Frequency and Magnitude

The frequency of something happening is not proof & Trading Portfolio; Momentum Q4 2021 update

Let’s talk about something that Holland Park Capital London has been guilty of as well. People try to convince others with statements like;

1. The US large cap stock market historically has gone up 70% of the time.

2. Active Portfolio Managers underperform the indexes (they are trying to beat) 90% of the time over historical ten year periods.

Interesting statements for sure and likely related to end performance, but not proof of stock market performance in itself. The above statements only talk about the frequency of something happening, but leave the magnitude of the moves out. It is another case where people make statements to sell their arguments that are lies. Lying with numbers, models and statistics is the flavour of the day at the moment. Lies, damn lies and statistics.

In the first statement for example let’s assume for argument’s sake that the stock market goes up 10% a year in up years (70% of the time) and the stock market goes down 90% in down years (30% of the time). Say one starts with $10000 and the sequence risk is positive for the first 7 years. So the $10000 compounds away nicely with 10% a year for the first seven years. At the end of year 7 the investor has about $19487. Then 3 years of down years follow. The $19487 goes down by 90% a year for 3 years in a row. A lousy $19 is all that the investor has left at the end of year 10. Magnitude risk is clearly very important as well.

If the magnitude would have been the same and the frequency & sequence the same the example would turn out rather differently. Let’s make the magnitude 10% in up and down years. First seven good years of up 10% a year increases the $10000 into $19487 again at the end of year 7. Then 3 down years of -10% a year means after the end of year 10 the investor will have turned $10000 into about $14206. Much better this outcome of course.

Sadly stock markets usually go up slowly, but when they go down stock markets tend to go down much faster.

Boat Afloat Image on the stock markets go down faster comment....

The second statement can be misleading as well. Let’s make an example where active managers underperform the index (passive) by 1% for the first 9 years. When active managers outperform however let’s suppose they outperform the index by 25%. An investor has invested $10000 in the “active managers” portfolio. The market return is 0% a year to keep things simple for 10 years. So the relative return drags the $10000 down by 1% a year into about $9135 at the end of year 9. So in the first 9 years the investor misses out by $865 compared to the index. In the 10th year the $9135 compounds by 25% however into about $11419. So the “active managers” portfolio in this example still outperforms the index by about $1419 at the end of year 10.

So what we really want to know when it comes to active fund managers is how big is the percentage of the underperformance for the active fund managers on average and how big is the magnitude/percentage of the outperformance for the active fund managers on average.

In the example if we make the magnitude 1% for underperformance (90% of the time) and 1% for outperformance (10% of the time) then of course we get a different end result. Again the relative return drags the $10000 down by 1% a year into about $9135 at the end of year 9. So in the first 9 years the investor misses out by $865 compared to the index. In the 10th year the $9135 grows by 1% into about $9226. So if the magnitude is the same the frequency does determine the end result. In this case an underperformance of the “active managers” portfolio of $774 versus the index.

So if we assume that there is a small elite group of portfolio managers (say 10% of the total pool of fund/portfolio managers that can outperform the stock market significantly it could still be rational for investors to invest with active managers and not invest purely in passive index trackers or passive ETF’s.

Also here the unlimited upside versus limited downside rule in equities applies as well. Say an investor has $10000 again and invests $1000 each investment in 10 different actively managed funds or investment trusts (closed end funds) for 10 years. Let’s assume the index goes up by 10% every year. The index would turn the start value of $10000 then into about $25937. Two active managers are terrible and piss all the money away (from $1000 per 1 terrible active manager into $0). Six active managers underperform the index by 2% a year. Each of the six active managers manages to turn $1000 into about $2159 at the end of year 10. The ninth active manager is not so bad and only underperforms the index by 1% a year. The ninth active manager turns the $1000 start value into about $2367 at the end of year 10.

So the first 9 underperforming active managers together turn their $9000 into the sum of $12954 (0 plus 12954 plus 2367). The tenth active manager however has skill and is part of the small elite portfolio manager group. The tenth active portfolio manager makes 20% a year for the investor. The tenth active portfolio manager turns $1000 into about $6192 at the end of year 10. So in this example the 10 active managers turn $10000 together into $19146 (12954 plus 6192). The index turned $10000 into $25937 after 10 years while the 10 active managers together turned $10000 into only about $19146. The index won by about $6791 after 10 years.

