Jazzi Young

I (Colin) haven't posted my Technical Analysis for a few weeks because this is the phase of the market where trend traders like myself tend to sit quietly on the sidelines. It's not a profit-friendly market for this style of trading. It's more of a range-bound, swing trader's market where oscillators work best. That's outside my circle of competence. Those who trade for a living usually master several different trading styles so they've got coverage across different market conditions (trending non-volatile, trending volatile, non-trending volatile etc). They might also trade different markets, so if stocks aren't trending, they can move to commodity futures or some other market that is trending. That's how they try to maintain a steady flow of income, they need a steady flow of trading opportunities. In contrast, our household relies on a diversified flow of stable dividend income to pay the bills. Trading income is only a discretionary bonus. I try to pick the low-hanging fruit at my favoured orchard when it's "in season". When that orchard is out of season, I don't go looking at other orchards that happen to be "in season" because they grow different fruit. The consequence of this approach is my trading operations can sit dormant for very long periods of time.

The S&P 500 index has been very choppy of late, oscillating above and below a flattish 200-Day moving average. This seems to be the short-term battleground level as the bulls and bears continue to duke it out, blow for blow. It's been a fairly epic tussle of late with neither side really getting the upper hand. As a long-only investor (and long-only trader), I feel the 3,800 level is absolutely vital to defend. If we breach that level and don't resurface quickly, we could easily head down to retest those lows at the 3,500 level. That would be sad.

The market definitely has a bearish tone with only 37% of stocks trading above their 200-Day moving average.

It's quite impressive how well the market has held up so far given all the hits that it's been taking. It's withstood so many hits, Rocky Balboa would be proud. I imagine few had "Bank Failures" written on their Bingo cards at the start of the year. Most narratives coming out of the institutions at the end of last year were all about anticipating a recession in 2023, continuing inflationary pressures, a hawkish Fed and declining corporate earnings.

As a Gen-Xer, the best advice I can pass on at the moment is the immortal words of Sergeant Phil Esterhaus:

Just a quick addendum to my previous post urging retail investors to favour simpler investment strategies over complex. Our complexity bias is our tendency to overcomplicate things because we believe that advanced solutions yield better results. Quite often, a simpler solution will yield the same result, if not better.

In my original lengthy post, I omitted a reference to an excellent piece of research about our tendency to add, rather than subtract. Cognitive research that utilises Lego is always going to get my full attention.

"When people want to improve something, they tend to only think about what they can add, not consider what they might take away. My collaborators and I have a series of observational studies showing that subtractive changes are psychologically inaccessible unless we prompt or cue or remind people to think about subtraction as an option."

Professor Gabrielle Adams

University of Virginia

The elegance of subtraction applies to many areas of our lives. Train your brain to think subtraction first, before you look to add.

When you look for opportunities to improve your investing process, ask yourself if there are unnecessary steps you can remove.

For example, do you have redundant metrics in your financial statement analysis spreadsheet? Are you using multiple liquidity and solvency ratios that pretty much tell you the same thing? Are you piling on the indicators in your stock charts that only serve to dilute your focus?

Maybe you've even included some steps that are a net negative. Is reading other people's opinion about a stock on Seeking Alpha or Twitter muddying up your own decision-making process? You want to make sure to cover any blind spots, but at the same time you might want to ease up on going down those social media rabbit holes.

When we stay conscious about our natural inclination to just add, we become more focused on streamlining. This is one luxury we have as retail investors over our institutional counterparts. Institutional investors are expected to have all their bases covered. They're expected to turn over all the stones in a rigid, comprehensive, in-depth analysis process. Anyone who has invested in the stock market for a reasonable length of time knows that returns aren't a linear function of effort expended. Past a certain level of due diligence, diminishing marginal returns really start to kick in. This is because of the uncertain nature of predictive fields like investing and trading. Piling on more and more input variables doesn't necessarily equate to better predictions. A light, well designed, streamlined process can produce just as good a result as a lengthy, detailed, exhaustive one. Lucky for us, a light, streamlined strategy is very accessible to the retail investor, but probably frowned upon in the institutional world. It might even be one of our edges.

