Most Popular ArticlesMay 26, 2009
Third, since equity investments are considered an inflation hedge, we must consider inflation when discussing drawdown. The purple curve shown in Figure 5 is the drawdown adjusted for inflation, as measured by the Consumer Price Index. Although the nominal S&P500 index made new highs briefly in 2007, the real S&P500 was fifteen percent below its 2000 peak at the time. Inflation adjusted drawdowns are steeper and longer than nominal drawdowns.
Drawdowns with devastating magnitudes are quite common. The market suffers losses in excess of forty percent more than a third of the time. Only a man of steel can withstand the frequent, prolonged, and torturous emotional trauma inflicted by staying fully invested at all times.
Figure 5
“No one purchases just one index. We diversify…” argue buy-and-hold enthusiasts. By constructing a portfolio of uncorrelated stocks, you can dampen the impact ofthe specific risk of each stock. But correlations among different asset classes change with time, depending on the market environment. Two previously uncorrelated stocks can suddenly move in unison and render diversification ineffective.
More importantly, diversification cannot dodge the systematic risk of the entire market. During bear markets, most stocks decline together. When systematic risk is exacerbated by the systemic risk associated with the catastrophic collapse of global financial institutions, not only do the equity markets take a blood bath, but most other assets follow. In 2008, all asset classes plummeted, including US equities (all styles, sizes, and sectors), emerging markets, bonds, real estates, commodities, and currencies. The only uncorrelated asset during a systemic crisis is cash. The prudent way to reduce risk is to rebalance your portfolio with cash equivalents. Isn’t that called market timing?
Buy-and-hold proponents may cling to the belief that market timing is futile, since no one knows the future. Who said that market timers must foretell the future? Active asset allocation practitioners like Brian Schreiner and Mebane Faber are trend followers. As mentioned in their recent articles, a ten-month moving average system would have avoided both the 2000 crash and the 2008 meltdown. Is the moving average system a sound investment methodology or just a myth? I will explore this topic in a future article.
Ask yourself this question, “If you could help your clients avoid most the bear markets, would they mind missing a few mighty rallies?” Human beings are more sensitive to the pain of losing than to the joy of gaining. That’s why most passive financial advisors don’t buy the “missing out” argument, especially during bear markets. You may not be ready to sign up for lifetime membership to The Market Timers Association, but if you are losing faith in buy-and-hold or are losing clients, you are not alone among mainstream passive managers.
Data – All data are total return series.
S&P500 Monthly Series – Provided by Robert Shiller of Yale University.
S&P500 Daily Series – Provided by Ultra Financial Systems, LLC.
Theodore Wong graduated from MIT with a BSEE and MSEE degree. He was General Manager of several Fortune-500 companies designing sensors for satellite and military applications. He started a hi-tech company via a LBO in partnership with a private equity firm. He now consults on management and investment best practices. While studying for his MBA in finance, he discovered his true passion was in investment research. He combines engineering analytics with econometrics modeling to enhance quantitative investment analysis. He seeks absolute returns by active risk management in both up and down markets. He can be reached at .
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