Refinements - 2021

Over the last several months, I have spoken with many subscribers about a few topics, including how they use the weekly publication and the recent practice of increasing Box #2 Cash.  This note summarizes the main points of these conversations and how the publications may change in response.  I hope to implement the changes before the next Plant season. Before discussing the refinements, I’d like to say that it is very helpful for me to hear your opinions of the portfolios; thank you.  My main objective is to make disciplined investing work for you.  The model portfolios and weekly publications are a means to that end.

A few main themes from subscribers and my comments:

·         Generally speaking, people are much more comfortable trading ETFs now than they were years ago.  When I first started over seven years ago, people wanted to trade just a few ETFs and were bothered when trades were clustered (meaning, for example, buying shares of UST one week and selling shares of UST the next).  I initially created model portfolios with one to four ETFs, and I intervened in the algorithms when I believed trades would soon be reversed.  Going forward, we will have portfolios with three to five or so ETFs, and I will not intervene to reduce clustered trades.  

·         Some people trade only a few of the ETFs in their selected portfolio.  In order to get the highest return with the lowest risk, one should trade all ETFs in the portfolio.  The only optional ETF is “SHY,” which has a cash-like return right now.  In a year or two, it may have a higher return, so I temporarily label it “optional holding,” and the corresponding amount of cash should be held as cash in your Schwab account. 

·         Some people have switched model portfolios a few times over the course of the last year.  Until the new refinements are fully implemented in a few weeks, the publications are not designed with switching in mind.  Especially in the early years of Focused 15 Investing, there was, by design, a wide range of portfolio structures in a single publication.  Some portfolios were aggressive.  Others were conservative.  Some rotated more aggressively. Others were stable. Some had more ETFs and some had fewer.  When I designed them, I thought it would be best to allow people to select the model portfolio right for them based on how many ETFs they wanted to trade, their risk tolerance, and how actively they wanted to rotate among the sleeves within the model portfolios.  Using the current and earlier portfolio lineups in the publications made switching based on recent performance problematic.  If one tried to improve returns by switching, one might switch TO a portfolio that has just finished its period of strong returns because of its structure.  Such switching is often too late.  To compound the losses, one could be switching FROM a portfolio that will soon begin its period of strong returns resulting because of its structure.  Going forward, all portfolios will have the same general structure and differ only in aggressiveness.  I’ll discuss this more in the future. 

·         People like the practice of increasing cash, which I discuss below.  Even those with long time horizons increased cash in 2021 and liked the practice. 

Box #2 Cash

The discipline of increasing cash is viewed favorably by virtually everyone.  As implemented over the last year or so, I suggested to people with short time horizons to increase the cash in their accounts when the MRI displayed what I consider a flash signal that has historically indicated a high risk of sharp but short declines that were difficult for the algorithms to respond to or navigate using our regular Friday trading schedule. These flashes occurred rarely, and one occurred just before the Covid crash in 2020. 

As luck would have it, in early 2021 there were several such flash signals.  However, NONE were followed by declines. By increasing the cash levels in response to these flash signals, our accounts had lower returns than the model portfolios we were following.  In 2021, the market moved higher consistently and any move out of the market hurt returns.  Very likely, the markets in 2021 were buoyed by various forms of pandemic stimulus, which probably made this practice unsuccessful. 

I discussed with subscribers the fact that increasing Box #2 Cash caused our accounts to underperform the model portfolio, yet most still liked the practice.  At the time of our conversations, they could recall the seemingly precarious nature of the markets at those times, and they liked my intervention. They also liked being able to take a psychological break.  I too have appreciated increasing cash levels during 2021.  I have slept better in 2021 than in 2020. 

Even so, I must be an advocate of getting the disciplines right and getting higher returns.  We need to have a better approach to making our accounts less aggressive in unusual situations. Increasing cash is a very blunt instrument. In most of the portfolios there are ETFs that should perform well during times of stress, such as UST and XLP, and increasing cash takes money away from these ETFs.  In addition, the amount by which to increase cash is subjective, which is a drawback.

