Reacting to the market can improve portfolio returns
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I learned in elementary school that I could not control the actions of other people. Undersized and wearing glasses as thick as Coke bottles, I was sometimes a target for bullies. I soon learned that although I could not prevent their harassment, the way I reacted could often influence their continued behavior. For example, if I responded to their taunts with with verbal jabs, an escalated conflict was virtually guaranteed. Ignoring the provocative behavior or offering a passive response generally meant the bully would seek a different target. While that type of response kept me in one piece, it wasn’t very satisfying.
Similarly, I have learned that I cannot control the financial markets. But I can control how I react to market movement and that can have a significant influence on my portfolio.
Most investors are familiar with the concept of asset allocation. In a general sense, it simply means that an investor diversifies assets among several different market segments. The theory is that by so doing, an investor limits the risk exposure he would have compared to only being invested in a single market segment. The rationalization is that no one knows exactly what the markets will do, so this passive approach is the safest response. It is kind of like ignoring the bully–it might work to some degree, but it isn’t very satisfying.
Fortunately, there is another alternative we call “active management” of “active asset allocation.” Instead of merely diversifying assets across a broad market spectrum, we attempt to move away from segments that are weak and allocate toward those that are stronger, while still maintaining a level of diversification.
During strong bull markets virtually every sector earns positive returns and the best strategy is often pick good investments and then just leave them alone as long as they continue to trend upward. The real value of active management only becomes apparent during periods of overall market weakness, like we have experienced the past several months.
Active management can use mathematical models. For example, Rod Jackson, a strategy consultant at Strategis Financial Group, uses differential equations to help him identify the momentum of various investments and to decide when to move from one market segment to another. I am not smart enough to do that, so I rely more on watching trends using a combination of can involve technical, cyclical and fundamental analysis.
Below is a chart that provides an illustration of what I am describing. The black portion of the chart shows the Nasdaq over the past year. We can see that it has lost nearly 20% from its peak in October 2007. The other three lines are exchange-traded funds (ETFs) that represent three of the strongest market sectors over the past year. The red line is streetTRACKS SPDR S&P China (GXC). China was the top-performing international sector for most of 2007. The gold line is iShares S&P Latin America 40 Index (ILF). Finally, the blue line is streetTRACKS Gold Shares (GLD).
Right now, these three funds have each returned about 44% over the past year. I’ve highlighted their convergence with a green circle. Although their returns are similar, that doesn’t mean they are moving in the same direction. Gold is continuing its uptrend, ILF has mostly gone sideways for several months, and the China fund is in a sharp downtrend.
Over the past year in my personal investment account I bought Latin America in early August, after it had seen a fairly significant correction. I held while it continued to correct for a couple of weeks, and then proceeded to watch it post some nice gains. I sold it in December after it was stalled for several weeks. My gain in the position was about 25%.
I missed the big gain in China and instead bought it in November after a pullback, hoping it would resume its upward trend. It rallied nicely for a couple of weeks but then it plunged. I sold it in mid-December and was lucky to break even on the trade.
I haven’t participated in the rally in gold. In spite of the nice uptrend I’ve been reluctant to buy because it remains near record highs. I’m afraid if I buy at this level it will drop, because I’ve been been burned by gold more than once in the past.
As the Nasdaq shows, the U.S. market offered few opportunities over the past year. The bottom portion of the chart is a moving average convergence divergence (MACD) of the Nasdaq. This tool turned up in February, signaling that there might be an opportunity for a rally. But overall the U.S. market remains weak, so I would anticipate any advance to be relatively short–a few weeks at most.
It is important to realize that the investments I’ve described here represent a small portion of my overall retirement portfolio. The bulk is invested much more conservatively. But an active management approach allows me to manage the overall risk exposure by moving away from volatile positions during periods of market weakness.
F.S.
If you would like active investment strategies that attempt to minimize risk but still provide the opportunity for solid growth, contact Strategis Financial Group at 800-279-3377.
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