INVESTING DURING TIMES OF UNCERTAINTY
Mach 1 Market Moment Podcast

Matt Walters (00:02):
Hello, and welcome to the Mach 1 Market Moment where we provide financial information on topics such as investing insurance, financial planning, and everything related to your money. This is Matt Walters here with Mike Frost and David Lee. And today we’re going to talk, be talking about investing during uncertain times or during times of uncertainty. Mike, David, how are you guys doing today?

David Lee (00:23):
I’m doing great. Just had a great Memorial day weekend and looking forward to a great start of the summer.

Mike Frost (00:30):
Same here, Matt. And this is a very timely topic for us to be discussing today.

Matt Walters (00:35):
Yeah, I thought the shoe fit with everything that’s been going. There’s been a lot of anxiety and nervousness or whatever you want to call it out there with people who are investing, people who have money in the market, and just everything. All of the uncertain times that we’re living through right now. I thought this would be a great topic to discuss. And we’re primarily going to be talking about the traditional solution for investing during uncertain times and what I mean by that is ‘the modern portfolio’.

Mike Frost (01:10):
And what you mean is what people get everywhere else, not at Mach 1.

Matt Walters (01:13):
Exactly. Yeah. So the traditional solution that you might see if you just go down the street, visit with an advisor that has a very kind of black and white approach, and follows kind of the rule of thumb that’s taught, in the school systems and in the books. It’s what I was taught in school. David and I were talking about this earlier. He actually asked me – “Were you taught about modern portfolio theory and is it what you studied?” And it absolutely was. I mean, it was by the book.

David Lee (01:41):
I just wanted to see how wrong your education was.

Matt Walters (01:44):
It’s always depressing when I think about it. So that’s what we’re going to focus on today – modern portfolio theory, investing during uncertain times and what are the good and bad part components of the modern portfolio theory and are there alternatives? Are there other ways to look at investing?

Matt Walters (02:01):
Let’s start with the definition. I’m going to give us a quick definition, high level of what modern portfolio theory is. It’s a theory on how risk averse investors can construct portfolios to optimize or maximize expected returns based on a given level of market risk, emphasizing that risk is an inherent part of higher reward.

Mike Frost (02:25):
Matt, what in the world did you just say?

Matt Walters (02:27):
Yeah, I looked up a sentence that was going to make me sound really smart. So to summarize, it’s essentially looking at how can we diversify into various asset classes to achieve the desired level rate of return that we want while keeping our risk in check. So, where did it come from? So Harry Markowitz actually kind of uncovered and came up with this theory back in the 1950s. It’s surprising how well it stuck. I mean, to this day, there are people who preach and teach and hold to the modern portfolio theory. And if you think just, um, realistically how much times have changed since the 1950s? I mean, it’s pretty quick, you can get to the conclusion that maybe we should look at things in a little bit different way from an investing standpoint.

David Lee (03:21):
Yeah and experience is the best teacher as they say, right, Matt? Seeing what actually works in the real world, is what obviously guides our investment decisions here at Mach 1. On that note, you brought up the fact that I was talking to you earlier about how your college education was, and I’d like you to share that with me. You talked to me about how you had, let’s call him an academic professor that had never been out there as an advisor in the real world and what his viewpoint of modern portfolio theory was versus one who had actually been an advisor out there.

Matt Walters (03:57):
Yeah, yeah, absolutely. So I had an academic, a one hundred percent strictly academic professor, great guy, but he definitely taught things by the books. You know, what the book said was, is what reality was for him. Then I had another professor, both in finance, and he actually managed client money. I mean, he was a portfolio manager and I don’t know all the details of exactly what he did, but I do know he was much more openminded and was not nearly by the books.

David Lee (04:32):
Was he just saying that modern portfolio theory wasn’t the one and only way to go?

Matt Walters (04:36):
Yeah, he wasn’t teaching it like it was gospel.

