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Managed Risk Investing
What is Managed Risk Investing?
Managed Risk Investing is a process of determining the overall market risk at any given time. We want to know when the market risk tells us to be fully invested or when the market risk is high and tells us when to be out of the market.
The best way to explain this is with real examples. Let's take a quick look at the major U.S. stock market meltdowns over the past decade that have been unprecedented since the Great Depression of the early 1930's, even back to the introduction of the US stock market in 1820s.
2002 Bear Market
March of 2000 marked the beginning of a collapse of the US stock market over the next two years, with 2002 being the worst year. If you were 'buying and holding' at that time, you watched your net wealth plummet, along with many other investors, as evidenced by the Standards & Poor 500 Index in the chart below.
But that didn't happen to Don Wilson. His Don's Funds Managed Risk Investing system analyzed the market conditions and told him to move his entire portfolio out of the market during that time, as evidenced by Don Wilson's Real Time Personal Portfolio (which followed the Tango Managed Risk Investing model).
2008 Bear Market
In 2008, we all know what happened to the stock market. But what happened to Don's Funds members that follow Don's simple approach to Managed Risk Investing? Lets take a look at both the S&P 500 Index and the TangoETF Aggressive Real Time Portfolio (which followed the Tango Managed Risk Investing model).:
Managed Risk Investing with Mutual Funds
Tango5 is the original trading system developed by market timing expert Don L. Wilson to help anyone who is investing in Mutual Funds to get the maximum return with the minimum risk. Tango5 is a managed-risk investing method. This method of investing is for the beginner, or person who does not have the necessary time, or does not want to spend the excessive time necessary for gainfully investing in the Stock Market.
The Tango5 system will start with 4000 no load mutual funds and automatically reduce those down to the top 1% of the funds that are performing the "best" now! Then it will tell you when the Market is in "buy" "sell" or "hold" mode. During the "buy" mode you will pick the funds with no or low redemption fees you want to buy. Daily Tango5 High Risk, Moderate Risk, and Low Risk reports are available to all subscribers.
Managed Risk Investing with ETFs
TangoETF is a proprietary trading system, designed by market-timing expert, Don L. Wilson, to help any individual who wishes to invest in the stock market, but has little knowledge of what to invest in, and when to buy and sell. Or those that do have the skills and just don't have the time for detailed analysis. The objective of TangoETF is to automate the process of ETF selection and timing of each trade, and to allow you the freedom of trading in the marketplace without time consuming analysis of stocks or mutual funds in the stock market. ETF's are funds (made up of a pool or basket of stocks) but are traded like individual stocks. This makes them ideal for buying and selling at anytime, and have lower risk due to their collective nature. And complete diversification over different asset classes can easily be accomplished with ETF's. TangoETF is designed to allow you to place the trades with your broker of choice. Daily TangoETF Portfolio trades & reports are available to all subscribers.
The Long Term Big Picture View
What is Managed Risk? A computer model is developed to measure the risk in the stock market using many proprietary indicators each measuring different aspects of the stock market. The stock market risk fluctuates up and down and our Risk Model measures this risk every market day. We draw a line in the sand and when the stock market risk is high enough to cross above that line in the sand our computer model sends a signal. The signal indicates the risk is so high that we must begin to reduce our investments in this market. When the risk level crosses below the line in the sand the model sends a signal, the signal indicates the risk is low enough and we once again increase our investments in the market.
Below is a graphic illustration of Market Risk:
So we use Manage Risk to lower the risk we are actually taking in the market. It is our opinion that Managed Risk usually lowers your performance. So why would we use Managed Risk and lower our performance? My portfolio represents my life’s savings. Everything I have worked for over the last 50 years is at risk when my portfolio is at risk. I don’t take this lightly. If your young and can rebuild, you may not see your risk as I see mine. You get my point; risk is my first and foremost consideration. Therefore I learned how to Manage Risk. I built my first Market Managed Risk computer model in 1994 and have honed that skill since then.
I use Managed Risk to avoid big prolonged “bear” (down) markets. What is considered a big prolonged bear market? The 1929 market crash and subsequent depression would be a big prolonged bear market. To further explain I need to define several profiles of bear markets.
Bear Profile One (P1), a correction (draw down in the market) of 0% to 10%.
Bear Profile Two (P2), a correction of 11% to 15%.
Bear Profile Three (P3), a correction of 16% to 20%.
Bear Profile Four (P4), a correction of 21% to 30%.
Bear Profile Five (P5), a severe correction of 31% to 90%.
Bear Profile Six (P6), a Melt Down correction of 91% to 99%.
Bear Profiles P1 through P3 don’t bother me. If that is where the corrections to the market would end, I would not use Managed Risk. When you listen to the so called Investment Advisor Experts, their thinking does not go beyond P3. Their advice is to use “Asset Allocation” and diversification to protect your portfolio from market risk. They are correct to some degree for P1 through P3, but what about P4 through P6. It’s P4 through P6 that get my attention. So do I really believe we could have a “melt down” 90% to 99% drop in the market? You bet as they say! The Dow Jones Industrials dropped 88% from 1929 to 1932, and the NASDQ dropped 77% from 2000 to 2002. These would not be considered P6 melt downs. Yes and no, history tells us we will have a melt down somewhere in our future but it is probably to far out in the future so I don’t not worry too much about a P6 melt down, my concern is really P4 and P5 which can really hurt your feelings, and have a significant negative impact on your portfolio.