I recently caught up with a fellow retail investor who I mentored many years ago. After a cursory catch up on each other’s lives, the conversation inevitably drifted to investing, a passion for both of us. My friend has always been the more "adventurous" investor (he's say "entrepreneurial"). Dollar cost averaging into a market index fund was never going to cut it for him. His investing journey involved futures and derivatives trading, contract for difference trading (CFD), forex trading, crypto trading and various other complex strategies that just make my head spin. He didn't do this all at once, he just transitioned from one strategy and trading instrument to another. I used to jokingly say to him: "if it moves, you'll trade it". I might be a little unkind for saying this, but he threw everything at the wall to see what would stick. That’s what goes through my mind whenever I speak to him. I was happy when he told me he's now restricting himself to just buying stocks on the US exchange and trading CFDs on the Australian exchange. We had a very entertaining time talking about his long circuitous journey before eventually landing back on a simpler path to building wealth.

For every investor starting out their investing journey, there’ll usually be a period of experimentation. You won’t know what you’re good at unless you try. There’s nothing wrong with this approach provided you manage your risk appropriately. I felt it’s important to remind my fellow retail investors: simple is usually best when it comes to investing. And this is not always intuitive. We harbour a complexity bias which has us believing that complex strategies can result in better investment performance. But among retail investors, that’s more the exception rather than the rule. An important principle is to know your limitations. Ego isn’t important, making profits is.

It’s easy to become enticed to add more and more input variables and steps into your investing process on the assumption that it will lead to better results. You read about institutional investors using proprietary indicators, beta neutral long-short strategies, arbitraging and a whole host of other buzzwords that sound impressive. But you have to remember that institutional investors are being paid to run complex quaint strategies. Their selling point is packaging up this complexity and selling it to the retail investor as a product solution. They know these strategies are largely beyond our resources and understanding. But just because an investment strategy is complex, it doesn’t mean you'll get a better long-term outcome. You only have to glance at the S&P SPIVA Scorecard for proof of this. While some quaint managers can perform very well over the long-term, we just don’t know in advance which ones will. Top performing funds shift positions quite substantially from year to year because reversion to mean comes into play.

A well-known example of our complexity bias has been highlighted by a study on how a baseball outfielder catches a fly ball. Scientists and mathematicians use complex formulas to explain the trajectory of a ball that’s been thrown or hit high in the air. In his book The Selfish Gene, scientist Richard Dawkins describes how we "supposedly" catch a ball:

Here is the mathematical formula that our brain might be solving at the subconscious level.

Got it? Good.

If that’s what our brain is doing, fantastic ! But that doesn’t explain why I’ve never been good at solving differential equations at any point in my life, but I was very adept at catching fly balls when I was young. It turns out that our subconscious brain is not solving differential equations, it’s doing something much simpler. Gerd Gigerenzer, a director at the Max Planck Institute for Human Development, describes what our brain really does:

Glorious !

Our brain employs a simple, but elegant shortcut to solve a complex mathematical problem. This shortcut is called the Gaze Heuristic. Gerd Gigerenzer is an advocate of simplicity and describes the general principle as follows:

Simplicity: Complex problems do not require complex solutions

Less Is More: More information, time and computation is not always better

We can apply this type of thinking in investing. At its core, investing is a very simple process. There are simple techniques to invest in the stock market that will make you very wealthy over the long-term. You don’t need complex formulas backed up by a bevy of micro and macro-economic theorems. Investment legend Warren Buffett recommends the following simple strategy for most retail investors:

In only 3 sentences, Warren Buffett outlines one of the most effective long-term investment strategies that is both simple and historically proven. It’s certainly not a get rich quick (GRQ) scheme. It's a sensible long-term strategy that everyone can follow. You can add more sophistication to this baseline strategy by adding your own individual stock picks or even allocating a smaller amount of capital to trade. Some investors prefer to construct a portfolio of individual stocks. This is perfectly fine as long as there’s sufficient diversification. You just have to realise as you add more and more complexity, you can quickly hit the ceiling of diminishing marginal returns.

Ben Carlson’s seminal book "A Wealth of Common Sense" dispels the myth of complexity:

He goes on to say:

The remainder of his book goes on to explain why a basket of low-fee index funds is the way to go.

