The common wisdom, “Buy low, sell high,” sounds rudimentary, but gauging market tops and market bottoms is no simple matter. To optimize for better returns on your portfolio, you should adjust your objective from selling at the top (or vice versa) and instead, try these strategies:
Forget Perfection, Just Skip the Negatives
The first and most important thing to understand is that, no matter how good investors are at anticipating trades, they will never be able to buy in at the exact bottom nor sell at the exact top each and every time. As such, an investor’s goal should be twofold:
- To capture most of the positives (e.g., when the market goes from an old high to new all-time high)
- To avoid the majority of large drawdowns or crashes by re-entering when the market has given a buy signal and is on firmer footing.
Key takeaway: Investors should focus their efforts on avoiding the market crashes.
Optimize for Conditional Value at Risk
Given the unlikely probability of catching every “best day” of the market, one method that may enhance returns is to develop a portfolio that is optimized based on its conditional value at risk (CVaR). CVaR is an extension of the value at risk (VaR) measurement.
VaR is a measure all complex firms use to evaluate risk on a per client, trade, or investment basis, or all of the above. It quantifies the level of risk within a portfolio under normal or average market conditions. Assuming a 95-99% confidence level, VaR determines what an investor can expect to lose on an investment over a set period of time.
One might think that high confidence level in a portfolio is good enough. Unfortunately, VaR only presents a view of one particular scenario of probable losses; it doesn’t account for larger losses that could occur within that 1-5% zero confidence margin.
More specifically, portfolio plans or financial plans are often built on historical market information of the last 20 or 30 years – or occasionally, as little as six months. This can skew an investor’s plan results to the positive and can ignore the effects of the negative. This can result in an investor’s portfolio being at unnecessary risk.
If building portfolio models based solely on VaR was a solid strategy, no one would have lost a lot of money during the crash of 2007 – 2009 or the Great Recession because everyone would have built a plan for that and that plan would have counteracted the market’s poor returns.
Key takeaway: An investor can’t build a static or stationary (otherwise known as “buy and hold”) portfolio that will tolerate all market environments well, especially the gravest ones.
The Great Recession crash was the second largest in the United States in 116 years of market history. It is rare. It is a tail event in the distribution of returns. Take a look:
|Percent Decline (Industry Term)||Historical Instances|
|-0% to -10% (Normal Correction)||12|
|-10% to -20% (Deep Correction)||29|
|-20% to -30% (Deep Correction, Possible Crash)||15|
|-30% to -40% (Crash)||7|
|-40% to -50% (Potentially Devastating Crash)||4|
|-Great then -50% (Devastating Crash)||2|
CVaR (Conditional Value at Risk) considers that.
Fortunately, the stock market recovered relatively quickly after the Great Recession. The crash and recession also illustrated which strategies work and which ones do not under extreme stress conditions.
Today, there more than a few savvy advisors who noticed the proverbial flies in the ointment. They are working to fix them in the form of better financial plans, with more robust risk measuring models and scenarios, which leads to better and stronger portfolio construction moving forward.
Key takeaway: Investors should have a professional advisor review the specifics of their portfolios to look for places where it’s possible to optimize.
Plan for the Worst to Aim for the Best
Essentially, CVaR asks, “When things get bad, how bad can they become?” A CVaR-optimized portfolio can help to reduce an investor’s chances of incurring major losses by accounting for tail end losses beyond the established value at risk (VaR). Planning for the maximum potential losses on an investment enables an investor to optimize his or her portfolio accordingly.
Here’s a potential scenario that outlines what it could mean to plan for the worst. Imagine an investor has $50,000. He or she feels strongly about a particular company, and so makes an investment of $10,000 in that company. Yet it goes down over 80%. The wise investor now has four times the value of his or her first investment to purchase stocks at lower prices and to buy more shares. The result? Now, the investor is only down $8000.00 on the total investment, or -16% versus -80%.
CVaR-optimized portfolios can help investors employ a variety of strategies to capitalize on market tops and market bottoms, depending on one’s risk tolerance. By applying it in a world of more traditional “buy and hold” methods, one can change to a “half-in, half-out” sell strategy when the markets are stressed. One can also move to more aggressive sell strategies before potential market crashes. These strategies can provide peace of mind during times of market turmoil.
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