What if You are Wrong?

Every time you make an investment in 2008, ask yourself the following question: What if I am wrong?

As we look forward to the next five years, we need to ensure we are always and everywhere operating with balanced ideas and temperament.

Our dialogue at Invest with an Edge starts and ends with the following: Having a Core Strategy and a Counter Strategy - just in case you are wrong!

One way we like to think about the capital markets and investing is the following: You can have a core set of beliefs, ideas, notions, and strategies. You can and would implement based on your core beliefs. However, what if your core strategy (or belief) is wrong, blows up, discontinues to work? In this case, you better have a back-up plan. That back up plan is what we refer to as a “counter strategy.” In some sense, this is the nature of diversification, but as you can guess, we do not believe in asset allocation and diversification just for the sake of it. Your core and counter strategy can still be opportunistic, and not spread out far and wide, because the far and wide asset allocation approach usually doesn’t stand a chance of beating the market over time and delivers mediocre results.

For example, you could be an aggressive investor, and your core set of beliefs is that we are in a day and age of progress, innovation, productivity…and you are going to build and design a portfolio that is technology heavy. It could contain semiconductor, software, and hardware type names…but maybe innovation also means biotech stocks, alternative energy, medical device companies, etc etc….these are clearly aggressive growth type companies, probably significantly tilted towards growth as opposed to value names. Bottom line, this is your core belief, and you hope to achieve substantial returns investing this way.

My question: what if you are wrong? Or, what if you are right, but wrong in the short term? The market has a nasty way of disappointing almost every investor, over time, and time and time and time again. Right? We’ve all been there. That investor better have something that might do well if his tech heavy portfolio lags, and that might mean owning financials, commodities, retailing, etc.

So, how should we address this situation in a simple way? The best way in our mind is to purposely mix a few specific strategies together in one global equity type portfolio. Let me address one thing – this is geared toward that 10% type long-term equity return. I am not taking into account fixed income, or a quasi balanced type approach. This is an equity only portfolio for funds earmarked for growth. There is a time and place for fixed income, but in this example, I am addressing the “equity return” objective.

Nonetheless, we combine an active sector, style and international rotational investing approach, with classic and longer-term/fully invested growth, value, and international funds so that we have the best of all worlds covered. First, it’s a global portfolio - we are neither taking a big bet for or against the U.S., or for or against non U.S. equity markets. Second, we run active rotational models as a core strategy, seeking to own what’s working and avoiding the laggards. However, our counter strategy is long baseline diversified equity funds – representing strategic & fully invested growth, value, and international asset classes. We think this type of portfolio stands the best probability to beat the market over time. All we are hoping to accomplish is that mythical goal of beating the market over time, and anything we can do to raise the probability that we can, we will implement!

They key point though, is that we are looking 5 to 10 years out, and we are willing to accept the volatility that comes with equity investing, and we make no guarantees or even statements about what the rate of return might be in that 10 year time frame. We will be subject to what the market serves up. Indirectly, it is a bet on capitalism and a bet that the equity markets will continue to perform better than bonds, enabling us to stay ahead of inflation and taxes. The key though, is simultaneously having core and counter strategies working for you at the same time.

Now, admittedly, there are numerous ways investors attempt to game the capital markets. However, that is precisely what makes the market tick! Also, some investors are faced with the limitations of the universe of funds available to them in retirement accounts or 401k type plans . In addition, this strategy is not a simple process - it is not easy to implement and to follow. It requires time and energy.

Therefore, one might think about a long-term portfolio that might look like this. S&P 500, MSCI EAFE, and a rotational strategy. The allocations to each are dependent upon personal circumstances and what not.

This is an important discussion for all investors and why I post it as my last post for 2007 - how to optimally manage a portfolio, especially since each and every one of us has some retirement objective in mind and some sort of lifestyle that is one day very important to us. If we seek to maximize our results against the benchmark, all the while considering that what we are doing could be wrong, then we will most likely succeed and our dreams will come true!

Good luck!

John

Beset by People Wanting to Get out of the Market

Another blog post that is quite the read....in some ways, rebutting the comments from yesterdays entry from Prieur du Plessis. Click here to read something from Victor Niederhoffer. An excerpt:

9. When considering the hornet's net of worries that the stock market has been exposed to each year over the last 100 as we have documented on Daily Spec, are these troubles that much more significant? And if they are, have they been discounted, and what happens when troubles are more or less than usual relative to the market move? A quantitative approach hear would be apt.

