Beating the annual performance of the S&P 500: it’s Wall Street’s be-all and end-all bar of a human being’s worth. And it’s grossly flawed.
More and more over the years, this standard has led to excessive risk taking that in the long run seems to consistently result in disaster. Hand in hand, Wall Street’s objectives and investors’ expectations need to change. In this comment I lay out the reasoning behind my argument and summarize how I do things differently in the ETF trading universe for my clients at miAnalysis, Inc.
IF ONLY I WENT LONG YESTERDAY!
A day, a week early or late on making a single investment and Joe fund manager fails to beat the market that year. He gets a smaller bonus (or portion of profits) and has to explain to clients why he “failed.” What does Joe do? He starts buying leveraged ETFs in order to goose returns. He develops a new interest in frontier market bond funds. He stops following sound money management rules. And why not? Consider his incentives: in a bad year, as long as the losses aren’t monumentally worse than the broader market, he’ll at least keep his job (except for cases in which clients leave and a fund closes, which does happen). Meanwhile, in a good year he can earn a bonus (or a portion of profits) big enough to make up for the years in which he had to settle for his base salary taken from fees. Imagine paying someone to gamble your money at a casino and they get $100 if they lose the same amount as the average gambler, and $300 if they do better. With terms like that, taking big risks becomes pretty appealing.
Perhaps I’m exaggerating a bit for effect, but you get the idea. And that way of thinking has permeated enough of the business to the point that clients are more dazzled by return potential than they are concerned with standard deviation of returns. It’s not healthy. And simple math shows it’s imprudent in the long run.
DO THE MATH
Consider the following two hypothetical scenarios.
Scenario A: Index Fund
Trader Dave starts with $100,000 in a trading account. He puts all his money in SPY (S&P 500 Depository Receipt) and leaves it alone. Here’s what happens over time…
Beginning Portfolio Value: $100,000
• Year One: SPY gains 10%; Dave’s account value grows to $110,000.
• Year Two: SPY gains 10%; Dave’s account value grows to $121,000.
• Year Three: SPY gains 10%; Dave’s account value grows to $132,100.
• Year Four: SPY falls 15%; Dave’s account value falls to $112,285.
Ending Portfolio Value: $112,285
Scenario B: Conservative ETF Trading
Trader Catharine starts with $100,000 in a trading account. She exploits the advantage she has over funds in not having to be fully invested all the time, and makes a select few position trades in ETFs based on a set of technical set-ups that have worked for her over the years, staying out of the market when trends aren’t clear and following strict money management rules. Here’s what happens over time…
Beginning Portfolio Value: $100,000
• Year One: Catharine grows her account by 8% to $108,000, underperforming SPY by 2%.
• Year Two: Catharine grows her account by 8% to $116,640, underperforming SPY by 2% annually, and 3.6% over the two-year period.
• Year Three: Catharine grows his account by 8% to $125,971, underperforming SPY by 2% annually, and 4.6% over the three-year period.
• Year Four: Catharine’s account is flat on the year, outperforming SPY by 15% annually and 12.2% over the four-year period.
Ending Portfolio Value: $125,971
This example is conservative in two ways. First, Dave didn’t even try to beat the market; he merely sought to keep pace. The drawdown in year four could have been bigger had he taken on more risk. Second, a 15% decline in SPY is merely a correction, whereas a cyclical bear market of a 20% loss or more would have meant the gains achieved over the preceding three years would have been pared more deeply. In the case of a 20% decline, Dave would be left with $105,680, or a 5.7% gain over the four-year period. That sharply contrasts the 26.0% gain Catharine pocketed.
CONCLUSIONS
Focus more on being out of the market during downtrends than on beating the market during uptrends.
It only takes one bad year for gains achieved over many preceding years to be deeply pared or even wiped out. The same reasoning applies to one bad month, even one bad day for day traders. Focusing on steady, modest gains when the market is rising and being square during bear markets, rather than beating the S&P 500 each year, will result in greater capital appreciation over time, accepting that it may take a few years for the benefits of this approach to become apparent.
Short-term trading may sound riskier than holding for longer periods but that’s actually not the case if you trade smartly. It means only acting on set-ups that have worked well for you in the past, staying out of the market when it isn’t trending well, avoiding leveraged ETFs and other vehicles that magnify risk, and adhering to strict money management rules about position sizes and stop losses.
Another point to consider is focusing more on portfolio risk than risk on a single trade when determining position sizes and stop loss levels. That theme is worth a discussion all its own, which I’ll address next time.
I hope this is of some help to you, and good trading. My best, everyone, Chris Burba.
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Learn more about Burba’s work at miAnalysis, an independent financial research firm, here.
Catch Burba’s market commentary each Monday on TraderPlanet.
