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Why do you think passive Buy & Hold strategies are not enough?
Why do you use ETFs for the InvestmentPOD strategies?
What are the tax consequences of the POD strategies?
How are you able to manage so many personalized plans?
Why does InvestmentPOD believe the Ulcer Index is a better measure of risk?
Why is the InvestmentPOD approach a New Paradigm?
Which custodians does InvestmentPOD use to trade client plans?
What is Power Value for an ETF? How is it calculated?
Why do you say Modern Portfolio Theory is flawed?
What is the Defensive InvestmentPOD Power Value Risk Management?
What is the Opportunistic InvestmentPOD ETF Power Value Selection?
What dangers are there if we have another 2008 financial crisis?
Buy & Hold strategies are passive by design. The basic idea is that there is some expected return from holding an asset class,
e.g., U.S. stocks. This expected return is sometimes called a “risk premium” to imply that there is something you will earn...
sooner or later…for being willing to accept the risk of holding that asset class. For example, some people think the risk premium
in stocks (above the risk-free rates of return) is in the 3-6% range. In reality nobody can know the future so we cannot know what
the return might be…no matter how long you hold the asset. There is also no way of knowing how much the asset could fall in value
in the meantime. Most stock markets around the world have had huge losses from time to time over the past century. The passive
Buy & Hold approach ensures that you will suffer the maximum loss in any down period (because you must hold on) and this can be
made worse by rebalancing to keep the same weight on the way down. While these bad periods may be rare, they are so bad when they
happen that investors have a very hard time sticking with the plan. They give up hope at the worst times. This is why the
“Ulcer Index” of passive Buy & Hold strategies is so high and the return per unit of pain is so low.
This is why we believe so strongly in having at least some of your liquid assets invested in a way that automatically gets out of losing investments at some point (The InvestmentPOD Power Value Risk Management Strategy or “Defensive”) and that can rotate into better performing assets (The InvestmentPOD Power Value Selection Strategy or “Opportunistic”).
InvestmentPOD likes to use ETFs for three main reasons:
1) They are highly liquid instruments that trade just like equities during the day enabling us to make trades and position adjustments easily when called for by the rules.
2) They usually have lower fees and expenses than mutual funds.
3) There is a tremendous amount of diversification potential.
ETFs cover U.S., developing and emerging market equities and can be broken down by different types of stocks (e.g., large and small cap, value, dividend yield, volatility, etc…), by stock sector (e.g., energy), global government and corporate bonds, high yield bonds, real estate investment trusts, inflation-protected bonds, commodities, commodity indices, natural resources, currencies and various strategies like currency carry, managed futures, private equity, long/short equity, etc...Not only does this diversification potential help reduce risk it also provides greater opportunities for finding specific asset classes that are performing well while avoiding those that are doing poorly. This is captured in the maxim: “There’s always a bull market somewhere.”
Since InvestmentPOD services clients all around the world, everybody’s tax
situation is different. Therefore InvestmentPOD cannot provide tax advice to
clients. In general, the passive Buy & Hold strategies are the most tax
efficient as there is the least turnover and they offer the potential for
long term capital gains treatment. The defensive and opportunistic strategies
involve more turnover and thus can generate short term gains or losses so,
for some investors, might best be traded within tax free or tax deferred accounts.
We advise any investor concerned about tax issues to consult with their tax advisor as part of their Investment Plan selection process. Some clients may want to have one Investment Plan for their taxable accounts and another Investment Plan for their tax sheltered accounts.
InvestmentPOD has created a sophisticated trading infrastructure that enables
us to automate the trading rules and associated execution of trades on behalf
of each client. We have set up master “omnibus” accounts with each participating
custodian. When our algorithms signal a trade, e.g., to exit the SPY (the US S&P500
index ETF), we can execute one order for all accounts at that custodian broker.
The proportionate number of shares are then allocated by the custodian to each participating account. We use various automated execution algorithms that allow us to execute the full order throughout the day with careful attention to the bid-ask spread. Many other financial planners just phone in bulk orders to the custodian’s trading desk and have no control over the quality of the execution.
