent drops happen more than twice a year; 10 percent, twice within three years; 20 percent, about once every three-and-a-half years; and 30 percent, once every five years. Over the next five decades there will be seven to ten recessions. (A recession is defined as a fall in GDP in two successive quarters.) The literature of psychology shows that most investors feel less pleasure from gains than they feel pain from losses. Seasoned investors love the bargain of a market correction that is painful to others. How you feel during market drops can be your test of how seasoned an investor you are.

Do this for 40 years, give or take a few to allow for good returns, poor returns, windfalls, changes in personal circumstances, changes in interests, and so on.

In retirement, withdraw 5 to 6 percent annually if you are managing your own portfolio and 3 to 4 percent if someone else is doing it for you. Your portfolio will be large enough to allow the same lifestyle that you had during your active income years, forever. It will be far larger than you would have built by buying the majority of the mutual funds that are available. Only with hindsight can you pick the very tiny percentage of mutual funds that would beat the approach to investing described here.

If this investment strategy is so simple, why aren’t all the mutual funds doing this? After all, mutual funds are run by intelligent, highly motivated people with access to the best investment tools available. Well, at the market bottoms, panicked investors are withdrawing their money from mutual funds and managers don’t have the cash to buy bargain-basement stocks even though they would love to. The opposite happens at market tops. Optimistic investors are pouring money into mutual funds when they are expensive, when there are almost no bargains, and when investors should be getting out. Since managers’ performance is monitored on a quarterly basis, they are almost forced to buy at high prices instead of keeping money in cash like you and I can.

We can possibly improve on these results further by writing covered calls or cash-secured, uncovered puts on a broadly-based index ETF. On the spectrum of available investments, both types of calls and puts are relatively low-risk, and with both, that risk is directly connected to the risk of owning the American economy as a whole as represented by that broadly.

Dr. Milan Somborac

The Monday Morning Millionaire Program supports do-it-yourself (DIY) investors which I have been for over 50 years. About my team and me