Alpha Power Investing Newsletter

November 1, 2016

The Critical Importance of Investment Discipline


There are essentially two steps involved in achieving investment success:
 
Step #1: Developing a plan that has a realistic probability of making money in the long run.
Step #2: Having the emotional and financial wherewithal to follow the plan.
 
In practice it can generally be stated that:
 
a) The majority of investors focus on Step #1, but;
b) Step #2 trips up more investors than Step #1
 
When it comes to any investment plan - no matter how well thought out, devised and implemented - the single easiest act in all of investing is to say "just this one time I am not going to follow it." The justification/rationalization for doing so invariably sounds perfectly logical at the time. But the price that one pays for not following his or her plan can be staggeringly high, both in the short-term and the long-term.
 
The Well Known Mistakes
 
No one plans to buy at the top, to sell at the bottom or to miss what in hindsight was a terrific opportunity. Because of the nature of the financial markets (i.e., prices fluctuate), bad things can happen from time to time even if an investor diligently follows his or her well thought-out investment plan. Yet when you talk to people who have actually endured one of these painful experiences, more often than not it seems to have involved either "doing something they hadn't planned to do" or "not doing something that they had planned to do".
 
The Hidden Effect
 
Buying at the top, selling at the bottom, or missing a great opportunity is something that can happen to the "best of us" - fear and greed when mixed with human nature being what it is. The attendant loss of wealth or the profit not made is the short-term effect. Fortunately, a single such experience - while painful - is typically survivable. The longer-term danger in these instances is the effect that they can have on an investor's psyche and decision-making process going forward.
 
The two most common "hidden effects" are:
 
Problem #1: Second guessing your plan more often in the future.
Problem #2: Feeling more comfortable with actually shunning your plan in the future.
 
Problem #1 is caused by the "fear" factor and/or the desire to "get even" after a costly mistake.
Problem #2 is caused by the "greed" factor and the feeling on behalf of the investor that he or she is "smarter than their system."
 
A Case Study in the Importance of Discipline
 
The Alpha Mid-Cap Power Index strategy buys the S&P MidCap 400 Index using leverage of 1.5-to-1 during three "Power Periods" within the fourth quarter of each year. Between those three periods, the strategy holds the Midcap Index with no leverage applied. The trades take place "systematically" without any additional input from any investor or advisor. To better appreciate the potential benefits of this type of discipline let's consider an extreme example - the year of 2008.
 
NOTE: The returns presented in the examples below are based solely on daily price data for ticker MID, which tracks the S&P MidCap 400 Index. They are presented for illustrative purposes only and are not intended to exactly replicate strategy returns. (Source: http://finance.yahoo.com)
 
In Figure 1 we see the action of ticker MID heading into late-October of 2008. From the high marked in June of 2008, MID had plunged a stunning -46.5%, prior to advancing during the two trading days prior to Power Period #1.
 
 
Those who were in the market at the time may recall what a fearful time period this was for investors. The other key thing to note is that the last day in Figure 1 is the third to last trading day of October. In other words, to take advantage of the first "Power Period" (the last two trading days of October and the first two trading days of November) an order to "buy" at the close of that day would need to be placed.
 
 
Now let's be candid. For the average investor making his or her own trades, the easiest thing in the world to do under these circumstances would be to say "I think I might just sit this one out." And many people would find this decision easy to rationalize given the fear that pervaded the market at that time. So to illustrate the importance of having the discipline to follow your strategy, let's consider the comparative plights of:
 
*Investor A, who follows the strategy exactly as planned.
*Investor B, who decides to sit on the sidelines in cash.
 
During the course of the four trading days in Power Period #1, ticker MID advanced +9.57%. Investor A - using the prescribed Power Period leverage of 1.5-to-1 would have registered a four-day gain of +14.35%. Investor B - who had subjectively decided that it would be "more prudent" to skip this trade - would have missed this gain entirely.
 
 
At this point, Investor A goes back to holding ticker MID using no leverage. Between the close on the second day of November through the close on the seventh to last day of November (i.e., the start of Power Period #2) MID declined by -22.19%
 
At this point - after a gain of +14.35% and a subsequent loss of -22.19% - Trader A is now down -11.0%. Also at this point Trader B could easily decide once again that given "the extreme level of volatility" in the market, or because the index had "broken out to a new low" - or for whatever other reason seemed reasonable at the time - the "safe" thing to do would be to stay out of the market. Over the course of the next nine trading days, the MID gained +8.83%, or +13.25% using leverage of 1.5-to-1, as shown in Figure 4.
 
 
Between the close on the third day of December through the close on the eighth to last day of December (i.e., the start of Power Period #3), MID gained +6.3%. The third and final Power Period in 2008 saw MID gain +2.84%, or +4.27% using leverage, as shown in Figure 5.
 
 
In the end: Investor A - who had the discipline to follow the strategy and make the trades as planned, gained +11.7% in the last two months and two days of a disastrously bad year for the stock market. Trader B - who chose to let fear drive his or her investment decisions - gained nothing.
 
Summary
 
One of the keys to investment success is to find and exploit a sustainable edge. Still, the only way to actually take advantage of such an edge is to follow your investment strategy as planned. Once subjective fear or greed-based decision-making enters the fray, investment performance is almost invariably affected in a detrimental way.
 
To learn more about our strategies, go to the Strategies and Performance page of our website at www.alphaim.net to read the brochures and fact sheets.
 

Jay Kaeppel
Vice President and Director of Research
Alpha Investment Management, Inc.
877-229-9400
www.alphaim.net
info@alphaim.net

Disclosures: Past performance is not a guarantee of future performance. Indexes are not investment vehicles. The returns illustrated above are not returns of any Alpha strategy and do not include management fees or the cost of funds, trading, or other expenses. To see the impact of these costs, please refer to the net of fees and expenses performance data for specific Alpha strategies. The illustrations above are designed to quantify the effect of certain time periods on a representative market index.

Alpha Investment Management, Inc. is an SEC registered investment advisor. Such registration does not imply a certain skill or training and no inference to the contrary should be made. The information and opinions expressed in this document are for informational purposes only. Any recommendation or opinion made in this document may not be suitable for all investors. The information contained herein does not constitute and should not be construed as investment advice, an offering of investment advisory services, or an offer to sell or a solicitation to buy any security.


© 2016 Alpha Investment Management, Inc.

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