The Importance of Verified Returns and Risk Management for Retail Investors

2022 was rough --- so rough it marks the greatest destruction of wealth in modern history with an estimated $57.8 trillion lost across all asset classes combined.

We’ve been accustomed to believe the inverse correlation to equities and bonds is universal. Since 1998, this relationship has held true, offering investors safety in bear markets with a rotation into bonds. This was not the case in 2022, as heightened inflation brought on a bear market in both asset classes.

According to a write-up by the Syz Group, 2022 smashed many records, including the only year in history in which both the S&P500 and the US 10-year Treasury bonds were down more than 10% each.

Certainly, if smart money struggled this much then so did retail investors. In fact, retail investors typically take the brunt of the losses in the stock market. According to a professor at the University of Oxford, “retail investors will always lose money because they lack the ‘education’ whereas financial professionals are well informed – that’s what they do.”

That’s a hard pill to swallow as retail investor communities swelled to a size not previously seen prior to Covid. Retail investors previously made up 10% to 15% of the market and now make up 25% of the market, according to Bloomberg Intelligence.

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This means the retail community was growing at the exact point in history that this investor type was most likely to get hurt in late 2021 and throughout 2022. According to Goldman Sachs, “retail net selling activity has accelerated over the past six months. In aggregate, selling over the past eleven months has completely reversed all the net buying in single stocks from 2019 to 2021.”

According to Goldman Sachs, retail investors have sold 1.5 times the amount accumulated in NDX 100 stocks, which indicates not only a complete reversal, but a complete reversal coupled with a steep loss.

Volatility is Driven by Machines

One of the primary culprits to the extreme volatility seen in recent years is caused by algorithms. Most newer investors envision a stock trading floor where market makers assist in trading stocks. The reality could not be further from the truth. In fact, those pictures of stock traders on the New York Stock Exchange floor are entirely for appearances. To truly envision how the stock market works, a more accurate picture would be of a colocation data center stacked with servers.

It’s true that quantitative easing caused too much liquidity, and in response, there was a knee-jerk reaction to quantitative tightening. However, it’s important to remember that machines were breaking records in both directions at the height of QE, as well. 

Here’s an excerpt from an editorial I wrote in 2020 when the market was seeing a record number of  limit up and limit down days:

“Nearly a decade ago, there was a flash crash that occurred on May 6, 2010. This “flash crash” caused the Dow Jones to drop 998.5 points (about 9%) within minutes, only to recover a large part of the crash later in the day. According to the Commodity Futures Trading Commission (CFTC), high frequency trading “did not cause the Flash Crash, but contributed to it by demanding immediacy ahead of other market participants.”

Flash crashes and flash rallies of 1000 points are now the new normal with sixteen occurring since March 1st. Four of these historical daily gains were above 9%. Trading curbs, known has circuit breakers, were hit four times last month.”

The editorial also discussed the prevalence of a “man plus machine” approach or woman plus machine:

“During the Q4 2018 sell-off, Guy De Blonay, a fund manager at Jupiter Asset Management stated 80% of the stock market is controlled by machines. In 2017, JP Morgan stated that “fundamental discretionary traders” accounted for only 10 percent of stock trading volume.

Billionaire Steven A Cohen’s hedge fund had to focus more on quant trading in 2017 when it lost money in most of its traditional trading strategies in that year, while its quant investors made money. For example, Steven Cohen’s $12-billion hedge fund, Point 72 Asset Management, is moving about half of its portfolio managers to a “man plus machine” approach.

According to Wells Fargo, robots will replace 200,000 banking jobs over the next 10 years. Citigroup has formed a lab to cross-train traders and developers for machine learning and artificial intelligence. The programming language, Python, is especially in high demand at leading banks, such as JP Morgan and Goldman Sachs.”

This creates a serious disadvantage for retail investors and those who do not have a team of Python developers to leverage quant systems that trade in a blink of an eye. Ray Dalio, the fund manager for Bridgestone, has openly discussed that the best approach to the modern-day stock market is what he calls “the man and machine.” His firm has 1,500-employees that use computer models to test hypotheses; which is just one of the many advantages hedge funds and institutions have over retailers.

According to Dalio, the ideal is to have an algorithm work alongside a portfolio manager for a customized approach to predicting the markets. Although the I/O Fund does not have a team of Python developers, this year we partnered with Vincent Duchaine of WealthUmbrella  in order to close the gap between human-driven actions and emotionless machines. This marked an important turnaround for our firm as we gave up what I would call “retail idealism” which centers around the idea that holding a stock for a long period of time is retail’s only defense. This works during times of economic expansion, but where this can go (horribly) wrong is when a new, more challenging macro can change the outlook for any given company.

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For example, the cloud sector is a favorite among retail investors yet has not been through a period of quantitative tightening. Most cloud companies were founded in 2010 or later, when funding was easy to secure. It did not matter if these companies were cash efficient or not, as the past decade has been marked with cheap money with over a decade of the Fed Funds rate at or near zero.