The myth of complexity has probably been perpetuated by the outdated investment management industry of old. Obfuscation (deliberately making things hard to understand) has been used to justify fees and keep clients locked into their services. Technology has since ushered in a wide range of simpler, cost-effective investment products that serve the mainstream investor extremely well.

I have a rule of thumb that rings true more often than not: The longer it takes a product salesperson to explain the fund's investment approach, the worse off the investor is likely to be. Complex products tend to come with higher fees, benefiting only the institution selling the product. Beware of people peddling needless complexity to an unsuspecting investor.

Here’s the paradox of the situation: the more complex the investment approach, the more enticing it will sound to the unsuspecting investor. In the final outcome, that investor will most likely be worse off.

Why Choose Simplicity?

A simple and understandable investing strategy leads to better outcomes because:

Successful investors have figured out that keeping things simple is the best path to success. They understand the nuts and bolts of how the markets work and find a way to break down the process of investing into simple, easy-to-follow rules.

Harry Markowitz has always been the source of my favourite anecdote about simplicity. Harry pioneered the concept of diversification, winning the Nobel Prize for Economic Sciences. His mathematical models can be used to determine the optimal mix of stocks, bonds and cash to maximise return for a given level of risk. Harry mathematically proved that you could improve your returns while reducing your risk (volatility) by spreading your investments across different asset classes. This works because different asset classes often move in different cycles (but not all the time as we’ve experienced first hand recently).

When asked in the 1950s how Harry invests his money, his answer was a little surprising:

Here the full quote for better context:

Harry doesn’t just provide a commentary on complexity, he’s also highlights the gap between academic theory and practice. Harry is taking into account the human aspect of investing: regret. He also touches on behavioural economics here, and realises the best investment strategy is not going to be the one that mathematically optimises return, it’s going to be the one that best fits your personality type.

Takeways:

Thank you for reading. I really had to get this one off my chest.

PS: There is of course another option to simplify your process if you like buying individual stocks:

You could outsource your stock research to friends of the platform @stockopine and let them do all the heavy lifting.

I seriously get no kickbacks from this (wouldn't have it any other way) and I don't know them personally, I'm just a fan of their work.

Comments from a hawkish Fed Chair Jerome Powell about increasing interest rates faster and higher-for-longer have knee-capped markets this week. This bearish tone was intensified by Friday's Silicon Valley Bank shut down by the regulators. I even spotted the word "contagion" being suggested in the headlines. I haven't heard that word said about the markets in a long while.

The S&P 500 index suffered a series of strong downward moves this week to close below the all important 200-Day SMA:

It was a tough week at the office. This bearish tone was felt across the board with a large drop in the percentage of stocks trading above their 200-Day SMA. A value below 50% is not good. We're trending the wrong way.

We can sum this up by saying the fun police crashed the disco, turned the volume down, turned off the mirrorball, shuttered the cocktail bar, and now the DJ has resorted to playing sad ballads. There's an atmosphere of melancholy among the party goers and there's no telling how long this gloom will last.

By now, everyone should be realising chart technicals have limited predictive reliability in a choppy, macro-news driven market. At the best of times, chart technicals just conform what you already know. In this case, there's been a short-term reversal and the short-term trend is now bearish. We plunged below the much-observed 200-Day SMA and the next important level to watch is 3,800. If we drop below that level and the news continues to be gloomy, we could make a run for the October 2022 lows. But this is far from certain because it's a choppy battleground market and bulls and bears are still duking it out. The short-term downtrend could reverse just as quickly if we happen upon better than expected news. Every prediction of market direction and future market levels is really just speculation. There might be ample data to support the prediction, but you can always find just as much data supporting the contrary view. This is why market forecasting is so hard.

Long-term investors know this is all part of the deal. We have to endure the volatility, stay resolute with our process and not succumb to the day-to-day headline risk:

I've always loved the word "smoked". Sums up my thoughts when I log into my brokerage account and look at a sea of red.

The recommendation for long-term investors is, and always will be, stick to your investment rules. You will get rewarded for consistency of behaviour, later. Sometimes it's a lot later.

As a long-tenured investor stumbling closer to the age of 60, I feel duty-bound to inform the younger investor what might lies ahead in the far-off horizon. Think of this as a preview of things to come. I hope a lot of investors under the age of 35 read this essay, then there’ll be no surprises when you find this out for yourself. You can embrace and plan for it. It might even influence some of the longer term decisions you make today.

