Since Jack Handy is no more...
Let's say a fund has 100% upside capture and 100% downside capture. Let's say this fund reflects the "market". This is Fund A. Similarly Fund B captures 80% of upside and 80% of downside. Fund C captures 60% of upside and 60% of downside. Fund D captures 40% of upside and 40% of downside. Fund E captures 20% of upside and 20% of downside.
Let's say "market" goes up 100%, goes down 50%, again up 100% again down 50%, and once more up 100% and down 50%, year over year. 6 years have passed.
Let's start with $100,000 balance and observe how much money one is left with.
FundA: 100000, 200000, 100000, 200000, 100000, 200000, 100000
FundB: 100000, 180000, 108000, 194400, 116640, 209952, 125971.2
FundC: 100000, 160000, 112000, 179200, 125440, 200704, 140492.8
FundD: 100000, 140000, 112000, 156800, 125440, 175616, 1400492.8
FundE: 100000, 120000, 108000, 129600, 116640, 139968, 125971.2
Always possible I made mistakes in my calculations but I don't think so.
Observations:
1) With FundA one went nowhere = $100000 => 0% return
2) 60% allocation and 40% allocation yields the same results = $140492.8 => 40% return with much "Lower" risk.
3) 80% allocation and 20% allocation yields the same results = $125971.2 => 25% return with a little "Higher" risk. "Higher" here is implying the cost of investing "too much" = 80% as well as the cost of investing "too little" = 20%
4) At end of year 2, 4, 6, both the "Higher" risk guys were on par at $108000, $116640, $125971.2. This is suggesting a market cycle of 2 years every 2 years. (This is why I'm so proud of my ANALysis).
5) Similarly at end of year 2,4,6 both the "Lower" risk guys were on par at $112000, $125440, $140492.8. Again suggesting a market cycle of 2 years every 2 years. (At this point I have given myself the Nobel Prize for ANAL)
Now someone who is smarter than me please tell me WTF this means. It is like I invented the Rubik's cube but I don't know how to solve it! There has to be something to learn from this about investing. I am feeling utterly useless right now.
Comments
Aside from that it tells you if you could know what was going to happen in the future you could mathematically determine which fund would come out best. Even if you assume the market does nothing over 6 years and you assume previous capture ratios continue to be the same for those 6 years, the timing of market increases and declines matters. For instance, if you change your market assumptions to by -50% in year 1 and then 14.87% returns for the next 5 years, which gets you back to flat....
Fund A is worth $100,000
Fund B is worth $105,250
Fund C is worth $106,795
Fund D is worth $104,200 (all slightly rounded)
The market's flat in both your example and mine but the bigger volatility in your example comes out much better in all cases except A. If you change it to an example where the market goes up over those 6 years in total then different funds can win depending on what you assume.
I'm sure someone with be able to explain the math more eloquently than I can but I never figured out the Rubik's cube either.
A 100,000.00, 200,000.00, 50.00%, 50%, 100.00%
B 100,000.00, 180,000.00, 55.56%, 60%, 92.59%
C 100,000.00, 160,000.00, 62.50%, 70%, 89.29%
D 100,000.00, 140,000.00, 71.43%, 80%, 89.29%
E 100,000.00, 120,000.00, 83.33%, 90%, 92.59%
F 100,000.00, 110,000.00, 90.91%, 95%, 95.69%
Col. 3 is the breakeven % required to get back to the same beginning value in Col. 1 (Col. 1 / Col. 2).
Col. 4 is the actual % value left after applying the negative earnings %'s.
Col. 5 shows the diminished impact of Col. 4 vs. the breakeven % required in Col. 3 (Col. 3 / Col. 4).
Hope this helps.
You are being much too hard on yourself. Not fully understanding or being able to explain a market result is more the rule than the exception. We often invent an explanation that is more fantasy than fact that justifies some bad decision making.
In your sample exercise, you proposed an annual return history that has a huge standard deviation. Given an average annual return that proposed volatility works to degrade end wealth and annual compound return. The approximate equation that couples a more meaningful geometric compound return to annual average return and volatility is as follows:
Compound annual return equals average annual return minus the term standard deviation squared divided by 2, or in equation format: CAR = AAR - SD^2/2
The minus sign is obviously significant. Compound annual return always suffers an erosion from market volatility. Only active traders love volatility. An optimum portfolio is sensitive to both uncertain market returns and volatility. Change a portfolios volatility and end wealth will also change.
The equation is simple enough (although it is nonlinear), but investing is still not easy. There is no correlation between IQ and investment performance. The most informed economic and financial wizards are not necessarily the most successful investment folks. However, knowing the cumulative compound return dependency on average annual return and portfolio volatility might help just a tiny bit in the investing decision process.
I hope this helps a little.
Best Wishes
Cherry picking some of your data, let's create a portfolio that hold 2 distinct "capture profiles" (deep & shallow).
For "deep capture" or "market deep capture" (100% up/100% down), I would imagine these would be "index" funds since they reflect the market and capture 100% of what the market offers in both up and down markets.
For "shallower capture" an investor might hold a higher percentage of uncorrelated assets (such as bonds) along with some percentage (20% - 80%) equities. Together this allocation (Stocks/Bonds) change the capture profile.
