Saturday’s post “Buyer Beware of Risk control” elicited a number of reader comments. Here’s one I want to elaborate on:

In your post, “Buyer Beware Of Risk Control,” you highlighted the statement, “It does not really matter how much of a return you make during good times, what matters is how much you keep when the markets turn south.” I feel that is an oversimplification, and you may be inadvertently playing the same game as that of American Century management.

From 1976 to date, the S&P; 500 has provided a buy-and-hold return of 10%/year. If one is satisfied with a 10%/year return, then the (paper) losses associated with bear markets pale into insignificance. And if one compares the bear market negative with the bull market positive returns, then I submit that maybe just the inverse of your statement is more accurate.

First, the buy-and-hold crowd always looks in the rear view mirror and, with the benefit of hindsight, comes up with returns of what the S&P; 500 has done. Just to clarify, for the period from 1/2/1976 to 5/15/2009, the annual compounded rate of return was 7% and not 10% as quoted above.

Second, while that sounds great on the surface, it does not emphasize the pain and agony investors went through, including the 87 crash, to get to these numbers. Bear markets and huge portfolio draw downs along with their emotional impact on an investor’s psyche are not accurately reflected.

Third, the time period of evaluation is critical. For example, the S&P; 500 stood at 1,469 on 12/31/1999. It closed last Friday at 883. That’s a 40% loss over 9-1/2 years for those who simply bought and hold and matched the S&P;’s return. In other words, most investors have made no money during this century and only because they did not apply a sell stop discipline.

Stories like this abound. Recently an investor called and told me that his advisor made him 35% per year for 3 years in a row—before losing 80% in 2008. Put the pencil to these numbers and you realize that, after these tremendous gains, he has lost 50% of his principal. Tell me, where is the value in that? Making great returns is a useless endeavor, unless you can preserve them during market downturns.

Of course, you should strive for good returns during bull markets, but be aware that it is more important, to hang on to a large chunk of your gains when the trend reverses.

Translated into your personal life this means “it’s not how much money you earn, it’s what you keep that matters.”

While my main day-to-day focus is on the use of a disciplined investment strategy via trend tracking, it pays to look at the big picture every so often to see where we stand economically and to assess the effects of the financial bailouts.

Other bloggers are more qualified to talk on that subject, and I like to reference articles that mince no words, have no bias and simply want to tell it as it is. This week’s hat tip goes to Dr. Housing Bubble, who reviews some facts of the trillions of bailout money, which have been flushed down the ever growing sink hole.

Here are some snippets, but I encourage you to read the entire article so you can better view the enlightening charts and graphs:

Banks, take the blue pill. Public, please take the red pill. If I had to characterize the current economic environment, it would have to consist of two completely different sets of beliefs.

The foreclosure chart above tells us one thing. We are not helping the public. We are not solving the housing crisis. The notion that bailing out banks would somehow trickle down to the public is absurd. How many issues of systemic failure did we deal with? AIG? Fannie Mae and Freddie Mac? Lehman Brothers? The list goes on and on. With the AIG bailout, we used systemic failure as the premise to funnel money through the firm as a conduit to Wall Street firms like Goldman Sachs. Can’t allow them to lose a penny because that would be systemic.

And by the way, do you remember those estimates last year that the GSE bailout was actually going to give us a profit in the long run or at worst, cost us $25 billion?

“It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.”

While we don’t control any of these facts, it’s important to be aware of them for the simple reason that they control and influence market direction. This “disconnect” between Wall Street and Main Street has been obvious over the past few weeks as the rebound rally neglected facts in favor of hope.

Being disciplined with your investing endeavors is the only way to survive once Wall Street gets hit with a dose of reality, whenever that will be.

With the mother of all bears having mauled most portfolios in 2008, mutual fund companies are scrambling to come up with solutions to alleviate investor fear that nothing has been done to avoid a repeat performance.

American Century believes that their attention to risk control has been paying off:

About one-third of American Century’s 79 funds are in the top quarter of their categories for performance over the past year, according to investment researcher Morningstar Inc. For the past three years, more than one half of its funds were in the top quarter, and one of every four landed in the top 10%.

Last week American Century was named Best Large Mutual Fund Company at the 2009 Lipper Fund Awards. The prize is awarded to the fund firm top in “delivering consistent, risk-adjusted performance, relative to peers.”

That’s nice. They receive an award for “delivering consistent, risk-adjusted performance, relative to peers.” Every mutual fund known to man got slaughtered last year yet performance awards are being given out.

