The Whipsaw Effect

In the last few days I’ve done a good deal of soul searching as I have reviewed our speedboat portfolio for the latest newsletter. Go back a couple of months and we were fully invested with stock markets at a long-time high. The portfolio had only been going for 6 months and was showing a return of nearly 25%.

You may well of heard the butterfly effect – a principle of `chaos theory‘, in which one small change could create a massive difference to other events at a later time. The central tenet is often summarised using a famous saying. Its origins and the quoted geographical regions vary, but for the sake of this piece we will say ‘a butterfly flapping its wings in Washington could cause a storm in Tokyo’. Well, on the 22nd May the US Federal Reserve butterfly (common name: Ben Bernanke) fluttered his wings by indicating that its programme of quantitative easing might be reduced. Within a few hours the Nikkei 225 had dropped by over 7%, and the value of our funds fell with it.

Markets continued to fall and within a couple of weeks the FTSE100 had dropped by nearly 12%. We followed our principle of selling when markets fall and were soon 100% in cash. The markets almost immediately recovered over half of the losses, and although we’ve reinvested we missed out on the initial gains.

It’s hard to think of a better example for our critics to use to demonstrate of one of the problems with momentum trading. They talk about the whipsaw effect where markets head in one direction, but then do a quick about turn followed by a movement in the opposite direction. These are the most difficult conditions for the momentum trader who is looking for trends that last for longer than a couple of weeks!

So does this mean our theory is inherently flawed – definitely not. By reverting to cash we protected ourselves from further falls. Although on this occasion they didn’t materialise they could have done. We may operate short term, but we’re playing the long game. If markets drop significantly, and then almost instantly recover, we have to accept that we always won’t time our selling and reinvesting perfectly and will either make a small gain, break even, or make a small loss – on this occasion we lost a few weeks profit. What really matters is the one time when markets start falling and then keep falling – not going safe in 2007 could have cost you 40% of your investment and don’t forget that even when the FTSE100 peaked in March this year it was still lower than it was in December 1999. In the last few years we have seen two other markets corrections, August 2011 and May 2012. On both occasions our ‘Tugboat’ portfolio headed for the safe haven, we minimised our losses and when we reinvested we had made a net gain.

Think of being active as an insurance policy – you may not appreciate paying your premium every year, but at least you can sleep at night, and when it really matters you’re safe.

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