Everyone in an index fund is happy as clams when the market is up and these investments are returning 100% of the market's upside (minus management costs). But what goes up must come down. Your spreadsheet show this pretty clearly. Also, your example seems to show that minimizing downside capture lets you keep some of your gains. Now what if a portfolio consisted of both deep capture and shallow capture investments.
What I am proposing, in addition to considering holding different upside/downside capture investments, is to hold both deep and shallow capture investments. This, I "deeply" believe might help hold onto gains and minimize losses. A reallocation strategy that, at specific time intervals (or percentage gain or loss intervals), shifts a portfolio to lower capture risk after gains (upside capture) as well as shift to higher risk after losses (downside capture) has presented itself.
So in your scenario, after a 100% capture moved your "Fund A" balance from $100K to $200K (let's call this a Nasdaq Index Fund...FNCMX) a reallocation rule might be that you reallocate the difference between this "Fund A" with a shallow capture fund (say VASIX... which is exposed to 20% of the equity market) or any other shallow capture fund that will help you hold onto your gains during downside capture periods. The reverse would be the case after "Fund A" experienced a deep downside capture event. You would reallocate from VASIX into FNCMX.
Your "deep thoughts' are welcome & appreciated.
The reason I chose 1 up year followed by 1 down year is because to me statistical outcome of two outcomes have 50% probability of coming true. Like a coin toss. Of course I pulled 100% up return and 50% down return from my a**. But it is not about the amount of return. It is about the exposure.
Let's try this differently. We have one Fund A which tracks the market. We have two people X & Y. X invests 100% of money in the fund. Y invests only 60% of his money. So what's different here is that Y's 40% in cash is getting the treasury return which has some marginal benefit, but let's not worry about that now.
So X's portfolio over 6 years once again stays at $100,000. But let me get really ANAL. His fund makes distributions, so he has to pay taxes while his cost basis is higher for future. Still his "return" at end of 6 years is now less than 0% because he paid taxes.
Now for how Y's portfolio does $60000 invested, $40000 in cash.
$120000 + $40000 for Year 1
$60000 + $40000 = $100000 for Year 2
And we can stop.
Person Z invests 40%, i.e. $40000 invested $60000 in cash
$80000 + $60000 for Year 1
$40000 + $60000 = $100000 for Year 2
Again, we can stop.
This prove's Ted's logic? Keeping some cash around does not help. But wait, it does if that cash is earning interest. At least to the extent interest on cash can help with the tax bill on the fund distributions.
I'm seriously wondering how market neutral funds work. If their exposure to market is nil, their return has to be on uninvested assets. Only way to get more return is to take risk on one side of the market, but the minute you do that you are not market neutral anymore.
In other words, Analysis is BS, and ANALysis is like going to Vegas. At least that's what I'm concluding. And I really want to go to Vegas where the odds are better than the stock market.
PS = For the record, I have solved Rubik cubes from 2x2x2 all the way to 7x7x7. I did it to get my younger interested in at least something in life besides Netflix. I started working on 8x8x8, but stopped when my then 13 year old beat me to it. One genius in the family is enough.
Contrary to your assessment, indeed I can predict a long term positive market return because that is exactly what the market has rewarded its investors historically. That's my assessment. Unless there is a drastic disruption in our economic and political worlds, the odds heavily favor a similar rewarding future outcome. Our population is expanding. Business is inventive with stable profits. We enjoy a positive GDP growth rate. Your dire projection is without supportive evidence for the long term.
You are ill advised to conclude that Las Vegas offers better odds than the stock market. By design, Las Vegas is a negative sum game for its players. Over a long timeframe, the stock market has proven to be a positive sum game for its players. These general outcomes will not change in the near future.
Market neutral funds don't have "nil" market exposure. They deploy numerous diverse strategies, but all these strategies involve market exposures in terms of holds, shorts and leverage. These aggressive strategies mostly address risk neutralization without significantly compromising expected returns. It's a tough, challenging market game that they play, but play they do.
The equation that I provided in my earlier post contains the answer to most of your questions and concerns.. As you reduce your equity exposure, interpret the average annual return (AAR) term as your projected market return which is commitment sensitive As AAR decreases, your portfolio volatility becomes a more dominant factor in your end wealth since compound annual return is reduced.
The equation is not magic. It reflects reality. Diversification with components having low correlation coefficients reduce portfolio volatility (standard deviation). This reduces one definition of risk. With patience and careful attention to distinctive historical class performance, this diversification construction can be accomplished without compromising projected returns too much.
"Optimism is the faith that leads to achievement. Nothing can be done without hope and confidence." That's a Helen Keller quote. Based on your comments, I suspect you have an evolving uncertainty about stock investing.
Please be careful, keep the faith and stay strong!
Best Wishes
I leave you with one of my favorite quotes.
Statistics is a like a bikini. What it reveals is interesting, but what it conceals is vital.
However, if you are hopeful US stock markets will not behave like Japan's, I'm good with that. After all hoping is what we do with every investment. No one dreams of an investment they made ending up in the toilet.