It’s fortunate that our skills in the field of investing and trading can be sustained for multiple decades. We don’t suffer the short "peak life" that track and field athletes typically experience for example. They peak around the age of 25 to 28, and then face a pretty daunting drop off. Despite the long "shelf life" of an investor, there eventually comes a time when the fastball analogy comes into play. We have to accept that as we age, our cognitive skills start to deteriorate. We also begin to lose touch with the dynamics of the stock market because we become "generationally separated" from the emerging industries driving the economy. I struggle to grasp the full ramifications that machine learning, AI and collaborative robots will have on business. I have zero interest in the metaverse. I’m no longer in the workplace to experience those shifts first hand. Once you retire from the workplace, your social circles begin to contract and it becomes challenging to keep abreast of new technologies. We're too busy curating our suburban lawn so we can yell "get off my lawn" at the neighbourhood kids.

According to research published by Professor David Liabson of Harvard University, there are 2 categories of intelligence:

Crystallised Intelligence: This is our ability to solve familiar problems because of our accumulated knowledge and life experience. We become better investors with more experience and wisdom.

Fluid Intelligence: This is our ability to confront and solve novel problems. Fluid intelligence helps us learn new things, grasp complex concepts and engage in abstract thinking.

Crystallised and fluid intelligence are countervailing trends. Cognitive research has found:

Aging is a difficult reality to face. We first see the adverse effects of aging in our grandparents, then our parents. It’s easy to push the inevitability of our own aging into the dark recesses of our mind and dismiss it as a far away problem. But most of us are committed long-term investors. We've conditioned ourselves to think long-term and unfortunately, this means we should also think about our mental fragility as we age. The rate of cognitive decline will be different for everybody, but like taxes, there’s no avoiding it. There’s truth to the cliché "failing to plan is planning to fail".

The following graph plots the growth and subsequent decline of our cognitive function:

This is a sombre research finding, but not surprising.

"What you have to do is come to terms with the reality of this kind of data and recognise that you just can’t count on cognitive functioning to be at a high level over your entire life"

Professor David Laibson

When you’re a young high achiever, it’s easy to sustain long periods of intense focus. Learning new skills, thinking on your feet, synthesising new ideas and juggling multiple tasks comes naturally. You can juggle the demands of your day job and also trade off a fair portion of your leisure time to focus on building your wealth. Your natural competitive instinct kicks in and you choose to construct a portfolio of individual stocks to outperform the market index. Market averages just won’t cut it, you know you’re better than average. You commit your time, effort and intense focus to uncover those potential 100-bagger stocks just waiting to be discovered.

Peter Lynch

As you head into your thirties, your passion for the stock market never wanes. But life comes at you fast and you get married, save for your first house, have kids and think about their futures. Decades start to pass quickly and then you start to notice a few things. It’s subtle at the beginning and you might laugh it off. But the signs become more frequent.

Professor Arthur Brooks

Harvard Business School

Cognitive load starts to take its toll. The graph of our decline in fluid intelligence is only an average. Even so, mild cognitive decline doesn’t impair your day-to-day functioning, you just start noticing you don't think as fast and as well as you used to. Warren Buffett and Charlie Munger are both in their 90s and are still very lucid and competent in the affairs of investing. But they might be the outliers. It’s dangerous to assume you’ll be at the same level as them at that age and fail to prepare for your own eventual drop-off in cognitive skill.

Our acumen as stock investors remains intact longer if we practice continuous learning. But I can confirm that learning new things becomes downright difficult as you get older.

Professor Arthur Brooks

Harvard Business School

Your greater crystallised intelligence is the resource that helps you become much better at fusing and combining ideas. It’s harder for you to come up with new ideas, but you can draw upon your vast library of wisdom to better apply the concepts you already know. You become better suited to teaching, mentoring and occupations that rely on "soft skills". It’s just unfortunate that fundamental stock analysis draws more on your fluid intelligence.

