The Importance of Your Investment Strategy Timeframe
“The more we value things outside our control, the less control we have.” — Epictetus
It is our observation that an investor’s timeframe is inversely related to volatility. As markets decline and volatility rises, even a long-term investor’s focus has a strong tendency to shorten, and sometimes dramatically. In this blog, we discuss the value of selecting appropriate timeframes for making allocation decisions. The timeframes you select to manage market exposure drives not only performance, but investor behavior, taxes, costs, and tracking error to your benchmark. Which variable do you solve for? When designing strategies, we consider all these factors and ultimately prioritize the variables in a way that we think optimizes the client’s experience.
In September 2021, we saw the first decline greater than 5% in a year, which aroused investors from their low volatility slumber. Not surprisingly, we noticed an uptick in the number of client meetings meant to address concerns. Though mostly reasonable, there were a few outlier examples of clients who thought a move to cash was perhaps warranted. As bull markets do, equity prices quickly recovered, rebounding from lows, and erasing the pullback – with some even making new all-time highs in the process.
September and October reminded us of a topic we have frequently discussed over the years: timeframe selection. In other words, when designing an optimal investment strategy for a financial goal, nothing is more important than selecting the right timeframe(s) for making allocation decisions/changes.
We recognize the importance of limiting downside while capturing as many market opportunities as possible. We also appreciate that managing downside may come with certain limitations, particularly for clients with taxable accounts. React too quickly and downside is averted but at the cost of potentially missing on sharp rebounds, like October, with the added sting of realizing gains that could have otherwise been deferred. React too slowly and market declines might cause clients to overreact and risk permanent loss of compounding.
Our strategies are designed for clients seeking to hit that “sweet spot” between too quick and too slow. Said another way, we strive to make our strategies “behaviorally friendly.” This process starts by having rules for tactical shifts that are responsive enough to minimize downside in meaningful bear markets like the tech bubble of 2000-2002 or the Financial Crisis, but disciplined enough to ignore what may turn out to be a harmless correction.
The graph below illustrates the process. Using SPY as a proxy for U.S. equities, you will notice its price (black bars) drop from the previous peak in early September to the low October 4. The graph is overlayed with the two moving averages that represent our intermediate-term time frame: the red line (10-day average) and blue line (100-day average). The moving average lines show how these timeframes responded, converging in mid-October but never materially threatening the intermediate-term trend.
Source: Barchart.com, 7/27/2021 to 10/26/2021
Conversely, a shorter-term system would have indicated a trend change in mid-October and missed out on a portion of the recovery, while realizing taxable gains and causing turnover in the portfolio. Our more patient process ignored the 6% decline and fully participated in the rebound.
In case you’re wondering, longer-term systems barely nudged toward an exit and ultimately never came remotely close to triggering a trend change.
Seeking the Optimal
Almost all investment strategies are gauged on before-tax returns over 1-, 3-, 5-, and 10-year windows. But what about the fact that most investors need to care about after-tax performance over horizons lasting 30, 40, 50, or more years? And what if those shorter-term windows do not include a meaningful bear market to consider the real risk of investing?
While we are confident that our strategies will stand up just fine over the traditional comparison periods, we admit that it is ultimately not what we are solving for. Rather, our goal is to offer you investment strategies that help maximize opportunities over the long haul. When you want sound, measured financial planning and investment advice, contact Solas Wealth.