A while ago I had an interesting discussion with a subscriber.
He asked a question that at first sounded easy, but the more I thought about it, the more I realised it was very difficult to answer. I could have come up with an answer immediately but I chose not to, to give me more time to think, but more importantly to give him a better answer.
As I researched the question I found that it was an issue that every great investor I looked at struggled with, at some time in his career.
An this, irrespective of how successful he has been over the long term.
The question was?
What do you do when your investment strategy underperforms the market, not just for a quarter or a year but over multiple years?
What if it happened to you?
Do you think you have the courage to stick to your investment strategy if it substantially underperforms the market for two to three years in a row?
Think about it for a minute. Picture yourself evaluating your performance over the past three years and for every year see how you underperformed the market.
Its important not to treat it as a theoretical exercise as it is not a question of IF it is going to happen to you but only a question of WHEN.
The simple fact is: No investment strategy beats the market every quarter, or even every year.
The better you can thus prepare yourself for when it happens the better you will be able to manage it.
As long time readers of my newsletter know, I?m a big fan of Joel Greenblatt and his magic formula. (Read more in ?What are your favourite valuation metrics??) I use the formula extensively to search for potential investment ideas.
In his book the Little Book that Beats the Market he said that in spite of the outstanding track record of the magic formula (288.9% 10 year total return vs. -1.5% of the index) it is unlikely that the strategy would get so popular that it would stop working.
The reason being that the strategy also underperformed the market some of the time. Sometimes for up to three years in a row.
Joel says you should accept it as a given and not a reason to deviate from the formula. It is the one factor that will ensure it is not so widely used that it will stop working.
Another example is Bill Miller, known for his outstanding track record as manager of the Legg Mason Value Fund in the U.S.A, which beat the S&P 500 Index for 15 years from 1991 to 2005. In the next three years he underperformed the index by over 40% before bouncing back.
Warren Buffett, probably the best known investor of our time, also substantially underperformed the market during the time of the Internet bubble. During this time a lot of journalists and analysts commented that Warren is out of step with the market and that investment formula does not work any more.
Well, you know how that worked out.
At this point you may be asking yourself; what do I do when my strategy substantially underperforms the market?
The first and most important question to ask yourself is; do I follow a time tested investment strategy or process that has proven its worth over multiple market cycles. (You can read more on investment strategies in ?The best investors have this… Do you??)
If you are sure that your strategy is sound you must stick to it through the ups and downs. Sticking to a good strategy will allow you to quickly recover from the period of underperformance when the strategy starts working again.
This is exactly what a lot of value investors did not do during the Internet bubble. They got so frustrated with their investments lagging the market that after a year or two they gave up completely and started investing in Internet stocks. This was just as Internet stocks were reaching their absolute peak, shortly thereafter Internet stocks crashed and they lost their shirts.
Had they stayed with the value investment strategy they would have done well as value investing returns bounced back as internet stocks collapsed.
If your strategy is under performing or you are suffering losses or both here are a few strategies to help you lower your risk and losses.
You can lower your market exposure and limit your losses by following a strict stop loss strategy. I know the following of a strict stop loss strategy is controversial but it will take you out of the market in steps as the companies in your portfolio decline in price.
What you should also consider is lowering your market exposure by 30% when your portfolio declines by more than 10%. The reason for the decline is either the market is falling or you are making bad investment decisions. Either way it?s a good idea to reduce your exposure.
Here is a classic strategy used by traders.
If your investments keep on moving against you the best thing you can do is close positions when a stop loss is reached, redo your analysis, and slowly, with smaller positions than you normally invest, move into the market in a step by step way.
The main thing is you must have a system in place that prevents you from suffering large losses as losses impact your future investment returns in two ways.
Firstly you have less capital to invest and returns have to be so much larger to make up for the loss (if you lost 50% you need a 100% gain to make up for the loss).
Secondly, and more important, when you suffer a large loss you lose self confidence and it keeps you from investing as you normally do thus also lowers your returns.
Another important point for you to remember.
You do not have to always be fully invested. It is perfectly logical to move to cash when your investments are underperforming or when you are suffering losses.
Cash should also be your default position if you cannot find any investments that fit with your investment strategy.
If you are not finding any attractive investments, it is for a reason. Most likely because the market has moved up too much and is overvalued.
Loosening your investment criteria will mean that you are selecting lower probability investments and thus that your returns will be lower and risk, should the market decline sharply, higher.
To your investment success