Howard Marks & Smoothing Out The Ride

Here's one way to smooth out the ride over the course of an entire stock market cycle.

Jeff Ptak had an interesting post at Morningstar about the benefits of smoothing out the ride over the long term as described by Howard Marks but Ptak then went on to discuss how elusive it is to actually do.

First the quote from Marks from 1990;

"As an alternative, I would like to cite the approach of a major Midwest pension plan whose director I spoke with last month. The return on the plan's equities over the past 14 years, under the direction of this man and his predecessors, has been way ahead of the S&P 500. He shared with me what he considered the key: "We have never had a year below the 47th percentile over that period or, until 1990, above the 27th percentile. As a result, we are in the fourth percentile for the 14-year period as a whole.' "

This is a concept I have been writing about since the beginning. My take is that if you can avoid the full brunt of a large decline and capture a reasonable portion of the upside, even if that means lagging on the way up, you will have a very good long term result and that is what matters, not the short term. Without looking, how did you do in the third quarter of 2015? You have no idea because it doesn't matter. Just like a couple of years from now I will ask, how'd you do in the first quarter of 2018 and you won't know because it won't matter. You do know whether you are ahead, behind or about in line with where you need to be and that is what is important.

If you knew you could get an 8% return every single year for the next 20 years, I mean exactly 8% every year, and that the stock market would have a volatile ride to come out at the same spot in 20 years you'd take reliable 8% instead of the volatility. This chart is what that looks like;

Taking the red line as an exactly linear return coming out at the same place as the market, you dramatically outperform in 2008 but if you look closely you see you would lag in the strongest bull moves like the dot com bubble and for much of the current bull market.

Achieving that red line is obviously impossible but contrary to Ptak, I do believe the effect can be captured; a smoother ride to a similar return. One building block of understanding is that the market's average annual return combined with an adequate savings rate and proper asset allocation will get the job done (having enough for retirement), provided self destructive behavior isn't repeated.

For anyone new, the way I attempt to avoid the full brunt of large declines is to slowly take defensive action when the S&P 500 goes below its 200 day moving average (slow to prevent whipsaw), the yield curve inverts and/or the two month rule is invoked (the S&P averages -2% three months in a row which happens rarely).

You can look in the archives at randomroger.com to see how I did this in the last bear market but the short version is I made just a few sales, used inverse funds, gold and alternatives. Then as the bear market wore on I slowly started to re-equitize (should have moved a little faster than I did re-equitizing).

Where Ptak's article focuses on managers of active mutual funds, I am talking about more direct active management that includes the use of passive vehicles and individual issues.