Active Management Can Improve Returns

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A new study by Hepburn Capital Management disputes traditional investment advice that often includes 'buy and hold, don't try to time the market". This study shows that active investment management can both reduce the risk of being invested and in the process, can produce more consistent returns for investors. Chart follows Body of text

One staple of stock market reporting is a consistent flow of articles extolling investors to stay fully invested and not to try to “time” the market. After all, runs the most common theme...What if you miss some of those very good days because you are out of the market? Your returns will plummet.

A new study by Hepburn Capital Management, LLC says “Take action to effectively manage your money.” The latest research shows that missing the market may have actually helped more than hurt.

The S&P 500 stock index has averaged 9.28% annual return (excluding dividends) for the 25 years ending December 31, 2005, the HCM study shows. Let’s compare that basic average to what happens if an investor actively manages their portfolio and misses some important days in the stock market.

If you happen to be the unluckiest investor on earth, and you miss just the 10 strongest days over that 25-year period, your return would have dropped to 6.96%. Move out of the market and miss the 20 best days and you end up with only 5.26% gains, and miss the 40 best days over 25 years and your average gain drops to a measly 2.42%. Clearly it doesn’t pay to be unlucky.

A star investor might miss the 10 worst days in the market, instead, and boost their average returns to 12.92%. If you are on a really on a roll and miss only the 20 worst days your returns jump to 14.97%, and if you are lottery-winning kind of lucky and your streak has you out of the market for the 40 worst days in 25 years your returns will soar to an eye-popping 17.65% annually.

But how likely to actually happen is either of these scenarios? Not very. In fact, history shows us that the best days tend to closely follow the worst days. Sometimes they occur back to back. So if you missed one, chances are you will miss the other, as well.

So what happens to an investor’s returns if one were to sit out for both the worst days and the best days? Remarkably, the average annual returns actually increase and become more consistent at the same time. This study shows that if one were to miss both the 10 worst and 10 best days the resulting average returns are 10.45%. Miss both the 20 worst and best, and annual returns become 10.33% and dodging the 40 worst and best days also creates returns of 10.33%.

The reason that missing both best and worst days increase one’s returns is that the worst days in the stock market tend to be much worse than the good days are good, so missing the worst days tends to be more important to portfolio performance than being invested on every possible good day.

Throw in the math of gains and losses and the case for risk management becomes clear. If you lose 20% you have to achieve a 25% gain to break even. A 50% loss requires a 100% gain to return to break even making it much more important to avoid a large loss than make an equal gain.

Although past performance does not assure future results, the Hepburn Capital study illustrates the point that investments actively managed for risk reduction may provide added potential benefits compared to a passive buy-and-hold approach, including more consistent returns and lower principal fluctuations.

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Will Hepburn, CFP is a private investment manager who specializes in active investment strategies. He owns the Prescott Center for Adaptive Market Strategies, and is President of Hepburn Capital Management, LLC, a Registered Investment Advisor. He may be reached by calling (800) 778-4610, by writing to 805 Whipple St., Suite C in Prescott, AZ, 86301, or by visiting his web site at http://www.AdaptiveMarketStrategies.com.

Copyright 2006. Permission to use granted when attribution is included.

        Missing the Market            

        1/1/81    Through    12/30/2005    

    S&P Index Annual Average*            9.28%    

    Missed    Missed    Missed    Missed    

     Days    Best Worst    Best & Worst    

    10    6.96%    12.92%    10.45%    

    20    5.26%    14.79%    10.33%    

    30    3.77%    16.21%    10.29%    

    40    2.42%    17.65%    10.33%    

    Analysis performed by Hepburn Capital Management, LLC.                

    805 Whipple St. Suite D, Prescott, AZ 86301, (928) 778-4000                

    http://www.adaptivemarketstrategies.com                

    Use with attribution permitted                

Data Source: Commodity Systems, Inc. (CSI) Securities offered through Cambridge Investment Research, Inc., Member NASD/SIPC. Cambridge and Hepburn Capital are not affiliated. The S&P 500 is an unmanaged index of stocks considered representative of the broad stock market. Investors cannot invest directly into an index. Past performance is no guarantee of future results. This data is for illustrative purposes only and is not indicative of the performance of any investment. Data does not include reinvestment of dividends.

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