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The Merriman Fright Simulator
by Paul A. Merriman Publisher and Editor
I’m not really interested in frightening you, but the title seemed too good to pass up, because we have a dynamite investment simulator for you. What we’re about to show you will never compete with Microsoft’s ever-popular Flight Simulator.
But if you’re thinking of embarking on any investment strategy with money that’s important for your future, here’s a tool that you should not pass up. It’s an excellent way to "Investigate before you invest." And if you’re contemplating investing money that’s important to your future in an aggressive investment strategy, a little bit of fright might even be good for you.
What’s an investment simulator? It’s an opportunity for you to experience, without any risk, what it might be like to embark on a strategy you are considering.
Whenever you’re thinking of making an investment, you naturally look to the past to see what has worked. You can pick a stock or a fund or a strategy that would have doubled or tripled your money.
However, you will have the benefit of hindsight. You’ll know how it turned out. That’s very different from experiencing what it took to get to the final results. When you fight a war, raise a child, move to a new place, you can’t know in advance how it’s going to turn out. You have no choice except to experience your life as it occurs, a day at a time, without knowing how it will end.
I think investors should take a lesson from airline pilots, who train extensively on computerized simulators. These exercises let pilots experience all sorts of conditions and situations, some routine and others unusual, in a risk-free environment. Seasoned pilots say the simulation training is extremely valuable.
An investment simulator can be equally valuable. Ours is very low-tech, consisting only of monthly returns from 1972 through 1998 for the Standard & Poor's 500 Index, with and without timing, plus five aggressive strategies using enhanced index funds such as those offered by Rydex, ProFunds and Potomac. For an explanation of these strategies, click here.
If you know how to use it, this low-tech simulator can give you a sense of what you would have had to go through in order to stick with any of these strategies since 1972.
Here’s how to use this simulator: Pick a column that corresponds to the strategy you want to simulate and a line representing the month you will assume you made your initial investment. I recommend you print the table, then cover each page with a clean sheet of paper. Move that sheet down one line at a time and reveal the monthly returns one by one. If you actually invested in this strategy, this will show you how you would experience it, a month at a time. Each time you move down one month, try to imagine how you would feel knowing only the past, not the future.
For instance, at the end of September 1974 in the S&P 500 Index, you would have just endured seven consecutive losing months in which 32.3 percent of the capital you had at the start of March 1974 had disappeared. In addition, the losses had been escalating. Most investors would find that very hard to "take in stride" without flinching. This period was an extreme test of the resolve of S&P 500 Index investors.
If you cover up all subsequent returns, you will see that at the end of September 1974, you had no way to know you were about to experience a month with gains of more than 16.5 percent. At the end of October, you might have felt pretty good. But you ended that calendar year with two more months of losses.
Imagine yourself in the first few days of January 1975. You had experienced losses in 11 of the most recent 14 months. You were probably reading articles in the press about "the end of stocks" as a viable investment vehicle, and you might have been easily persuaded to bail out of the market and "cut your losses." Early in January, you had no way to know you were about to experience six straight months of gains.
This simulator will show you many long strings of positive returns in some strategies. But the positive returns aren’t very important for simulation purposes. You won’t have any trouble accepting success. Focus instead on the hard times, and try to imagine how you would react.
The lines at the end of the table showing compound returns and various measures of risk are not part of the simulator. They represent information you would not have possessed as you went through the process of achieving those results.
We have started the table at the beginning of 1972, the earliest date for which we have adequate monthly data to make this study. That’s a long time ago, and many investors seem to place a lot more importance on recent returns than on those from some years back.
But if you’re considering making a long-term commitment to a strategy, you should go back as far as you can to collect data. And it’s especially important to include the early 1970s because that period encompasses the worst bear market since the 1930s.
To many of today’s investors, 1973 and 1974 may seem like ancient history, hardly relevant. But nobody who had U.S. stock investments in those two years is likely to forget those gut-wrenching times. If you’re going to "plan for the worst and hope for the best," you’ve got to plan for times like ’73 and ’74. In fact, the first half dozen years in this simulator might be the most important ones.
I hope you’ll spend some time studying the numbers in this simulator, because you won’t find them anywhere else. Here’s a suggestion: Unveil the returns in the first two columns, one month at a time. That will show you the Standard & Poor's 500 Index vs. a simple four-system market timing strategy without the use of any enhanced index funds.
The returns in this simulator are based on data we obtained from Champion Capital Corporation, which has an enhanced index product that allows accredited investors, those with a net worth of $1 million or more, to pursue these and other variations of this strategy.
You can go right to the tables by clicking here. The table assumes you know the meaning of our strategy labels such as 1 to 0, 2 to –1 and so forth. For an explanation of each option, click here.
