For the last couple of years I have been publishing my year-end portfolio synopsis. As I document my findings, the hope is that there are some lessons that I can carry forward into the new year. This process is akin to what is known in the criminology world as post-mortem analysis.
In recent years, a new concept has emerged from managerial sciences, referred to as pre-mortem. Work done by Deborah Mitchell and colleagues in late eighties found that prospective hindsight– imagining the future outcome today — increases the ability to reason for future outcomes by 30 %. The method of prospective hindsight analysis for failure of a given project is called pre-mortem. A pre-mortem in a business setting comes at the beginning of a project so as to improve the success outcome for the project as opposed to post-mortem, an autopsy of failure.
I think, pre-mortem is a great idea for investment analysis as well. So, this blog post is about pre-mortem analysis of my active investment portfolio. Specifically, I will try to address the following set of questions, as suggested by Ben Carlson in his post on portfolio pre-mortem.
The questions are:
- What will I do and how will I feel if stocks reverse from these levels and fall 10%, 20% or 30%?
- What will I do and how will I feel if stocks continue to rise another 10%, 20% or 30%?
- How much money am I willing to lose in my portfolio before I become uncomfortable and act irrationally?
- How will I react if my future portfolio performance is lower than expected?
- How will I react if my future portfolio performance is higher than expected?
- Does my investment plan take into account the fact that I will be wrong from time to time?
Pre-Mortem
Let us begin with the first question: what will I do and how will I feel if stocks reverse from these levels, and we see a significant draw-down?
To begin to answer this question, let us look at the following chart, showing the annual S&P 500 returns, dating back to 1920s.
In the last 80-odd years, S&P 500 dropped >30 % only twice, first was during the period of great depression starting in 1929 and the second, more recent during the period of great recession of 2008. I would wager that we are unlikely to see a draw-down of epic-proportions such as above in 2020.
Let us look at two macro trends, the S&P500 average returns and the nominal yield on 10-year treasury (Source: JP Morgan Asset Management Guide to the Markets)
By every earnings measure, S&P 500 is trading above historic norms. However when viewed through the lens of where treasury yields (and inflation) are, relative to historic norms, the markets do not look expensive at all. This tells me the chance of markets seeing a significant draw-down, unless interest rates move on the upside is highly unlikely. Even then, events such as the crash of black-Monday in 1987 do happen and I do not want to completely discount the likelihood of such a scenario happening in 2020.
Back to the question, given the evidence above, I will feel very excited and will act if markets do fall 10, 20 ,30 %. To me such a draw-down would represent a massive opportunity, except for a scenario where the draw down is a result of fed-policy change to interest rates, to get some of my cash reserves working again.
There are quite a few value bargains already out there for me to work on independent of a draw down. With a draw down, I would look to gobble up stocks of stable growing companies that are currently trading at a premium.
What will I do and how will I feel if stocks continue to rise another 10%, 20% or 30%?
If the first trading day of 2020 was any indicator, the likely scenario for 2020 is that the stocks will continue to rise another 10, 20 and 30 %. Below is a fascinating chart on unemployment/wage-growth in the US
The downward trend in unemployment has continued unabated since the great recession of 2008, and finally we are seeing wage-growth catching up to the historic average of 4 %. I want to wager that in a low interest environment, all the extra cash into individual/family pockets will drive increased consumption and investments into equity assets, resulting in a positive feedback loop of increased corporate profits and further gains in equity valuation. I expect this cycle to last atleast through 2020.
Given this observation my response will be to continue to do what I have been doing in 2019, increase cash reserves, diversity retirement-investments in AV Portfolio and keep looking for value bargains.
How much money am I willing to lose in my portfolio before I become uncomfortable and act irrationally?
If there is one thing I have learned over the last several years of my study into investing philosophy is that risk averse investing, i.e., investing with a mindset of capital preservation and not loosing money as opposed to hitting-a-jackpot, should never make me uncomfortable with my portfolio and therefore I will never act irrationally.
