As I am writing this the Dow is down over 300 points today, which is a decline of about 13% since its November high. Likewise for the S & P 500 index. In that context, the attached article must at least be considered. Whether the author’s scenario will be played out in the coming decade no one can really know at this time, but I ask that you take special note of two paragraphs, one from the author, the second is Jonathan Wilmot’s quote in the article.

“Wilmot runs through a bunch of investment strategies that might see renewed interest in light of these financial conditions, ranging from equity funds that offer some sort of hedge against volatility to big-data-driven quant funds. He also mentions risk premia investing, an investment strategy that focuses on risks (like volatility or momentum) as opposed to asset classes (like stocks or bonds).”

“Paradoxically, as the fashion for passive investing sweeps the world, the potential benefits of high quality active investment are about to increase enormously,” he (Jonathan Wilmot) said.”

I do not know Jonathan Wilmot nor his preferred investment style, but from the author’s final comment, I assume Mr. Wilmot leans toward active rather than passive management. The difference is passive management adheres to a buy-and-hold philosophy, whereas active management is a tactical “investment strategy that focuses on risks (like volatility or momentum) as opposed to asset classes (like stocks or bonds).” In other words, passive attempts to manage risk through diversification among multiple asset classes. That theory worked reasonably well in the 1900s, then 2000 and 2008 hit and it didn’t work well at all. In 2008 there was no place to hide. Every asset class had substantial losses. The truth is buy-and-hold, by definition, requires NO management.

So why should you consider a tactical approach when the investment advisory world has been promoting Buy-and-Hold for so many years. Because, “This Time it Really is Different,” for at least two reasons. First is the internet. Buy-and-Hold worked when information travelled slowly and corporations and businesses had time to react to changing market and economic conditions, and the US market didn’t know what happened halfway around the world for several weeks. A company’s fundamentals actually meant something. Today, information is instantaneous. What happens in China, Greece, or South American countries has an immediate impact on the US stock market and interest rates. No US Company has control over international markets and the impact it has on their profits and losses.

The second reason is computers. You may have heard about computer trading. Many major stocks trade on multiple exchanges, like the NASDAQ and OTC (Over the Counter). Computers have become so powerful and fast, that traders can monitor the same stock on both exchanges. It is even critical that the computers be geographically close to where the trading takes place. The time it takes for information to travel from an exchange in New York to a computer on the west coast is too long. There is usually a time delay of milliseconds on the price of the same stock as quoted on each exchange. For example, ABC stock is trading at $25.10 on the NASDAQ and $25.08 on the OTC. The computer automatically recognizes that differential and places an order to buy 20,000 shares on the OTC and places a simultaneous order to sell 20,000 shares on the NASDAQ, thus capturing a 2-cent profit. That doesn’t sound like much, but multiplied by thousands of transactions in one day and the profits become significant. The point is, fundamental analysis plays no role in these decisions. The computer is looking for volatility and momentum, as Jonathan Wilmot mentions in the article. Ask yourself why it is almost normal now to have triple-digit swings in one day almost every day? It can’t be only individual or even institutional investors.

Here is a very simple illustration of why tactical management should be considered. Assume over a 12-month period the SPY (exchange traded fund that mimics the S & P 500) price starts at $100/share and ends at $100/share and you bought 10 shares with $1000. The buy-and-hold strategy produces a 0% return. However, during the year you were able to sell your 10 shares at $125 and then buy back in at $83.33/share, so you could buy 15 shares. At yearend your value would be $1500 (15 shares X $100/share) for a 50% return versus a 0% return. Needless to say, knowing when to sell and when to buy is the tactical nuance that is difficult to achieve, but not impossible. Even if the timing is wrong and the sale is $110/share and the buy-in at $105/share, the gain would be about 4.75%; still better than zero. To be fair, it can also go against you if you sell at $110 and the market keeps rising. Your choices are to either do nothing (of course you still made $100 but lose the potential upside), or buy back in at a price higher than your exit price and then the market declines, in which case your loss could be greater than had you employed the buy-and-hold strategy. There is no perfect strategy.

Whether Mr. Wilmot’s prediction becomes reality is really less important than preparing for the possibility. No one can accurately predict the future or make decisions that can avoid some losses. What we can know is that markets experience deep declines and large run-ups multiple times. From my point of view, the buy-and-hold ensures a portfolio will experience those large declines, and it takes many years for the run-up to restore the value back to breakeven (about 6 years for SPY). Unfortunately, that may also be just about the time the next decline hits. A decade of zero or very low returns will not help you achieve your goals. A tactical approach at least increases the probability of achieving, although not guarantying, satisfactory results in declining and increasing markets. Good investing is a function of utilizing strategies that increase the probability of success.

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