David Lee (04:39):
Yeah. And I think that obviously you and I agree on this, Matt, I think the reason why the one who had been an advisor, who had been out there in the real world and wasn’t teaching modern portfolio theory as gospel is because probably – I’m assuming here, I don’t know this professor, but I’m assuming it’s because he’s observed the same things that we have in the real world. Which is that typically when you need modern portfolio theory to work the most, and again, modern portfolio theory, very simply stated if you boil it down – is just diversification, right, Matt? And in other words, you have the right mix of bonds and stocks and gold and stuff like that. So the theory is, is that these asset classes are typically not highly correlated. In other words, let’s say, real estate. Real estate may be doing well when maybe stocks aren’t, or maybe bonds are doing well when stocks aren’t or gold or some other asset class. And so if you get the mix correct in any of these different categories, you should have a stable portfolio. That’s the theory.

Mike Frost (05:48):
So an example that we’ve just been through where the tech stocks weathered this storm fairly well, where the oil stocks didn’t – they are not correlated. They don’t go in the same direction. That’s kind of what you’re saying.

David Lee (05:59):
Yeah. Another example is, I think back to the 2008 market. Many of us can still remember that pretty vividly. You think about what did oil prices do back then? Gas prices. They went way down. Before the 2008 crash gas prices were at over $4 a gallon. By the end of it, they were down to below $2, if I remember right. Stock prices, everybody remembers that one with the crash of Lehman brothers during 2008, stock prices cratered. Bond prices, cratered. Even gold cratered back then. So, housing, everybody remembers that part of the 2008 crash as well, the housing market cratered. So all these asset classes, they’re supposed to be uncorrelated each other, meaning they’re not moving in the same direction – as you said, Mike. All these asset classes that are supposed to be uncorrelated become highly correlated when you most need diversification to protect you -when everything’s falling apart, they all become highly correlated. They all moved down together.

Matt Walters (07:03):
Exactly. Yeah. In times of panic or uncertainty, people just start selling stuff. It doesn’t really matter what it is. They just get scared. And that’s kind of what we just went through, you know, to some degree now. It doesn’t matter what it is. People are just selling stuff. So those bonds and stocks can be extremely highly correlated at times. And, like David mentioned, oftentimes when you need it to be uncorrelated, at the least opportune time, right. When you’re expecting that bond position to provide you some safety, is when it doesn’t right? They’re getting sold off and can get really beat up as well.

David Lee (07:41):
I’ll say one other thing about that. You talked about how, you know, when markets become panicked, human emotion starts to take over, right? I often say there are two emotions, human emotions that drive the market – fear and greed. That’s what drives the market. And and fear tends to be a more powerful emotion than greed is. People all tend to get fearful simultaneously, and they all kind of stampede for the exits and they’re trying to sell everything like you said. And, um, and so, you know, even though you might logically know in your mind prices, aren’t going to go to zero. You may even have an advisor telling you, hang in there, hang tight, but it can be a lot easier said than done. Obviously there’s an old saying that says, markets can remain irrational longer than you can remain solvent. And so it can, even though we all know that markets won’t continue to go down, we just don’t know how far they’ll go. And especially when we’re in or near retirement, it becomes, a frightening thing to watch account values go down. So that’s why we need something to mitigate volatility in client portfolios.

Mike Frost (08:50):
Well, we just went through that here in March, right? All the stock indices are way down – 30 to 50%. And then even the 10 year treasury was down. Oil was down. So if we had a diversified portfolio, we all rode that roller coaster down.

Matt Walters (09:08):
Right. Absolutely. Let us be clear. We’re not saying diversification in and of itself is bad.

David Lee (09:15):
Right.

Matt Walters (09:15):
Or irrational.

David Lee (09:16):
It’s a good thing.

Matt Walters (09:18):
It’s a good thing. Right. We want to be diversified. We do want to have money in different asset classes, different places, different products, different stocks. We don’t want to rely solely on asset class diversification as our sole source of protection. Especially if it’s not structured properly, right? Here at Mach 1, we have some very unique strategies that a lot of people don’t offer or don’t have. One of the big things that we use to provide that downside protection that negatively correlated asset class, I guess you could call it to our larger positions is a derivative.

Matt Walters (10:04):
Someone might ask, “well, what’s a derivative”, right? “I’ve never heard that word in my life”. Derivatives can be multiple things. It can be futures. A lot of people have heard of futures, right? Maybe back when you got the newspaper, you saw the corn futures or the cotton futures and the gas futures, right? There’s futures contracts out there. There’s forwards, which are very similar to futures. There’s also swaps, which are not as common…but then there’s options contracts as well. So these are kind of the four most common types of derivatives. In our portfolios, we use options contracts to provide that negative correlation with our investments that help offset and truly provide that protection.

