Don't Underestimate The Sleep Factor

It is important to construct a portfolio and strategy you can live with.

Nate Geraci Tweeted the following quote by Dan Vaillalon from AQR Capital;

A good portfolio you can stick with is better than a great portfolio you’re unable to stomach when times get tough.

This is a succinct way of articulating a pretty important concept for enduring a full stock market cycle. When markets are doing well, or even just in the absence of a big decline like this year for the most part, it is easy to forget how important the sleep factor is which is a manifestation of greed. When markets are puking down over a period of months or even just a few weeks like in late 2018, it is easy to be desperately bargaining with yourself to just get back to even, forgetting that you've been through these before and that this time is not different. This is a manifestation of fear.

To the extent anyone wants to avoid these emotional high points, they are best thought out and mitigated early on. This is one reason why I use the S&P 500's relationship to its 200 day moving average (DMA) as an indicator. It warns of potential trouble long before the market has fallen a lot. Critics will rightly point out that it gives false positives which it does. A simple way to offset this issue is to start out with just one or two defensive trades like simply buying an inverse fund. Buying an inverse fund without selling anything as a first step causes minimal disruption to a portfolio in the event the market turns right back around and goes back up.

We've explored other approaches like maintaining a large allocation to client holding AGFiQ US Market Neutral Anti Beta (BTAL) in conjunction with an equity portfolio. We wrote last week about a 75%/25% portfolio, 75% to something like SPY and 25% to BTAL. I don't do this, not even close, clients have roughly 2-3%, but the concept of 75/25 is easy enough to understand. For anyone interested in this approach I would say to use several funds to build the 25% portion in case something unexpected happens with one of them.

A semi-static 75/25 would probably help the sleep factor during dicier periods but I would argue for a slightly more dynamic approach. Falling back on the statistic that the stock market has an up year 72%, portfolios don't need this sort of protection that often. And as the market's performance since the financial crisis shows us, if you take no protective action at all, then time will bail you out. It could have been more or less time than was actually the case but eventually it happens. If you don't believe that, then you should sell now, within just a few percent of the all time high and never invest in stocks again. Even though time will bail you out (I believe this to be true), I would rather no subject clients to that volatility if at all possible. People get worried which can lead to bad decisions and people have income needs from their portfolios regardless of what markets are doing.

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