Copyright 2012. Tom Madell, PhD, Publisher
-Want To Do Better? Try "Testing" Your Investment Strategy
by Tom Madell
-Political Storm Clouds
By Steve Shefler (on separate page - to view, click here)
I hope regular readers of my Newsletter articles will recognize that there is indeed something different about my columns. If not, I will spell it out: I do not expect readers, or even myself, to have blind confidence in any of my forward-looking Newsletter content. Rather, nearly everything I say I regard as a way to eventually "test" the subsequent validity of my strategy and how relatively successful or not my expectations turn out.
Effectively, my strategy really translates into how I expect the majority to act in terms of propelling certain categories of investments ahead resulting in rising prices, while causing other types of investments to lag behind, resulting in lesser gains or even falling prices. So each time I make forward-looking statements (which I believe are what investors are looking for when they read a newsletter), including presenting my recommended asset allocations and my Model Portfolios, I am repeatedly laying the groundwork for a new test. While this might seem to some as reflecting a lack of confidence, it should be obvious that no one should be too confident or certain when it comes to investment forecasts, no matter who is making them. Therefore, one should not feel any more uncertain about my forward-looking statements than they feel regarding the forecasts of other analysts who do not see their statements as subject to testing the way I do.
I feel such testing, along with reporting the results, is a key differentiator in what I try to present, and has been since I began my Newsletter over 12 years ago. However, let's be clear: The purpose of this testing hasn't mainly been to prove that I was "right." In fact, down through the years, there have been times when I would have liked to have been far more right than later proved to be the case (although long-term readers will likely agree I have been right more than a majority of the time).
The real purpose of this testing has been to gradually refine and improve my investment approach as I learn more and more about what seems to quite reliably "work" in investing. I hope (and believe) that down through these 12+ years, I have become a wiser investor in my own investing, and that I have been able to pass down this ever-improving strategy to my readers. Of course, my readers should recognize that the approaches presented are still subject to losses when the overall stock market performs uniformly poorly, especially as it has cumulatively over the entire last five years or so. Since I do not "short the market," and tend to invest in mainstream funds, this will likely continue to be true in such instances (although higher bond fund allocations could, as they have since we started publishing, serve as one means of outperforming when most stock funds tumble). Our goal is, and always has been, to do better than the "overall" stock and bond markets, which means doing better in an up market and losing less in a down market.
It is with this in mind that I present what follows. As you will see, I urge investors not only to hopefully see value in my "tests" of my own investing advice, but to themselves take up the challenge to test their own investment actions in order to help them to see if they have been on the "right" course, or perhaps, whether they might better profit by considering modifying their customary courses of action.
Whether you have been a) an active investor, or, b) in buy and hold mode with your investments, or, c) just sitting on the sidelines in cash, your prior actions or inactions represent your decisions about what you felt has been an appropriate course of action. Even if you have been a relatively inactive investor, it makes sense to examine whether the application and timing of your prior buy, sell, or "considering buying a fund investment but do not" decisions are helping or hurting your bottom line.
Looking back over at least the last several years, we'd all like to hope we made the right decisions when we either bought or sold or held back on making an investment. If it turns out we were right, this means we either made a profit or avoided a loss. But if we were wrong, this means we missed out on a potential gain or actually suffered a loss.
Experience has shown me that many investors, surprisingly, don't really have a clear idea of which of these two basic possibilities it was, or at least, the extent to which they might have benefited, or failed to do so, as a result of their choices. This is especially true in instances when they sell completely out of a fund or elect to sit on the sidelines; in each of these instances, it is more than likely that they will not track what might have been the result of doing otherwise. Click here to see a little more detailed and visual example of what I mean.
Obviously, one can get a general idea of how a given stock or bond fund has performed by checking its reported performance in newspapers or on websites. But, especially with highly volatile investments such as stocks, these sources cannot likely tell you how wise your decision was because they won't show performance from the day you acted (or could have) right up to the present. They only show buy and hold performance over one set period, such as exactly over the last year. Since it is extremely unlikely you would have held your fund only over that same exact period, the return shown will not be valid for any other period of ownership. Or, say your potential decision occurred when the fund was either at what turned out to be a relatively high or low price during that year; your return could then easily vary significantly from that reported in a year-over-year table. Your actual return becomes even more complicated if you made more than one buy or sell decision on different dates during the year.
Even if you are sure that your actions resulted in more gain than loss, you may want to put your belief to an accurate, quantifiable test that either confirms or refutes your belief. After all, we know from research that the majority of investors self-appraise their decisions as being above average, leading to what has been named "the better-than-average effect." Obviously, most investors cannot all be better than average. Human egos dictate that most people tend to be overly positive in the appraisal of their own abilities, whether about investing, driving, or most things actually.
