The reason we are talking about risk is because forecasts aren't reliable. What you think or what people say will happen next to the stock market, or to interest rates, or to the economy, is totally unreliable. If it was reliable, if it was sure, if we knew what was going to happen, then people would not talk about strategy, because the best strategy would have been to bet everything you have on that forecast. But since we don't know if the forecast is going to be accurate, we cannot bet all we have, because our chances are we will lose it…therefore we are talking about strategy.
The reason the forecast can never be accurate is because a forecast is achieved through many steps, and at each step a new element of uncertainty is introduced. The most important step in achieving a forecast is the assumptions that the forecaster makes and the assumptions are based on what the forecaster believes and the forecaster's experience in similar situations. For instance, an assumption could be that with a given policy of the US Government - the level of taxation and the level of real interest rates - inflation cannot rise much above current levels. This is an important assumption, because as we will discuss in detail later in this book, if inflation is stable, the odds are that there will not be major financial disturbances. That means the economy will remain stable and jobs are likely to be plentiful.
An assumption of low or stable inflation also suggests that interest rates will not rise, and the stock market will probably remain in a rising trend. As you can see, the assumption is a very important step in reaching a forecast.
The second step in making a forecast is to understand the relationships between economic variables on a historical basis. For instance, an example of a relationship is when short-term interest rates rise, the odds favor a more volatile stock market and poor price performance. This relationship is something the forecaster will have experienced and will likely use this relationship again in the future. Understanding this history provides a logical connection between economic variables.
The third step in achieving a forecast is to understand what is happening now. The forecaster, for instance, can recognize that interest rates are declining or stable and there are several signs pointing to a weak economy, giving a clear indication of what is happening now. Sometimes, as the reader has experienced following the commentaries on television or the radio, not all economists agree on what is happening now, let alone what will happen. Is the money supply growing too rapidly? Are orders for durable goods too strong or too weak? An assessment of what is happening now is a most crucial aspect in achieving an accurate forecast.
In the fourth step, the forecaster puts together all these steps, the assumptions, the historical connections of all the economic forces, and understanding what is happening now. This will lead the forecaster in the direction of determining what is happening. What is important to recognize is that there is a strong element of uncertainty in each one of these steps. Therefore, an error is introduced with every progression in achieving a forecast. This implies risk. The forecast is likely to be incorrect. Therefore, one must recognize that an element of uncertainty exists and investors need to protect themselves from the error of these forecasts. All components of each forecast have to be clearly understood. As we mentioned above, it is important to recognize what the assumptions have been, the historical connection between the economic variables and what is happening now, and the process of extrapolation.
The more comfortable the reader is with the steps used, the more accurate the forecast will be. However, no matter how comfortable readers are with their own forecast, it is important to remember there is always a strong element of uncertainty. The best way to reduce the uncertainty is to review the forecast often - every time a new element is made available by government agencies, by the Federal Reserve or by the market itself. All those elements should be reintroduced into the process and the forecast begun again. This process will reduce the element of risk as it increases the understanding of what is happening and the conviction that the recognized trends are accurate.
Another important issue from an investment viewpoint is to recognize the trends; this is where the money is made - not in forecasting. Is the economy going to grow at a 2% or 6% rate? Is the economy going to slow down or continue to slow down? Are interest rates going to continue to rise or rise more slowly? To set values - interest rates will rise to 6%, or the economy will grow at 5% - has limited value from investor’s viewpoint. Large profits can be derived only when investors recognize broad, fundamental trends. Once they recognize these trends are in place, they are likely to stay in place for months or even years. These are the trends that investors will learn how to recognize from this book, and these are the trends that will help them profit.
Consider this simple equation and its financial impact on your entire portfolio of assets:
+ 15% + 15% + 15% - 15% = + 6%
Yes, if your portfolio increased 15% per year for three consecutive years and you lost 15% the fourth year, then your total return for the four-year period would be slightly higher than 6% per year. This simple exercise demonstrates how important it is to protect your portfolio against losses.
