I got some pushback from a reader to my weekend post (see How to spot the bear market bottom) about the FT Alphaville article indicating that former Secretary of Defense Mattis raised concerns about how the White House lacked a decision making process. The reader went on to defend Trump’s decisions.
I try very hard to remain apolitical on this site. Everyone is entitled to their own opinion, but there is a distinction between a decision, and a process. Here is an example from the investment realm. Josh Brown recently ranted about people “who called the correction”. Click this link if the video is not visible.
Josh Brown’s main complaints can be summarized as:
- Anyone can make a market call. If you are wrong, very few people will remember, or you can delete your articles or tweets.
- Managing a portfolio is a much tougher task. Portfolio managers are measured by actual returns. As an example, if you decide to sell out, what is your discipline for buying back in?
- Just because someone doesn’t say anything, it doesn’t mean that they are unprepared for market volatility. Most firms have compliance guidelines about what individual portfolio managers or advisors can or cannot say or publish.
Despite my own efforts at transparency (see A 2018 report card) where I have published my track record, and owned up to bad calls, I sympathize with Brown. Josh Brown’s rant amounts to distinguishing a decision (market call) to an investment process. A timely market call means little if there is no investment process behind it.
What is an investment process?
At a minimum, here are the steps that professionals have in an investment process. They may call it different things, but the steps are more or less the same:
- Decide on what to buy and sell, otherwise known as alpha generation;
- Decide on how much to buy and sell, otherwise known as portfolio construction, or risk control;
- Timing the trade so that you take maximum advantage of short-term conditions, and, if you are responsible for lots of assets, make sure your trading leaves a minimal footprint in the market; and
- Periodically review and diagnose steps 1-3 to ensure that they are working as intended. In particular, good organizations learn from their mistakes, and make adjustments when things go wrong.
We focus most of our energy on step 1 because that’s the sexy part of investing. My timely call for a top in August (see Market top ahead? My inner investor turns cautious) was exciting. On the other hand, I would lose most of my readership if I devoted most of my time discussing the different ways of dissecting factor risk, or the pros and cons of arrival price vs. VWAP as a trading benchmark.
That’s the essence of the difference between a decision and a process. The market call is the decision. The process is how you implement that decision. The returns of your portfolio depends the strength of the investment process.
What I try to give you is step 1, the rest is up to you. Incidentally, the decision making process in step 2, how much to buy and sell, is a function of each portfolio’s return objectives, risk preferences and pain thresholds, tax situation and jurisdiction, and a whole host of other factors. Most portfolio managers will develop an investment policy statement (IPS) as a framework for step 2, which I know nothing about. That’s why nothing on this site can be construed as investment advice.
My limited guidance for investors
While I cannot give specific advice, here is some guidance that I can offer.
Over the years, I have been asked by readers on guidance on how to develop their personal IPS. I have hedged my answers, since I am not in a position to give investment advice for the reasons I cited. However, this liquidity based strategy from UBS can served as a useful framework for creating an investment plan.
The approach calls for splitting an investment portfolio into three buckets:
- Liquidity: What you need for the next three years, which includes considering life and disability insurance needs.
- Longevity: What you need to for the next 4 years and your lifetime.
- Legacy: What you are going to leave for the kids.
On a separate topic, the recent equity market weakness would have moved the equity portion of many balanced portfolios below their equity target weight. The question then becomes, “When should you rebalance your portfolio weights as part of a disciplined investment process?”
The most obvious approach is to rebalance either periodically (quarterly, or annually) back to target weights. I call that the value approach of buying assets when they are cheap (gone down) and selling assets when they are expensive (gone up).
However, a past post from 2014 (see Rebalancing your portfolio for fun and profit) uncovered a research paper that indicated a price momentum strategy could yield better results. Here is the abstract [emphasis added]:
While a routinely rebalanced portfolio such as a 60-40 equity-bond mix is commonly employed by many investors, most do not understand that the rebalancing strategy adds risk. Rebalancing is similar to starting with a buy and hold portfolio and adding a short straddle (selling both a call and a put option) on the relative value of the portfolio assets. The option-like payoff to rebalancing induces negative convexity by magnifying drawdowns when there are pronounced divergences in asset returns. The expected return from rebalancing is compensation for this extra risk. We show how a higher-frequency momentum overlay can reduce the risks induced by rebalancing by improving the timing of the rebalance. This smart rebalancing, which incorporates a momentum overlay, shows relatively stable portfolio weights and reduced drawdowns.
Go check it out.