I was recently asked to speak at a conference hosted by one of the largest financial publishers in the industry.  There were no restraints placed on me….I could talk about anything within my area of expertise.

I mulled multiple possibilities.  Since I didn’t know beforehand the level of audience sophistication, I knew I should try to keep the presentation fairly basic.

The challenge then became, how in twenty-five minutes can I share everything an investor needs to know about rules-based investing?

And more importantly, why should they care?  And why should you care?

As I was preparing my notes and outline, one benefit seemed to stand out more than others.

Predictability. 

It was the single word on my second slide.

For me at least, one reason we use models is that it creates a certain degree of predictability. (I will discuss mathematical expectancy in greater detail in a future post)

I think that one reason that people don’t invest who should, is because of the uncertainty that often surrounds investing and the emotional angst caused by the uncertainty.

There are two types of data.  That which is known, i.e. the past; and that which is unknown, i.e. the future.  Everything else is just noise.

None of us are diviners of the future.  Thus all future market data is unknown.  (Which is why “forecasts” are worthless despite investor fascination and interest in them)

Traditional investing advice such an indexing and buy and hope have you accepting the market’s future returns regardless of the outcome.

It’s random.

And it is highly unpredictable.

And psychologically, deep down, there is something unsettling about this.

But…

What if, we placed our focus on strategy.  On process.   After all, that is the only thing we can control.

What if our process managed our major concerns? Meaning…it had the ability to always adapt to the best opportunities at any given time.    And if the “best opportunity” at the time was to be defensively positioned on bonds or cash, so be it.

In essence, we manage the unpredictable stream of future market data with a clearly defined, tested, researched, and predictable process.

How many investors have watched this market from the sidelines waiting for a pullback for better entry?   Thinking all along that “it was too high”.

If however, investors knew that it did not matter…that the investment strategy would protect them should the need arise…then investors could and should invest anytime capital is available.

Unfortunately, many investors approach investing as an all or nothing proposition that is rigid.  And this is where the internal psychological battle begins.   Questions like” what if I’m wrong” or “what if the market declines” and “what if this is a mistake?” take command.  And the result is often paralysis that results in inaction.

Markets adapt and change.  Why shouldn’t your portfolio be allowed to do the same?

Strategic allocation approaches, indexing, and buy and hope do not adequately address the element of predictability.  Consider the following table of historical returns for the market.  Notice that even in 20 year periods of time that the range of returns is from 1.9% to17.9% for the S&P 500.

Does that seem predictable?

And it’s worse the shorter your time frame.

The financial industry is always quick to say that every 20 year period in the market has been positive.  True.  But what it doesn’t mention is the possibility that half of the returns will be below the 20-year average return of 10.1%

If you were estimating on achieving an “average return” to reach your financial goals, there is a 50% chance you will fail.  That after all is the simple mathematics of an “average”.

I ask again if any of this makes investing seem predictable?

What if your timing is unlucky and you earn well below the average?   Success becomes based upon luck and hope that the return sequence delivers what is required.

So we come back to focus on process.  To make sure that our portfolio is allowed to breathe.  To make sure that our portfolio can adapt to new market regimes.

This is why I am so passionate about rules-based investing.  It allows us to program in the ability for our portfolio to maximize profits when times are good and protect our capital when markets start to head south.  Simple mathematical formulas can replace our emotional involvement and provide a predictable process to manage the market, no matter what it throws at us.

In my next post, I will discuss how some of the tools we use can help create an element of predictability.

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