I’ve personally found it difficult to sustain my own focus crunching the numbers and conducting the same level of in-depth due diligence that I used to for individual stocks. I’m gradually finding my process of stock ideation, prospecting, evaluation, selection and monitoring is becoming too onerous. My battery of cognitive energy is like an aging iPhone battery: quick to discharge and slow to recharge. There’s no such thing as a rapid charger at my age. If I take a nap, I come back at half capacity. A full nights sleep is needed for a full recharge.

I’m also afflicted by the willingness aspect. Quite frankly, I just can’t be bothered anymore. I might be combing through the balance sheet of a stock and then suddenly something on the TV captures my attention. Then I’ll want to look up something on the internet. A few hours later, it's bedtime and I haven't done my due diligence. This procrastination might be linked to my struggles with declining fluid intelligence, but now that I’m retired, I want to spend my available cognitive energy on new pursuits like studying architecture, art and design. These are subjects I never appreciated when I was younger, but now I find myself very intrigued to learn about them. I have the luxury of taking my time and working at my own pace. If I misunderstand or don’t get the concepts, it’s not going to be a costly mistake that risks my livelihood like buying bad stocks.

This has profoundly changed the way I invest. Whenever I sell out of an individual stock because I it’s slipped into secular decline, I no longer replace it with a new stock. Instead, I invest the proceeds back into my core market index and smart-β funds. From the 30 individual stocks I owned when I first retired at age 50, I’m now down to 15 (7 years later). That’s still a lot, but I expect it’ll be whittled down further.

One of my previous posts talked about how conditioned volatility composure allowed us to transition to early retirement with a portfolio comprising 90% stocks and 10% cash. This stock portfolio is now predominantly ETF-centric. If I’ve chosen well, they’ll require minimal attention, freeing up my time to spendo n other pursuits … including time to watch Netflix, read books and sitting in quiet cafes drinking coffee while watching other people hurriedly trying get to work on time. Of course I’ll still be reading about the markets and checking my portfolio every day. I’ll also jump on any opportunistic trades I see, provided all my entry-rules are satisfied. I haven’t found trading based on technicals to be cognitively draining at all.

Dr Carolyn McClanahan

Co-founder of wHealthcare Planning

If I use a timeline to track our exposure to individual stocks, we seem to be going full circle:

We started off fully invested in mutual funds in the late 80s. As our knowledge about stock investing grew, we sold our underperforming mutual funds and blazed into a portfolio of individual stocks. When our portfolio inevitably started to lag market returns, we scaled up our allocation to market index and smart-β ETFs.

Today, our allocation to individual stocks is dwarfed by our ETFs. We’ll eventually end up exclusively invested in market index and smart-β ETFs. It’s a reflection of the circle of life. You enter this world wearing nappies, you leave wearing nappies.

Everyone experiences aging differently. How you adapt your strategy to deal with it will be your own preference. Just realise you won’t be the same person in your 50s that you were in your 20s and 30s. A decline in fluid intelligence might just be the trigger that changes the way you invest. The other trigger might be a reluctance to continue doing the same level of due diligence you did in your younger years. Your investing behaviour will evolve with your life stage. Here are some ideas to ease that transition:

You owe it to yourself to think about your "way-out-there" future in your strategic life planning.

Wow, what a day !

It was such a key battlefield day because the 200-Day simple moving average was at stake today. This is such an important level for market technicians because almost everybody keeps tabs on this particular moving average. It's the most recognised long-term trend indicator: fund managers refer to it, academic papers have been written about it, and investment decisions are made based on whether we are above or below it.

Today, we kept our head above water. The market has been looking a bit sick all week until we got to the point where we were seriously challenging this key level. Yesterday we bounced off it. Today, the bears had another run at it from the get-go during the opening trading session.

We closed the day at the 50-Day SMA, which another level commonly watched by market technicians. It's less important than the 200-Day SMA, but a good indicator of short-to-medium term trend.

If we drill into the intraday chart, we can see how the market gapped at the open to dip below the all important 200-Day SMA. This didn't last long as the index recovered to keep its head above water, but bounced around to retest that level.

After a few hours of indecision, we finally got some strength in the afternoon to drive the index higher. At the time of posting this, it's too early to get volume figures for the S&P 500 index from my broking platform, but I'm assuming buyers stepped in on hopefully greater volume to push the index higher. If there isn't an uptick in volume, it usually means it's the sellers who began to exhaust first. There's a couple of strong green candles in the afternoon.