Additional Option for Reducing Aggressiveness of Our Accounts

In the last few months, while researching forces that may drive the movement of the MRI, I identified additional signals that I believe will give us greater lead times in preparing for some vulnerable periods. While these signals are not currently strong enough to build into the algorithms themselves, they can be leveraged to implement an additional option for reducing the aggressiveness of our accounts, in addition to the current option of increasing cash levels. Both these options would be for those wishing to reduce risk of market declines (e.g., individuals with time horizons less than, say, 7 years).

Specifically, the new option is that I would instruct subscribers to switch to a model portfolio than the one they have selected for long-term use. This instruction could be gradual in the sense that I could suggest an addition switch later on to further reduce aggressiveness. My instruction would be informed by, among other things, the greater lead times in preparing for vulnerable periods (mentioned above). I expect that instructions to move to a less aggressive portfolio would be given within our regular Friday trading framework in most cases. This option is more methodical than the option of instructing subscribers to increase cash levels, which could occur at any time during the week,

The second option would be to give guidance to increase Box #2 Cash as we have done in 2021.  I would give this guidance in cases that require immediate action. 

We all must recognize that reducing aggressiveness may reduce our returns compared to staying with our selected portfolio.  But the mental health benefits of a switch may be worth that cost.  Again, those with long time horizons should generally avoid reducing the aggressiveness of their portfolios. 

On the surface, switching portfolios goes against the well-justified admonition to avoid switching portfolios that I espoused for many years. But the reality is that we need to manage our psychological health and be mentally ready to invest over the long periods ahead of us.  As investors, our risk tolerance does change over time especially we trade our own accounts.  The last few years have shown us the challenges of managing one’s own account. 

Current Period

Turning back to the projections of vulnerable periods that might not be navigated quickly enough by the algorithms, the present time is a key example of a period of projected vulnerability. While the MRI and computer models indicate that the market is still somewhat resilient, the projections have indicated that this time (early December of 2021) is likely to be the beginning of an especially vulnerable period – one that occurs every few years.  In similar conditions in the past, the algorithms responded but the response was a week or two late because the market had been especially strong just prior to the period.  The time from the projected beginning of the period of unusually high vulnerability to the actual strong stock market declines is from one to roughly seven weeks.  In addition, the higher the stock market valuations, the closer to the projected beginning of the period of vulnerability.  Both of these conditions appear to be present now. 

These conditions cause me to be concerned about stock market losses over the short term, despite believing that past government stimulus and future spending will strongly support economic growth and support stock prices.  Our philosophy is to respond to the changes in resilience/vulnerability and not factors such as government spending. We may find that the stimulus again overwhelms the market’s vulnerability and stock prices may stay level or even move higher. If the Fed follows through on promise to allow interest rates to increase, it will cause investors to be less tolerant of high stock valuations, high real estate prices, and high commodity prices.  Since investors’ lower tolerance for these could be coming during a time of higher natural vulnerability, I believe it is prudent to be less aggressiveness with our accounts. 

Because I could not test, introduce, and answer any questions shifting model portfolios to reduce aggressiveness, I increased cash levels and took other measures to reduce risk during this period.  I believe it will be the last time I use this process to the current extent. 

Switching Model Portfolios to Reduce Aggressiveness

Going forward, I will indicate when we are coming to a vulnerable period that might not be navigated effectively by the algorithms.  Those with short investment horizons, can downshift to a less aggressive model portfolio.  This way, we can stay invested in the portfolios but reduce risk as we approach what I expect to be vulnerable periods.  I will maintain the option of increasing Box #2 Cash for more extreme cases. 

By refining the practice of switching portfolios, we may find other options for using it.  After a major market correction, some may want to temporarily use a more aggressive model portfolio.  I will indicate those times as well.  If you want to reduce aggressiveness for purely personal reasons, the publication and shares-to-trade worksheets will be set up for you to easily use a different model portfolio and stay invested.

I’ll provide more information over coming weeks.