However, it is only human to act irrationally and a draw down of 50 % will surely test the mettle of any investor. It is therefore important to assess the pain threshold and the duration of pain for any investment draw-down. We can get some sense for these numbers from the table below (Source: JP Morgan Asset Management Guide to the Markets)
On average bear markets tend to last for about two years, with about 40 % draw down. Although the past two bear markets have been quite strong with draw downs close to or upwards of 50 %. In any case, going by the averages, I believe, having a cash buffer (defined as amount of cash necessary to sustain a given life style) of at least two years should allow me to sustain a bear market draw down without taking any irrational steps such as selling into the bear market.
So there you have it, my threshold is 50 % draw down dragged for a period greater than 2 years before I take any action that is out of the norm for my style of investing and portfolio management.
How will I react if my future portfolio performance is lower than expected?
How will I react if my future portfolio performance is higher than expected?
I have grouped the above two questions because they are related and some what easy to answer for me. At the present stage of AVI family life cycle, my reaction is some what independent of lower (or higher) future portfolio performance. Let us look at the performance of my most actively managed account for the last 3 years (Blue: AVI non-retirement active portfolio returns; Yellow: S&P 500 returns):
For 2017 my returns were 5.49 % vs. S&P 500 21.83 %. I got crushed. For 2018, it was a wash, my returns were -4.72 % vs S&P 500 -4.38 % and for 2019, I handily beat S&P 500, my returns 41.26 % vs S&P 500 31.49 %. 3 year average for my active portfolio: ~14 % as opposed to 16.3 % for S&P 500.
I trailed the markets, I walked in step with the markets and then I beat the markets. Through all these, my investment strategy has remained unchanged. I am and will probably always remain a contrarian value investor, always trying to find hidden gems that for whatever reason are in trouble for markets offer them up for sale.
So there you have it, for a foreseeable future, unless other wise life-circumstances warrant, I will remain agnostic to how my portfolio performs relative to markets with the anticipation that my style of investment will eventually (as I get close to retirement) produce superior returns relative to the markets.
Does my investment plan take into account the fact that I will be wrong from time to time?
For the final question, my answer is an emphatic yes! The whole idea for me to divide my investments into different buckets.. retirement–passive; active and non-retirement–passive, active is to acknowledge that I will be wrong from time to time and that even if I am wrong, I should under no circumstance be forced to take unwarranted corrective actions that may hurt my long-term portfolio growth outlook.
I want to always focus on risk averse investing as opposed to growth focused investing with unknown risks. I should always consider a margin-of-safety in my investments. I should be patient and willing to wait for markets to offer opportune moments to invest. The companies that I invest in should for the most part have high free cash flow, strong balance sheet and are share holder friendly. If after doing all this, the market gods turn against me.. so be it!
So there you have it.. pre-mortem of my investment portfolio. I will revisit this post towards the end of the year to see how and/or whether this analysis played any role in my investment decisions into 2020.
Video/Book/Article/Audio for the Week
- Books: The greatest trade ever, by Gregory Zukerman. This is the first book in my list of 2020-readings. I am on page 417, of 767 and so far am loving it. The characters in the book remind me of a similar book (and a movie), titled- The Big Short. I had watched it when the movie was released, but yesterday, I re-watched it again. Its been fun revisiting–arcane finance instruments–CDO, CDS, synthetic-CDO, that turned out to be the atomic bomb of finance in 2008.
- Books: Unaccustomed Earth, by Jhumpa Laheri. The other day I was browsing through book shelve of a local goodwill store and happened to see this book. Being aware of Jhumpa Laheri’s earlier works, Namesake, I got curious and a quick look at book reviews on Amazon.com made me purchase the book. Though not on my list of readings, I have started reading this book and its been an amazing read thus far. The book resonates quite well with a person of my background: ““
- Article: JP Morgan Asset Management- Guide to Markets 2019. Fascinating summary of current economic environment in charts!