Investing’s Two Masters: 2021 Year in Review

In a way investing has two masters and it’s very difficult to please both of them.

While studying Geometric Balancing, I would spend hours going through the backtest attempting to imagine what investing through each year would feel like. How did it feel in the good times? How painful were the bad years? Since we already know the future, this is very difficult to do, but I felt it was necessary to get into the psychological experience of the strategy. 1999 stood out as an interesting year.

The 1999 Challenge

1999 was a great year in the stock market,. The S&P 500 climbed by 21%, and the NASDAQ went up much more. Today 1999 is often remembered as the peak of the dotcom bubble. While I was just a bit too young for investing back then, I have distinct memories of CNBC always being on the television at the golf course, and all the old men sitting around at lunch talking about how well thier investments were performing.

Everyone was focused on how much money they were making in the stock market, and they were making lots of it. If your investments weren’t along for the ride, it would have been difficult to sit at those lunches.

So I knew that the backtest returns of 1999 wouldn’t have been fun to experience in real time. The backtest showed Geometric Balalncing returning 1% (not including trading costs) in 1999, 20% less than the market.

The First Master: Zero

Zero is the first master of investing. All returns below this number are losses, and you will feel them. Due to loss aversion , you feel deeper losses more than others, but no loss feels good. We would all rather not see the minus sign.

Focusing on this master is what allows us to compound growth as fast as possible. Nearly every post on this blog aims to satisfy this master.

In many ways, this should be the only mental hurdle required. But it’s not.

The Second Master: The Market

However, there is another feeling inside of us which can’t stand being left behind. Often our feelings about investing performance are relative.

If the markets are down 35% yet your portfolio is down 10%, does that even feel like a loss? In some ways no, because you know you’re “ahead” even though you are now poorer. The relative gain makes the absolute loss seem to disappear. Now ignoring absolute losses is dangerous in terms of long term growth, but in the short term, it might not feel so painful when you lose less than the market.

However, what if you’re up 10%, but the market’s up 30%. Does that truly feel like a gain? It’s a good gain, probably nearly equal the long term average of whatever strategy you’re employing. But you are still going to feel like you’re falling behind even though the absolute returns are still reasonable. ¹

2021 Results

This brings us to 2021. Geometric Balancing return 7.2% (trading fees or costs not included²). The market returned 28.7%. Bonds were down, gold was down. The year feels a lot like 1999. ³

Go back to the welcome post. Geometric Balancing’s 40 year backtest showed a Sharpe Ratio of 0.88, standard deviation of 8.4% absolute return of 11.6%, and a return above the risk free rate of 7.1%. 2021’s Sharpe Ratio is nearly identical to the one shared at the blogs opening. The standard deviation is just a bit higher. Returns above the risk free rate, very similar. Absolute returns are a bit lower. The statistics here aren’t really out of tolerance.

And yet it does feel like something was left on the table this year doesn’t it? Just one column over the S&P 500 went on a tear this year. Some years, a 7.2% return and a Sharpe of 0.89 will feel great. Some years, it might feel disappointing.

Now bonds and gold–2/3rds of our possible risky assets–were both down for the year. If you benchmark to other highly diversified strategies like the permanent portfolio, Geometric Balancing looks ok. Comparing to the risk parity type All Seasons Portfolio shows similar results. These may be better benchmarks as they have similar volatility profiles.

But ultimately, I believe over the long term Geometric Balancing should keep up with the market. Some years you lose to the market master, and some years you win. But the market is always in the back of our mind as a reference point.

Geometric Balancing isn’t going to chase historically great market returns, and (yes this past year was one of the best ever ). Geometric Balancing aims to provide stable returns, no matter what the market is doing. This means it won’t likely chase the big years up, and it likely won’t plunge down with the bad years .

This year means the 1999 issue isn’t theoretical any longer. The experience is real and not just on paper. And while I’m not discouraged because I knew this kind of return outcome was possible, I often contemplate the tinge of envy this kind of year creates. I think this feeling mostly comes from only experiencing part of the cycle.

1999 Wasn’t Unique

1999 wasn’t the only backtested year showing underperformance vs. the S&P 500. 1980 had similar under performance. 2009 shows the same. As did 2013. These years have a few things in common which caused the large difference in returns from the market. One, bonds and gold did poorly. When 2/3rds of your risky investment landscape does poorly, the portfolio is not likely to do great. Secondly, stock market returns in these years were spectacular.

As much as I’ve tried to imagine what it would have been like to experience these years, it’s nearly impossible because I already know what happens in the neighboring years. 1980 preceded a 20 month bear market where the S&P pulled back 25%. 1999 of course preceded the dotcom recession, where the market pulled back nearly 50% over two and half years. 2009 came in the rebound of the great financial crisis when the market fell over 50% in 18 months. 2013 is a bit different, but it wasn’t that far away from 2015-16 where the market fell 15% over 9 months, bottoming below the peak in 2013.

For each, I already knew that the market underperformed in the adjacent years, providing geometric balancing an opportunity to “catch up”. So it was easy to ignore relative under-performance in a single year when over the full cycle you already see the benefits.

It’s easy to focus on the first master, zero, in a backtest. But in real life, when you don’t know what happens next, the second master, the market, always creeps into the back of our mind. Time and trust may be the only way to vanquish this master.⁴

I hope that unlike the years similar to 2021, we aren’t about to embark on a multi-year recession. But if we are (and please don’t assume we are because nobody knows), I trust geometric balancing will safely navigate it.

Footnotes:

1-This master may not be entirely mistaken either. We don’t know the future, so it is technically possible that years like 2021 continue. Another example is that while I’ve examined this strategy through various inflationary regimes, I’d only be guessing how it would act in hyper-inflation. And in that world, If you aren’t’ getting the returns equal with your neighbors, you truly are falling behind.

2-Results for the year are taken from positions posted on the portfolio page and were not derived from actual trades. They are hypothetical.

3-Another similarity is that in 1999 stocks rallied on increases in volatility (not their typical reaction), and they did the same thing in 2021.

4-I do wonder if there is a way to satisfy the second master more directly without harming the first noticeably. I think there might be, but thats a topic for another post.