- “Whipsawed” refers to a loss that can occur when the purchase or sale of a security is followed by a sudden reversal in the price of a security or the direction of the market.
- A passive investment approach that maintains consistent allocations to stocks and bonds eliminates the risk of being whipsawed, but can also result in big swings in a portfolio’s value, which in turn can lead to poor decisions.
- Using a sound, rules-based investment strategy to direct tactical changes to asset allocations can lower risk and generate superior long-term returns.
A whipsaw is a two-person handsaw that was popular with lumberjacks until the advent of the chain saw. A whipsaw consists of a straight, stiff blade with two handles. One logger was positioned above the log that was to be cut, and the other below it. The two lumberjacks would rapidly alternate pulling and pushing in opposite directions. By sharing the burden of each stroke, loggers were able to cut logs using a whipsaw more quickly and with less effort.
In the 1800’s people began to use the word “whipsaw” as a verb referring to being pulled in opposite directions. Today, the term is used in financial circles to describe a sudden reversal in the price of a security or the direction of a market. An investor is said to have been whipsawed by selling when the market is falling, only to buy it back at a higher price after the market springs back.
The sharp drop in the U.S. stock that occurred in the fourth quarter of 2018, and the sudden rise that has occurred this January is a classic example of a whipsaw. On September 20th of last year, Vanguard’s Total Stock Market ETF (VTI) closed at $151.31. On Christmas Eve, the closing price was $119.70, a drop of over 20% (the classic definition of a bear market). Last Friday, VTI closed at $136.47, which represents a nearly 14% recovery.
Whipsaws can be quite dangerous. Traders who sold stocks in December and moved to cash have missed out on the January market rally, and would pay a high price if they were to reinvest now. At the same time, if December’s sellers remained in cash and the stock market continues to move higher, their pain will only get worse. What’s an investor to do in times like these?
The simplest way to avoid being whipsawed is to maintain consistent asset allocations regardless of what’s happening in the market or the economy. Passively investing in a diversified mix of index funds eliminates a fair degree of the risk of being whipsawed because consistency eliminates the risk of buying at a price that was higher than when you sold. Countless academic studies have demonstrated that a passive investment strategy will outperform most attempts to time the market. As legendary investor Warren Buffett put it: “Huge institutional investors, viewed as a group, have long underperformed the unsophisticated index-fund investor who simply sits tight for decades”.
Unfortunately, passive investing is not “the one-approach-fits-all” panacea that some of its most ardent advocates think it is. That’s because human nature encourages us to act when we feel threatened. Logic may tell us it is pointless to try to run from an aggressive dog, but that won’t keep most of us from doing just that if we are unfortunate enough to cross paths with a growling Doberman Pincher that is bearing its teeth and has drool running down the side of its mouth.
Similarly, even sophisticated investors who well know passive investing’s impressive track record can find it very difficult to do nothing when their financial security is on the line. For better or worse, most of us are simply not cut out to sit on our hands when there are large fluctuations in the value of our life savings. What’s an investor to do?
One option is denial. That is, deny the legitimacy of decades of academic studies that demonstrate that stock-picking and market timing are bound to fail over the long term unless the stock-picker or market timer is very lucky or endowed or a one-in-a-million talent for trading.
For most investors, the second (and far more reasonable) option is to use sensible, academically supported rules-based investment strategies (such as those developed and utilized by The Milwaukee Company) to direct your investment decisions. This approach goes by many names, including “tactical asset allocation”, “dynamic asset allocation” and “smart beta”.
Whatever you call it, not all rules-based investment strategies are created equal. In my view, tactical asset allocation works best when the strategy’s algorithm is designed to (i) deliver the targeted rate of return over a full business cycle (as compared to over the next few days, weeks or months; and (ii) generate alpha (outperformance), in part by limiting the degree of portfolio volatility.
A sound tactical asset allocation strategy has a good chance to outperform a passive investment strategy. Nonetheless, because a tactical strategy uses trading in an effort to lower risk it may be vulnerable to being whipsawed. Recently, that’s exactly what is happening to investors who have been using momentum-based smart beta strategies in an effort to generate alpha.
How can you lessen the risk of being whipsawed when using a tactical asset allocation strategy?
- Be Realistic. Recognize that when it comes to investing there is no such thing as a free lunch. If an investment strategy uses momentum to lower risk, the investor should be prepared to be whipsawed occasionally, and needs to understand that this risk is the price tag for better long-term expected returns. Realistic expectations encourage patience. (See point 3.)
- Rather than relying on a single investment strategy, use multiple strategies, each focusing on different market factors to generate positive results. The advantage of strategy diversification is that if market conditions are not conducive to one strategy, those conditions may be conducive to another. Winners encourage patience. (See point 3.)
- Be Patient. Patience is all-important and very difficult. Try to always remember that even the best investment strategy can underperform at times (and in unusual market conditions can underperform for extended periods). But the longer you remain committed to a well-designed strategy, the more likely it will generate the expected results.
It may seem that the foregoing discussion raises as many questions as it answers. You may be asking yourself: “How do I know if a tactical asset allocation is sound?”, “What are the market factors that have the potential to generate alpha?”, and “How do tactical asset allocations lessen risk?”
I will be addressing all these questions in future blog posts.
For now, relax, kick back with your favorite beverage, and let “Bosko the Lumberjack” serve as a reminder that preparing for whipsaws should be part of every risk-management plan.
Thank you for reading.
The Market Commentator
(Disclaimer: The Market Commentator makes no warranties, either express or implied, that you will find the recommended video clip humorous. ?)