As seen in Paragon’s 4th Quarter 2008 newsletter
Written by Nathan White, Chief Investment Officer

photo by Rene Ehrhardt

Would you drive your car looking through the rear-view mirror and not use the front windshield? Of course not, but when it comes to investing many seem to engage in that type of behavior.

When the markets become volatile people are often scared into new investment strategies at just the wrong time. They do this because their current investment strategy didn’t live up to their short-term expectations.

Right now it is easy to cherry pick and find one of the few investment strategies that had minimal losses. These investment strategies are few and far between. While they look enticing, the question to ask is “How have their returns been over the long-term? How have they performed in other stock market environments”?

What is your investment strategy?

Every style or investment strategy has a cost/consequence. Most of the investment strategies that have performed well this year have significantly underperformed in other years. They are currently having their 15 minutes of fame and then will likely return to their normal behavior of sub par performance. It is similar to the old 80-20 rule where 20% of the time these types of investment strategies outperform (and I would argue it is even less) and 80% of the time underperform.

Most people chase recent performance when choosing their investments. That it is true for any type of stock market environment. The current market turmoil will cause many investors to switch to those investment strategies that have recently done well just in time for them to underperform.

I am always amazed at how short-term most people are with their investment choices. People have a tendency to extrapolate current trends well into the future. When oil prices skyrocketed to $147 a barrel there was no shortage of experts proclaiming that oil would go to $200 a barrel by year-end. Now that oil is at $40 a barrel there is a new crew of experts telling us that prices will soon be $20 a barrel. Extrapolation into the future is human nature, and it is usually wrong.

If you believe that the recent market crash will continue, then investment strategies that bet on market declines are the place to be. However, stock market history has shown that violent market sell-offs are usually relatively short-lived. They happen so fast and are so broad and deep that everything is dragged down together. The real question is whether the current market volatility and downward movement is something that will continue indefinitely or is a short-term phenomenon.

The only asset class to post positive performance for 2008 was U.S. Treasuries. Every other asset class, stocks, bonds, real estate, etc., was down with most being down by historic amounts. Those chasing performance and seeking safety are piling into Treasuries. On January 2, 2009, U.S. Treasury yields were as follows:

The government is paying next to nothing to borrow your money. What do you think is the likelihood of these government issues outperforming other asset classes with these incredibly low yields? With a 10-year Treasury you are locking in an annual return of 2.21%! If inflation goes above 2.21% you will receive a negative rate of return. The S&P 500 currently yields around 3.90%. This is one of the rare times in history when you can get paid a higher yield owning stocks and waiting for them to recover.

The forester Value Fund

Let me use another example of the psychology of chasing returns. The Forester Value Fund is a 5-star Morningstar Fund and the top performing large cap value fund for 2008. It is one of the only stock funds to post a positive gain for the year (0.1% vs. -38.5% for the S&P 500). That is significant achievement by its manager Thomas Forester during a horrible year.

I have nothing against Mr. Forester or his fund, and I’m not trying to disparage his management. I’m simply going to use his fund as an example of investor behavior.

After such a horrible year, many people will be out searching for recent good performers. Since recent performance is what entices many people to invest, many short-term, performance driven investors will likely flock to this fund. Investors constantly tell me that they do not chase hot funds or base their decisions on short-term performance. Surprisingly, most of the portfolios of potential clients that I review are full of funds purchased because they had outperformed the previous year. Also, many investors insist that they understand investments are for the long-term, but then proceed to scrutinize monthly or even weekly returns!

I’d like to go back to the Forester Value fund example. If we apply the same logic that people use in buying the fund based on its great performance this year then it is fair to apply that same logic to the fund’s performance for last year (2007). How do you think the short-term performance chaser would have reacted to the fund’s poor performance the previous year? They would have sold just as the fund was about to outperform. This is where I come to Mr. Forester’s defense. Investors should not buy his fund solely because it outperformed this year. Neither should they have sold his fund in 2007 because it had a bad year. Those types of investors, short-term performance chasers, set themselves up for failure and usually do not make good investors.

Paragon’s Investment Models

I don’t like taking investment losses. If you don’t succeed in your investment objectives, I don’t succeed either. We, at Paragon are committed to being the best alternative available for your investments. Unfortunately, there is no Holy Grail model, indicator, or strategy that works 100% of the time. According to data compiled by Bloomberg, just six of 1,591 U.S. stock mutual funds with at least $250 million in assets made money during 2008. This was one of those years that could be called an “outlier” in statistics or a hundred year flood in nature.

Even though our models didn’t get us out of the way of this ‘tsunami’ we still have confidence in them over the long-term. They have worked very well over the past 10 years and are responsible for Managed Income and Top Flight’s exceptional long-term track records. Our long-term performance shows that our models reduce risk and enhance returns in most market environments. With that in mind, we constantly monitor and evaluate our systems to see if they can be improved. Most of our efforts at Paragon are spent on research. Our objectives continue to be to reduce risk, enhance returns, and win more than we lose over the long haul.

We are currently positioned for a trading rally off of deeply oversold conditions. If that develops we will follow our indicators as the market moves up to gauge whether the trading rally will develop into something that will last longer. At that point we will decide whether or not we need to move to a defensive posture. Stay tuned on our weekly blog, moneymanagerslive.com, where you can receive updates on our holdings and our view of current market conditions.