Playing by the Rules and Winning the Game

You can distinguish one money manager from another by how well they play the game.  In order to determine the winners and losers, you must know the objectives.  Here they are:  consistent returns, positive returns, and–for the bonus round–outperformance of equity benchmarks at all times.  There is no rulebook for this game.  Nor was this game shrink-wrapped neatly on the shelf of a Toys-R-Us [sic].  These are the rules imposed by clients.  While these requirements do change, the past ten years and the current “new normal” economy have formed these parameters.

An S&P 500 level of 1049.33 feels rather distant.  However, this was the closing price as of August 31, 2010; some 11% lower and just 8 short weeks ago.  With a historic September, and a modestly positive October, the S&P 500 has managed to transform a 5.9% loss into a 6.1% gain, year-to-date (as of October 22, 2010; excluding dividends).  This marks a turning point in portfolio strategy.  Successful money managers are those who were able to deliver positive returns through August and will be able to capitalize on the uptrend through the end of the year.

How can I be confident that the S&P 500 will end the year higher than where it is today?  The reason is because the majority of people who handle clients’ money are not successful.  They do not understand the psychology of the client.  Their negative returns during the first half of the year necessitate amplified positive returns when the trend changes.  After all, if your portfolio is down as much as the S&P 500 through August, you need to obtain significantly better performance on the upside to justify the cost and risk exposure.  And how do you outperform the index in an uptrend?  You buy higher beta equities.  The more uptrend you miss out on, the higher the required beta.

Given the “uncertain” outlook on the economy and the speed with which this equity market has moved, one can be fairly confident portfolios are still, and will be, under pressure to capture upside performance.  At the end of the year, every individual will review their statements.  If performance is not positive, you’ve lost.  If you have taken on too much risk (i.e. month-to-month returns are too volatile), you’ve lost.  And if performance is not positive enough, you haven’t lost; but you haven’t won, either.

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