Capital Preservation Paul, Part VI
Bull Markets and Bear Markets are such momentous events that they tend to fixate investor attention to the exclusion of more important matters. Most people, for example, would define a “market cycle” with reference to Bulls and Bears.
Typically, investors might view a market cycle as extending from the peak of a Bull to the bottom of a Bear (or vice versa). But the best way to describe a market cycle is not with reference to the markets themselves, but with reference to the investors in those markets. Thus, a full market cycle is one that presents a wide enough range of conditions to encompass all the main behavioral challenges investors face.
In the case of our investment contest, we’ve included the following types of markets, each with its own behavioral challenges:
1. A modestly positive market environment. This sort of market would not seem to trip up investors, but it regularly does. For example, Typical Tom, who was positioned well below his equity targets thanks to the prior bad market (before out contest began), didn’t view Year 1 as interesting enough to get fully invested. As a result, his portfolio rose only half as much in Year 1 as an indexed portfolio. Much worse, Tom was still underinvested when the Bull Market began in Year 2.
2. The early, substantive stages of a Bull Market. When markets begin to rise rapidly from a point at which equity prices are below long-term averages, as was the case with Year 2 of our contest, smart investors will be positioned to take advantage of the Bull because they will be at or slightly above their target equity exposures. This was the case with Lauren and, mostly, with Patty and Paul. Alas, it was not the case with Tom, who entered the Year 2 Bull Market significantly underexposed to equities.
3. The later, speculative phase of a Bull Market. Many investors imagine that “ a Bull is a Bull is a Bull.” But there is a big difference between a Bull that takes stock prices from undervalued to fairly valued to slightly overvalued, and a Bull that takes stocks prices from overvalued to seriously overvalued. Year 3 was the latter kind of Bull Market. Lauren and Paul navigated this market reasonably well, lightening up on equities and staying with value stocks and cautious managers. Patty, whose portfolio is unmanaged, rode along with the speculative Bull, her equity allocation rising inexorably. Tom, alas, became wildly overconfident during Year 3 and intentionally raised his equity allocation into the stratosphere. He actually outperformed the market in Year 3, but he was setting himself up for a serious fall.
4. A Bear Market. Bear Markets are fairly rare events – during our contest only one in five of the years experienced a Bear Market. But Bear Markets separate the men from the boys and the women from the girls. Lauren, perhaps because she was the most confident of our contestants, sold into the Bull, unworried that she was missing out on even more gains. While the indexed (diversified) portfolio dropped 20% in Year 4, Lauren was so modestly invested in stocks that her portfolio declined “only” 18%. Paul stayed within his equity ranges and lost 24%. But Patty, with a big equity allocation going into the Bear, lost 36% and as for Tom, well, the less said the better: he lost fully 50% of his total capital.
5. A partial recovery from the Bear. Some readers might object that Year 5, a partial recovery from the Year 4 Bear Market, simply repeats Year 1. That would be true if we thought of market cycles with reference to markets themselves. But as noted above, a true market cycle refers to the investors and the behavioral challenges they face. Year 1 wasn’t a partial recovery from a Bear Market; it was just an ordinary year well-removed from the prior Bear Market. Yet, Typical Tom still hadn’t rebalanced back to his equity target. According to a 2016 Fed paper, retail investors who were burned in 2008 didn’t begin to tiptoe back into the stock market until 2013. Thus, Year 1 and Year 5 examine different behavioral responses.
Many investors can show well under specific market conditions, but the most successful investors are those who can make the fewest mistakes in all the conditions, succumbing, that is to say, as little as possible to the treacherous behavioral shoals those markets present.
Here are the final standings:
Lauren: …………………………………. $130,947
Next week I’ll interview each of the contestants to get their take on the contest and on how they navigated the many challenges the markets presented over the course of five years. That will bring this series of posts to its merciful conclusion.