COMPLACENCY IS THE ENEMY

by Paul Cormier, President, Cormier Strategy Advisors Inc.

September 2014

Ever notice that bad things seem to happen when everyone is comfortable that everything is OK? Stock markets tend to be more subject to rapid declines when complacency is high (when bears are hibernating), banks write bad loans when they extrapolate today’s good economic climate indefinitely into the future and business processes prove vulnerable when employees have gotten used to them “always working.”

This should remind us of our need to continuously seek ways to improve what we do. Complacency is the true enemy of business.

As an example, I have developed and managed several stock market investment models which I use to determine asset allocation for my family’s investment holding company and offer to clients on a subscription basis. The composite version of the model has generated a published, annualized return of 23.9% per annum since its launch about five and a half years ago (beating the S&P 500’s annualized total return of 18.9% over the same period). We have been quite pleased with this performance as the model has generated excess return over the market at lower risk – just what it was designed to do.

One component of the model specifically identifies short-term trading opportunities on the S&P 500 based on movements in what is known as the Volatility Index (VIX). We call it the VIX Trading Model.  Using the criteria for “buying the market” on data going back to 1992, this model would have generated correct buy signals 80% of the time, generated an annualized return of 9.2% (versus 7.1% for the benchmark S&P 500) and only been invested 42% of the time (reducing risk that one would be in the market during a major decline).  There is every reason to be happy (complacent) with that kind of result.

However, I always felt something was missing from this model that I developed almost a decade ago – the ability to identify times when the market would decline (we had other longer-term models that did this, but we could never figure out the right criteria to make it work in a short-term model). But I had an idea this summer and upon back-testing the idea determined that 68% of the time the market did indeed decline when the criteria we applied were met.  Applying our new criteria for market declines, plus some minor tweaking to the thresholds for buy signals, we moved our return levels for the VIX Trading Model from 9.2% to 12.1% over the same test period.

Will it work going forward? There are no guarantees in life or markets, but improvement to our models gives us a larger margin of safety in applying our trades.  I would much rather apply criteria that have worked in the past than rely on instinct or guesses.

The same holds true for any business process. Sitting there satisfied is a sure way to end up behind the curve.  Always ask if there is a way to make the process better.  There usually is.

Paul Cormier is President of Cormier Strategy Advisors Inc., a firm which provides clients with strategic consulting, project management and short-term management services.