Broker Check

Portfolio Smoke Detector

Can you let me know when the next big drop in the market is about to happen so we can get out first?

That is a question many clients have asked of their Financial Advisor at one time or another. It's a reasonable question based on the belief that the Financial Advisor and the Wall Street firm that they work for have the knowledge to see bear markets approaching and can thus advise their clients when to sell so they can avoid some or most of the ensuing damage that bear markets inflict on investment portfolios.

Unfortunately for most investors who asked that question, they did not get the answer they were looking for. Instead they were told, “it’s not timing the market that’s important but time in the market”, or “predicting market drops is impossible so you have to hold your stocks through all markets, good or bad” or “stay the course, the declines in the market are temporary as the market always comes back over time”. After hearing these responses, a client might think, “I can buy stocks and hold them through big drops on my own. That’s painful but easy, so what am I paying you for?” We know of no way to forecast the exact day that a top or bottom of a market will occur. However, it is possible to create a computer algorithm that recognizes the pattern of data that occurred before past large market drops and warn us of the possibility of a large market decline in the immediate future when it spots a similar pattern of data.

If computer algorithms can warn us about impending blizzards, hurricanes and other extreme weather events, if computer algorithms can land jumbo jets safely and stop our cars automatically before we hit the car in front of us and if computer algorithms can model the spread of a virus throughout a country, why can’t they tell us when the next big market downturn might be starting? They don’t have to be perfect to be extremely helpful. The smoke alarms in our homes save many lives but they don't predict when a fire will start. They just give us an early warning so we can get out. During his last year of graduate school, our founder set to work on creating a mathematical algorithm that could be helpful in solving this problem. With the help of a friend with a PhD in Applied Mathematics and machine learning tools, they created our Portfolio Smoke Detector.

Portfolio Smoke Detector (PSD) is a data-driven portfolio management tool that is designed to signal when the risk of a market drop is high (sell signal) and also when the risk of a market drop is low (buy signal). This allows us to be fully invested when the risk of a market downturn is low and retreat to the safety of a money market fund when the risk of a bear market is high. PSD works on other publicly traded investments despite being developed for the equity markets. PSD was back tested all the way back to 1930 to see how it would hypothetically perform in real world conditions over long periods of time.

In order to demonstrate how helpful PSD can be, we hired an outside consulting firm to test it by comparing it to simply buying and holding the S&P 500 index. The S&P 500 index is widely regarded as a good gauge for US stock market performance. In our testing when PSD gave a buy signal, the PSD portfolio was fully invested in the S&P 500 index. So, when PSD gave a buy signal, there was no difference between the PSD portfolio and the S&P 500 portfolio. When PSD gave a sell signal, the PSD portfolio was 100% invested in US Government Treasury bills, which are considered the benchmark for safety. Let’s take a look at the results.

**Returns do not account for dividends paid on the S&P 500 index**  


As every investment model has limitations, let’s look at the drawbacks of using the Portfolio Smoke Detector. Like the smoke detectors in your house, PSD will generate false alarms. A false alarm sell signal could cause you to sell an investment and potentially buy back that same investment at a higher price at a later date which will detract from performance. This can cause the PSD portfolio to underperform the S&P 500 index over any given year. A false alarm buy signal can cause a similar result. When compared to a buy and hold strategy, PSD will cause you to buy and sell securities from time to time which could generate short term capital gains if done within a taxable account. If a sudden market crash were to occur out of the blue due to an unexpected event (such as the terrorist attack on 9-11), PSD may not be helpful. This is not a strategy for investors who are seeking to beat or outperform the market indexes.

We believe our Portfolio Smoke Detector is a good tool for investors who want to earn the long-term returns associated with equity investments while minimizing the volatility or pain associated with those returns. PSD has historically given investors returns similar to market indexes but with significantly less volatility. The less volatility the better. Volatility can be very bad for investors. No one likes to experience downside volatility as it causes our net worths drop in value. Potentially even worse, it can cause an investor to sell at the bottom and permanently retreat to the low returns of investing in only safe assets. We cannot eliminate volatility from equity investing but PSD has shown that it can be helpful in reducing it. Schedule a call with us if you would like to learn more.

Many people are not familiar with standard deviation as a measure of volatility. Volatility is the measure of how much a single year's return differs from the average return. If the average return is 10%, then a return of 12% differs from the average by 2%. Assuming that returns are normally distributed (bell curve), it is expected that 68% of all returns to be within plus or minus 1 standard deviation from the average. It is also expected that 95% of all returns will be within plus or minus 2 standard deviations from the average. To apply this to the results above:

Based on the results from 1990 - April 24, 2020 [Calculations are GIPS compliant]

For the Portfolio Smoke Detector:

** 68% of the time your annual return would be between +17.1% and -2.5%

**95% of the time your annual return would be between +26.9% and -12.3%

For the Buy and Hold S&P 500:

**68% of the time your annual return would be between +25.2% and -10.2%

**95% of the time your annual return would be between +42.9% and -27.9%

Portfolio Smoke Detector (PSD) is available exclusively through our Discretionary Fee-Based Managed Accounts Platform.