Matt Walters (10:45):
David, give us an example. If you don’t mind, I know we use the Walmart example a lot. Someone who owns Walmart stock. Run us through that example real quick of how you could use specifically a put option contract to protect maybe a Walmart stock position.

David Lee (11:03):
Yeah. You’re not talking a short position on Walmart, but like a Walmart put, you mean?

Matt Walters (11:10):
Yeah like a protective put.

David Lee (11:10):
The easiest way to explain puts is to relate them to something that you probably are already familiar with. You might have, if you’ve listened to our podcast for awhile, you’ve probably even heard me compare it to an insurance contract. Just like with an insurance contract, a put option has an expiration date, similar to how your homeowners insurance policy has an expiration date on it. And a put option also has a, you might call it a deductible, kind of like your homeowner’s insurance policy has a deductible, which is the maximum amount of risk you’re willing to take the closest equivalent to the deductible on a put option would be what’s called the strike price.

David Lee (11:50):
So if Walmart’s trading at around, what are they around a 130 something right now? Around 124? Okay. So let’s say we had a put option on Walmart stock that expires at the end of the year with a strike price of 100? Then we’re basically accepting pretty much all that downside risk down to that strike price of 100.

David Lee (12:10):
Now, just like with an insurance contract, I have to pay a premium to buy that protection. So I pay the seller of the put, a premium, an amount of money that gives me the right, but not the obligation, to sell that Walmart stock back to the seller for a hundred dollars per share. If my strike price was one hundred and you have to buy, if you sell me that put option, you have to buy that stock back from me for a one hundred dollars a share, no matter how low the price of that stock has dropped.

David Lee (12:42):
So that’s why a put option specifically can mitigate volatility in a, in a portfolio because unlike stocks, for example, where there can be multiple winners and multiple losers, right? If you buy Walmart and Walmart goes up 20 bucks, well everybody who owns Walmart wins and vice versa, if it goes down was with put options, it’s kind of a zero sum game, right? 

David Lee (13:05):
There’s, there’s a seller and a buyer on every contract. And so effectively, there’s like a winner and a loser you might say on every contract. So if you sell me a Walmart put option with a 100 strike and it drops below 100, then you’re losing on that contract and I’m winning. Money comes out of your account to me to make me whole.

Matt Walters (13:25):
Right. Right. Yeah. And when you think about the way people usually use modern portfolio theory and bonds, it’s not because they want a lower return, right? I mean, they’re not, they’re not like, “hey, let’s put half our money in bonds because we want a 4% return when we could get an 8”. It’s because they think it’s going to provide a level of safety. So if we feel like stocks would be better to produce longterm returns, why would we not allocate to stocks and get that level of protection using something like a derivative. A derivative, going back to the definition – think of it in terms of that – it derives its value on another underlying asset. So if you buy a put option on Walmart stock, that contract has to increase in value if Walmart stock is going down, it’s directly linked and negatively correlated to Walmart stock.

David Lee (14:20):
So the more Walmart drops below the strike price, the more profitable it becomes for the buyer.

Matt Walters (14:24):
Right. Exactly. We keep talking about Walmart, but the way this can be done though, is on like a general stock portfolio. Maybe we’re diversified into 50 different stocks, right? We could buy, put options on, um, you know, against an S and P 500 ETF or something that protects us against a broader market sell off. So if you think of it, it allows us to allocate more money to stocks. If that’s where we think better, longer terms returns are from.

David Lee (14:51):
I’ve got a great example that just came to my head. So, to your point, if you thought that the real estate market was where your best longterm returns were going to be – maybe you go out and buy a bunch of real estate. Maybe go out and buy a bunch of rental homes, but you know else are you going to buy on those rental homes?

Mike Frost (15:09):
Homeowners insurance.

David Lee (15:09):
A homeowners, insurance policy so that in case one of those homes burns down, you don’t lose all that investment, right? So we’re not betting that the rental homes are going to burn down. We’re just simply buying insurance protection against that loss, but we’re really investing in the real estate because we think that’s where the opportunity is. What’s the same way we manage stock portfolio.

