Investors Likely to Repeat Astonishing Losses

People are likely to repeat what they did in the past.

Do you believe it?

Ok. Let’s see.

Get hired as a Surgeon without the schooling, licensing, and experience and tell them:

Don’t worry about my background – I can do it!

Hire a Surgeon for an operation on you who didn’t earn a medical degree, or complete a residency program, and has no real experience.

Fly to a professional baseball team and tell them you’re going to play this season with no track record of hitting, running, fielding, or pitching.

Tell them you’ve played baseball online – hypothetically!

Is that enough “experience”?

Fly the plane yourself with no flight experience.

Fly a plane yourself after just some simulated experience.

Race a car on XBox, then attempt to the same in a real racecar. I don’t care how many times you’ve driven a Stringray Z06 around Sebring on XBox over 150MPH. The game may be accurate enough that it helps to get familiar with the track, but when you drive it for real, it’s an entirely different experience. In real driving, the shift between gears and turns provide real feedback and the risk is real. You don’t get to press “Rewind” when you crash.

It’s unlikely you’ll survive any of that.

Don’t do it!

Our track records matter. A track record is the past achievements or performance of a person or organization.

Marriam-Webster says:

Track Record: A record of past performance often taken as an indicator of likely future performance.

If you’ve lost a lot of money during bear markets, you’ll probably find some way to do it again. You’ll likely make the same kind of decisions – so will your advisor or investment manager. Our track record of the past is all we have to determine what to expect about what we’ll do in the future. We can say we’ll do this or that next time, but what is, is.

When the markets started declining in October 2007 through March 2009 everyone made decisions along the way. Buying and selling are decisions. Holding on and doing nothing is a decision. You are probably going to respond the same way you did then the next time it happens. It’s what we do. It’s why our resume, background, and track record matters in everything we do. It is what it is.

We can’t get into medical school without the right academic credentials showing we likely have what it takes to make it through.

We can’t become a professional athlete without a proven track record.

We can’t fly a plane without flight experience.

In the investment industry, we say that “Past performance is no guarantee of future results” and that is true. Past performance of a security, strategy, or index is no guarantee of future results or investment success. The market’s past performance isn’t guaranteed to repeat nor is any investment strategy.

An experienced pilot isn’t guaranteed to land safely, but is likely to, and far more likely than one without a track record of safe landings.

A Surgeon can’t guarantee every procedure will have the desired outcome, but one with a track record of success is more likely.

It isn’t certain a great college baseball player become a star professional, but it’s more likely.

Whatever your past results, you are likely to repeat it.

It was your actions and decisions that created it. The same goes for investment managers and advisors. You better know what they actually did because they are likely to do it again.

Market trends are like snowflakes – they aren’t exactly the same. That’s why past performance is no guarantee of future results. But, bear markets have historically unfolded in similar patterns – downward sloping swings of lower highs and lower lows. The magnitude of the swings will be different and vary in length.

Some will try to hold through the losses and tap out when the losses get too large.

Others may exit sooner in the decline, but the fear of missing out will urge them back in, just in time for the next big downswing.

There are many ways of losing a lot of money in a bear market trend of downward sloping swings of lower highs, and lower lows on its way to -50% or more.

I thought of this when I came across my performance chart from 2005 to 2010. The stock index had declined -56%.

I can’t guarantee I’ll execute through another one the same, but I do know I am applying the same risk management methods I did then. Having successfully operated through bear markets, I believe I’m better now than I was then. I know what it feels like as the markets are swinging up and down as it all unfolds. I know how the emotions play out, no matter how mechanical or discretionary the methods used. I know how investors tend to respond to changing trends. I know when mistakes are likely. I know it even better now than I did then.

I know of investment managers who didn’t execute so well through those periods and though they have “new models” now, they won’t know if they can execute them until after it’s over. Some of them say their models are so systematic and mechanical that they remove the emotion. That is far from reality.They may instead discover a whole new kind of emotion they haven’t yet experienced. When they do, they don’t yet know how they will respond.  In fact, the required disclosure for backtested models  and hypotheticals is essential to read and understand:

“HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN; IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK OF ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL WHICH CAN ADVERSELY AFFECT TRADING RESULTS.”

Investment results are probabilistic, not a sure thing, but backtested models introduce a whole new element of risk.

I’d rather bet on someone who has done it and has done it well.

It isn’t a sure thing, but it is stacking the odds in your favor and that’s all anyone can do.

Fear and Greed is Shifting and Models Don’t Avoid the Feelings

Investors are driven by fear and greed. That same fear and greed drives market prices. It’s Economics 101 “Supply and Demand”. Greed drives demand, fear drives selling pressure. In fact, investors are driven by the fear of losing more money when their account is falling and fear missing out if they have cash when markets go up. Most investors tend to experience a stronger feeling from losing money than they do missing out. Some of the most emotional investors oscillate between the fear of missing out and the fear of losing money. These investors have to modify their behavior to avoid making mistakes. Quantitive rules-based systematic models don’t remove the emotion.

Amateur portfolio managers who lack experience sometimes claim things like: “our quantitive rules-based systematic models removes the emotion”. That couldn’t be further from the truth. Those who believe that will eventually find themselves experiencing feelings from their signals they’ve never felt before. I believe it’s a sign of high expectations and those expectations often lead to even stronger reactions. It seems it’s the portfolio managers with very little actual performance beyond a backtest that make these statements. They must believe a backtested model will act to medicate their feelings, but it doesn’t actually work that way. I believe these are the very people who over optimize a backtest to make it perfectly fit historical data. We call it “curve-fitting” or “over-fitting”, but it’s always “data mining”. When we backtest systems to see how they would have acted in the past, it’s always mining the data retroactively with perfect hindsight. I’ve never had anyone show me a bad backtest. If someone backtests entry and exit signals intended to be sold as a managed portfolio you can probably see how they may be motivated to show the one that is most optimized to past data. But, what if the future is very different? When it doesn’t work out so perfectly, I think they’ll experience the very feelings they wish to avoid. I thought I would point this out, since many global markets have been swinging up and down. I’m guessing some may be feeling their feelings.

The CNN Fear & Greed Index shows investor fear and greed shifted to Extreme Fear a month ago as the popular U.S. stock indexes dropped about -12% or more. Many sectors and other markets were worse. Since then, as prices have been trending back up, Greed is now the driver again. I believe fear and greed both drives market prices but also follows price trends. As prices move lower and lower, investors who are losing money get more and more afraid of losing more. As prices move higher and higher, investors get more and more greedy. If they have reduced exposure to avoid loss, they may fear missing out.

CNN Fear and Greed IndexSource: http://money.cnn.com/data/fear-and-greed/

This is the challenge in bear markets. In a bear market, market prices swing up and down along the way. It’s these swings that lead to mistakes. Below is a chart of how the Fear and Greed Index oscillates to high and low points over time. Investors who experience these extremes in emotion have the most trouble and need to modify their behavior so they feel the right feeling at the right time. Or, hire a manager with a real track record who can do it for them and go do something more enjoyable.

Fear and Greed Over time investor sentiment

Source: http://money.cnn.com/data/fear-and-greed/

Back Testing

The glossary on Stockcharts.com explains it well:

“Back Testing: A strategy that is optimized on historical data, then applied to current data to see if the results are similar. Rarely done properly and usually resorts to a form of curve fitting.”

Yep, that is what it is…

Back testing can be useful to quantify a complete system, but back testing has many weaknesses and is very rarely applied and used correctly. To be sure, just look at the actual performance post back test of those who advertise back tested performance.

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