Here’s a quick overview: Every strategy other than the S&P 500 Index is based on market timing. The first number in each title tells the strategy’s beta when all timing signals are buy. The second number tells the strategy’s beta when all signals are sell. (Zero means money-market funds; a –1 or –2 means an attempt to make money when the market is falling.) Thus a strategy labeled 2 to 0 attempts to double the performance of the S&P 500 Index when all signals are buy and is completely in money-market funds when all signals are sell.
Except for the S&P 500 Index, all returns in the table should be considered hypothetical. We have managed accounts in all these strategies since mid-1996.
If you’d like a guided tour of the simulator, here are some of my own observations.
Let’s start with the assumption that you invested in the 2 to –1 strategy at the start of January 1972. That means that in an ideal world, you were expecting to double the returns of the Standard & Poor's 500 Index during good times and to get the exact inverse of the index in the bad times. You recognize that your expectations are unrealistic, but you still have a notion that you should do much better when the market is going up and that you should make money when the market is falling.
Let’s also assume that you chose your strategy only after experiencing some anxiety about whether you should embark on the short-side version (2 to -1) or stick to the more conservative version (2 to 0). But based on the potential for higher returns, you decide to take the –1 route.
1972: The 2 to 0 and 2 to –1 results were exactly the same for January through May. That tells you there was no time when all four timing systems generated sell signals, and thus the inverse side of the 2 to –1 strategy never came into play. In March, your performance is almost exactly double that of the market, and you are probably feeling secure and smug.
June is the first uncomfortable month for you. The market was down 2 percent and you were down 4 percent. That wasn’t supposed to happen, was it? No! At this point you are probably feeling mildly betrayed, as if you were in a machine that has stopped working. But I would guess that you think this is just a fluke. Your loss wasn’t a result of taking the short side; it happened because your timing systems kept you in the market during a decline.
Then in August, you are up 6.6 percent, considerably higher than the market, and once again you are feeling confident.
September and October deal you a small loss followed by a small gain, and you get an 8.4 percent return in November and you’re up 2.0 percent in December. For the year, the market is up a very satisfactory 19.0 percent, and your 2 to –1 strategy has appreciated 31.1 percent. At this point you are quite happy with market timing, and you haven’t experienced any benefit – or any penalty – from undertaking the short-side strategy of –1 instead of 0.
1973: January presents you with a 3.6 percent loss, and February is the first of six straight monthly gains that give you reason to smile, especially as you compare your strategy to the S&P 500 Index, which dropped in five of those same six months. And in five months, your –1 strategy handily outperforms the 2 to 0 that you passed up.
Let’s take a moment to look at February, which looks in retrospect like a "textbook" month for all strategies with timing. The base for all the strategies, of course, is the Standard & Poor's 500 Index, which was down 3.3 percent. All four timing systems said "sell" throughout that month, and all three "0" strategies were obviously in money-market funds. The –1 strategies gained 4.1 percent, showing how the inverse funds can work fine. And the –2 strategy gained 7.8 percent, well above its target of reversing the double of the market. April was another "textbook" month, and May and June came close.
Returning to our simulation, your smile turns to ice in August, as your aggressive strategy loses 7.7 percent – more than twice your previous worst monthly loss – while the S&P 500 Index loses 3.2 percent. Nothing had prepared you for this!
You start to feel as if you’re on a roller coaster in September as you gain 7.8 percent; the fourth quarter is quieter, and you note with great satisfaction that in November your short-side strategy was up while the 2 to 0 version lost more than 5 percent (and that same month, the S&P 500 Index lost nearly 11 percent).
You end the year with a 12.7 percent gain, compared with a loss of 14.8 percent on the S&P 500 Index and a loss of 2.9 percent for the 2 to 0.
1974: You’ve now ridden this 2 to –1 strategy for two years, and you’re up 47.8 percent, compared with a meager gain of 1.4 percent for the Standard & Poor's 500 Index and a nice but considerably smaller gain of 27.3 percent for the 2 to 0 strategy. You start bragging to your friends and family about your enhanced index fund strategy!
The first half of 1974 seems quite calm until June, when you lose 6.3 percent – a loss that is especially disconcerting because it’s more than twice the loss of the 2 to 0 strategy. You may react negatively to that, feeling as if you’ve been kicked in the shins once again after the 7.7 percent loss in 1973 – in which case you may be tempted to bail out. Or you might react by recalling that you survived that loss – in which case you’ll be inclined to stay the course.
And soon you are very glad you did, because you have two consecutive monthly gains of 8.1 percent followed by a gain of 8.9 percent, while the S&P 500 Index is suffering heavy losses and the 2 to 0 strategy is on the sidelines in money-market funds. Finally, your short-side strategy is paying off; you are really making money while others lose.