Today ended up being a good day for the longs. The unfortunate thing is we're in a choppy, battlefield market and any trend follow through has been weak of late. There's relief we closed above the 200-Day SMA, but tomorrow is a brand new day. The market has not been very accommodative to trend traders.

This updated chart shows the depth and duration of our current bear market compared to the previous 4 bear markets using the S&P 500 index.

I'm using the conventional definition of a bear market as a drop of at least 20% from peak to trough. Bear markets aren't over until we recover to the previous peak.

All we can really conclude is it could be a lot worse. To date, it's been a shallow decline and still fairly short in duration.

Notice how the recoveries (except for the 2020 pandemic) have been long affairs.

Strap in. It might get better, it might get worse, but your job as a long-term investor is to stay the course and stick to your plan.

In the midst of every bear market, financial publications seem to roll out these types of articles like clockwork. Here are the key fragments from the article:

If you're a retail investor, reading these types of articles quickly gets old because it's simply NOT HOW INVESTING LIFE IS LIVED.

Few receive a massive lump sum of money, have the misfortune of investing all of it at the very peak of the market ... and then have no money to invest after that.

The vast majority of us have jobs, diligently spend less than we earn, and invest the savings.

This means we invest over time. Sometimes we happen to invest at the peak of the market, sometimes at the trough.

One of the conclusions of the article is "the long term doesn’t always work out". The long-term is sure as hell more likely to work out better for us than the short-term. The short-term is a crap-shoot because we're battling market noise and volatility. The long-term nullifies that.

Here's another statement intended to be a gotcha: "Far from being unique, the Nasdaq’s disappointing return over the past 23 years serves as a powerful reminder that the stock market doesn’t always go up". The only thing a retail investor should conclude from this statement is they had better get busy dollar cost averaging. You'll make good profits on the money you happen to invest at the trough of the cycle.

This might seem like a rage against author Mark Hulbert, but that's not my intention. We've heard Mark speak at the AAII Conference. His talk was excellent and he has a lot of good wisdom to impart. But every once in a while, he rolls out articles like this which aren't constructive at all to a retail investor.

It's a hit piece that presents a surface-level problem, and then fails to offer any solution or mitigating strategy.

Investors who read articles like this and find themselves hesitant to invest should heed the advice from legendary investor Peter Lynch:

"Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves"

If you're a wage and salary earner with a desire to achieve financial freedom, your best bet is to get busy investing.

Article source: https://www.barrons.com/articles/dot-com-bubble-nasdaq-performance-inflation-aa8caaf5?siteid=yhoof2

It's been another challenging week with the S&P 500 index down 2.6% for the week. We fell below the psychological 4,000 level as the macro numbers continue to show inflation remains persistently high. This market is in true "fight the Fed" mode. The last time I remember this term being used prominently in the headlines was when I first started investing back in the late 80s.

Looking at the chart, we unfortunately we blew below the 50-Day SMA. The index bounced off the all important 200-Day SMA which mew looks to be the key battlefield level. Drop below this level and all bets are off. We're clearly in a short-term down leg, but from a technical analysis perspective it's still too early to conclude we're heading back to test our 3,500 bear market lows. If the macro hits keep coming and we do end up dropping below the 200-Day SMA, the next key level to watch will be 3,800.

The only good news today is we bounced off the 200-Day SMA support level during the late morning. The daily candle's long shadow/tail shows buyers were willing to come in and stem the selling pressure. However, this is a choppy market and every day is a new day with a new narrative. Most trend traders don't try to predict direction when the markets are this choppy. They'll wait to see if there's a convincing breach below the 200-Day SMA, or conversely, a recovery to higher levels before placing small directional bets to test their hypothesis. Few experienced trend traders make big bets when the market teeters directionally like this.

Now is the time to be patient. If you're a directional trader, wait to see what transpires. These aren't fun times, but they're the best times to gain market experience.

Successful long-term investors don’t allow their emotions to coerce them into impulsive actions that can sabotage years of good work. Our natural fight or flight response doesn’t serve us well in the financial markets and this instinct can be difficult to neutralise. It causes us to double-down on losing positions that we really should’ve cut long before our losses started to mount. Denial, the need to be right, loss aversion, stubbornness, inflexibility … these all work against us. If we allow our emotions and instincts to govern our investor behaviour without restraint, we’ll end up impulsively buying high and selling low.

