Side Effects of the Stock Market May Include…

Pretty much everyone has experienced the agony of having their TV watching interrupted by the ubiquitous pharmaceutical advertisement. In fact, they have become so commonplace that an assortment of entertaining spoofs have been created, like this one.

As the video above highlights, one of the memorable aspects for many of these medications is the absurdly long list of expected and potential side effects. Now, I respect the fact that these disclosures are important in providing consumers the necessary information to make an informed decision, but that doesn’t eliminate the irony of risking death for seasonal allergy relief.

After enduring yet another round of drug ads during a recent weekend of baseball, I was struck by the similarities between prescription medication and the stock market. Both are designed to address a specific problem, from eczema to paying for long-term healthcare and education expenses. Both also have side effects.

Drowsiness, headaches, and upset stomach are relatable issues when taking medicine, but what about investing? If you are using the stock market as the main vehicle for achieving your clients’ financial goals, then you know a primary side effect is uncertainty expressed in the form of volatility and drawdowns in account value.

Like drug side effects, investing side effects can cause clients to stop using the “medicine,” which can take them back to square one, or even make them worse off than when they started.

Could Systematic Investing Be A Medication To Manage Uncertainty?

Using systematic investing to focus on asset prices (aka trend following) is a process some believe can lessen those side effects.

To examine this, I analyzed the results of using a very basic form of systematic investing, which is to own stocks when their price is above the previous 200-day average (aka “uptrend”) and to sell or be out of stocks when they are below their 200-day average (“downtrend”). (Financial advisors can download and review the results of the simulation for themselves.)

I used the S&P 500 Total Return Index beginning in 1993 to align with the inception date of the similar, investable product: SPDR S&P 500 ETF Trust (SPY). I considered the S&P 500 Index’s performance in three regimes:

1. The full sample (buy-and-hold)
2. When in uptrends: Price was above the 200-day average when the month ended
3. When in downtrends: Price was below the 200-day average when the month ended

For each regime, I looked at four key metrics:

1. Compound annual growth rate (CAGR)
2. Annualized volatility
3. Maximum drawdown (the max daily peak to trough decline)
4. Sharpe ratio (a measure of return versus risk)

Testing Systematic Investing in 3 Scenarios

In my view, the data showed there are side effects associated with owning stocks when the S&P 500 is in downtrends, potential missed opportunities when in uptrends, and strategies financial advisors could consider for addressing both.

My analysis dug into whether systematic investing could help with risk management, and I looked at how using it impacted a portfolio in these three scenarios:

1. Using systematic investing to determine when to move from the S&P 500 to cash when stocks are in downtrends
2. Using systematic investing to determine when to move from the S&P 500 to a similarly lower-volatility instrument (Vanguard Short-Term Bond Index Fund, VBISX) when stocks are in downtrends
3. Using systematic investing to allocate more aggressively when stocks are in uptrends

Financial advisors can download and review the data for themselves.

Contact Your Asset Manager If You Experience Volatility Lasting Longer Than…

While no investment strategy comes without the side effect of risk, the role of an advisor is to seek to minimize its nature and severity.

Just like achieving seasonal allergy relief may include some drowsiness but should not bring the risk of death, achieving financial goals should not have to come with a high risk of significant, long-term account drawdowns and volatility.