What do you do when you think the market is risky and over-extended? Rahul Garg has felt that way for over a year, but instead of running to cash, he managed to beat the S&P 500 for 2016 with a few adjustments to his investment strategy. Here’s how he did it.
Rahul started his Marketocracy fund in August, 2012. For the last 3 years he outperformed the majority of U.S. Equity mutual fund managers. In 2016 Rahul beat the S&P500 12.77% to 11.96% respectively.
Ken Kam: Congratulations. You outperformed the market last year despite being cautious all year.
Rahul Garg: Thank you! For the past year, I have been concerned that the market is over extended. We are likely closer to the top than to the bottom since S&P has tripled since its March 2009 bottom.
But one has to believe that the markets can stay irrational longer than we can imagine. So one has to stay invested. One can be more cautious, maintain certain amount of cash position, do some arbitrage to generate income and buy income producing stocks to protect themselves. But there is a significant risk of not being in the market.
Kam: What do you mean by that? If the market goes down 30%, then they would have saved a lot of money!
Garg: You are right. But to predict each market crash perfectly is impossible. And since the market goes up an average of 7-10% yearly, one is taking that much risk if one is completely out of the market. Maybe 10, 20 or even 30% cash positions could be considered.
History teaches us that the biggest risk is to try to time the market. S&P 500 closed at 118.05 in 1972. Then it declined to 68.56 by the end of 1974, which is over 30% crash. Now it is over 2250. So just by staying invested, one would have made 20x their investment in 40 years. The returns are likely to have been even more if one had some liquid cash to put in 1974.
But there are plenty of folks who in aggregate did not make money and even lost money in the market in those 40 years. Ultimately, it is a game of buying good companies at good prices. Then having patience and long term mentality along with unwavering belief in the American business can guide one to produce good returns. It is definitely easier said than done!
For example, I was cautious with the portfolio last year. But I considered that I could be wrong as a real possibility. So the portfolio was invested 85% or so (excluding arbitrage) at the beginning of last year. By the end of year, it is similarly positioned again. I am buying good companies at good prices but not being greedy. If the market crashes, I will likely get even better prices and invest the remaining cash/arbitrage positions as well as the incoming dividends.
Kam: So how did you perform last year?
Garg: Including fees which were about 1.9%, the portfolio returned 12.77% versus 11.96% for the market. So not a great year, but a win. I played defense most of the year and scored at the end after Trump’s election.
That brings up an interesting point. An investor has to be cautious about jumping quickly from one equity to another or for that matter, one manager to another. These jumps are usually made at precisely the wrong time leading to permanent capital destruction. Every manager including Warren Buffett has underperformed the market at times. Whenever those naysayers come is the precise time one should doubt them.
Kam: What are your thoughts for the 2017?
Garg: There are so many possibilities of what could happen. Maybe nationalistic forces will break the European Union. Maybe we will see the Indian Rupee fiasco leading to recession there. Maybe here in the US, the oil prices spike leading to interest rates increases that are faster than expected. Maybe dollar increases cause a recession in US since it is a global economy. We know that the interest rates will increase but nobody knows how fast and when.
This is the second longest recession-free time period in US, so one has to be cautious. But the risk of not investing is significant as I have explained above.
I have positioned my portfolio for a recession caused by inflation. If wage growth is greater than inflation, then inflation would not cause a recession. But efforts to control inflation likely by raising interest rates could lead to recession. Certainly if inflation is greater than wage growth, maybe that could cause problems. I really do not know what will happen. I remain cautious and will likely add to our cash in the first half of our year. I will adjust as we see the story playing out.
My Take: Many investors who shared Rahul’s assessment of the state of the market last year went heavily into cash. While going to cash protects you from losses, it also takes away any potential for gain. If your financial plan assumes your portfolio will grow by an average of 7% to 10% a year, then going to cash can drive your entire plan off the rails.
Making adjustments to portfolio strategy when the markets are risky and over-extended is something index funds don’t do. Index funds are cheap, but they stay 100% invested in the same stocks come hell or high water.
Rahul kept his portfolio ahead of the market during a volatile period and kept his investors financial plans on track. That is the kind of management that is worth paying for.
This article was written by Ken Kam from Forbes and was legally licensed by AdvisorStream through the NewsCred publisher network.