By learning to separate the immediacy of your emotions from your investment actions, you can enter a zen-like state about the markets. You’ll strengthen your "emotional detachment muscle", and this enables you to stay calm and composed during times of market turbulence (volatility composure). My previous post outlined how you can use a rule-based investment process to inject latency between your emotional self and your subsequent actions. You don’t deny your emotions, you just use them to tell you whether you need to refine your investment process that regulates your future actions. This is how you avoid knee-jerk reactions you might regret later when a cooler head prevails.

This might not be the only way, but it’s is the fastest and most effective way I know how to keep emotions in check and not let them sabotage your investment journey. Over time, the market will prune out investors who can’t control their skittish and impulsive tendencies. It will also prune out investors whose confidence surpasses their competence. You want to make sure that it’s not you who’s been cut from the game.

It’s fair to say without a rules-based process, your "emotional detachment muscle" will eventually become strengthened over a long period of time through sheer grit and tenure. But this only works if you can survive long enough and not cut and run when things get dicey. We discussed in my earlier post how the most common advice to avoid skittish behaviour is to stop looking at your portfolio too often. I’ve always been a fan of Charlie Munger’s philosophy of "invert, always invert". Hear me out on this mental exercise. What if we took that common advice of "check your portfolio infrequently" and did the exact opposite: "check your portfolio balance every day". If a beginner investor made this a habit, would it invite investor ruin?

Every day the beginner investor would observe how the daily ebb and flow of the market causes an oscillating rise and fall of their portfolio balance. They would experience the pleasure of seeing their daily balance grow, and the pain of giving those gains back to the market on a regular basis. Assuming their portfolio moves in the same direction as the general market (and most will), there’s a 46% chance the beginner investor will experience a negative return for the day and a 54% chance of a positive return. This experience would be repeated each and every day. They’d quickly become conditioned to the daily ebbs and flows of the market and eventually treat it as just noise. This is exposure therapy at work and the investor would become immune to normal market volatility. It would only be the larger market moves like days when the market moves 1% or more that would capture their attention.

The longer we remain invested in the market, the more corrections and bear markets we experience. Even during the years when the market closes higher, there will always be an intra-year drawdown at some point and these can be non-trivial. The following chart uses the S&P 500 index as a proxy for the extent of the drawdowns that have to endured each and every year, regardless of whether the index closes up for the year or not:

Exposure therapy conditions us to become numb to the daily noise of the market, and over the longer-term, conditions us to become numb to any large intra-year drawdown. Price volatility will no longer trigger any hasty reactions on our part and that becomes important contributor to our long-term investing success. We’ll still be dismayed on the days our stocks flounder in a sea of red, but our default reaction would be one of benign inactivity.

For the beginner investor no rule-based process to back them up, exposure therapy is a longer road to building up an immunity to market volatility. There’s always a flight risk if the new investor walks right into a market crash after investing a non-trivial sum of money. An investor who doesn't have a written plan and doesn't know their base rates when it comes to drawdowns is at risk of abandoning the market. Long-term stock investing always demands grit and a survivor mindset. Sticking to a rules-based process, which can be as simple as dollar-cost averaging into a market index fund each and every month without fail, gives you the best odds of surviving the market long enough to develop an immunity to market turbulence. Once you’ve developed your "natural immunity", things can get really interesting when it comes to your investor preferences.

Financial planning teaches us about life stage investing. Your asset allocation devision divvies up your investment money into stocks, bonds, property and cash. This decision is one of the most influential factors determining your future long term returns. It also dictates the degree of volatility you'll experience. The general rule is "the greater the potential return, the higher the potential risk as measured by price volatility". Financial planners guide their clients into asset allocation decisions based on their life stage and risk appetite (how comfortable you believe you can ride out the variability of asset prices).

