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How Investing is like Blackjack (the 6th Secret)

How Investing is like Blackjack (the 6th Secret)

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by September 27, 2016 Finance, Investing

If you’re just getting started investing, there are five, time-proven strategies that you should be employing when managing your long-term investments. The secret to these strategies is that there is no secret. They’ve been researched in academia and tested in the real world. They require constant savings, a diversified portfolio, and the self-awareness to realize that you can’t time the market.

But what if I told you that you could time the market?

It’s true! Well… sort of. Do I know what’s going to happen a year, a month, or even a day from now? No. But, using the same principles used in card counting, you can improve your ability to beat the market over the long-run by being more heavily weighted in equities when a big payout is more likely.

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(Photo Credit: Javier Micora)

How Do I Time the Market?

When allocating assets, I use the Cyclically Adjusted Price-Earnings (CAPE) ratio to determine what percentage of my total portfolio should be in equities. Vanguard found that the CAPE ratio had the highest correlation to S&P 500 returns out of any commonly used statistical measurement. The lower the CAPE, the higher the returns on average. After I determine an asset allocation based on my age and risk tolerance, I adjust it on a semi-annual basis to reflect the CAPE delta, and rebalance my assets according to this new allocation.

For example, I was 90% in equities in January 1, 2010 when the CAPE ratio was 20.53. Over time, I have adjusted my holdings to 87% in equities as of July 1, 2014 when the CAPE ratio was 25.82 to 86% in equities as of 9/27/2016 when the CAPE ratio is 26.78. (These percentages may be too aggressive for you, but the principle of adjusting based on the CAPE ratio should remain the same: Be less in equities when it’s high, be more in equities when it’s low.)

How is Market Timing like Playing Blackjack?

  1. For most people, both are a form a gambling and it’s likely they’ll walk away with less than they started with.
  2. Even experienced card counters (or even traders investing on inside information) don’t know what the next card or next day will bring – randomness and black swans still rule.
  3. If you know when the probabilities change, you can adjust your bet to match them.

According to Blackjackapprenticeship.com:

Keeping a running count and a true count are essential to knowing when the house edge flips in favor of the player, but if you don’t use that information to change how you play, you’ll just be playing a mentally exhausting game of blackjack. In order to capitalize on the information you get from counting, you have to raise your bets as the true count rises. You want to bet really big when the cards favor the player and really small when the count is negative or neutral and doesn’t favor the player. Bankroll management and proper betting strategy can get complicated, and it’s easy to cause a lot of damage to your bankroll if you don’t properly understand how to bet.

The same thing is true in investing. When the CAPE ratio is low, bet big on equities, and when it’s high, reduce your exposure. Sure, occasionally you’ll bust even when you know there are only two 10s left, but in the long term, the odds are in your favor.

Want Proof?

Using Robert Shiller’s data, I’ve gone through the past 60 years of S&P returns to chart out what happened a year after the CAPE ratio was within a certain range. What I found is that the lower the CAPE ratio, the better the mean return. It isn’t a perfect correlation, but you can clearly see below why it’s better to be over-weighted in equities when the CAPE is low and be more conservative when it’s rising.

6-109 11-15-9 16-20-9 21-259 26-30-9 31plus

In fact the five months in which the YoY return ended up being the worst in the past 60 years all occurred when the CAPE was over 22 (don’t say that no one warned you!). Meanwhile, four out of the five best years in the stock market occurred when the CAPE was at historically low levels. But as April 1997 showed, you should use the CAPE ratio to change your bets, but you should never take all your chips off the table.

yoyreturns

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