Markets swing from one extreme to the other, which exposes your investments and profits to continuously changing risk and volatility. To see how you can protect yourself, take a cue from games of strategy. Acquire knowledge of a game before you play it so you know your odds of winning. Before you play poker, blackjack or go to Las Vegas, chances are you take time to learn something about the game, and how different circumstances such as card sequences or dice rolls change the odds. The idea is to be aware of your chances of winning.
But even more important, is being aware that the games are dynamic. The odds change as the game is being played. For instance, the odds of winning in team sports change depending on the shifts in morale, injuries, and what happens to the other team during the course of the game. Think of any game you like and several examples will come to mind. The importance of acquiring in-depth knowledge on the rules of the game is to establish risk. The main idea is to determine the chances of winning with a given set of strategies.
As a result, new strategies need to be developed to improve the odds of winning the game. It is a dynamic process the strategist must evaluate continuously. It is very likely that financial strategists who review their strategies on a daily or weekly basis, are likely to be more successful than those who review them monthly or quarterly. Financial decision-making is no different than playing a game. At the end of a recession when companies are selling at a very low price, the odds of making money through acquisitions are very high.
The same situation occurs after a long decline in stock prices. The odds of making money after a prolonged decline are very high. As more and more investors recognize the situation and buy, the market rises and stocks become less attractive because now they have become expensive. In other words, as the market rises, the odds of losing money increase because a rising market is getting close to over-valued levels. The risk changes as the market moves.
In 1995, the economy slowed down and interest rates peaked. The Federal Reserve, for fear of too much of a slowdown, began to inject liquidity into the economy. With declining short-term interest rates and a market that went through some wide - though not sharp - declines in 1994, investors recognized that stocks were undervalued and began to buy. The stock market began to rise, accompanied by declining short-term interest rates and rapidly growing liquidity.
As soon as these trends become apparent, it is important to begin to buy - initially a small amount of money, because the uncertainty is high and investors don't really know if this is the important bottom they were waiting for. But as soon as the trend appears to establish itself, investors should continue to increase their investment and establish their positions.
However, following the same example, in 1999 exactly the opposite took place. The economy was very strong, the liquidity in the system began to grow more slowly and interest rates started to rise. Clearly, the market was more expensive than what it was four years earlier. At this time, the odds of losing money increase and are very high. As you will learn in this book, you will recognize that in this situation it is appropriate to slowly reduce your exposure to stocks and wait for better times. These are times when it is more appropriate to be in money market instruments than go through the frustration of having your portfolio losing value.
The important thing about this example is that in 1995 there was a low risk point for the market and investors should have increased their exposure to stock. In 1999 there were all the characteristics of much higher risk and therefore investors should have exercised more caution.
Professionals continuously evaluate this dynamic process on the basis of what happened one-minute, one-week, and one-month earlier. In any game, and especially in business and financial management, one has to invest an amount proportional to the probability of being right. So when the probability of being right is low, as it is in determining a turning point, one has to invest only a small amount. As the probability of being right increases, the amount invested in a position should be increased to take advantage of the higher chances of making money.
In 1995, for instance, as soon as interest rates started to decline and the money supply began to accelerate, investors should have recognized that stock prices were very close to the bottom. As you know, it is very difficult to know for sure if that is the bottom. The odds of being wrong at a turning point are very high. For this reason, in 1995 the best strategy would have been to recognize that declining interest rates were the harbingers of important changes in market trends. The appropriate way to approach this situation would have been to increase your investment in stocks by a small amount. If you were wrong, and the market continued to decline, you would have not lost much because you had only a small amount invested.
On the other hand, if interest rates continued to head down and the market to rise, then you had more money, more capital to invest. You just have to wait a short time, perhaps one month. If you see that interest rates continue to decline and the growth of liquidity rises, then you know this is an important fundamental trend and you should increase your investment with the knowledge that the odds of being right in assessing the situation are good. This book will provide you with the information to establish the odds of being right. From the odds of being right, you can then establish an investment strategy to take advantage of those odds.