A well written article. Enjoy!

A Shockingly Bullish Statement....

from a guy across the pond. His name pops up from time to time in John Mauldins' musings. He hails from South Africa, and his name is Prieur du Plessis. The WSJ blog picked up on this incredibly rookie-like statement. Click here for the WSJ piece. Here's the actual excerpt:

Prieur du Plessis, in his Investment Postcards from Cape Town blog, says it hasn’t looked this bad in all his years. “Not since buying my first stocks in 1968 have I experienced the stock market outlook to be as murky as we are experiencing today,” he writes. “The fears are well documented and, in short, include lingering concerns about the financial system, a US economy on the doorstep of recession, and mounting inflation worries.”

Why do I call this a "rookie-like" comment?? The part that gets me is this: "The fears are well documented." I bolted out of my seat and almost wanted to load up on S&P calls when I read that. Why? Simple - the stock market discounts all known information - as it trades well in advance of facts, pricing in today what will happen in 6 months. Frankly, the market outlook is always and everywhere murky, it's never ever easy, a sure thing, something so crystal clear that we can invest today with 100% confidence in the outcome. However, the market is terrific at discounting the future, and the level of bearishness and the cacophony of noise surrounding recession, subprime, inflation, the dollar, etc etc., is such that it is more likely the surprise will be these things aren't as bad as once thought, and the investor out or short the market will get caught looking the other way. Therefore, the path of least resistance could be higher, as those short or in cash are forced to cover or get long as things ultimately turn out much better than once feared. This is perverse thinking, but that's exactly how it works on Wall Street. Again, the key point is the "known information" part...markets move on new information...so we'll watch and wait for new information and see how it impacts our positions. Good luck.

An Efficient Market?

Why the angst on Wall Street today? If the futures market was pricing in a 53% chance of a 25 bp fed funds rate cut, that means 47% were calling for something else. We can keep this whole analysis simple - that's close enough for 50/50 for me. Therefore, the market should have neither gone up a lot or down a lot, since theoretically, the discounting nature (efficiency) of the market had both outcomes priced on either side, close to a 50/50 type bet, although except for something extraordinary, such as a rate hike, or 75 bp cut or more. Therefore, neither side should have been enthused, nor dismayed. But we read and hear all sorts of dismay and disgust with the Fed, and all of a sudden the market declines 2% in less than a few hours.....Good luck efficient market theorists..surely didn't pan out today for you!

Volatility Means - I'm Losing my Shirt!

Caroline Baum has been writing for Bloomberg for as long as I can remember. I recall viewing her articles straight off the Bloomberg machine in Woodside, California a decade ago. She has a neat way to call it like it is, and I always like to hear what she has to say. Click here for a link to her most recent article. She points out that the word "uncertain" pops up in times of distress.

She states, for example, during good times central bankers don't pepper their official statements and speeches with references to uncertainty, which makes me think uncertainty is a euphemism for ``things are worse than we imagined.'' It's an excuse, in other words: a way to paper over a bad forecast. Recently, she dissects speeches where the word is used quite frequently.

In fact, in a similar vein, I discussed the word "volatile" last August in a post here as well.

Which leads me to the following...

"Freedom is just another word for nothing left to lose" Janis Joplin

Trapped in a Bear Fund

Read an article at cbsmarketwatch today whereby the author mentions getting hit with email regarding bear funds and asking if now was the time to buy. Click here for the article. This is classic investor behavior. After a significant decline for the averages in November, we find investors now believe a bear market is here, and consequently, are losing their grip on discipline and now buying bear funds, although probably too late! Now is not the time to change your long term plan...especially in light of a market that has been hit with bad news after bad news, and is still up 4% for the year on the S&P 500. This tells me the discounting nature is working well, and we are close to bullying forward and attacking the old highs. There will be calm after the storm, but you have to get out in front of it and buy before fact. The subprime mess will end, the credit crisis will subside, and the angst and fear amongst investors will ultimately change to optimism..but by then, it will be too late to buy! Good luck sorting it all out.