Our strategies are designed to make our orders small, aiming to minimize and sometimes even beat the bid-ask spread by being very patient.
In the early days of Modern Portfolio Theory, practitioners found it convenient
to define risk as the standard deviation of the returns around the average return.
This was a reasonable approach if markets behave normally (they don’t) and if
upside and downside deviations are equally important (they aren’t...investors feel
the pain of a given % decline twice as much as the pleasure from the same % rise).
In the real world, investors care about what are called “drawdowns” in their wealth... how much did they lose from the peak. The Ulcer Index is a statistical measure that takes into account all of the peak to valley drops along the way, penalizing deep drawdowns and long lasting drawdowns.
Passive strategies like Buy & Hold often appear to have reasonable volatility, e.g,, 16% for the stock market but the drawdowns can be much larger than would be expected if this volatility was occurring in a normal distribution. In fact the distribution of stock prices is not normal…it has far too many downside deviations (also known as a “fat tail” to the downside).
The Ulcer Index captures this reality so the historical return/Ulcer Index for the stock market is very poor. By contrast, strategies like the defensive InvestmentPOD strategy have much better return/Ulcer Index than passive Buy & Hold precisely because the approach automatically cuts off the fat tail events.
This is one of the reasons that practitioners have been so slow to recognize the importance of active risk management in the real world. They are still looking at the wrong measure of risk! They think of risk management as “market timing” whereas InvestmentPOD thinks of it as a way to control ulcers by avoiding large drawdowns of wealth in any asset.
The Old Paradigm of financial planning/wealth management has been around for at least 60 years since the development of “Modern Portfolio Theory” which can hardly be called “modern” any more. The core idea behind the theory was sound, i.e., that diversification reduces risk. However the application of the theory has not been sound. The problem is that in reality you have to know the future returns, risks and correlations among assets in order to construct the so-called optimum portfolio. It is actually impossible to know these future parameters regardless of how much historical data is available. In particular, errors in estimating the future returns result in portfolios that are far from optimum. While it can be proven scientifically (see Markets as Complex Adaptive Systems) that it is impossible to know these future returns, deep down investors understand that literally anything can happen in the future…wars, recessions, depressions, deflation, hyperinflation, bubbles and crashes…so how can anybody possibly know how things will work out? In fact, the more time that passes the more the future can unfold in surprising ways.
The InvestmentPOD “New Paradigm” is simply a reflection of this deep understanding that the future is unknowable and therefore our investments are at great risk. We cannot simply sit by passively and “hope” that we achieve some return, we must take an active role in our investments to shift with the tides…using risk management to keep the downside under control while dynamically redeploying assets to the new trends that develop. In a way, the markets give us a lot of clues as to what to do if we pay attention. This is exactly what the InvestmentPOD strategies do. If a market is going up smoothly there is no need for us to do anything. However if a market starts to fall and/or becomes more risky we take action. We also stand ready to move resources away from these risky falling markets and into something else that is behaving much better. We don’t need to know the future…we just need to know what is happening right now. The empirical evidence (as can be seen with our Investment Simulator) supports the idea that it is possible to achieve good, safe results by adapting to market shifts rather than trying to predict the unpredictable.
We have all heard expressions like: “It is dangerous to make predictions, especially about the future.” Yet investors do not seem to realize that they (and all the experts in the media) are making investment predictions all of the time…a futile exercise. Even the expression “stocks for the long run” is a meaningless prediction. Yes it may be likely that stocks will go up in the long run but it is definitely not certain. The U.S. stock market dropped 90% during the 1930s and Japanese stock investors are in an over two decade old bear market that started in 1990. How long is the long run for a human being looking toward retirement?