I have touched on this many times. If a mutual fund/ETF outperforms the typical S&P; 500 benchmark, this is a historic event and deserves praise. Never mind that the S&P; 500 lost over 38% in 2008. If a fund loses “only” 35%, they can boast that they have “outperformed” the index.

The fact that an investor in this fund is now sitting on mind boggling losses, which require him to have to gain 50% just to reach the break even point again, does not matter in the perverse world of Wall Street returns.

American Century still had several funds that trailed their benchmarks last year.

Chang added that while American Century stresses risk management, it also expects stock portfolios to be fully invested and not hold cash.

[My emphasis]

I am not sure why anyone would publish this information. The Ultra Fund lost 41.7% in 2008, yet it “is doing exactly what we told investors it would.” This has to be one of the most ignorant and selfish statements so far this year.

Take a look at the numbers. Ultra gained 21.8% in 2007 and lost 41.7% in 2008. A $100k investment in this fund would now be worth (at the end of 2008) only $71k, or a 29% loss.

It gets better. The Discovery fund lost 52.2% in 2008, but gained 31.5% in 2006 and 24.5% in 2007. On the surface, it seems that you should be ahead with those prior year gains, but you’re not. Your $100k actually shrank to a little over $78K.

I am not picking on American Century here; all fund companies will distribute similar information. My point, which I have been hammering on for over 20 years, is this:

It does not really matter how much of a return you make during good times, what matters is how much you keep when the markets turn south.

In other words, avoiding big losses is far more important than happily salivating over gains.

Hopefully, investors will have learned this lesson.

When you read stories like the above one above touting risk control, be aware that this has no effect on you as an investor. Mutual fund companies will always function as the ultimate buy-and-hold institutions no matter what wording is used. When the trend heads south again, it will up to you take action in order to avoid a repeat disaster of last year.

My latest No Load Fund/ETF Tracker has been posted at:

http://www.successful-investment.com/newsletter-archive.php

A long overdue pullback handed the bulls the first loss in six weeks.

Our Trend Tracking Index (TTI) for domestic funds/ETFs remains below its trend line (red) by -1.10% thereby confirming the current bear market trend.



The international index has now broken above its long-term trend line by +1.94%, which triggered a Buy signal effective May 11. We are holding our positions subject to a trailing stop loss.

Reader Frank had this comment regarding the need to set up stop losses:

I have been reading your column and understand the need for the trailing stops; however, the cost to transact at brokerage houses or the redemption time period at mutual fund firms are additional costs that must be considered and could become prohibitive in some cases.

Do you have a favorite place to transact so that these additional fees will not excessively burden the transaction?

Sure, all brokerage firms have some type of transaction costs when it comes to ETFs and early redemption fees with respect to mutual funds. However, that is totally unimportant when it comes to implementing a sell stop strategy because the risk of staying in the market at crucial turning points as opposed to getting out can be very costly as the last year has shown.

Trading costs have become very inexpensive but vary depending on where you keep your account. I use Schwab and selling an ETF typically costs 12.95 (but can be as low as 9.95) while the early redemption fee for buying and selling a mutual fund within 90 days is $49.95. Some custodians like E-Trade may have even lower fees.

Again, I need to stress that nowadays the costs of getting out of a position are not prohibitive in scale; what is prohibitive is staying in the market when trends turn south again and watching your portfolio values evaporate.

Transaction fees are part of life but, when used in conjunction with a sell stop discipline, they fulfill the function of portfolio insurance to assure that you can survive treacherous market conditions.

Monday’s moderate sell off spilled over into Tuesday, until late buying set in—but only the Dow ended up recouping all intraday losses by closing in positive territory.

It was a day that could have ended up really ugly as a menu of negative news ranging from weakness in housing, the selling of financial and technology stocks along with higher oil prices pulled the markets lower before the bungee effect catapulted the averages out of the doldrums. Even the increased probability of GM’s bankruptcy did not break the mid-day recovery.

After yesterday’s close, here’s where Trend Tracking Indexes (TTIs) ended up in respect to their long-term trend lines:

Domestic TTI: -0.69%
International TTI: +2.17%
Hedge TTI: +2.81%

We are maintaining our domestic hedges and have invested in the international arena. Our trailing sell stops are set, and we now need to wait and see if more upward momentum can be generated or if the upcoming dog days of summer are keeping a lid on further advances.