Matt Walters (15:33):
Right. Right. I think everyone automatically assumes, lower risk has to come with lower returns. So this is a little bit thinking outside the box here. So that’s what we’re essentially saying is we’re trying to push against that a little bit. Lower risk does not have to coincide with lower returns. We can achieve superior returns while also achieving & having lower risk.

Mike Frost (16:03):
So, Matt, this is all good information in the modern portfolio theory. We said that word now about 10 times. So put it in a real world example for our clients. We have one of these strategies. We call it equity long, short. And so far this year, that strategy is up double digits. We cut our losses in half on the downside during March and so now we’re only down about half, as much as the market. And then we took advantage of that to outperform the market on this upswing. And you compare that to the S and P 500 that still in the negative.

Matt Walters (16:44):
Right. So during the most recent downturn, you know it’s not like the stocks we own, none of them lost value, right? They lost value, but the protection, the heads, the put options that we owned increased so much in value, it helped offset more than half of those losses. And then it gave us a ton of cash to sell those, put options, reinvest, and we’ve outperformed on the upside.Your losses are less, you have more capital to invest when stock values are lower. Um, it’s a, it’s a great way to invest. And it makes a lot of sense for a lot of people. Our goal is just to get the message out there and educate people on it.

Mike Frost (17:21):
David has a 15 year anniversary coming up. He’s been in business. And this year, I think is the first time he’s ever had a client, send him a fruit basket, thanking him for minimizing the losses during that 22% 30% downturn. That was fantastic.

David Lee (17:37):
That’s true. I’d forgotten about that. Yeah. Truly, we did get a lot of, thank you cards and emails and messages from clients, thanking us for what a good job we’ve done managing through this risk, but like you said, Matt, it’s not that we’re better stock pickers than anybody else. That’s not the case at all. When the market drops 34% and you’re in stocks, they’re going to take a beating. You’ve got to have something different in the portfolio. Just like if a fire sweeps through your neighborhood, your house is probably going to take on damage. So unless you have a homeowner’s insurance policy, you’re going to get hurt. So we have the philosophy that any money that you’ve got in the market, especially if you’re in or near retirement, you really need to have that protected with a ‘fire insurance policy’ so to speak in case the market catches on fire.

Matt Walters (18:30):
Right. And options, just to be clear, you know, options can be used in a lot of ways. They can be very complicated investment vehicles. We’re just kind of focusing on one way they can be used for downside protection by buying a put option, but they can be used in a lot of ways.

David Lee (18:53):
Yeah. They’re in fact, I’m glad you mentioned that, Matt, because one of the questions we get a lot of times, I know you’ve probably heard it, Mike, you probably heard it too is “I don’t know if I like this idea of options because aren’t options risky?”

David Lee (19:06):
You hear that all the time and it’s true. If you use them a certain way, they can be very risky. There’s a speculative way to use options, but we use them in a way that we’re hedging portfolios, rather than in other words, we’re not trying to “invest in options for gain”, we’re buying options for downside protection.

Matt Walters (19:28):
Exactly. Big difference.

Matt Walters (19:30):
Moving on real quick, as we get closer to wrapping up for today, we talked about bonds, we don’t look at bonds or maybe use bonds the way a lot of advisors do, or a lot of people do, but we still think people should have safe money. We still think, we believe, we are big advocates that people should have money that’s not directly invested in the market. We’re not advocating, “Hey, take all of a hundred percent of your assets and buy stocks and then buy a put option”. That’s not the case. Diversification is important.

Matt Walters (20:03):
Mike, what do we use and give maybe a couple examples how they can be used, versus a traditional bond portfolio?

Mike Frost (20:10):
Yeah. The annuities we use are fixed and fixed index annuities, meaning for our clients, there’s not a fee to them. They love that piece of it. And also, there’s no way for them to go down unless they take money out. So that is safe money. If you’re in or near retirement, you want to have a piece of that set aside. So, you know, you can get to it in case we have another 30% drop. So that’s how we use it. And we can do lifetime income benefit annuities off of it as well.

