Inconsistent Investment Returns: Your investment returns are very inconsistent and there have been some fairly sizeable drawdowns. Why is that, and is there anything you or your clients can do to smooth out the equity curve? This is probably the most vexing question I face and a major concern that scares away potential clients and causes some, usually fairly recent, clients to leave. To some extent, the inconsistent returns are inherent in the aggressive design of the systems I use. My objectives are to achieve exceptional profits over time with a reasonable level of risk. What is reasonable obviously varies among investors, but I want to keep the risk level about the same as that of the S&P 500 Index. My trading systems' short-term volatility will usually be considerably higher than that of the index. My goal is to keep the overall drawdowns to about the same level as those of the S&P. The drawdowns may not come at the same time because my systems do not correlate strongly with the S&P, which is considered a measure of broad market activity. After periods of strong gains, such as those in Biotechnology earlier this year, the drawdowns may be much worse than those of the market because what goes up the fastest tends to fall the fastest and I will normally sell after the peak.
My Rydex sector system owns just one fund at a time. That leads to much higher profits when it has the right fund, which it usually does when there is a strong trend. However, it can mean greater drops in comparison to diversified holdings when we get into the wrong fund, which happens from time to time. The NDX trading system also owns just one fund at a time, one that is linked to the often volatile Nasdaq 100 Index. Neither of these approaches makes for a smooth ride.
I have done a considerable amount of research to see if there is a way to smooth out the equity curve without severely impacting the profit potential of the systems. So far, I have not found anything that I consider to be a reasonable trade-off. However, investing, trading, and life in general are continuing learning processes. As time goes by, we gain more data and possibly better insights and the ability to improve methods.
There are some things my clients can do that should make the inconsistent returns easier to take. I have discussed these frequently, even earlier in this issue. Probably the most important is having a long investment horizon. Money that is likely to be needed in less than three years should not be in stocks unless substantial losses will not keep you from having enough when needed. The long horizon enables holding on during the inevitable down periods because there is a lot of time to make good profits before the money is needed. All this assumes you have made a careful assessment of your financial position, objectives, and when you are likely to use the invested funds.
If you have limited your aggressive investments to a reasonable portion of your portfolio, then the drawdowns as a percent of your total holdings should not make you feel too uncomfortable. This is another area where a thoughtful self-assessment is important.