Rising or Falling Markets? Roll with it!

Luck’ll come and then slip away
You’ve gotta move, bring it back to stay
You just roll with it, baby

— Roll with It, by Steve Winwood

By Noah Solomon

Special to Financial Independence Hub

There is never any shortage of pundits opining on what could make markets rise or fall. Tragically, the greatest cheerleading has tended to occur when markets were at their riskiest and the loudest fearmongering has tended to occur when markets have harboured the greatest opportunity. However, this does not change the fact that anything can happen at any time:  markets have and always will continue to periodically present investors with dynamically evolving combinations of risk and reward.

To never suffer losses is an unrealistic objective for those who wish to receive a satisfactory return on their investments. Rather, it is far more efficient (and financially rewarding) to roll with it: which entails adapting to changes to (1) maximize gains when markets offer above-average returns with relatively low risk and (2) to minimize losses when markets offer below average returns with above average risk.

This month, I present a framework for investors to dynamically manage their portfolios to meaningfully participate in rising markets while limiting losses in bear markets.

The Sine Qua Non of Successful Investing

If 100% of your portfolio is sitting in cash, then it is impossible for you to lose money (at least in non-inflation-adjusted terms). However, if markets rise, you will miss the proverbial boat and suffer significant opportunity loss. At the other end of the spectrum, if your portfolio is 100% allocated to equities, while you won’t miss the party if markets advance, you will most certainly suffer substantial losses in the event of a bear market.

The Latin phrase sine qua non means “without which not,” which refers to something that is a necessary or indispensable requirement. The sine qua non of successful long-term investing entails constantly assessing and reassessing the magnitude of potential losses relative to potential gains. When downside risks are elevated and potential gains are muted, you should hold a more conservative portfolio. Conversely, when the risk of loss is eclipsed by potential gains, it is prudent to take more risks with your investments.

Theory, Practice, and Yogi Berra

Baseball legend Yogi Berra stated, “In theory, there is no difference between theory and practice. In practice, there is.”

If you dial up your risk profile when the odds favour doing so and take some chips off the table when the probabilities dictate as such, your long-term performance will inevitably be well above average: so far so good. Unfortunately, accurately assessing and reassessing these probabilities as they ebb and flow over time is no easy feat.

You can’t Predict Behaviour

First the bad news: I don’t believe there is any accurate way to calculate the relative magnitude of upside vs. downside risk over the short term … and by the short term, I mean periods of at least one to two years! One need only to observe markets over the past three decades to appreciate that investors can persist in irrational behaviour for longer periods and with greater voracity than might seem possible.

In hindsight, most investors should have exercised prudence long before tech stocks reached their peak in early 2000 or real estate sung its swan song in 2008” but they didn’t. Similarly, they should have been scooping up bargains en masse either before, during, or not long after markets bottomed in early 2003 and March 2009: but they didn’t.

Excesses and financial aberrations cannot be explained by classic financial theory. Rather, their root lies in human behavioural biases and emotions, which can prove sufficiently powerful to propel asset prices to unrealistically optimistic and pessimistic levels. Greed and fear are impossible to precisely gauge or time and are arguably the largest determinants of prices over the short term. Given these facts, attempting to assess the relative risk of loss vs. opportunity cost over shorter horizons is an exercise in futility.

Valuations are a Proxy for the Margin of Safety

Valuations serve as a proxy for the margin of safety that is embedded in asset prices, and by extension for how vulnerable prices are to delivering subpar or even negative average annualized returns over the next 5-7 years.

Market Responses to Various Environments by Valuation Level

• When valuations stand near the high end of their historical range, even strong economic and earnings growth may fail to result in higher-than-average annualized returns over the next several years, while anything short of such an environment is more likely to result in anemic performance or even losses.
• When valuations stand near the middle of their historical range, prices are most likely to track economic conditions and profit growth.
• When valuations reside near the bottom of their historical range, average or even above-average returns can persist even in the face of subpar economic conditions and/or profit growth, while more favourable or even average conditions are likely to produce strong gains.

Risk and Reward: Probability Distribution by Valuation