The global market declines in early August offered a fine example of the kind of conditions that cause me to exit my long positions and end up in cash. For me, this is a normal part of my process. I predefine my risk in each position, so I know my risk across the portfolio. For example, I know at what point I’ll sell each position if it falls below a certain point in which I would consider it a negative trend. Since I know my exit in advance for each position, I knew in advance how much I would lose in the portfolio if all of those exits were reached due to market price movements trending against me. That allowed me to control how much my portfolio would lose from its prior peak by limiting it to my predefined amount. I have to take ‘some’ risk in order to have a chance for profits. If I took no risk at all, there could be no profit. The key for me is to take my risk when the reward to risk is asymmetric. That is, when the probability for a gain is much higher than the probability for a loss.
The concept seems simple, but actually doing it isn’t. All of it is probabilistic, never a sure thing. For example, prices sometimes move beyond the exit point, so a risk control system has to account for that possibility. More importantly, the portfolio manager has to be able to actually do it. I am a trigger puller. To see the results of over 10 years of my actually doing this, you can visit ASYMMETRY® Managed Accounts.
Absolute Return in its basic definition is the return that an asset achieves over a certain period of time. This measure looks at the appreciation or depreciation (expressed as a dollar amount or a percentage). For example, a $50 stock drifts to $100 is a 100% absolute return. If that same stock drifts back from $100 to $50, its absolute return is -50%.
Absolute Return as an investment objective is one that does not try to track or beat an arbitrary benchmark or index, but instead seeks to generate real profits over a complete market cycle regardless of market conditions. That is, an absolute return objective of positive returns on investment over a market cycle of both bull and bear market periods irrespective of the direction of stock, commodity, or bond markets. Since the U.S. stock market has been generally in a uptrend for 6 years now, other than the -20% decline in the middle of 2011, we’ll now have to expand our time frame for a full market cycle to a longer period. That is, a full market cycle includes both a bull and a bear market.
The investor who has an absolute return objective is concerned about his or her own objectives for total return over a period and tolerance for loss and drawdowns. That is a very different objective than the investor who just wants whatever risk and return a benchmark, allocation, or index provides. Absolute returns require skill and active management of risk and exposure to markets.
Absolute return as a strategy: absolute return is sometimes used to define an investment strategy. An absolute return strategy is a plan, method, or series of maneuvers aiming to compound capital positively and to avoid big losses to capital in difficult market conditions. Whereas Relative Return strategies typically measure their success in terms of whether they track or outperform a market benchmark or index, absolute return investment strategies aim to achieve positive returns irrespective of whether the prices of stocks, bonds, or commodities rise or fall over the market cycle.
Absolute Return Investment Manager
Whether you think of absolute return as an objective or a strategy, it is a skill-based rather than market-based. That is, the absolute return manager creates his or her results through tactical decision-making as opposed to taking what the market is giving. One can employ a wide range of approaches toward an absolute return objective, from price-based trend following to fundamental analysis. In the ASYMMETRY® Managed Accounts, I believe price-based methods are more robust and lead to a higher probability of a positive expectation. Through my historical precedence, testing, and experience, I find that any fundamental type method that is based on something other than price has the capability to stray far enough from price to put the odds against absolute returns. That is, a manager buying what he or she believes is undervalued and selling short what he believes is overvalued can go very wrong if the position is on the wrong side of the trend. But price cannot deviate from itself. Price is the judge and the jury.
To create absolute returns, I necessarily focus on absolute price direction. Not relative strength, which is a rate of change relative to another moving trend. And, I focus on actual risk, not some average risk or an equation that oversimplifies risk like standard deviation.
Of course, absolute return and the “All Weather” type portfolio sound great and seem to be what most investors want, but it requires incredible skill to execute. Most investors and advisors seem to underestimate the required skills and experience and most absolute return strategies and funds have very limited and unproven track records. There is no guarantee that these strategies and processes will produce the intended results and no guarantee that an absolute return strategy will achieve its investment objective.
For an example of the application of an absolute return objective, strategy, and return-risk profile, visit http://www.asymmetrymanagedaccounts.com/
One of the keys to managing investment risk is cutting losers before they become large losses. Many people have difficulty selling at a loss because they believe it’s admitting a mistake. The mistake isn’t taking a loss, the mistake is to NOT take the loss. I cut losses short all the time, that’s why I don’t have large ones. I’ve never taken a loss that was a mistake. I predetermine my risk by determining before I even buy something at what point I’ll get out if I am wrong. If I enter at $50, my methods may determine if it falls to $45 that trend I wanted to get in is no longer in place and I should get out. So when I enter a position in any market, I know how I’ll cut my loss short before I even get in. It’s the exit, not the entry, that determines the outcome. I don’t know in advance which will be a winner or loser or how much it will gain or lose. For me, not taking the loss, would be the mistake.
I thought of this when a self-proclaimed old-timer admitted to me he still holds some of the popular stocks he bought the late 90’s. Many of those stocks are no longer in business, but below we revisit the price trend and total return of some of the largest and most popular stocks promoted in the late 90’s. The black line is Cisco Systems (CSC), Blue is AT&T (T), Red is Pfizer (PFE), and green is Microsoft (MSFT). AT&T’s roots stretch back to 1875, with founder Alexander Graham Bell’s invention of the telephone. Pfizer started in 1849 “With $2,500 borrowed from Charles Pfizer’s father, cousins Charles Pfizer and Charles Erhart, young entrepreneurs from Germany, opened Charles Pfizer & Company as a fine-chemicals business”. At one point during the late 90’s “tech bubble” Microsoft and Cisco Systems were valued more than many countries. But the chart below shows if you did buy and held these stocks nearly 20 years later you would have held losses for many years and many of them are just now showing a profit.
chart courtesy of http://www.stockcharts.com
The lesson to cut losses short rather than allow them to become large losses came from a book published in 1923.
“Money does not give a trader more comfort, because, rich or poor, he can make mistakes and it is never comfortable to be wrong. And when a millionaire is right his money is merely one of his several servants. Losing money is the least of my troubles. A loss never bothers me after I take it. I forget it overnight. But being wrong – not taking the loss – that is what does the damage to the pocketbook and to the soul.”
-Reminiscences of a Stock Operator (1923)
If you are unfamiliar with the classic, according to Amazon:
Reminiscences of a Stock Operator is a fictionalized account of the life of the securities trader Jesse Livermore. Despite the book’s age, it continues to offer insights into the art of trading and speculation. In Jack Schwagers Market Wizards, Reminiscences was quoted as a major source of stock trading learning material for experienced and new traders by many of the traders who Schwager interviewed. The book tells the story of Livermore’s progression from day trading in the then so-called “New England bucket shops,” to market speculator, market maker, and market manipulator, and finally to Wall Street where he made and lost his fortune several times over. Along the way, Livermore learns many lessons, which he happily shares with the reader.