By the end of September or early in October, you’ve probably added more money to your account and persuaded some of your friends to embark on this strategy, too. But in October, you don’t feel so smug: You lose 0.7 percent while the 2 to 0 strategy is up 6.5 percent and the S&P 500 Index makes more than 16.5 percent.
You thought you had signed up for a way to double the gains of the market. Shouldn’t you have made 32 percent in October? You’re suddenly face to face with another unexpected result.
If the truth be told, any investment strategy you choose will expose you to an experience that isn’t what you expected. For example, bonds outperformed stocks from 1965 through 1982. For another example, international stock indexes outperformed U.S. stocks by a ratio of five to one from 1970 through 1989; then from 1990 through 1998, U.S. stocks beat international ones 12 to one.
Back to 1974: November hits you with a loss of 17.3 percent, more than four times the loss of the S&P 500 Index (and somewhat more than the 15 percent loss in the 2 to 0 strategy). WHAM! You have been plunged back to reality.
Based on my experience helping thousands of clients with their investments, this is likely to be the breaking point for some investors. No matter that your investment returns have been excellent until this point and you are still way ahead of somebody who just invested in the Standard & Poor's 500 Index.
I can almost guarantee that a loss of 17.3 percent in one month will command your full attention. At this point, I suspect most investors will be at least thinking about whether to bail out of this strategy. They will "annualize" monthly losses of 17 percent and conclude that they’d be broke within six months. (It’s not quite that bad mathematically, but that argument will fall on deaf ears!) They will start to question the timing systems, asking: "Have these systems lost their ability to deal with the market?" And the only truthful answer to that question is that there is no way to know.
These investors will start looking around at other strategies, asking their advisors: "What else do you have?" They will look for some strategy that has performed well in the very recent past. And even if they don’t understand that alternative strategy – they’ll want it.
So my guess is that, in this simulation, there’s probably a 50/50 chance that you will bail out at this point. With the benefit of hindsight, we can tell you that this was the worst month you would experience in the entire 27-year period in this study. (There were four more double-digit negative monthly returns in store for this strategy, the worst of which was a 14.3 percent loss in December 1980. But there was absolutely no way to know that in the fall of 1974.)
For the purposes of this simulator, we’ll assume you stick with your strategy. You experience a partial recovery in December and wind up ahead 5.5 percent for the year. That’s not a great return, but it looks a lot better when you compare it with the 26.5 percent loss for the S&P 500 Index and the 11.7 percent loss in the 2 to 0 strategy.
In 1972 through 1974, the short side was what made you the most money. You don’t know it at this point, but the short side will cost you money in 1975 and 1976.
1975: In three years, you are up almost 56 percent, while the S&P 500 Index is down about 26 percent and the 2 to 0 strategy is up 12.4 percent. A gain of 12.8 percent in January seems to confirm your good sense, though you might wonder why you didn’t do better than that in a month when the S&P 500 Index was up 12.5 percent for the month.
(If you study the line for December 1974, you can probably figure out why that happened in January. Notice, for instance, that your strategy in December gained while the S&P 500 Index fell. That could happen only if you were invested in the short side for a significant part of that month. Sometime in January, the S&P 500 Index started moving up rapidly, and it could have taken your timing systems a few days or even a few weeks to move from an extremely bearish posture to a fully bullish posture. And that delay could be the reason you barely outperformed the S&P 500 Index in January.)
You make up for some of that lost time in February, when you are up 11.4 percent while the market is up "only" 6.7 percent. This indicates that the +2 side of your strategy is working as it should.
The next four months give you strong gains, but at the end of July you are stunned to find you have lost 9.4 percent (while the market lost 6.6 percent). Though this is much less than the 17.3 percent you lost the previous fall, it doesn’t feel good at all. After suffering losses in two of the next three months, your confidence is shaken further. Then in December, while the S&P 500 Index loses about 1 percent, your portfolio drops by 9.3 percent. Now you are really shaken, and you can’t help noticing that the 2 to 0 strategy lost "only" 5.9 percent in December.
It’s true that you had a very good year, up 34 percent. But the market was up 37.3 percent and 2 to 0 was up a stunning 48.6 percent. You’re beginning to see that the short side isn’t always a ticket to easy wealth.
Still, you are way ahead after four years with this strategy. For every $1 you invested at the start of 1972, you now have $2.09. Very nice indeed for four years. Had you invested in the Standard & Poor's 500 Index, every $1 of your initial investment would be worth $1.02. That doesn’t seem like much to show for four years. Had you invested in the 2 to 0 strategy, you’d have $1.67 for each of your initial dollars.
