By Peter Mauthe
As part of a wealth-management firm, I often get the opportunity to talk to financial advisers who visit our home office. Just last week, one such visitor shared that he grew up with a passion for aviation and had become a pilot at an early age. This led to a discussion about the checklists pilots use to help manage the risks associated with flying. I was once told, and our guest confirmed, that pilot checklists are composed of items that would have prevented accidents in the past if they had been checked.
He went on to point out that pilot checklists don't change often because the engineered systems used by pilots haven't altered much over the years. Yes, they have been updated and are more sophisticated, but they are functionally similar.
Our rules-based, systematic approach to investing is similar to following a pilot's checklist. Each of the rules we have developed is there because following it would have helped manage portfolio risk or capture opportunity at some point in the past.
However, unlike the rarely changing systems pilots use, financial markets continually evolve through legislative action, technology advancements, or innovation of financial products. These changes influence the way investors behave and drive markets.
The world is always changing. What does that mean for your approach to risk?
In less than 50 years, we have deregulated commissions, allowed banks and brokerage firms to be affiliated, invented the internet, and introduced electronic trading. We have also created new financial instruments in the form of options, financial futures, and exchange-traded funds. And that is the short list.
This is another area where the checklists of pilots and rules-based portfolio managers differ. The pilot's checklist is designed to provide the status of systems that monitor the physics of flying. The portfolio manager's checklist (or rule set) is designed to drive prudent responses to market action that is propelled not by physics, but by investors and their emotion-driven behavior.
Investors respond rationally to economic, political, and market-related news and data most of the time. Likewise, the rules portfolio managers design to respond to such rational market behavior are effective at managing portfolio risk and opportunity most of the time.
Yet, unlike the laws of physics, which remain constant, human emotion and the resulting behavior can switch from rational to irrational with little notice. When such irrational investor behavior becomes the controlling power in the markets, rational rules may struggle to respond effectively. Fortunately, irrational investor behavior has historically been short-lived. Nonetheless, it is important to understand that it is often these periods of irrational investor behavior that drive sharp corrections (drawdowns) in markets and portfolios.
Without a rational approach, investors are vulnerable to "irrational" markets
It's easy to identify market corrections driven by irrational investor behavior. The declines are usually very sharp and very short-lived and likely to reverse just as sharply and quickly. Examples of such corrections are highlighted in the following graph.
These market events can happen in the stock, bond, or alternative markets. Whichever asset class the sharp decline originates in, the effects are generally felt in the other asset classes. Often one or both of the other asset classes move in the opposite direction of the asset class experiencing the sharp decline.
Unfortunately, these short-lived events often cause investors to want to change portfolio tactics and structure. My experience and history strongly support the approach that well-designed portfolios often quickly recover from such short-lived declines despite being set back by them.
The key to investing success is to adapt
The checklist of a rules-based portfolio manager is constantly adapting in response to these perpetually changing markets, economic globalization, and the evolution of risk-management techniques available.
Reputable rules-based portfolio managers continually learn from the behavior of their strategies in the ever-changing markets and use that knowledge to improve them. They use technology to test incremental improvements over time to make their rule sets more effective at managing risk and taking advantage of market opportunities. This is an integral part of the rules-based portfolio manager's responsibility to their financial adviser clients and their investor clients.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.