Let me be clear, I am not an economist, Wall Street professional, nor do I have any other lofty financial background, so I may not be qualified to speak here. However, I am qualified to protect myself from stock market risk. At the present time we have world economic imbalances that in past history provided the fuel for economic collapse. Just one current example, no society in the past has avoided this dire result that has gone to a fiat currency.
A fiat currency is one that is not backed by gold or any government hard assets. It is therefore concerning that today you can not convert your paper dollars into hard assets from the U S Government.
So what would cause this melt down? Just one example, the world is awash in US Dollars that have no backing. You think China, Japan, Malaysia, Germany, Russia, or any other sovereignty will not try to be the first out the door to sell their US Dollars if it should start to drop precipitously?
I am not a doomsayer so don’t get me wrong, I’m a glass half full guy and will continue to put my money into the stock market. I just want to be as ready as possible for any big negative market swings. What matters is I protect myself against Bear profiles Four and above.
Recovering from Market Corrections
Investors are surprised when they discover that a loss of 50%, takes a return of 100% to recover to break even, so losses must be avoided as much as possible.
The First Rule: “Many have heard that the first rule of investing is “Don’t lose money.” That rule is important because losses have a disproportionate impact on compounded returns. Simple returns are the returns that occur each day or month. Compounded returns reflect the cumulative impact of gains and losses on prior returns and represent the kind of returns that we can ultimately spend. For example, if an investment is up +10% one year and down -10% the next, is the investor at breakeven over the two-year period? The result is 0% if we simply average the two years, yet the investor actually will be down by -1% in his account (on an accumulative basis). This occurs regardless of the order of the gain and loss periods. It actually takes a +11% gain to make up for a -10% loss. Further, as the loss increases, it requires a greater percentage gain to restore the account to breakeven. For example, it takes a +25% gain to recover from a -20% loss and a +50% gain to recover from a -33% loss. As tech bubble investors have experienced, it will take a +400% recovery to offset the -80% decline that occurred in the NASDAQ.”
The Shorter Term View
We would ultimately like to use a buy and hold investment approach. Over the long term the stock market goes up giving you a meaningful advance in your brokerage account. But this approach means you also participate in the significant market declines. This is unacceptable from a risk standpoint, because once in awhile we have a severe bear market which will wipe out a generation of investors and take years of recovery for those not wiped out. Depending on your investment time horizon, you may not have time to rebuild your wealth to the level prior to a severe bear market. At any rate, we want to concentrate on building wealth not rebuilding it. One way to do this is through Managed Risk Investing.
Although managed risk models have their good side in limiting loses as previously discussed, it also has a frustrating side. All managed risk sell signals are not a sign of a severe decline, some are false alarms and some are minor market corrections, these signals cause small gains or losses but they are part of the process. And when you do get a severe decline as in 2000 to 2002 and 2008, managed risk investing will keep your wealth in tack. We then make most of our money during the buy signals and save our money during the sell signals by “avoiding most of the significant declines” and “participating in most of the meaningful advances”.
Managed Risk models are not perfect. Designing a Managed Risk model is always a series of compromises. Risk models are not human; they are a series of mathematical formulas driven by market data that crosses predetermined thresholds. This data at times crosses the threshold before or after you want it to. So ideally you would like to move the threshold so that it gave you a “good” signal every time. Of course this is impossible, since you would have to know in advance what the market is going to do. Neither the best minds on Wall Street or in the world for that matter, know what the market will do in the future (so we have to learn to live in this “imperfect” market world).
There are many other aspects to successful investing, this article addresses only one aspect of risk (market risk), and the other aspects are addressed in subsequent parts of the web site.
For an illustration of Managed Risk Models reducing market risk, I have included a few charts below.
The chart below of the Russell 2000 for a period of 21 years has the Managed Risk Model applied (Red). You can see the dramatic difference compared to the lower chart (green), the red line is the equity curve using the Managed Risk Model. The green is the equity curve without any managed risk (buy and hold).
The best measure of risk is SD (Standard Deviation) which is 3.67% (Red) based on the Managed Risk equity curve. The SD (Green) of the Russell 2000 is 5.86% based on the no Managed Risk equity curve. This means you have reduced your risk by 50% in SD just by using a Managed Risk Model.
Also on the upper right BP (stands for Between the Poles or the total period of the chart) has a Total Return of 326.22% for the no timing equity curve. The Chart (in Red) has a Total Return, over the same period, of 2,090.48% for the Managed Risk equity curve. So the result is 6.4 times the profit at half the risk.
The Chart below is TRPrice Small Cap Value fund; you can see the same results. We can demonstrate over and over again how “Managed Risk Investing” can increase your wealth over the long run. In subsequent parts of the web site I refer to MRI (Managed Risk Investing) as our model to reduce and control market risk.
Charts by www.fasttrack.net