Why do investors really need to know their own "personalized" performance, rather than the general performance found in a fund performance table? Such performance tracking is particularly important, not just to satisfy curiosity, but to help you appraise what your future strategy should be. Should an investor always continue to use what has been their customary decision-making strategy? Probably only if one's prior strategy has been consistently working to help them achieve better returns than they might have received using a different strategy.
If, for instance, they learn that their active decision-making strategy is not performing as well as a low cost index fund, perhaps they would be better off abandoning that strategy in favor of a pure buy and hold or passive strategy that involves hardly any decisions or strategic analysis. In fact, trying to figure out the best time or conditions under which to buy or sell an investment is so difficult that the great majority of investors, and even mutual fund managers themselves and their research/investment teams, more often than not fail to beat comparable indexes.
Let's say you have $10,000 sitting in a money market account or a bank earning very little right now. Suppose you would like to invest that 10K but are unsure where to invest it, and whether you should invest it right now or wait for the "best" opportunity. And, should you invest it all at once or try to "time" your purchases gradually according to either the calendar or your thoughts about the market?
While the buy and hold investor might opt to invest it all at once and merely hope for the best, many investors might wait for a market drop, or attempt to maximize gains by investing only when "signs" pointed to potentially greater gains ahead. In other words, the more active investor might follow some sort of strategy, either complex or straightforward, whereby he invested only when he determined the time was right (or followed an advisor who felt that way).
Obviously, there is no absolute way to know in advance what will turn out have been the "most correct" approach for this particular 10K; such can only be known in hindsight. However, once you have already made some prior investments (or tracked those you didn't), you can tap into your previous experience to help you get a better idea of what might be the most effective strategy for future investments. Of course, if you don't really subject your past investment decisions to a reasonably rigorous test, you likely won't really have enough of a basis to go on to guide you in making your current decision. Instead, you might mainly rely on your above-mentioned subjective ego which could easily give you reason to think that your prior decisions were indeed good, even without solid confirming evidence. It follows that you will be less likely to consider an alternate strategy. At the end of this article, we will spell out in detail an example of perhaps the best way to prove beyond a doubt how effective particular prior decisions were.
You can also put to a meaningful test any prior decision to either partially or fully sell a fund investment (except those made because you needed the money for a non-investment expenditure - this is more of a "forced" decision.) More likely, such decisions are executed because you (or your advisor) have determined that this would be a wise action, with the goal of coming out better than holding on. What would certainly be helpful is accurate data on whether your prior sale(s) wound up helping or hurting your bottom line. Too many "hurting" rather than "helping" decisions might suggest a change of strategy.
As we have said, many people will never closely examine whether their prior decisions indeed later proved to be wise or mistaken. They likely feel some relief at making a decision, but then move on without ever really examining whether there might be a pattern of missed gains or increased losses in their actions.
A way to accurately see whether your decisions are helping or hurting you is readily accessible and should involve only a small effort on your part. Using it just once or twice on a few of your key past investment decisions could help convince you your decision making is either on track, or perhaps needs to be altered. Unfortunately, the method to calculate your actual rate of return in these types of situations has been given the ugly name of Annual Percentage Yield (APY), or also the Internal Rate of Return (IRR). However, all it entails is determining an annualized rate of return that takes into consideration the timing of investment decisions, including purchases and sales, as well as the compounding of the returns over multiple year periods.
One of the reasons that index funds quite often beat managed funds, and fund returns in performance tables are almost always higher than the long-term "investor returns" the public actually achieves and thus are a relatively inaccurate method of estimating one's own potential returns, is undoubted related to what we have discussed thus far. When investing in an index fund, you are nearly assured that no fund manager will make decisions as to when is the "right" and "wrong" time to buy and sell. You would think that a financially trained, professional fund manager would typically be able to outperform an index such as the S&P 500 by making astute decisions. He/she would focus on the "best" investments at the time, and avoid the "worst." But because, in my opinion, there is such a considerable aspect of investing that is counterintuitive (meaning not discernible through a logical analysis but more successfully attacked by going against what the majority concludes), neither professional managers nor ordinary individual investors will typically be able to "figure out" what the best stocks to own are, nor the best time to buy or sell them. Even when a fund manager does make successful choices, the very presence of a highly paid, skilled manager as well as his associated trading costs, will often pull down his winning advantage so that he is no longer able to beat the index.
The same is likely true of individual investors regarding their fund investing. Aside from some buy and hold investors who may make no attempt to act on their investments, most fund investors (or their advisors) feel that there should be some advantage in using whatever knowledge they have to formulate good guesses as to when to buy and sell one or more funds. But are they able to buck the difficulties that stymie professional fund managers? Not very often.