If we change the numbers for the 10th elite active manager however the end result can change fast as well. Let’s give the 10th elite active manager the performance we took away versus the index for the underperforming active managers. That is 10 plus 10 for the 2 terrible active managers. That is another 6 times 2 for the six active managers. That is 1 for the ninth active manager. The 10th elite active manager then delivers 33% outperformance per year (10 plus 10 plus 12 plus 1). The index did 10% a year so the 10th elite active manager makes 43% a year with the investments for 10 years. Now the 10th elite active manager turns $1000 into about $35757 after 10 years. Combined with the $12954 of the other nine active managers this makes a total of about $48711. That is getting close to double the $25937 the index ends up with after 10 years.

The last above example was perhaps a little extreme but it shows investors are basically buying a call option on outperformance when going active. Most of the time this call option expires worthlessly and the cost of the call option (higher fees paid to active fund managers than passive managers) detract from the end result. For some investors the decision to go active can pay off handsomely though if they have somehow ended up with investing money with an elite active manager (be that a fund manager of a hedge fund manager). It also explains why the active money managers that have skill tend to be greedy. After all the bigger the pile of money they actively manage the more difficult it becomes to achieve big swinging outperformance.

Let’s change the performance of the 10th elite active manager into 25% a year. Peter Lynch after all managed 29.2% a year so this is possible for the lucky and or skilled few and Warren Buffett achieved with Berkshire Hathaway 28.3% in the 1960s and 39.1% in the 1980s according to the awealthofcommonsense.com website in the article “Buffet’s performance by decade” written by Ben Carlson. At 25% a year $1000 turns into about $9313 after ten years. Combined with the $12954 of the other nine active managers this makes a total of about $22267. That is getting close to the $25937 the index ends up with after 10 years, but the active managers would still underperform.

If we make the performance of the 10th elite active manager 30% a year then $1000 turns into $13786. Combined with the $12954 of the other nine active managers this makes a total of about $26740. That is marginally better than the $25937 the index ends up with after 10 years, so the active managers would outperform slightly.

So the key takeaway is that if you invest with active managers you need to find some active managers that win big. An outperformance of 1% or 2% is unlikely to make up for the underperformance of some of the other active managers.

Maybe that helps to explain why it can be rational to invest 10% of your actively managed money with say an ARK Innovation ETF (ARKK). Yes the one year total return is as of today now -38.6%. Not great. The three year total return is still 30.21% positive now. So when the strategy of this actively managed ETF works the ARKK ETF wins big. Of course 2020 stands out with a win of 156% in 1 year. Another great year was 2017 with a win of 87%. No risk no return. The year 2022 could be a very bad year for the ARKK ETF.

Despite that it could be rational to make an ARK ETF or Baillie Gifford fund investment as one of your 10 picks in active managers. As long as you do not forget to also diversify in the investment styles of the active managers. The above examples have shown you can overcome very bad performance of 2 out of 10 of your active manager picks. You cannot overcome however a very bad stock market performance of 10 out of 10 of your active manager picks. A diversified balanced investing portfolio matters big time. If anything that is a key takeaway from lessons learned in 2020 and 2021.

Inflation in the US is now at the highest since 1982. The annual inflation rate was 7% in December 2021. This is going to be an interesting year in 2022 for the stock markets. Central banks cannot continue to increase their balance sheets faster than GDP growth and keep interest rates way under inflation rates if central banks want to regain a modicum of credibility from the financial markets. Central banks are now forced to stop the game they have played since 2009. As Milton Friedman said; “Inflation is always and everywhere a monetary phenomenon.” In December 1982 the FED Target rate was 8.5%. Today’s US FED Funds Rate Range is between 0% and 0.25%. With an US inflation rate now of 7% it is no wonder people think the central banks have lost the plot. Governments and central banks have been playing with fire and now they will reap what they sowed. Say the US interest rates would jump to 8.5% in 2022 like they were in 1982 Mr. Biden would have to increase his interest payments on all that US debt by a whopping amount. Governments all over the world are now so indebted they simply cannot afford higher interest rates any more. At least the US has their own currency the $. Portugal, Spain, Greece, France and Italy don’t have that luxury. Might 2022 be the year of new all time highs for the gold price?