Currently InvestmentPOD is set up to trade customer accounts at Charles Schwab or Interactive Brokers. Depending upon customer demand we can also start similar relationships with other major custodians. If you currently have accounts at these custodians, we can simply hook your account up to our master account at InvestmentPOD. If you don’t, depending on the size of your account, we can either start a relationship with another custodian of your preference or you would need to move or open accounts in your name at either Charles Schwab or Interactive Brokers. When you are ready to proceed with your Investment Plan you can contact InvestmentPOD and we will send you the online links to set up your account.
Once the account is set up you need to give InvestmentPOD discretionary authority to make the trades pursuant to your personal Investment Plan. These trades occur in an omnibus account at the custodian and then are allocated to each client’s own account. Thus, the process is fully transparent and you can see all of the trade activity and positions at the end of the day. InvestmentPOD has no authority to move money, only to carry out trades so your assets remain under your control at all times.
Power Value is a proprietary calculation created by InvestmentPOD as a way of measuring and comparing the risk-adjusted performance of ETFs. In simple terms it is a way of measuring the “trendiness” of each ETF. The actual calculation is quite complicated as it involves looking at the day by day returns from the perspective of different time horizons. For example, some investors might be looking at the performance over the past few days, a month, several months or the past year. The one year trend might look good but the past month might be quite poor…our algorithm creates a composite measure of the quality of the trend from each of the historical time horizons from a few days to over a year. This reduces the dependence on any particular time frame in the calculation.
The Power Value can take into account a desired minimum rate of return, e.g., the risk-free rate or a higher return hurdle. That is, we can calculate the Power Value based on the net returns after subtracting the hurdle. This can be useful because some assets, e.g., a short term bond fund, might have a smooth performance profile but the actual return is too low compared to alternatives. In general, if we dial up the hurdle rate the top ranked ETFs will be assets with higher return potential…with associated higher risk.
The Power Value is expressed as a percentage between -100% (consistently declining asset) and +100% (strong and consistent upward trend). Our computers calculate the Power Value for every ETF daily after the market close.
In the InvestmentPOD strategies, Power Value is used in two ways. In the InvestmentPOD Power Value Risk Management (Defensive) strategy, an exit from an ETF holding is signaled if the Power Value falls below a pre-specified lower tolerance level. That ETF can be re-entered if the Power Value goes back above an entry threshold. This is equivalent to a “stop-loss” strategy as it gets you out of assets whose trends have turned down…just in case that downward trend might continue.
In the InvestmentPOD Power Value ETF Selection (Opportunistic) Strategy, the Power Value is used to choose a set of top performing (upward trend) ETFs at each monthly evaluation period. In this case we might switch out of an ETF even if it is still performing ok…if there is something else doing even better. It is a strategy intended to keep exposure concentrated in the best performing assets…going with the leaders rather than the laggards.
Although the detailed calculations for the Power Value may be complicated, the basic idea behind Power Value is something all investors can understand. This is not some mysterious black box algorithm but a sensible way of measuring and comparing performance on a risk-adjusted basis. An investor can easily see…by looking at price charts…why a particular ETF was removed or replaced. InvestmentPOD takes care of all of the calculations in order to make sure everything in your Investment Plan happens in a consistent, sensible and systematic way.
Modern Portfolio Theory was developed in the 1950s as a way of thinking about the role of diversification in reducing risk. The basic idea is that, for any particular risk level, one could find an “optimum” set of assets and associated weights (allocation percentage) to maximize the reward for that level of risk. The theory was based, like most theories in economics, on a set of assumptions. If the assumptions were true then the mathematics all work out neatly.
The problem is that the assumptions were wrong. One assumption was that all investors are the same with the same utility function (risk tolerance) and response to new information. Another assumption was that prices follow an (approximately) normal distribution around some known return. Another assumption was that prices were independent of each other.
