The Problem: Change is Inevitable

Investing in the financial markets can be scary sometimes, like that first big drop on a roller coaster. No one likes market volatility – unless the volatility is all up volatility – and that rarely happens. Market fluctuations often mean spending more time dropping and climbing back to where you started than gaining momentum. With markets constantly evolving, shouldn’t our portfolios adapt to create a smoother investment experience?

Change. The world, the economy, and markets change. Economic forces cause technology, industrial, healthcare companies, real estate, bonds, gold, and international stocks to fall in and out of favor. It’s important to understand these cycles to make them work for you. The key to thriving, not just surviving, lies in understanding the phases of market fluctuations and adapting your strategy.

Emotional Cycle: We experience a predictable cycle of emotions with market fluctuations.

How do we experience the positives that financial markets can offer without all of the heartburn? We must recognize the following realities.

Diversification ≠ Protection

One often-cited strategy is to have a globally diversified portfolio. The problem is that diversification alone does not equate to risk management. Sometimes, everything goes down. That’s when diversification fails. And that’s when you need protection the most. While spreading investments across various asset classes can mitigate some risks, it does not address the fundamental need to manage downside risks actively. Effective risk management requires a more strategic approach, eliminating potential losses rather than merely spreading the risk.

The Reality: All Markets Move in Three Phases

Regardless of whether the investment is real estate, stocks, bonds, commodities, or crypto, all markets move in three phases.

1. New Money Time (Capital Creation)
   a. Up market
   b. Hitting new highs

2. Decline Time
   a. Down market
   b. Falling from a high

3. Recovery Time
   a. Up market
   b. Getting back to old highs

The 80/20 Reality

Whether we look back over the past 100 years or the past or the past 50 years or 20 years, markets spend most of their time declining and getting back to even. It’s not just your portfolio! And this isn’t just stocks. This isn’t an investment problem. This is a strategy problem.

Market gains are brief and powerful. But they can be sporadic. This means most investors spend more time clawing back from losses or waiting for a rebound than they do enjoying the substantial gains of New Money Time, the most important phase.

The 80/20 rule, also known as the Pareto Principle, reveals a surprising reality about investing: generally, about 80% of your time will be spent with investments declining and recovering from decline. Only about 20% of the time will actually be spent creating New Money or new capital for you.

And by the way, Pareto Portfolio Principle® extends beyond stocks and bonds. It applies to different types of investments like real estate, commodities, cryptocurrencies, etc.

Markets spend most of their time in decline and recovery phases, with only a small fraction of the time in capital creation.

This principle is a wake-up call, emphasizing the importance of focusing on gains and managing and minimizing the inevitable declines.

The Response: Addition by Subtraction

1. Have a Plan for Up Markets,

2. Have a Plan for Down Markets, and

3. Have a Clear Way to Know the Difference.

In investing, sometimes it's not about what you add to your portfolio but what you leave out. Eliminating investment vampires and zombies and replacing them with more attractive or safer investments may produce a better investment experience.

The Value of a Plan for Down Markets

Missing a portion of extended declines can have an outsized impact on portfolio results and make the emotional cycle easier to deal with.

By strategically exiting the market before major declines and re-entering during recovery phases, we help our clients avoid substantial losses and capitalize on market upswings.

A well-managed portfolio can mitigate losses during downturns and recover quickly, leading to a smoother and more rewarding investment journey.

A Process For Making Decisions

The Usual Approaches. One approach to portfolio management is to make no or extremely minute adjustments. This is the traditional buy-and-hold approach. The argument is that no one can predict anything, so take your lumps and deal with it. Another approach is to make changes based on the analysis of a market celebrity, guru, or economist making a fortunetelling prediction of the future based on their analysis.

Our Methodology. A better approach is to use diagnostic tools to read what the market is saying, independent of how anyone feels or thinks about the current situation. (Our quantitative signals, indicators, and algorithms measure trends and risks. For the trend, our signals determine the fundamental supply and demand market forces. For risk, we use dynamic support levels that are regularly updated based on market volatility, time, and range.) Math isn’t concerned about opinions, emotions, politics, fame, or ego. No methodology is 100% accurate 100% of the time. Given the alternatives, we like how the odds stack up using this approach.

We use a mathematic approach because it is research-based, data-driven, and market-tested. It has allowed us to create a repeatable process.

Three-Part Plan for Navigating Volatility (Getting Off the Market Roller Coaster)

1. Have a Plan for Up Markets: When the market is climbing towards new highs, having a plan in place ensures you can capitalize on these brief moments of significant gains. This involves understanding the market's momentum and strategically positioning your portfolio to benefit from the upward trend.

2. Have a Plan for Down Markets: Equally important is having a plan for when the market declines. This involves setting up safety nets and risk management strategies to protect your investments from significant losses during downturns. It’s about tightening your grip on the roller coaster when the ride gets bumpy. We should always know our exit point before we invest.

3. Have a Clear Way to Know the Difference: Being able to differentiate between the market phases is crucial. Tools like the Directional Strength Indicator (DSI) gauge market trends by analyzing supply and demand, enabling you to adjust your strategy accordingly. Knowing when to hold tight and when to adjust your position can make a significant difference in your investment outcomes.

Creating a stable and rewarding investment journey involves knowing and executing the three-part plan for navigating real-world investment realities. With the right approach, you can turn the market’s ups and downs into opportunities for growth and success.