Costs and Benefits of a Systematic Approach
“It is not really within human nature to comprehend that you may not know everything you think you know, and, further, that what you believe in could change on a dime.”
Global equity markets began the year with a large dose of downside volatility, and many investors are realizing that their definition of risk may need a revision. With the exception of the Coronacrash and Q4’18, the last 10 years have experienced record-low equity market volatility and well-above-average returns. To many, January served as a stark reminder that there is real risk inherent in equities and that the last decade may not be an appropriate analog when pricing in future risk.
In this blog, we discuss the costs and benefits of generating long-term outperformance. It seems a universal truth that to generate superior long-term results, an investor must also accept periods of underperformance. With trend following, this is a conscious choice and one where the potential costs and benefits are measured beforehand to ensure the appropriate emotional fortitude necessary to execute the long-term plan.
Counting the Costs & Measuring the Benefits of Outperformance
Every strong structure has pillars, or focused areas where support is strongest and vital to the surrounding pieces. Remove a pillar and the structure tumbles. Maintain the pillar and complementary pieces can be arranged to supplement strength, appearance, or both.
Solas Wealth has investment pillars that allow us to create a repeatable process and thereby, in our view, provide you with the best chance of achieving your goals.
One of these pillars is the concept of defining and subsequently limiting risk while leaving potential rewards uncapped. Practically speaking, this means first counting the cost of a particular approach, decision, and/or process; determining what rules or restrictions can act as a collar; and then deciding if the upside is worth it. Creating a systematic investment process is a mathematical and engineering exercise that takes a sometimes nebulous, subjective idea like “risk” or “reward” and turns it into a picture that everyone can see and touch.
While every market environment is unique in its own way, if you analyze historical data, you tend to see similar patterns. Market action witnessed in January is an example of something we have seen many times, and it serves as a real-time illustration of us practicing one of our pillar beliefs.
Taking the idea of trend following to its natural conclusion means pressing continued winners (right now that means technology and growth stocks) at the expense of laggards (showing up currently as value and dividend stocks) until it is clear that these long-enduring trends have truly changed. For a trend to change there must be divergent behavior for a meaningful amount of time. Stated more directly, outperformance is not free. If one wants to enjoy the benefits of growth over value or U.S. over international stocks and maximize that until it is clear the ride is over, then one must also be willing to pay the price of that reversal. Ideally, this cost is but a token charge on the ride to outperformance, leaving one much better off overall.
This is precisely how we view January’s performance against the backdrop of 2021. Our portfolios substantially outperforming comparable benchmarks in 2021. Then came January, and we (like the everyone) had no crystal ball to tell us anything would change in January. Therefore, we have continued to press winners, relying on price as our guide. To date, this has meant marginal underperformance versus the same benchmarks against which we outperformed in 2021. When viewed holistically, January’s underperformance is but a fraction of the trailing year’s outperformance and thus a cost we believe it is prudent to pay.
In addition to allowing us to stick with winning trends beyond a mainstream view of what’s possible, trend following also allows us to be highly adaptable. So, while we have steadfastly stuck to winning positions, we are unafraid to act decisively when dictated by trend changes. As a result, we can easily go from being more aggressive than a comparable benchmark in one month to more defensive by the next.
That is what will occur as we enter February 2022. While portfolios will continue to participate significantly in long-term equity uptrends, shorter-term trends have indeed shifted, meaning we will react in a responsible way according to our rules. Should markets rebound quickly, then we will enjoy positive performance with an eye toward once again resuming full allocations to equities as early as March. If, on the other hand, these corrections remain in effect longer, portfolio risk will remain more balanced, with the possibility of further cuts in exposure on the horizon.
We hope our disciplined and dedicated approach to our rules provides comfort in these uncertain times. Our adaptable approach means we won’t “go down with the ship” on any asset class. Instead, we will actively search for strength and emerging opportunities in the form of new trends as they occur. Contact us today to schedule a conversation.