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The healing power of dynamic risk management Print PDF
The healing power of dynamic risk management

I’ve been dealing with knee problems for a couple of years now. That and a fall last week led me into the medical literature looking for options. Last week I read a blog post by Dr. Kevin Stone of the San Francisco–based Stone Clinic. The clinic is considered one of the pre-eminent knee clinics in the county. It is the first stop for many pro athletes dealing with knee injuries.

Dr. Stone pointed out that the days of advising patients to “go home and rest in bed” to heal everything from a cold to an injured knee are largely a thing of the past. Much as we have found in managing client accounts, Dr. Stone has learned through years of practice that passively managing one's recovery is outdated and largely ineffective.

He gave the following example:

When a football player’s knee joint is hit from the side, the medial collateral ligament can rupture. In the past, the knee was placed into a cast or a fixed splint and the ligament healed over a six-week time frame. But the physical properties and strength of the healed ligament were weak, leaving it—and the player—vulnerable to a repeat injury.

We have since learned that if motion is applied early in the healing process, the ligament heals with a more normal appearance.

In the financial arena, we have learned that a passive buy-and-hold managed portfolio can seem acceptable during a recovery with periodic rebalancing. However, most investors have learned to their sorrow that it is not effective in preparing one’s investments for a return to the normal ups and downs of the complete market cycle.

Not only does the resulting loss of dollars hurt the pocketbook but it permanently scars investors. They become fearful of investing in the next market cycle, being slow to return to investing in stocks. This is injurious to their long-term financial health, which is dependent on the appropriate use of equity investments.

Dr. Stone, too, addressed the issue of scarring. He pointed out that scar tissue is not only ugly but that it is detrimental to healing:

At first, the eruption of the tissue repair process creates a tangled mess of collagen fibers. While normal tissues are made of a mixture of small and large collagen fibers, this new tissue contains only small-diameter fibers and has the biomechanical and structural properties of scar tissue. Over time, the body can either remodel this scar tissue into normal tissue (as it does with bone) or form the familiar scar tissue we often see with healed skin. 

To prevent this, medical research has found that adding activity early in the recovery process is essential. Without activity, scar tissue results rather than truly healed tissue.

Notice in the quote from Dr. Stone at the beginning of this article that his findings relate to activity in the early stages of the healing process. It is not enough to add it later in the process.

In finance, we know the need for early action. That’s why most of our clients have gone to professional financial advisors for advice on their portfolios long before, or early in, retirement.

Their financial advisors, in turn, know the value of creating a financial plan. They prepare portfolios that can take advantage of the recovery process from financial crises like those seen in 2000–2002 and 2007–2008.

These astute advisors also know that you must have a plan for when the recovery ends or the unpredictable happens. They’ve learned that such events can leave their clients vulnerable to portfolio losses. These can easily be on the scale of the 50%-plus losses in the financial disasters of the first decade of this century.

In medicine, Dr. Stone recommends activity to prevent further injury, but what kind of activity?

The motion has to be enough to provide stress, but not so much that it disrupts the healing fibers. This motion stimulates the repair cells to produce fibers that are oriented along the lines of stress. The motion-aligned fibers also have a more normal distribution of large and small diameters, rather than the tangled variety of fibers formed when the knee is placed in a cast.

Similarly, the activity used to prepare a portfolio for a black-swan crisis is not just any kind of motion. Studies show that activity generated by investors acting on their own has been injurious. In a contradictory manner, they can procrastinate and act too quickly. They respond to emotion and news events.

The activity spurred by these actions has proven harmful. Yearly studies demonstrate this. Investors managing their own accounts fall substantially behind even the passive indexes.

As Dr. Stone concludes: “But how do you know exactly how much motion is enough and not too much? As physicians and physical therapists, we make educated guesses. We know impact exercises are often too much, and cycling is often just right.”

In the case of risk-management firms such as Flexible Plan Investments, Ltd., we use proprietary research spanning decades to create strategies and portfolios that are responsive to past market environments, including the major financial crises. In fact, we’ve created a Crash Test report for portfolios of our strategies to illustrate this. It’s now available to our advisors and, through them, to their clients. Advisors can find it by logging in to FlexiblePlan.com and choosing “Crash Test Analyzer” under “New Accounts.”

Just as medicine seeks to use activity to speed recovery, all of our strategies use an active approach. They are designed to use activity to provide another layer of risk management that passive portfolios just cannot deliver. In addition, by combining these strategies or simply adding them to a passive portfolio, the resulting diversification can far exceed the preventative care attainable by a portfolio diversified only by asset classes.

As the doctor says, passive treatment in recovery is outmoded, just as dynamic risk management and strategic diversification are today’s preventative prescription of choice for the unpredictable time when the present recovery ends.

Market update

While stocks hit an all-time high early in the week, most of the major stock market indexes finished the week marginally lower (the NASDAQ  was the exception). Furthermore, contrary to the trend since the election (in which stocks have registered double-digit gains, and bonds and commodities have moved lower), bonds and most commodities gained in value during the last five trading days.

In terms of the big picture, the stock market rally that has progressed since March 9, 2009, has been impressive. The rally in the S&P 500 is the second-longest lasting rally (without a 20% correction) since the start of the Index in 1928, and it is the third-best percentage advance—soaring 254.70%!

The new highs in the S&P 500 have generally been matched by new highs in the other indexes as well—and by most of the measures of market breadth. While advance/decline indicators failed to confirm the new high, net new highs and the stocks above their 50-day moving average all set new highs in tune with the Index.

These are all good technical signs of a healthy market that wants to go higher. Better yet, it is clear from the following chart that stocks are nowhere near overbought conditions.

All of our intermediate-term, market-timing-type strategies continue to be fully invested. Some even continue to employ leverage, which has blown out returns as the market has continued higher. Self-adjusting Trend Following and Volatility Adjusted NASDAQ, for example, which suffered mightily last year, have gained more than 30% for the year (after max fees of 2.6%).

In terms of investor sentiment, a correction in accord with the numbers is possible. The Irrational Exuberance Indicator created by Bespoke Investment Group shows that it, too, is at all-time highs, and that is worrisome.

Economic reports were few and far between last week. Retail sales were mixed: April figures were below expectations, but the March numbers were restated as higher than previously reported. At the same time, the report on unemployment claims fell to the lowest level since 2003.

Earnings reports ended up beating expectations by more than 60%, but that was lower than the last three quarters. Still, the revenue numbers continued to surpass expectations, with the highest beat rate since 2013.

So, as usual, the indicators were mixed, with the edge going to a continuation of the rally in the short term. This is consistent with our tactical strategy positioning.

As previously discussed, our dynamic risk-managed strategies are designed to help prevent the losses experienced by both the passive indexes and the underperformance of the active investors in a full market cycle. That means it’s time to listen to the doctor and protect your portfolio with strategies designed to protect you when this amazing recovery ends.

All the best,

Jerry, the “JD”



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Disclosures

To our In My Opinion readers:
Everything in the newsletter pertains to strategies available on our Strategic Solutions platform at Trust Company of America. The same strategies are implemented on many other products: mutual funds, variable annuity, variable life and retirement platforms. Therefore, we expect the strategic discussion may be of interest to you. Note, however, that since these products have their own subaccount and fund universes and different internal expenses, the results and trading of the same strategy on other platforms may differ substantially from those described herein.

In My Opinion: Managed Retirement Plan Participants:
Most of you are managed using Lifetime Evolution and our sub-advised funds, so those topics will be most applicable to your account. But, more and more of you are in plans using Market Leaders. If so, that newsletter section may interest you