Friday, September 3, 2010

Schizophrenia and Relative Value Investing

The stock market began the month of September with a gain of close to 3% and I’m not happy this morning. The month of August was terrible and I’m pleased. What’s wrong with this picture? The answer is simple. When we have positioned our portfolios to defend against market declines then any market rally is a cause for concern and market sell-offs are something to look forward to. It is difficult to describe the mixed emotions that result from positioning portfolios to be defensive in bear markets, and then being correct in your forecast. On the one hand, Pinnacle strategies have a high r-squared to general market direction which means that a market decline on any given day will typically result in lower portfolio values for our clients. This is bad. It is bad for them because their financial plans usually require that they accumulate wealth to fund their retirement and other objectives, and losing money…any amount of money…does not help to achieve their financial goals. Blessedly, Pinnacle clients are highly educated consumers of investment advice and they seem to understand that there is, in our opinion, no fundamentally sound investment methodology to completely avoid portfolio declines. Time diversification allows us the flexibility to manage accounts without making dangerous asset allocation bets that require us to completely abandon risk assets in bear markets. Of course, there is a difference between asking our clients to be patient (buy and hold and pray) and asking them to be patient (give us the time to allow our active strategies to work). Since there is no barrier to exit a relationship with Pinnacle, I am thankful for our clients’ forbearance every single day.

On the other hand, if we get our forecast right in bull markets or bear markets our relative performance can soar versus both the broad market and our blended benchmarks. In declining markets, assuming we are defensively positioned, the pros would say we earn positive alpha, and our clients would say thanks because they have friends that lost a whole lot more than they did. It is admittedly rather confusing to find yourself rooting for a market decline in such situations. Yesterday’s relative portfolio performance is going to look awful. Yet, it looks like Pinnacle portfolios performed beautifully during the month of August and the numbers are going to be excellent on a relative basis. The S&P 500 Index lost 4.57% during the month with dividends reinvested and Pinnacle portfolios lost a small percentage of that total. However, as always happens in conditions of falling markets and portfolio values, my enthusiasm is measured. The bottom line is that yesterday our client made money and after the month of August our clients are that much further from retirement and we (the partners at Pinnacle) took a cut in pay. However, by minimizing the negative compounding of the portfolio, we are laying the groundwork for being able to help our clients systematically accumulate wealth over time. There must be some medication for this…