It is not hard to see that these assumptions were unrealistic at best. In reality, every investor is different from every other investor in many ways from age, education, experience, trading strategies, time horizon, willingness to accept risk, etc… The long history of market prices shows that prices occasionally deviate far from normality, with many more “multiple standard deviation” moves than could possibly be expected if prices are normal. The assumption that prices are independent of each other is also incorrect as it is investors who make all the buy/sell decisions at each point in time and they clearly affect and are affected by the path of prices. Furthermore, the price movements are affected by a link to external events, e.g., falling stock prices cause investors to feel less wealthy so they spend less (e.g., on new cars) which causes the stock of auto companies to decline. These kinds of positive feedback loops between humans and the economy and prices occur frequently. The legendary investor George Soros called this interaction “reflexivity” and this understanding was key to his trading success. Prices do not move independently of each other but instead are a constant feedback loop between prices and the human traders and back again.
The fact that millions of human beings around the world determine prices rather than some invisible unseen hand is exactly why Modern Portfolio Theory has failed to explain real world price movements. We can describe the real operation of markets as being driven by heterogeneous agents (the wildly different humans trading against each other), operating in a feedback system (the never ending loop between each new price and humans and back again) in a self-organized setting (the highly organized global trading infrastructure) competing for a limited resource (wealth or profit).
Scientists (as opposed to Economists) have seen this type of process in many different fields…from our own evolution, our brain function, our immune system, the functioning of ant colonies, traffic flow, etc… In the world of science, these processes are called “Complex Adaptive Systems.” The name is quite descriptive. The process is complex, not because the individual agents (ants or traders) are doing anything particularly complex, but because there are so many possible interactions that the outcomes are very complex to model. The process is adaptive because the agents are constantly adapting to what is actually happening at each moment in time.
In a general sense, it is easy to see that this is the kind of system we are dealing with in markets. We have all of these individual traders with their own way of reacting to new prices and new information…constantly adapting to what is going on. There is no way of knowing what each individual will do under each new circumstance so the path of prices could literally do anything. It is highly sensitive to the particular choices made at each point of time. This is exactly why prices can do such strange things because we are all reacting and adapting all of the time and finding ourselves creating positive and negative feedback loops. This is why we can have what seem like irrational bubbles and crashes.
The Complex Adaptive System framework explains all of the behavior that Modern Portfolio Theory cannot. Complex Adaptive Systems are a branch of Chaos Theory which, as everybody knows, is associated with strange behavior. Small events (the proverbial butterfly flapping its wings in Brazil affecting prices in China) can cause big changes while sometimes large shocks have little impact. Bubbles and crashes are expected to occur from time to time in a Complex Adaptive System. Prices will not follow any simple distribution like the normal distribution assumed by Modern Portfolio Theory.
It is most important for investors to realize that, under the Complex Adaptive System description of markets, it is impossible to predict the future path of any risky asset. In particular we cannot know the future returns, volatility or correlations of assets. Since these parameters are the basic input to a Modern Portfolio Theory Buy & Hold portfolio, it is a futile exercise. It also means there is no such thing as “reversion to the mean” since we cannot know what the mean is! Yet this is the basic rationale given for advising investors to buy more of falling assets and less of rising assets, i.e., to keep rebalancing to the previous weights. This is the big fallacy with this type of advice…in “normal” markets it might make sense to buy low and sell high but in chaotic markets it makes no sense and can be highly dangerous. The reality is that markets can shift from normal to chaotic at any time…that is their nature.
The InvestmentPOD strategies were designed on the understanding that markets are examples of Complex Adaptive Systems. Thus we need to be adaptive as well…always being alert to danger (having an exit strategy for falling markets) while looking for opportunities (new favorable trends emerging). We accept the fact that the future is unknowable and create strategies to deal with the shifts. Investors do not have to understand Complex Adaptive Systems to use the InvestmentPOD models. However it does help to have a basic understanding of why markets are so different from the simple assumptions made by the proponents of Modern Portfolio Theory. It will help because so many practitioners are trying to keep the Old Paradigm alive and will try to tell you things like “market timing doesn’t work” or “Buy & Hold is the only way to go.” The New Paradigm of Complex Adaptive Systems is correct from both a scientific and empirical point of view…it takes a strong will to adopt a New Paradigm when the establishment fights against it. We want our investors to be educated by the scientific data, to be informed about the real truth behind investment markets and the wealth planning industry and to stay strong, to stay the course.
