The Critical Importance of Objective Indicators

The entire field of behavioral finance emerged to tell investors that humans are not very good at many types of decision-making.  The only way to combat the investment risks associated with that reality is to adopt objective rules or indicators to guide portfolio construction.

There is no magic bullet here:  adopt rules that are too strict and you risk being dogmatic at market turns in a way that limits returns.  The value of using objective indicators lies not in their infallibility or as a guarantee of performance but in their usefulness in reducing reliance on forecasting, limiting emotionally driven decisions, and aiding in reducing any portfolio’s downside risks.

We blend two types of objective indicators.  The first is the use of a financial conditions framework to assess overall market conditions.  Based primarily on the Chicago Fed’s Financial Conditions Index, it has been shown to have a high correlation to risk assets:  when conditions are loosening risk assets rise over longer periods, when they tighten risk assets fall.

Secondly, we use a 30-day moving average framework as a guide to price momentum for any security.  We want to invest in those above their 30-day moving average, and we want to reduce or eliminate those that fall below that average convincingly.  When there is little movement around that average, as tends to happen with trend-following rules, we are biased to either hold or reduce a security based on the overall market risk picture as determined by financial conditions.

Here are seven reasons why we think investors should embrace objective indicators, and why we favor investing in securities that are themselves either passive or follow rules-based frameworks:

1. Provides an objective decision-making framework
   Instead of making decisions based on fear, headlines, or market narratives, exposure changes are tied to observable market behavior. This improves consistency and reduces discretionary mistakes.
2. Helps limit major downside risk
   One of the biggest determinants of long-term compounding is avoiding catastrophic drawdowns. Indicators are designed to reduce exposure during sustained market declines, which can help preserve capital during bear markets and major trend breakdowns such as 2000–2002 or 2008.
3. Improves investor behavior during stressful periods
   Behavioral finance research consistently shows investors tend to:

• panic near bottoms
• chase performance near tops
• abandon plans during volatility

A rules-based framework can reduce emotionally driven decisions and provide transparency in knowing in advance how risk management decisions are made.

• Encourages participation in long-term market trends
  Unlike fully discretionary market timing, moving average systems are trend-following in nature. They are designed to keep investors invested during sustained uptrends while responding when market trends materially deteriorate. This allows participation in long-term equity appreciation while still incorporating risk management.
• Reduces sequence-of-returns risk
  Large early losses can permanently impair retirement portfolios, especially for investors taking withdrawals. By attempting to reduce exposure during prolonged declines, moving average frameworks may help mitigate sequence risk for retirees and distribution-phase investors.
• Creates a repeatable and scalable investment process
  An objective indicator framework creates:

• repeatable implementation
• transparent portfolio governance
• documented investment discipline
• Many  studies show objective indicators like moving average strategies can improve:

• volatility
• drawdowns
• Sharpe ratios

Investing well is a matter of making good decisions.  And ensuring those decisions are as scrubbed of the foibles of humans as they can be, is a key path to helping a manager—and clients—sleep well at night.

• James Barrineau, Chief Investment Officer
• Fiduciary Capital Management LLC
• Direct:   (914) 588-1978
• Schedule Appointment