Burton Malkiel, Professor of Economics at Princeton University and author of investment classic "A Random Walk Down Wall Street", suggests the following asset allocation for each life stage:

You can see at a young age, the allocation to stocks is high. You have plenty of time to ride out a market crash. In fact, many young investors will be comfortable having a 100% allocation to stocks (as were we). This percentage allocation to stocks should fall as you get older and you funnel more money into bonds. The rational is when you get older, capital preservation and income becomes more important. Stocks provide the highest return over the long-term, but over the short-term, market volatility can threaten your retirement well-being. As you approach retirement, the sequence of returns risk comes into play. This is the risk that a market crash occurs just as you begin you retirement years. Companies can suspend dividend payments which can severely curtail retiree income. This risk will need to be mitigated because any forced selling of stocks at fire sale prices to meet a gap in living costs can seriously endanger your retirement future. The assumption here is that many retirees begin a slow and steady phase of asset decumulation.

"Sequence of return really is, in our view, the largest risk for the youngest retirees. When your balance is the largest, you've got the most time in front of you. If you have a material 20%, 30%, 40% reduction in your balance, which would mean a really large equity correction, you're risking your ability to generate income in the future if you sell"

Anne Lester

Head of Retirement Solutions

JP Morgan Asset Management

Of course this risk is easily mitigated by being so incredibly wealthy that money is never going to be an issue. But realistically, anyone reading this isn't likely to be in that position ... at least not yet.

Financial advisors suggest you implement a contingency strategy as you approach your retirement cliff-edge decision:

Bonds help mitigate the retirement sequence of return risk. However, a high allocation to bonds exposes the retiree to longevity risk. We're living longer thanks to medical advances and better healthcare. In 2020, the life expectancy of a person aged 60 years in the United States of America was 23 years. Back in 1975, a 60 year old was expected to live another 18 years. Of course this is only an average, many are expected to live much longer.

Some retirement researchers suggest we begin to gradually increase our allocation to stocks again a couple of years after retirement when sequence risk has eased to avoid outliving our money. Given that we can easily live 2 to 3 more decades after retirement, we still need reasonable exposure to growth assets. A systematic rule often suggested is to increase your stock exposure by 1% every year after retirement (systematic rebalancing) until you reach a 70% to 80% allocation to stocks. Bill Bengen, the financial adviser who developed the 4 percent withdrawal guide for retirement found an allocation to equities of 75% results in the potential for higher safe withdrawal rates to ensure you don’t outlive your money.

We came across this idea of increasing our allocation to stocks after retirement a full decade before we reached our financial freedom number. This really got us thinking. We were at the stage where we should be thinking about ramping up our allocation to bonds, or at least get started. But had gotten comfortable with a 95% allocation to stocks for several decades now. We carried this allocation into market crashes and came out the other end, frazzled but still standing. To mitigate sequence of returns risk at early retirement, we just has to ensure we had enough cash to protect our stock holdings in the event of a long and protracted bear market. Some colleagues suggested we could always go back to paid employment in our professions, but that was out of the question because my ego wouldn’t allow that. It would be perceived by friends and family as a clear and abject failure to manage our finances and I pride myself in my fiscal acumen. I allow myself to be crap at everything else, but not finance.

All we needed to do was to build up a 10% allocation of cash that would cover our living expenses and a reasonable amount of discretionary spending for 3 years, assuming a scenario where all our dividends were cut to zero. We wouldn’t need to sell down any stocks at fire sale prices and hand the opportunistic market player the bargain of the decade.

Applying Dr Stephen Covey’s "Begin With the End in Mind", we never wavered from our 90% - 95% allocation to stocks except for a brief and ill-fated dabble with direct residential property investment that I conveniently store in repressed memory. We've conditioned ourselves to endure market volatility and remain confident that our rule-based process will keep us from regressing into bad investor behaviour. When I use the royal "us", what I really mean is "me (Colin)".

This is the asset allocation by life stage we followed, breaking most of the conventional guidelines:

We were never interested in bonds. Even today with bond yields now at reasonable levels, we still can’t get interested in an asset with no potential for capital gain if held to maturity. Almost all of our long-tenured, retired stock investor colleagues feel the same way: it’s stocks all the way. We’re certainly not suggesting everyone follows this asset allocation plan because not too many people would be comfortable with this degree of stock exposure. But once you earn your stripes as a long-tenured stock market investor, don’t be surprised if you feel the same way at retirement and discard all the conventional rules around life stage asset allocation. Conditioning will do that to you.