The InvestmentPOD Power Value Risk Management (Defensive) Strategy does exactly what the name suggests…it uses each ETFs Power Value in order to decide whether to be in or out of that market. As you know, Power Value is a summary measure of an ETFs risk-adjusted trend strength over the past year or so. The basic premise is that we are willing to hold assets that have demonstrated steady appreciation but to get out if the trend has turned down. The Power Value is a range from -100% to +100%. Thus, an example of a risk management rule could be that we hold an asset as long as its Power Value stays above zero. This rule can be applied to any set of ETFs. In practice, just as with Buy & Hold, we start with a diversified set of ETFs, e.g., covering U.S. and international stock markets, global government and corporate bonds, real estate investment trusts, commodity/natural resources exposure. We then determine the weight (percentage allocation) to be invested in each of the chosen ETFs, e.g., equal weight to each or a risk-adjusted weight. The InvestmentPOD Investment Simulator allows you to choose among three variations within the Defensive ETF strategies. To simplify, let’s suppose we had 10 ETFs in our portfolio with 10% of the money allocated to each.
The big difference between this strategy and passive Buy & Hold is that we will reduce the allocation in a particular ETF from 10% to 0% if that ETF’s Power Value falls below the pre-specified minimum level. Thus, the overall allocation within the portfolio could also vary all the way from 0% (none of our selected ETFs is in an uptrend) to 100% (all of the ETFs in the portfolio are in an uptrend).
This is a very important difference. If all markets are trending nicely upwards the defensive strategy will have a full 100% exposure just like a Buy & Hold strategy with the same ETFs. However, if some of the ETFs are not performing well, the defensive strategy is automatically cutting exposure in those ETFs…hence putting more cash on the sidelines…until those markets start performing well again.
Over the long run (based on historical simulations) defensive strategies tend to get returns similar to a passive Buy & Hold approach but with much lower downside volatility and drawdowns. In practice there are really three key market environments that matter:
1) Persistent bull markets:
In this environment, both passive Buy & Hold and defensive strategies will track closely because there will be no exit signals in the defensive strategy.
2) Choppy markets with few sustained trends:
The defensive strategy will tend to underperform in this environment as there may be some exit signals which are soon followed by a re-entry, possibly at a higher level. This is the “whipsaw” price we are willing to pay to have the defensive risk management protection in place.
3) Deep and prolonged bear markets:
This is where the defensive strategy tends to have a huge advantage as the passive Buy & Hold approach will suffer the full extent of any bear market whereas the defensive strategy will have cash on the sidelines waiting until the bear market is over.
The real key to the defensive strategy is the systematic, unbiased and unemotional way that it deals with the decision to hold or exit from an asset. It is important to understand that a Power Value exit is not a “prediction” (since we don’t believe predictions are possible in any event) that the market in question will continue to fall. It is better to think of it as a “line in the sand” where we say that this market has fallen enough and we are not comfortable with letting it fall any further. Just as with waves, sometimes a wave goes just beyond the line in the sand and then reverses. But sometimes a huge wave comes, not only going past the line, but then knocking us over or in the case of a market crash or “tsunami” wiping out many homes into the sea. The tradeoff is between small losses when we exit and it turns out to be a small wave (false warning) and the big savings that occur when we avoid the big wave.
The passive Buy & Hold strategy will be hit with every big wave that ever happens. That is why you should use the defensive strategy for some portion of your overall Investment Plan.
The InvestmentPOD Power Value Selection (Opportunistic) Strategy is a way of keeping your investment exposures aligned with the best performing assets and out of those performing poorly. The passive Buy & Hold strategy sticks with its pre-selected set of assets regardless of how they perform in the future. The defensive strategy also starts with a pre-selected set of assets but can exit from some or all of them (but does not replace them) when they are not performing well. Thus, the defensive strategy can vary all the way from fully invested to fully on the sidelines.
