My mother has always been a big fan of Victor Fleming’s "The Wizard of Oz." When I was a kid, it would be on TV at least once a year, and mom always made a point to watch it. I usually joined her...up until the part where the witch and her creepy troop of flying monkeys showed up. From there I would typically escape somewhere to avoid them, until they returned later that night to rule in my nightmares...
The characters are all memorable due to some of the basic themes they represent, but my favorite is The Scarecrow. He values a brain over anything else and, in an ironic twist, he turns out to be the wisest of the group.
A recent running of the classic, combined with our collective enjoyment in slaying investment industry sacred cows, has me thinking about another famous strawman: the best 10 days rule.
SCARECROW, MEET STRAWMAN (THE BEST 10 DAYS RULE)
Strawman Argument: an intentionally misrepresented proposition that is proposed because it is easier to defeat than an opponent's real argument.
Besides the Scarecrow, my other favorite strawman is an argument offered by those who believe that buy-and-hold is the best way to succeed in the financial markets. When discussing different approaches, such as dynamic allocation strategies, one will typically hear something like, “But, what about the best 10 days rule?”
For those who may not know, the best 10 days rule is the concept that missing just the 10 best days in the stock market dramatically reduces your long-term return. This is almost always used as a justification for staying fully invested in stocks regardless of the environment.
What makes it a strawman argument is that it leaves out critical information and misrepresents what an alternative approach might do instead. It also assumes that one would intentionally develop a strategy that misses only the best days in the market, which is ridiculous.
Complicating matters is that the argument is technically true – missing ONLY the top 10 BEST days does reduce return. In fact, it cuts return by 63% for an initial $1,000 investment made in 1928.
But this is not the whole story of this strawman.
VOLATILITY GOES BOTH WAYS – NOT JUST DOWN
The tables below show the best 10 and worst 10 days since 1928.
Astute readers will recognize something interesting about the timing of the best 10 days and worst 10 days. Many of the dates on the 10 best list occurred during not-so-favorable environments, during periods of instability and uncertainty.
In other words, volatility begets volatility.
WHAT MATTERS MOST? PARTICPATING IN THE BEST, MISSING THE WORST, OR AVOIDING BOTH EXTREMES?
The next question a reader may ask is, "If volatility clusters, then what happens if you avoid both the best AND worst days? Further, is there a reliable to way to do so?" My response is the same as Hans Landa in "Inglourious Basterds": “That’s a bingo!”
It just so happens that a simple trend following strategy that bought (or held) when the average close of the last 10 days was above the average of the last 100 days, and sold when the inverse was true, would have avoided all 10 of the worst days since 1928.
On the flip side, you would have missed/sacrificed eight of the best days.
According to the basic idea of the best 10 days rule, one might assume that performance of this trend-following strategy would be severely hindered because it captured just two of the best days.
Let’s test the assumption.
The graph here compares the performance of buy-and-hold versus missing BOTH the 10 best AND 10 worst days. It turns out that missing both provides a greater return than buy-and-hold – and with less volatility. This ratio leads to better risk-adjusted returns. It also likely would provide a better investor experience for clients, given the more palatable outcomes.
Fast forward to six months from today and assume markets have normalized from a volatility perspective. Now imagine how much better your recent client meetings could have been if you could illustrate for the client that their exposure was reduced before the worst phase of the recent drawdown using a simple, repeatable process that will resume exposure once volatility dies. I imagine having this type of narrative in place would be a competitive advantage for goals-based advisors.
The Journey Affects Arrival at the Destination
"If anyone treads on my toes or sticks a pin into me, it doesn’t matter, for I can’t feel it. But I do not want people to call me a fool…" – The Scarecrow
At first blush, the best 10 days rule is a compelling thought, but upon deeper inspection, it is a distraction from the importance of investor behavior.
Absolute returns are the destination, but the journey matters. Providing a more comfortable ride can give advisors an important moat in this increasingly competitive industry. More importantly, it helps your clients to stay the course during unprecedented periods in market history.
As always, Blueprint is here to help. Feel free to reach out.