April 2005: Making Money in "Flat" Markets

MAKING MONEY IN "FLAT" MARKETS

The best way to describe the current investment environment is "no low hanging fruit," which is another way of saying there are no easy pickings for outsized investment profits. The past year offered paltry returns from stocks and bonds, and it would not be surprising if this year provided more of the same. (Don't dismay ... there is a solution to this dilemma.)

Regardless of whether or not the stock market and bond market produce returns that are abundant, meager or negative, our job as your investment managers is to make the most of whatever investment environment comes our way, seeking profits and protection of your capital at all times. Since we don’t get to pick and choose what will or will not happen in the world, we need to have an all-weather investment strategy that seeks the best outcome in any situation. That is the driving purpose of the asset allocation strategy we have developed and entrusted with your and our money.

How can investors make money in a "flat" stock market that seemingly makes no progress? When the overall stock market (i.e., average of many individual stocks) is flat, many of the individual stocks that make up the market can be experiencing significant changes in their prices. This means there are opportunities for mutual fund managers that are skilled enough and nimble enough to find and exploit the opportunities presented by fluctuating prices, even if the "stock market is flat."

Our expectations, based on past history, are that our "A team" of balanced fund managers has the potential to eke out positive returns in flat or nearly flat markets, much like the past twelve months. We believe that a major contributor to the past success of our carefully selected fund managers was their ability to identify and buy the right stocks at the right time.

"Would you rather use mutual fund managers with lengthy histories of success and above average results, or use below average mutual fund managers that balance out the pack?"

We believe that the managers of the funds we have selected are among the best at helping us meet this task. Furthermore, we believe that the combination of these managers offers an even stronger prospect of achieving our goals of profits and protection of capital. Past results cannot guarantee future results, but would you rather use mutual fund managers with lengthy histories of success and above average results, or use below average mutual fund managers that balance out the pack?

Let's look at a couple of key concepts that are incorporated into our investment strategy, how they help you, and why we think we can potentially do well in a market that might not offer an easy road ahead.

ZIGGING AND ZAGGING

The benefit of using a combination of independent, top flight fund managers can be explained simply — reduced portfolio risk. Legions of MBAs in graduate business schools across the nation are taught to reduce risk using the gospel of "Modern Portfolio Theory," explaining such matters using mathematical terms such as covariance (the relationship between the movements of two variables and how much they move in sync). But, it really isn’t all that complicated and you don’t need an MBA if you just remember this --- the key to reducing portfolio risk is you gotta have some of your investments zigging when other investments are zagging.

 

In his book, The Wisdom of Crowds, James Surowiecki says that "collective decisions are most likely to be good ones when they’re made by people with diverse opinions reaching independent conclusions, relying primarily on their private information." Hey! That pretty well describes the group of balanced fund managers we’ve assembled for you!

A key benefit of using a combination of skilled managers is they don’t all need to get it right all of the time (and they probably won’t). By the same logic, it’s also highly unlikely that these skilled managers will all be wrong in the same way at the same time. The advantage of using a combination of experienced managers that don’t all think the same way is this; when their independent decisions are aggregated, there are some investments zigging while others are zagging, thereby smoothing out the returns of your portfolio.

THE IMPORTANCE OF NOT LOSING

Not losing when stocks and bonds are declining is a major factor in long term investment success. That’s why we are so pleased with the performance of client portfolios this past quarter and year. You have enjoyed good returns in a world that has not offered an abundance of opportunities.

 


If our portfolios lag during a strong stock market (like the fourth quarter of 2004) we are willing to accept that if, in exchange, they don’t go down as much when the stock market declines (like last quarter). The math is simple — if you lag a little in an up market, but more than make up for it in a down market by not losing as much, you’ll come out on top every time. This is the importance of not losing.

 

PREPARATION

"Chance favors the prepared mind." — Louis Pasteur

Preparation seems to be one of the cornerstones of long term successful investors. Just about anything can happen in the investment world. You just never know. As in life, many things in investing simply cannot be foreseen and are beyond your or our control. But, the way we approach and prepare for these uncertainties is not beyond our control. We can and have made every effort to devise an investment strategy that has the potential to withstand whatever comes our way and still prosper. Asset Allocation Advisors’ investment strategy is a pragmatic answer to the needs of investors seeking profits and protection of their capital. ***

Greg Schultz & Bruce Grenke
© 2005 Asset Allocation Advisors, Inc.