Matt Walters (20:36):
Exactly. So they can’t, so they can’t lose value based on market performance. Whatever amount we need to have in a safe bucket, but we also want to earn better than you bank rates are what the bank would pay us – that’s a great amount to look at. Annuities are like every other vehicle, they make perfect sense for some people, they don’t make any sense for others. We use several different kinds. We think they’re a great solution for a lot of people. There’s a lot of negative stuff out there on annuities, but what we find typically is when a client sits down and educate themselves on what they are and how we use them, they actually become huge fans of annuities.

David Lee (21:21):
Yeah. In fact, probably one of the most common things that I hear my clients say now, after having done this for 15 years, my longer term clients, a lot of times they’re coming in for their annual reviews and they’ll tell me, I can’t tell you how many times I’ve heard this. They’ll tell me, “David, I hear all these negative ads and commercials telling me how bad annuities are. My annuities have done great. What am I missing here?”

David Lee (21:44):
I think what the key is, is it all has to do with what your expectations are on the front end. If you think that your fixed or indexed annuity is going to average double digit returns. Yeah. You’re going to be disappointed. We always tell clients, expect hopefully a 4-5% per year average annualized return if you’re talking to an indexed annuity.

David Lee (22:06):
If you think about it for safe money, which is important as we get closer to retirement, people tend to want more of their portfolio safe for safe money in an environment where CDs are basically 0% because the fed just set rates to zero and we’re stocks are highly volatile. There has to be some medium where you can have some money where you can sleep at night, not having to worry about the market and knowing that it’s making better than a zero to 1% rate of return. That’s where index annuities can be great.

David Lee (22:38):
I just was doing a review this morning with a client and this last year, they happen to make five about five and a half percent on their annuity with no risk. So that’s an example of why you may want a portion of a retirement portfolio in an index annuity.

Mike Frost (22:57):
And I think that we talked about one of the strategies we had that you knew last half, what the market did, and now it’s up positive with the market’s tilt negative. And now we’ve talked about annuities where the secret sauce is. And as we three advisors is how we create the mix for each individual. Nobody’s going to be exactly the same. They’re all going to be different. Some are going to have more annuities and less , but it’s how we work that out with the client and give them the right mix is where the secrets come in.

Matt Walters (23:25):
Yeah, Mike, that’s a really important topic and it’s one that we could talk quite a while on. So we’re going to actually touch on that next podcast when we discuss asset allocation and how we come up with that solution for clients and new prospective clients.

Matt Walters (23:41):
We got a question in this last week, we always wrap up towards the end with a Q&A session. We always encourage people to go to our podcast icon on our website or email podcast@mach-1financial.com & send us your questions.

Matt Walters (23:56):
We had a question from Ramona in St. Louis. She’s asking – this is great timing. I couldn’t have teed it up any better, but – she’s asking “What are crash contracts?”.

David Lee (24:08):
Yeah. Ramona, good to hear from you. Thank you for submitting that question. Hopefully I’ll see you and your mom here in the office again soon. Again, thank you for asking that question.

David Lee (24:21):
So, “What is a crash contract?”. Well, it pretty much what we’ve been talking about in the first half of the program about why you want to use put options for downside protection. Remember how I was saying earlier, think of a put option is like fire insurance against a market that catches on fire? Well, another way to say it is the way you asked the question, it’s crash insurance against a market that crashes. So it’s just another term for the same derivative contracts that we’ve been discussing in the first half of the show. It’s a great question. And, um, it’s what we’re already doing for you, Ramona, that some of the, some of the stuff that you’ve got in your portfolio right now as a matter of fact.

Matt Walters (25:00):
Yeah, absolutely. So great conversation. We were all looking forward to talking about modern portfolio theory. This is one we’ll probably circle back to here in a few months or down the road, really get into it, maybe have a guest on to talk about it.

Matt Walters (25:11):
Mike, we want to wrap it up with a thought of the day. What do you have for us today?

Mike Frost (25:17):
The thought of the day today, Matt, would be investing is the age old, never ending emotional battle between fear of the future and faith in the future.

Matt Walters (25:29):
Yeah. Wise words from Mr. Frost.

David Lee (25:33):
So have faith and not fear.

Matt Walters (25:34):
Absolutely. Yeah. Good words. Especially in times of Corona. Right?

David Lee (25:38):
Amen.

Matt Walters (25:38):
So that’s it for today. We appreciate you guys listening to the podcast and we look forward to you joining us next time on the Mach 1 Market Moment.