Let's call the current global stock market what it is, a combination of:

• Government stimulus propping up prices;

• Some investors trying to play catch-up now that the S&P 500 is 75% higher than it was in early March, 2009;

• Some investors extrapolating forward the recent improvement in the economy (tell that to most of the country and you will get quizzical looks), and concluding that the next new opportunity in stocks is here;

Many investors taking the same approach to evaluating the consumer that those consumers took toward their own behavior until late 2007 (and you know how that worked out).  Specifically, consumers kept spending and spending, borrowing and borrowing, leveraging and leveraging, until they were forced by law or contract to stop. 

That was then.  What is now is a world still in the early stages of a slow, painful, deleveraging process that most have never experienced in their lifetimes.  Can you blame them for not knowing how to act?

 

Am I predicting that the market will fall soon?  GreenThought$ readers know me better than that!  I am simply pointing out the risk that comes with the near-term reward.  We were here in 1987, we were here in early 2000, and we were here in mid-2007.  Here we are again.  I don't know when stocks will fall, bond prices will fall or if the economy will enter a "double-dip" recession.  My job and yours is to gauge risk along with reward, absorb a lot of extraneous information, and act on our conclusions by maintaining and adjusting an asset allocation strategy that we feel best suits that reward-risk tradeoff at any point in time.  When conditions (as we perceive them) change rapidly, we are more active in our portfolios.  When conditions change slowly, so does the pace of change in our holdings, weightings and hedging strategy (if we are indeed using a hedging strategy at that time). 

 

Some investors emphasize reward over risk.  Others do the opposite.  Most have a tradeoff somewhere in the middle.  In non-industry terms, some are OK with a bumpy road on the way to their eventual destination, because their car can ramp up to high speeds.  But it also can break down sometimes and that may keep them from reaching their destination as early as they would like.  The flip side is they may get there very quickly, and that is the motivation that overrules everything.  They trade consistency in their returns for a higher return in good markets.  In industry terms, this is what we call a "high standard deviation" investor or portfolio manager.  I will use the acronym "HSD" for short.

 

Others drive more slowly, because getting to the destination quickly takes a back seat to the primary goal...getting there at all.  They emphasize minimizing the chance of the car breaking down along the way.  They also may need to put higher-quality gasoline in the car, and that costs more (i.e., their investment cost to get that smoother ride is somewhat higher) than the HSD investor's gasoline costs.  This passenger's car has very good shock absorbers, and will start to rattle at very high speeds.  All of this is part of their priorities, which is a smoother ride than the HSD investor is likely to endure.  We'll call this other type of investor--one who seeks consistency first and then as much as they can make given that constraint--a low standard deviation investor.  For short, we'll call them LSD investors and portfolio managers.

 

The explanation above has a clear, vital purpose -- to get you to understand in real-world terms and to think about the concept of Standard Deviation in your portfolio.   Hopefully my car-driving analogy "drove home" the point.  Just in case, here is what www.businessdictionary.com defines an investment's Standard Deviation as "the variability (volatility) of a security, derived from the security's historical returns, and used in determining the range of possible future returns. The higher the standard deviation, the greater the potential for volatility."  Standard Deviation is really all about consistency and predictability of one's range of returns in various market conditions.

 

Standard Deviation is perhaps the most common measure of investment "risk" used by the investment advisory business.  You have likely seen a four-quadrant graph of an investment's historical "return" on the horizontal axis and "risk" on the vertical axis.  The return figure shown would be the investment's actual return (typically annualized) over whatever period of time the graph covers.  The "risk" figure used is most commonly the Standard Deviation of the investment over that same time period.  I suspect this is because Standard Deviation is measured consistently regardless of what type of investment style or security you are analyzing.  It is calculated simply by averaging the historical returns and figuring out the average ("standard") distance ("deviation") from that average.  To me, "risk" is best defined by using some other measure of volatility, such as Downside Capture Ratio (email me if you are not familiar with that term) or perhaps Beta.  However, those are measured against an index, so it is tougher to standardize the presentation of them.

 

Consider the market's manic behavior in both directions from September 2007 through April 2010:  We saw the S&P 500 double on two separate occasions, and also lose at least half of its value on two other occasions.  As I write this, we are in the midst of a rally that has advanced about 75% off the lows of 13 months ago.  The most important question any investor or financial advisor should ask themselves right now is, "am I an HSD or an LSD investor?"  And if you are somewhere in between, you had better figure out where on the HSD/LSD spectrum you are.  If you don't, you have a high risk of disappointment, either from jealousy in roaring, stimulus-propelled up markets, or from heartbreak during vicious, unrelenting declines.  Expect both in the coming years.  Even if volatility stays at its multi-year lows for a long time, you will be glad you at least figured out who you are as an investor.  After all, reducing the possibility of disappointment also reduces the likelihood of emotional or erratic investment decisions. Besides, it's nice to know who you really are...and consistency is a great attribute.

(c) Emerald Asset Advisors

www.emeraldassetadvisors.com