The opportunistic strategy, by contrast, aims to maintain a constant 100% exposure in a set of assets that have been performing the best. We use the InvestmentPOD Power Value to rank each ETF in the available ETF universe (restricted to those with sufficient volume and liquidity). The idea is to be invested in the top ranked ETFs as of each evaluation period (once a month). This is clearly a very dynamic adaptive strategy because the portfolio will always include the best performing ETFs regardless of which asset class they represent. Thus, in a period when equities are doing poorly the opportunistic portfolio might include a lot of global government bond ETFs since they tend to do well in times of economic dislocation. In a more inflationary period the portfolio might be concentrated in commodity or natural resource oriented ETFs. There also may be times when some specific stock sectors are outperforming, e.g., energy or financials. Or some country stock markets might be performing very well even when others are going nowhere.
Why does the opportunistic strategy work? In the simplest sense it goes back to the well known maxim, “There’s always a bull market somewhere.” The idea is that we want to deploy our risk capital in markets that are actually going up while avoiding those that are stagnant or falling. While this makes sense in a conceptual way, there are real reasons why the strategy works in practice. The first reason relates to the way humans actually make decisions. Deep down we know that we don’t know the future so we are looking for clues as to how to proceed. One of those clues is what other people are doing…if they are buying financial stocks or gold and the prices are rising we think that this must be a good thing to do so we follow them. This creates a self-reinforcing positive feedback loop. In extreme cases we can get markets that accelerate rapidly into a bubble…like the internet in 1999 or gold in 1980. While the bubble may eventually burst, significant returns can be made on the way up…as long as there is a mechanism for exiting early on the way down. This is exactly what the opportunistic strategy is designed to do…recognize the strongest trends in the world at any moment in time, participate in those trends as long as they persist, and move on to something else when the leaders become laggards.
The second reason that the opportunistic strategy works is related to the true nature of markets as Complex Adaptive Systems. As discussed, these markets are chaotic in nature and do not follow any known distribution. Instead they have short periods of equilibrium and then can have large magnitude moves in any direction. The opportunistic strategy is designed to ignore markets in equilibrium or in downside moves while standing ready to opportunistically capture the large upside moves in any asset. Again, there is a simple phrase to describe this “The trend is your friend.” The opportunistic strategy seeks out the very best trends at each evaluation period and looks to earn excess returns from the occasional exceptional move, while simultaneously staying out of any bear markets since their Power Value numbers will always be too low to qualify for selection.
The opportunistic strategy has a higher return and higher risk strategy than the defensive strategy because it maintains 100% exposure at all times and that exposure can be more concentrated than the defensive strategy or passive Buy & Hold. It is distinctly different in its tactical approach to both passive Buy & Hold and the defensive strategy so it does offer some significant diversification potential at times. This can be seen in the InvestmentPOD Investment Simulator by varying the proportions allocated to the opportunistic strategies.
Nearly all financial planning and wealth management firms offer modest variations on the passive “Buy & Hold” approach based on a Modern (now, in our opinion, antiquated) Portfolio Theory of the 1950s. The basic idea is to hold a diversified portfolio of assets using some simple weighting scheme and to maintain that portfolio regardless of what happens going forward. This advice is like the mother ostrich telling her chicks to keep their heads buried in the sand, hoping that by not looking they will be safe from anything going on around them. It is like deciding to cross the ocean in a ship and setting a straight course that will never deviate no matter what waves, hurricanes, tsunamis or icebergs might stand in the way.
In reality, this is a dangerous and unrealistic way to invest. The history of markets is full of unanticipated financial storms that caused huge losses for investors. These storms include everything from the crash in 2008 that took global stock markets down approximately 50% to the 90% declines during the Great Depression era and more. This list shows how often financial crises have occurred throughout recent history.
Oddly, investing seems to be the only area where people are so passive in dealing with future risk. We buy insurance for our health, homes and cars, we install security systems to thwart burglars, yet the average investor does not worry about the risks of their money.