Let’s see how the old performance favourites the NASDAQ index and Bitcoin will have performed this year at the end of 2022. The stock market game has changed. This stock market doesn’t give a shit (that is a professional term) about a company’s revenue growth if there are no earnings on the bottom line as well. Netflix reported earnings this week that showed the free cash flow was negative in Q4 2021 again. Netflix closed down 21.7% on the back of that. Cold hard dollar earnings at the bottom line are what this stock market wants to see. Not the manipulated accounting earnings kind either. Just real earnings of the free cash flow positive kind.

It is now time for a quick update on the Trading Portfolio; Momentum project.

The first quarter of 2022 has already started again. After taking out the dividends of the above portfolio at the end of Q4 a rebalance was done in the second week of January. The current value is now $70563. In the previous blog the value was $72284.

So the Trading Portfolio; Momentum experienced a negative absolute return in the last couple of months. This was the first negative quarter since the start of the project. The stock market is like a junkie addicted to free money from the central banks. The stock market junkie doesn’t like to go cold turkey and is throwing a big tantrum in the direction of the central banks. This is unlikely to change until the FED gives a clear plan of what to plan to do when. Forward guidance is likely to make a comeback soon.

The relative return was terrible in Q4 2021. The relative return was ahead of the return of the VOO S&P 500 Etf on both portfolios tracking websites (Sigfig and Stockrover) at the end of Q3. Now the Trading Portfolio; Momentum value is behind on both portfolios tracking websites.

The Sigfig website has the VOO Etf position value as $71276.

The Stockrover website has the VOO Etf position value as $71039.

The real money broker portfolio (Trading Portfolio; Momentum) is currently valued as $70563.

In the summer it will be 2 years since Trading Portfolio; Momentum went live. So far the strategy doesn’t work. Simply investing and holding the Vanguard S&P 500 VOO etf is a lot easier and makes more money. Hopefully the Trading Portfolio; Momentum portfolio can get some outperformance in the coming year so the rebalancing work is not all for nothing.....

Of the 8 U.S. stock equity factors listed on the Seeking Alpha website the Momentum factor is the only one in the minus on a 1 year time horizon (down 6.2%). Luckily the Trading Portfolio; Momentum also has a touch of the Equal Weight factor in it as that one is up 15.98% over the past year. The Trading Portfolio; Momentum is up 15.29% over the past year (1 year change). For reference the 1 year change of the S&P 500 is now 13.99%. So maybe Trading Portfolio; Equal Weight would have been a better name for this investing project.

It will be interesting what 2022 will bring for the stock markets. In general any position that had good stock market returns in 2020, had bad returns in 2021 and vice versa. So far 2022 looks different again with the US stock market as one of the worst performing of the major countries worldwide. Brazil which had a terrible 3 years of past stock market performance is up 6.59% YTD now. The S&P 500 index is down 7.79% YTD after having a fantastic past 3 years of performance. It looks like a classic case of what went up in the last 3 years must come down now.

As always thanks for reading the blog and good luck with your own investment journey.

The blog is not advice on what you should do with your money and was written for information purposes only. When you invest in the stock markets it is possible to lose money. Please do your own research. If in any doubt what is best in your individual situation, please hire a licensed financial advisor.

Holland Park Capital London hopes you enjoyed the information in the blog. Holland Park Capital London Ltd is not receiving any compensation from anyone to write this blog. Holland Park Capital London is long the stocks and ETF’s that were mentioned in the above blog. Holland Park Capital London has no business relationship with any company whose stock is mentioned in this blog. Holland Park Capital London expressed its own opinions. This is not advice. Make your own decisions please. Please go and see an authorized financial advisor before making any investment decisions. What works for Holland Park Capital London may well not work for you and your personal situation is unknown to Holland Park Capital London. Stocks go up as well as down and you may get back less than you invest. Any information in this blog should be considered general information and not relied on as a formal investment recommendation. This blog is for information purposes only and helps Holland Park Capital London expand on the book “Beat the Stock Market Casino” and brings extra discipline in the investment process. Holland Park Capital London is not liable for any mistakes in this blog. This blog cannot be a substitute for comprehensive investment analysis. Any analysis presented in this blog is illustrative in nature, limited in scope, based on an incomplete set of information and has limitations to its accuracy. The information upon which this blog is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore the accuracy cannot be guaranteed. Any opinions are as of the date of publication and are subject to change without notice.