Philosophy

There is a question asked philosophically about the “black swan”. The question asks, “Are there any black swans?” The reply is usually, “No, because I have never seen one.” The philosophical point to be made is that until you have seen every swan that has existed, you cannot say there are no black swans. And, more importantly, the fact that one never has existed doesn’t mean that one never will.

The lesson for investors and the principle that guides Scotia in its investment philosophy is, “Just because something has never happened before, doesn’t mean it won’t happen today.” Put into practical terms, “One must never risk more than one can afford to lose.” Simple mathematics show the investor that it is much more important not to lose money than it is to make large returns. Huge returns are necessary only to overcome losses in excess of what an investor can afford to lose. Most investors do not approach investing this way. Most, when asked about return expectations for their investments will answer, “As much as I can get with as little risk as I need take.” While everyone understands why we want this, few actually realize it is a nonsensical answer to a serious question. Quantity and quality are inseparable factors of nearly everything in life. Investment returns are no different.

There are two approaches to avoiding the risk of absolute loss from which one cannot recover. The first is to commit very little of one’s investment dollars to anything that carries any kind of downside risk. Guaranteed and insured investments are the only alternatives in this case. Bank CD’s and the like offer downside protection but the investor sacrifices return opportunities to receive the protection. Active investment management offers a more adaptive methodology to having some or all of one’s portfolio in low risk/low yield securities by finding strength in various market segments and only investing a part of the portfolio at any time in those segments which offer a high probability of success. Sector Rotation strategies utilize this approach to limit downside risk while trying to expose the investment dollars to the opportunity of growth.  At any given moment, there may be 100% of the portfolio in a money market fund or some percentage of the portfolio may be invested in one or several equity or index securities that are indicating a higher probability of success than some others. These relative return methods (trying to lose less in down markets) offer opportunities for consistent returns but protracted bear markets can provide little opportunity to grow assets. 

A second approach to avoiding the risk of absolute loss from which one cannot recover is to allow the assets in the portfolio to be invested for only short periods of time. By allowing the assets to earn interest in the relative safety of a money market fund most of the time and exposing all or part of them to equity market movement for only a few days at a time, the opportunity for risk-of-ruin is limited. This second approach offers the most opportunity for absolute return (positive return in up or down markets) but is the hardest to do consistently for long periods of time. Many of these types of strategies fail to provide returns in any market after a few years of performing well.

Scotia Partners believes that both approaches have merit, and we develop and test investment strategies that utilize both methodologies. The consistent starting point for any investment strategy that Scotia develops is that the strategy must be based on sound philosophical principles. All of Scotia’s strategies begin with an idea that is born out of an understanding of the laws of supply and demand and the movement of markets in response to those laws. Rather than looking for statistical anomalies that seem to yield positive results in the short term. Scotia builds its strategies on ideas that have been proven true over decades of market history. An other way of saying this would be, “The returns in a portfolio have to make sense”.

Additionally, Scotia knows that no investment strategy can be built that is right all the time. This is not important to us and is sometimes the hardest concept for the individual investor to grasp. Scotia looks for mathematical probability of success over many trades and does not place a high level of significance or importance on any one trade in testing. The trading concept of “Expectancy” allows a model to be wrong on its trade entries more than half of the time provided that when it is wrong it is wrong in a small way. Conversely, when the strategy makes entries into the market that are successful those “wins’ need to be larger than the losses. Expectancy is a mathematical equation that determines whether a strategy has any chance of making money given the number of wins and losses and their relative size. It is as if the investor wants to become the “House” as in a casino, where the probabilities favor the casino. The House knows that it will always win as long as it does not allow itself to face the risk of ruin on any single large wager or series of wagers. Scotia builds strategies that do not look for the one big win (the bettor’s approach). Rather it looks for odds that will allow it to win consistently and lose insignificantly (become the house).

Money management is the final piece of the investing puzzle and Scotia likes to approach this component in two ways. Its relative return strategies have a de facto money management feature built into the strategies themselves with small pieces of the portfolio being invested across market segments at different times. The times when these strategies have the most money at risk are the times when the markets are showing their greatest relative strength. The absolute return approaches require a different mind set. It is tempting to throw all of one’s investment dollars at a strategy that has demonstrated the ability to earn high return rates historically. However, since these kinds of approaches also offer the greatest risk to the downside, Scotia suggests that only a portion of the investors portfolio be allocated to any one of its strategies. Many advisory firms have discovered that the best way to achieve consistent results for their clients and to limit risk of loss, is to make Scotia strategies among several that they use for clients. At Scotia, we think this a wise and prudent way to handle investment dollars. Indeed, although we use our own strategies to manage our own investments, we allocate our dollars among several strategies since “earning the most” is not our ultimate objective in investing. Rather, our goal is to meet our overall financial objectives, one of the most significant of those being, to earn consistent returns with limited downside risk.