My ETF Portfolio: Chapter 3, Shoulda, Woulda, Coulda?

by: John Crossman

On Monday, as threatened in my previous post, I bought enough shares (I already had some) to get my ETF portfolio to 500 shares of EWH at 19.63, 370 shares of EPI at 26.76, and 130 shares of TUR at 74.87. I paid $7.95 a trade so at Monday closing prices shown in brackets, I was left with my three positions and $526.85 in cash. At the end of a dreary trading week, my portfolio is worth $29,365.55 for a 2.11% loss.

So how do I feel about losing 2% in the first week? That’s right, I said “feel”.

After all, this is my blog about My ETF Portfolio. And whether we want to admit it or not, emotions play a big role in investing at all levels. If you are in doubt: stop, look and listen. Analysts talk about their “high conviction ideas”. TV personalities narrate market action as if it were a prize fight. The internet is full of blogs and comments that border on the hysterical (both in the funny and frazzled senses of the word).

These investing related emotions flow freely from the ancient (in evolutionary terms) part of the brain referred to as the Limbic System. Everyone has this key piece of wetware and as a result, it is a very human emotion to look backwards, have regrets, worry and wonder what one could have done differently.

Well, the answer is that I am not overly concerned about this week’s paper loss because I have organized my investment process into a “System” which allows me to control and evaluate the process with no need for emotions.

How does that work in practice?

First, I am not a relative return guy. In these markets, I am not investing to lose less money than the next guy or some market index. Cash is always an option. If someone did better than me, I tip my hat. If someone did worse, I extend my condolences. However, I cannot spend or write off someone else’s losses or gains.

Second, I am not looking to avoid downside risk at all costs. When designing the “System”, we were meticulous about not adding the false bells and whistles that drain upside potential to give the false promise of protecting against any downside risk. Many of the quant funds I worked with tried to deliver on this promise of limited downside with good upside. In the maelstrom of 2007 - 2009, they ended up delivering neither.

Third and finally, nothing I have seen this last week suggests that there is a problem with either my strategy (buy the most promising 3 of 20 asset classes) or my tactics (rank weekly). The ETFs I invested in are still ranked at the top of the list. Nothing in the news over the last week altered the fundamental environment (are we really surprised that Ireland is suffering or that the Euro patch job from 6 months ago is starting to peel?). Emerging markets are still growing faster than developed markets. Thanks to vigorous FED and ECB bank support operations, money is still flooding into these emerging markets to stoke inflation in everything from vegetables to luxury apartments to equities. The System says that Hong Kong Equity ((NYSEARCA:EWH)) looks more promising than US Treasuries with maturities over 20 years (NYSEARCA:TLT). I am still OK with that assessment.

To sum up, neither the “System” nor I care about relative returns as we are in this to make money. I recognize that some weeks will be down (and that 2% does not signal a fatal flaw in the “System”). And, the Plan is working as expected and kicking out results that stand up to scrutiny.

Have I always been this calm about investing? No. And, to be fair, emotion was both fun and profitable when the markets generally headed ever skyward in the 80’s and 90’s (after all, you were bound to be right at some point in the near future). There was even some money to be made after 9/11 with a “damn the torpedoes or the terrorists win” type of attitude. Negative real interest rates helped too.

System readings for 11/19/2010But, even though the Global Financial Crisis showed us that we were entering an era of deleveraging that would fundamentally change the rules, old habits die hard. I still had to take one more shot in June 2009, the peak of the “sucker’s rally” that had started in March. Don’t you remember that peak? I do. That was when my gut told me “short” while the “System” told me to stay “long”. I have a nice short term capital loss in RYVNX on my June 2009 statement to remind me of that one.

The problem with Shoulda, Woulda, Coulda is that one will never know for certain what next week will bring in the financial markets. Unless you can figure out a way to make these emotional, regret seeking habits add to your investment performance, you are better off without them.

By all means use past performance to see if your strategy or your tactics are in need of adjustment. But have a framework that allows you to look dispassionately. And, if you determine that your Investment Plan is still serving you well, look forward.

Looking forward

The System is still recommending my three positions so there will be no trading in the portfolio this week for those of you following along at home. I will be saving my energy for the US Holiday shopping season. Black Friday will be the first datapoint. The only question is: have we pushed expectations low enough to be surprised when the recently departed US consumer turns out to be not so dead after all?

Disclosure: Long: EWH, TUR, EPI, DBA