By now you can probably get the feel for how to use this investment simulator. You’ve got to try to put yourself in the frame of mind of an investor who does not know how it’s going to turn out. This takes some imagination, and it’s not nearly as dramatic as a computer game like Microsoft Flight Simulator. But if you take the time to study the numbers, you’ll be able to get a sense of investing.
If you’re a conservative investor, you may have already decided that the 2 to –1 strategy is too rich for your blood. It’s vastly preferable to find this out before you invest your money than afterwards. And that’s where the simulator comes in handy. Let’s continue our simulated history of your imaginary investment in the 2 to –1 strategy.
1976: This year begins with an encouraging 9.7 percent return that starts to look pale when you compare it with the 2 to 0’s 14.9 percent gain and the 12 percent rise in the S&P 500 Index. Weren’t you supposed to get twice the return of the index? That would be 24 percent for January. You are now torn. On the one hand, you are quite satisfied with your actual return; but on the other hand, you feel cheated out of the 24 percent that you think you should have achieved.
You talk to your investment advisor, who points out that the only way you could be sure of getting twice the returns of the market is if you had perfect timing systems – in other words, a perfect view of the future – and if you took an all-or-nothing approach. That approach would prevent you from ever retreating partially to money-market funds. You’d either have all your money in a fund (like ProFunds UltraBull) that doubles the movement of the market or all your money in a fund (like ProFunds Bear or Rydex Ursa) that does the inverse of the market. You calm down a bit after concluding that you certainly don’t want to take such a bold approach.
But January’s damage is compounded in February when you lose 2.1 percent as the market loses only 0.6 percent. Hey! You were supposed to double the performance of the index in the positive months, not the negative ones. March’s 5.84 percent return calms you down a bit, as it’s in the ballpark of twice the return of the market. But April and May leave you with losses that are larger than those of the market.
By this time you are probably feeling less enthusiastic about your aggressive strategy. June is a good month, up 7.7 percent, and the only further drama in this calendar year is a 9.8 percent gain in December. You feel like you’ve been on a roller coaster, but you end the year with a gain of 24 percent. That’s very nice, but the S&P 500 Index gained 23.7 percent and the 2 to 0 strategy was up 29.8 percent. You think you should have done better.
Remember those friends and relatives to whom you were bragging about your strategy a few years earlier? Let’s imagine one of them, say your uncle Roy, liked the idea but refused to get in until he could see a five-year track record. You now have five years, and over the New Year’s holiday you and your uncle go over the numbers.
In five years, you have turned every initial $1 into $2.59. In the same five years, your uncle’s account in an Standard & Poor's 500 Index fund has turned every initial $1 into $1.27. He sees a good track record and decides to join you in the 2 to –1 strategy.
1977: At the start of January, your uncle jumps on board and immediately things get ugly. You can see that from the losses in January, February and March – each of which is a greater loss than that of the market. After the first quarter, you might not be quite so popular with your uncle Roy!
After a quiet April, you get hit with a 4.3 percent loss in May followed by an 8.9 percent gain in June – and you are happy to notice that the 8.9 is almost exactly twice the performance of the S&P 500 Index. That’s exactly the way it was supposed to work.
Then you face four straight months of losses, and this calendar year winds up giving you an overall loss of 18.5 percent. And the market lost only 7.4 percent. Suddenly those early years of enthusiasm seem slightly misguided, and your uncle, since this is his first experience, feels downright betrayed.
You add up your cumulative returns and find that for every dollar you invested in 1972 you now have only $2.11. That’s a lot better than the $1.17 that you’d have for every dollar you put in the S&P 500 Index in 1972. But you still aren’t feeling too good about the last two years. And your uncle has only about 82 cents for every dollar he put in.
In fact, 1977 was a killer year that shook the confidence of most investors who used market timing. It was a year in which the U.S. stock market had lots of volatility and almost no trends that timers could latch onto. We have looked at many timing systems, and we have had trouble finding any that could detect and capitalize on the patterns in 1977.
Seen as part of this whole period, 1977 was just a temporary blip. It was the only year that produced a significant annual loss in the 2 to –1 strategy. But of course you had absolutely no way to know that at the start of 1978. And if your uncle had extrapolated 18.5 percent annual losses, he could have concluded that he’d lose three-quarters of his money in less than seven years.
There’s no logical end to this article, no final conclusions. This simulator is a work in progress, and the future will continue to unfold one month at a time. We will update the simulator as new data becomes available.
Finally, I have a favor to ask. Please let me know what you think of this simulator. If you find it useful, I’d like to know that. And I’d like to know what you discovered. If you find the whole thing baffling, or if you think it’s not worth the trouble, I’d like to know that, too.
Please send me an e-mail. The address is paul@paulmerriman.com. I look forward to hearing from you.
Source: http://www.fundadvice.com.
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