When investors have to make decisions to buy or to sell, that decision is, in most cases, made complex and complicated because there is a tendency to always think in terms of buy or sell. How much should I invest in that stock or that asset, or how much should I sell? As the probability of being right increases, the amount invested in a position should be increased to take advantage of the increased chances of making money. If the analysis of current events suggests the markets are approaching a top, this translates to a simple fact, risk is increasing. Investors should start selling an amount based on how close they believe the market is at its top. One has to enter a certain position gradually and sell gradually. Since it is difficult to know exactly what the markets will do, it is much better for the investor to think of a gradual entry into a position or a gradual exit from a position.
Understanding what is happening is one of the most difficult things in establishing a strategy because there are overwhelming emotions involved. The data show you what is happening, but more often than not, you don't want to believe the data. 1999 is a good example of this situation. Rising short-term interest rate, a strong economy and slower growth in liquidity was a deadly combination for the stock market. Furthermore, a strong economy, as you will see later in this book, forces interest rates to rise. This deadly combination is likely to persist for some time. As emotions take over and investors don't want to believe what they see, they always hope they might be wrong. The greed factor is also important and makes the investor ignore what is happening.
Once one recognizes what is the bearish combination of factors for the stock market, the most appropriate action is to slowly reduce your investment. A small move is something that can be taken easily. For instance, reducing your exposure to stocks by 10% is probably the best way for the investor to start a defensive strategy. In 1999, as the majority of stocks kept declining, it would have been appropriate to reduce stocks by another 10%. As the situation continues to deteriorate and as the indicators continue to suggest caution, the odds of making money decrease. As the odds of losing money increase, it is appropriate to continue to sell slowly and gradually.
Turning points, that is those points that offer the greatest profit opportunity, are very difficult to predict, because again, they happen very rarely. A buying opportunity seldom happens, and for this reason, the probability of being right is very small. What does that mean? Using the analogy of the poker player, that means if the probability of being right is small, the amount being invested has to be small. When the time has come that risk is low and there is an opportunity to buy, investors will be well served to develop a strategy that says, "I'm going to invest 25% of my capital." See what happens. If the market goes in the direction expected, 75% of the money is still available to be invested. There is plenty of time to take advantage of the expected trend. If, on the other hand, investors were wrong, and the market did not go up as they expected, because of the small exposure to stocks, the losses incurred are small. This is the advantage of investing with the odds of being right. This is what it's all about.
The same concept applies in a situation when investors decide to sell. The same gradual plan that is followed on a buy situation should be followed on a sell situation. If risk is increasing and the probabilities of a downturn are increasing, which means that the probabilities of making money are decreasing - again like a poker player - the investor has to bet less. Investors have to take some money off the table. For instance, they would have to sell 20% of their portfolio, or 15%, whatever the risk profile of the investor is. If they are right, they still have 80% or 85% invested and they can take advantage of the market rise. If the market starts to decline, as suspected, the odds of a weakening market are increasing. Investors, therefore, should start selling more, for instance, another 20 or 30%. They gradually adjust to the trends in the market, and by doing so, greatly reduce the risk of their portfolio.
Should I buy or sell? The issue is not to buy or to sell, but is whether the situation is attractive, and how much of the capital should be invested in that particular situation or how much should be sold. The issue is not should I sell or should I buy, but how much should I buy or how much should I sell in order to have a portfolio that better reflects the risk profile of the markets.
The concept of risk, as we have discussed, provides an excellent guideline on how to do this. This approach leads to maximizing returns and minimizing risk.
Poker offers a good analogy. The players do not bet the same amount each time. They begin with a small bet because they do not know how their hand will develop. They increase their bet only if their hand looks promising.
Depending on what the other players do, they raise their bet only if the odds of winning increase. If the odds turn against them and the risk of losing is too high, they fold their hand. Investing your money offers similar challenges. Whether we like it or not we are all participants in the investment game. The markets are your opponents and economic and financial forces - the dealer - are continuously changing the risk-reward profile of each market. You need to adapt your investment strategy, that is your bet, to the changing risk so that you protect your investment against the volatility of the markets.
(From my book Profiting in Bull or Bear Markets)
George Dagnino, PhD Editor,
The Peter Dag Portfolio.
Since 1977
2009 Market Timer of the Year by Timer Digest
Portfolio manager
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