By using the technique we are about to give you, you can find out precisely whether your own decision regarding a particular past fund investment has turned out relatively well or not so well, and if the latter, whether you should consider altering your strategy in the future and merely use a more "passive" method, or even perhaps switch to a more counterintuitive/contrarian approach of going against the majority.
You might think "past is past" or "let sleeping dogs lie" - i.e. there is nothing one can/should do about any inopportune decisions one might have made, so just forget it and move on. While this is likely what many investors do indeed do, it might be better to test the facts than to accept simply making assumptions about them which will likely have varying degrees of accuracy. There is something you can do to help stop missing out on lost opportunities but first you must be able to recognize if this is indeed happening and the extent it may be affecting your prior results. Of course, if your decisions turned out to have been profitable, then perhaps nothing new needs to be done. But if you don't know for sure, then any possible future improvements become equally hard to discern.
Suppose you had $10,000 at hand in cash back in early 2009. You correctly sized up that the US economy was in one of the worst morasses in generations so that made you extremely apprehensive about investing that money anywhere near the stock market. So far, so good - you likely avoided some significant losses in stocks.
But what about further into 2009? Stocks came roaring back with a vengeance beginning that March. Was the turnaround to be trusted? Obviously, like always, everyone had their own opinion; some investors decided it was still too risky while others started buying.
If you were in the latter group, perhaps influenced by my Newsletter which for the first time put out an overall Buy alert for all 9 US "Morningstar grid" categories plus diversified international stock funds on Nov. 12, 2009, you might have put that 10K to work in one or more stock funds on that very day and continued to hold. If so, let's "test" how you would have done compared to not acting right up to the present time (Jan. 30). (Note: My Newsletter has not issued a "Sell signal" for any of these categories during the elapsed period, and instead, has advocated continuing to hold.) Let's also assume that the fund you chose to buy was my most highly recommended fund in terms of percent allocation as of that time, the Vanguard Growth Index (VIGRX) (given my "overall" Buy signal, it could have been any fund in these 10 categories). In fact, I was so positive on the Large Growth category that I had even earlier, on Oct. 8, 2009, issued a "Buy signal" for this category on my website at http://funds-newsletter.com.
How well you would have done reflects the price (NAV) on the Nov. 12, 2009 purchase date as compared to the NAV now, taking into account distributions, and annualizing the result over the period of nearly 27 mos. Unless you have your own software to compute how well you would have done, I recommend using this online tool that will easily perform the calculation for you; all you need to do is plug in, in addition to the starting date: a) the amount of the investment; assume that you invested the entire 10K on the above date; the tool also allows you to enter any additional investments ("payments") as well as any sales ("withdrawals"); b) the ending date; and c) the current value of the account which, as an investor in the fund, you can get either from your fund's website, or by taking the number of shares you currently own and multiplying by the current NAV; this amount is referred to as the "future value." (Do not add as additional investments the shares credited to your account from distributions; these amounts are not payments that you make and are "included" automatically when you get the future value.) That's all there is to it!
If you never "pulled the trigger" and made that investment, you can still compute what return you would have made if you had. However, since you won't have a ready amount for the future value, you will need to find out what the distributions would have been on the number of shares you would have purchased with $10,000 at the NAV on 11/12/2009. This information may be available on the fund company's web site, or you can contact them for that information.
In the above example, our tool shows the Internal Rate of Return (IRR) is 13.0%. This annualized rate of return can then be compared to what you would have gotten by staying in cash - probably just a fraction of a percent - or perhaps going into a bond fund.
We computed the IRR for the PIMCO Total Return Fund Instit (PTTRX), our most highly recommended bond fund as of 11/12/2009, and found that it was 6.9%. As you can see then, in this example, you would have been considerably better off by investing in the above stock fund than in PTTRX; but either choice would have been immensely better than staying in cash over the entire period.
Aside from the above mentioned Buy signals, we made several others beginning first in early 2009 up to the most recent ones this past summer, as can be seen by reviewing our Newsletters. In fact, had one acted on our Buy signal for the Small Cap Growth category and invested in the fund we regularly recommended to our readers, the Vanguard Small Cap Growth Index (VISGX), the IRR from the Jan. 31, 2009 date of our signal through this Jan. 30 computes to an annualized 28.1! or over 110% cumulative; a $10,000 investment would have grown to over $21,000 over the nearly 3 year period!
For those who are interested, all of our current signals for the above 10 categories, while not Buys, are Holds which means we still expect investors to show a moderately good outcome when our recommendations are held over the next several years.
Continue on to Political Storm Clouds by Steve Shefler