Tornados, Sirens, and Storms

Earlier this week, the city and outlying suburbs of Dayton experienced some of the worst storms its seen in years.  Sirens went off and ultimately, tragedy struck as a tornado touched down, killing one and injuring more than 90.  Many more in the surrounding areas affected by the storm found themselves unscathed on the other side of the cold front, and while one death is too many, I think it’s safe to say that things could’ve been a whole lot worse.

 

Ask yourself, when you hear tornado sirens, do you head to the basement, or do you “play the odds?”  Some of you might feel you’ve been through several storms wherein tornado warnings occurred in the past, but you never experienced an actual tornado, so why head to cover?

 

It goes without saying that tornados have killed hundreds of people over the decades, in many cases, due to the fact that their home was hit while they were sleeping.  But even for those twisters that show up during waking hours, I think it would be an accurate assumption to say that most individuals head to the safest place in their home when the sirens go off, even if the odds are in their favor.

 

The stock market is similar in this way.  Most professionals implement a “Buy & Hold” investment strategy.  If you personally utilize (or work with someone who implements) this type of strategy, it works like this, metaphorically speaking:

 

You hear a siren, which indicates a tornado has been spotted.  So, you pause your favorite show on DVR to listen for a second, think over the probabilities, and then you hit play and completely ignore the warning.  Does that sound like it makes any sense at all?!

 

We implement a strategy that we call Defense First®, which aims to do the opposite.  If we hear a tornado siren, we turn off the TV, grab our spouse and kids, and head for cover (even if they’re reluctant to do so!).

 

In the chart below, you can see that, using our strategy, there have been a total of 12 “sirens” that have gone off in the last 25 years (rose-shaded areas).  You can also see that only 2 of those 12 resulted in actual tornadoes.  But was avoiding potential disaster worth the time in the basement in each situation when it was just a false alarm?  I’d say so…

 

Some of these sirens are false alarms, but what’s the worse that can happen?  We get a little behind on our favorite TV show (especially as compared to our risky friends who just ignored the sirens altogether – they’re already on the next episode!).  In other words, our retirement portfolio lags the market in the short-term whenever there is a false alarm because we spent time out of the market to avoid a crash, when in reality, it was just a false alarm.  Just remember, the key phrase here is “it lags the market in the short-term,” not the long term!

 

Recently, in Nov/Dec of 2018, we witnessed the 12th tornado siren in 25 years, we got out of the market, and at least so far, this one seems to have been a false alarm, which has forced us to buy-back into the market at higher prices, between February and April.  This is what we call “lost opportunity cost for the sake of safety and avoiding catastrophic losses.”

 

You can see in the chart below how the market experienced an unprecedented recovery off the December lows, headed to new all-time-highs at the beginning of May, and has since pulled back a bit.  It is absolutely crucial to understand that there is a difference between a tornado siren and a typical, common rain-storm.  Storms are inconvenient, they get us wet, mess up our hair, ruin weddings and parties, but they don’t typically kill people (or our retirement portfolios).

Right now, we’re currently in the midst of an ordinary, run-of-the-mill rain storm, when the market pulls-back to the tune of -5-10% or so.  It should also be shared that the market drops by -5% on average, roughly 3-times-per-year.  So, if you’re freaking out right now, it’s either because you’re either paying too close and frequent attention to the month-to-month fluctuations in your account value, or you’re allowing “Trade War” news to distract you from the long-term picture.

 

If I had a nickel for every piece of negative news that I’ve witnessed in my 18-year career – all of which warned of doom and gloom – and the vast majority of which were nothing more than useless noise.

 

If the market continues to decline to a point where the tornado sirens start to go off again (for the 13th time in 25 years, I might add), we will be getting out of the market, no questions asked, with the sole objective of avoiding a catastrophic, -40-60% loss in our clients’ investment portfolios.  If the siren ends up being a 2nd false-alarm in less-than a year, we’re okay with that because false-warnings and short-term underperformance is the cost of protecting our hard-earned savings.

 

I mentioned above that implementing our strategy the way we do is “worth it.”  Here is a simple back-test, very similar to the strategy we use, that shows how a $1MM investment portfolio would’ve performed going back 20 years (blue), as compared to ignoring all the tornado sirens (red).  All the times we would’ve been out of the market (due to these tornado sirens screaming at us) are highlighted in lime-green:

 

  • $1,000,000 would’ve grown to $2,508,390 in the tactical strategy, which is very similar to the one we use today.
  • This is compared to a “Buy & Hold” strategy, which grew to $1,686,751.
  • The deepest drawdown (loss) in the tactical strategy was -16.0% (in 2015-16).
  • The deepest drawdown (loss) in the Buy & Hold strategy was -57.8%.

So in summary, a tactical strategy that takes action and reacts to tornado sirens (even when they’re false alarms) produces far better long-term performance with less risk, less volatility, shorter time-to-breakeven, and shallower drawdowns than a “set-it-and-forget-it” approach to investing (i.e. – Buy & Hold).

 

Of course, in times like this (or worse, in times like 2015-16, when two tornado sirens that went off over the course of two years), it can be difficult for some to apply the necessary patience required to wait for sunny skies.  Patience truly is an advantage when it comes to success and retirement planning, and it can hurt investors in their pockets in more ways than one if they don’t practice it well.

 

You don’t watch your odometer with every mile that ticks by on a cross-country road trip, do you?  No!  You might watch the clock, or follow a map or GPS, checking in on where you are, how long you’ve traveled, and how much further you have to go from time to time.  You should treat your retirement planning and portfolio with the same level of patience.  And for those who think that this market isn’t “crying wolf,” only to get as many investors desensitized away from a potential crash, I’ll share one of my many, favorite quotes:

 

“Those who cannot remember the past are condemned to repeat it.”

~ George Santayanna

 

In conclusion, the stock market is going through the stormiest times its seen since 2015-16.  Before that, we have to look back eight years to 2011 to witness a similar, turbulent times.  Still, investors need to remain focused on the long-term trend, avoiding the short-term noise that aims to distract you from reaching all your retirement goals.

Till next time…

Adam

Categories: Adam Koos, CFP®, CMT®, Market Commentary

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