As much as the investment landscape may change from time to time, it really hasn't changed at all. Investors want to invest money at point A and get to point B.

What has changed, however, is how we as human beings view investments and the new methods that are being delivered by investment professionals to accommodate our human bias.

The human bias is this: People want to earn as much as they can while not incurring declines in the value of their portfolios. Especially when the income from employment or owning a business has stopped, the human bias worries about losses and the individual's ability to generate the income needed to sustain the life of their dreams.

We humans are also easily conditioned. Enter the scene all of the financial TV shows and publications that make many individual investors feel like the next coming of Benjamin Graham. And for those who do not feel that they can manage their own assets, the abundance of real-time financial information and breaking news makes clients think that by hiring an advisor, their portfolios will always be on the cutting edge in terms of sectors and timing. Again, these magazines that many advisors foolishly leave in their lobby are inviting your client to ask you why you didn't own that hot stock on the cover or why you didn't avoid the emerging markets meltdown of 2013.


So what is new really isn't that new at all. It is simply old methodology that has been refined by technology. The idea is that of technical or tactical asset management. Tactical asset management dates as far back as there is data. What it means is that someone looks at market data and uses that data to notice trends or momentum.

The data they use could be moving averages, whether it is 200 days, 50 days or whatever time frame your quantitative analyst deems appropriate for the conditions present in the particular marketplace in which they invest. The data may also include the Purchasing Managers Index, the bull/bear ratio, the put/call ratio and many others.

Tactical managers were once thought of as voodoo economics or market timers. Perhaps that was true during the days of manual equity pricing and manually prepared charts. But in today's world of big data, some tactical managers can even explain how they use the data to make decisions. Others, however, still talk in terms of the black box that they've got, with no detail or rationale for their actions.

Today, there are tactical managers for nearly everything. There are strategists offering tactical portfolios that are U. S.-based, global-based, commodity-based, or based on anything investable with a long record of accessible big data. Since the markets misbehaved so badly in 2008, many investors are looking for a better mouse trap that is designed to keep them out of harm's way, with perhaps a more level glide path from point A to point B. And the investment community, which hates nothing more than losing assets, has come to market with many offerings.

The hardest part is evaluating these offerings because they all sound great in theory. Start your evaluation process by completely understanding the underlying algorithms. If they can't explain them in a way that you understand, keep asking until you do understand it or keep looking for a tactical manager.


Performance is a good place to start when evaluating tactical managers. The problem is that very few actually have a long-term track record, as it has only been in the past five years or so that many of these managers have emerged.

Ask the manager that you are evaluating if the performance numbers that they are touting are real or back-tested. Back-tested means that they have run their algorithms on the available market data going back into history to give you an estimated return -- that is, what they might have earned had their strategy been available at that time. Back-tested numbers infrequently take management fees into account and are therefore overstated compared to what your client may receive had they invested in the strategy and paid management fees. Back-tested numbers are better than nothing, but not always air-tight.

Others claim that they had real dollars invested in the strategies while they were being developed but before the rollout of the strategy to the investment public. These too may be a little less than what you may expect. Ask specifically to see the data and the actual account(s) that were established to validate their claim that there were hard dollars invested.

The period from 2007 through today is a great time to study the tactical manager's actions, performance and trade history. Ask to see what precipitated any of their moves to verify that they actually acted on the data that they analyzed. You may be surprised to see that some tactical managers had losses nearly as bad as the U.S. equity markets, while others fared much better. Of course, just because a manager's style or algorithm worked during the last market meltdown doesn't mean that it will work during the next. You as the advisor cannot simply invest in this type of strategy and go away; your diligence must be continuous.


The concept of loss mitigation particularly resonates with investors who have experienced significant losses in the past, or those who are retired and cannot simply add more to their accounts to make up for losses. But tactical strategies are not the only method that has emerged on the scene post-2008. Risk mitigation or volatility-based portfolios are also gaining momentum in your clients' accounts.

This gets a little technical, but let me try to explain how volatility analysis can work. If you have a client who owns a product representative of the S&P 500, there is a certain amount of volatility inherent in that investment. That means that over the long term, this position can be expected to deliver a volatility that happens to be in the range of between 15%-19%. That means in a one-standard-deviation event, you can expect your portfolio to deviate from the norm by as much as 15%-19% in either direction. The problem arises when we have an environment like 2008, which was a three-standard-deviation event causing losses far greater than the range of volatility in a one-standard-deviation event. In 2008, for example, U.S. markets were so bad that the volatility was about three times greater than expected if you took no action in your clients' portfolios, and consequently the losses were far greater than many had expected.

What a volatility loss mitigation strategy would do is to attempt to keep your volatility range in the 15%-19% range during all market conditions. Therefore, this type of manager should have lightened up substantially on your U.S. exposure as things were melting down. Done skillfully, this wouldn't have eliminated all losses for 2008, but it would have performed better than staying fully invested in your S&P 500 look-a-like product. This style of management is very difficult in an environment where volatility is very low, like in 2013. Therefore most managers using this style would have underperformed that U.S. large-cap S&P 500 index.


While these strategies sound like science, I think they are equal part science and art. What is important from the planner's perspective is to get our clients the returns that can keep them sleeping at night and the returns needed to achieve all of their goals and dreams. This is nearly impossible year in and year out, so I offer the following tips for planning with clients.

First, explain volatility clearly. Let your clients know the range of possible outcomes based on historical data. Again, this does not mean that it could not get worse - it could. But letting your client see just how bad things have been in the past may be enough for them to decide on how they want you to manage their money.

Second, consider a blend of strategies so that you are not completely dependent on one manager or set of algorithms. It is always a good practice to diversify your holdings. I believe that it is also good practice to diversify your strategies.

Third, and perhaps most important, know what your clients' investment needs are. It is not enough to have a client tell you that they want all the gains and none of the losses, because that is not possible. Instead, you should quantify for them the long-term rate of return that is needed and then design your allocations and strategies to give the client the best possible chance of achieving that rate of return. If their needs are unreasonable, such as they need a 15% rate of return to retire comfortably, it is your job to tell them that unless they earn more or spend less, their goals may be a bit unrealistic.

John P. Napolitano, CFP, CPA, PFS, MST, is CEO of U.S. Wealth Management in Braintree, Mass. Reach him at (781) 848-2390.