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Prudence Is an Investment Virtue

10/15/2015 08:38 EDT | Updated 10/15/2016 05:12 EDT
Harvey Tsoi via Getty Images
Close-up of a ballpoint pen pointing at the stock quote chart on a computer monitor.

The volatility over the past few weeks has really woken many people up to the realities of the markets -- they don't just go up, and they can be very unpredictable. Volatility has been hiding for the past six years, but like the old Chuck Norris joke, "not sleeping, waiting."

But for those who are concerned, don't be... it's reality. The markets are risky. They are a great thing, but they aren't a sure thing. Now, if you don't like that message, well the reality is the markets aren't for you. But if you want to achieve a return greater than cash, you need to accept some risk to do it. Once you understand this, the good news is there are ways to manage this risk to make it work better for you and provide a higher probability of success.

Of course, the most critical way to manage risk is through diversification. It is still one of the most important rules to obey in building any portfolio, the free lunch for every investor. The fact is it is critical, it works and you should make sure you are diversified.

Simple test to see if you are diversified: does everything in my portfolio go up and down at same time? If yes (that's bad, by the way), then you need to do a better job.

Another key way to manage risk is by investors at any point in time making a decision on whether their portfolio should be aggressive or defensive and what balance to take. If you get this wrong you are not going to succeed regardless if you are a good stock picker or not. If you get it right, you don't even have to be a good stock picker to do well.

Today, for instance, when we look at the markets, there is no question stock values are priced rich. Stock prices and most assets today are not so high that you shouldn't be invested. That said, prices aren't so low that you shouldn't be doing it without some defensiveness. I believe you should favour defence. Not exclusively defence, but balanced with a tilt toward defence.

So, how do you do this?

We can make excellent investment decisions with the information we have at present, without needing to make guesses about the future. We never know where we're going but we sure as hell better know where we are. No one knows exactly what is going on in the economy or what the market will do next year, month, or week, but we should have a sense for what type of market environment we are in today. You should know if we are in a hostile or friendly environment and how other people are acting.

One major piece of information the market is giving us every day is its moving average technicals. The moving averages tell us when the market is moving upwards with strength or declining with strength. They tell us when the markets are starting to show some weakness at tops, and at bottoms they can tell us when markets start to show strength. We at Purpose believe in them as a great way to decide when to play more offence or when to show more prudence.

We do this in our Purpose Tactical Hedged Equity Fund (PHE) and our Purpose Tactical Hedged International Equity Fund (PHW). We are fully invested in a portfolio of value stocks with quality focus. We like these companies and believe they will be great holdings. But it's the market risk we don't necessarily always like.

So, we hedge the market risk we have at any time based on the moving average trends the market is signaling to us. Today for example, we are cautious, defensively postured because the market has told us to be. We built these products with the very specific goal of achieving a long term equity return of eight per cent, but to do it with a different path focused on trying to avoid the major drawdowns that destruct an equity portfolio. What drove us to build these strategies was our belief that if we reduce our drawdowns during the periods where the markets lose significant value, we will compound our returns better for long term investors.

Some will call this market timing. The fact is no one gets timing exactly right. The real question is can we improve upon the buy and hold approach, the faulty timing that the "herd" engages in?

We believe so.

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