For our premium members, I wrote an earnings report in August on two stocks that were brutally beaten up entitled “It’s the Economy Stupid.” The analysis asked an important question: are these stocks down as a result of poor management, something unique in their financial profile --- or because a weak economy is simply too hard to contend with?

Although retail investors were busy pointing fingers at specific stocks, if it was the latter, then all consumer stocks would eventually be affected. Fast-forward, and hundreds of tech stocks finished down 70%, and nearly every tech stock finished down 50%. This includes the indestructible FAANGs, with many trading at historic low valuations. In 2022, an investor would have to be in denial to focus on the poor performance of an individual company rather than acknowledge something much bigger was going on.

The point was to encourage our readers to let go of the idea that picking good stocks could save a portfolio in the tech industry and to instead fully embrace risk management tools.

Risk Management Tools

In April of 2022, the I/O Fund stopped relying on stock picks as the primary, offensive measure because this approach simply was not working in the new macro. After partnering with Wealth Umbrella on an automated hedge, the I/O Fund began to boldly hedge up to 100% of our portfolio, at times.

We pivoted to playing defense rather than offense. Those who watch team sports will understand this transition well, as the strategy changes from attempting to make money (or make a goal) to a strategy that prevents losses (or prevents a goal).

The first four to five months weighed on our returns, yet our portfolio performance in 2022 stands apart from all-tech portfolios that only played offense. In addition to being evident in our soon-to-be published performance results, we also believe the positive effects of this pivot toward playing defense will be seen throughout 2023 and onward. 

Unlike many other all-tech portfolios and ETFs, we believe a more active stance is necessary for long-term tech investing. We also believe that the easy years of buy and hold are over, marked by the great growth cycle post-GFC, and that a more active approach will be necessary to survive, and even profit. As a result, we rotate our portfolio frequently, raise cash and actively hedge our portfolio with an automated signal.

In addition to hedging, real-time trade alerts are sent to our members the minute the hedge is on, or is turned off, or when the allocation changes in terms of percentages, such as 25% of our portfolio value, to 50% of our portfolio value, to 75% and so on.

Please reference “The Best of I/O Fund’s Newsletter in 2022” for More Information on Analysis the I/O Fund published last year relating to Technicals and the hedge and a few fundamental calls, as well.

For those who may not be aware, this is extremely challengingextremely challenging to do as it combines the two most advanced forms of portfolio management.

1. One of the most advanced forms of portfolio management is real-time trade alerts. This places immense pressure on a portfolio manager as the stakes are high to record what you do every second in real-time. To voluntarily choose to have the highest level of accountability in retail is nearly unheard of, yet registered fund managers are required to do this and file their stock trades.
2. Secondly, hedging up to 100% of a portfolio is also a large psychological hurdle, and  traditionally a risky one. Markets spend the vast majority of their history in uptrends, for one. Secondly, the amount you can lose on a short is literally infinite, to where one’s downside risk is capped at 0 on the long side. To overcome these hurdles, we have spent considerable resources developing a “man and machine” signal with the help of Wealth Umbrella that is truly state of the art.

It’s only natural for retail services to want to ease the pressure of having to report in real-time. The stakes are much higher when what you do is recorded the minute the action is taken, but overall, having the highest level of accountability possible has made the I/O Fund much sharper investors.

Logging trades in real-time also places immense pressure on the analysts at the I/O Fund, as well, who are not allowed to simply choose a stock but must also determine the allocation for the stock. After recommending a stock, the analysts must help the portfolio manager actively manage the position, which can change at any time.

There is a reason most services do provide this level of transparency and activity. The more granularity that is offered, the more skill is required. Also, compare this to social media, where some investors will casually claim trades that were not logged in real-time.

Verified Returns

In addition to a lack of risk management tools, I believe a lack of verified returns in the retail space contributes to the losses this investor type experiences. Smart money is careful about who they consider a good investor -- they do not take someone’s word they are a good investor; they make the investors or firms they follow prove it. Every single hedge fund has to report their returns, which reduces the chances of posturing.

Retail is not offered these checks and balances, and instead, this investor type follows many influencers and research sites who verbally state their performance without proper verification. Across the board, retail is offered a very low amount of accountability – this includes unverified month-end reviews, a list of stock tickers, unchecked screenshots, or other methods that are easy to manipulate. This widespread acceptance of loosely stating a stock performance is odd, to say the least, considering the finance industry is more inclined than any other industry toward deceptive practices.

How the I/O Fund Sets a High Bar for Accountability

Over the past three years, the I/O Fund has invested over $130,000 into accountability and transparency for our Members. When we launched in July of 2019, for the first year or so, we used a forum hosted by Tribe for our trade alerts, but by January of 2021, we had migrated to SMS and email tools that were the least likely to experience an outage for our real-time trade alerts. This costs us $40,000 per year.

In addition to this, we use an auditor from a large firm in San Francisco to mathematically review and verify the performance of our I/O Fund portfolio trading account and crypto account. The process is quite extensive and it takes up to four months to complete. This costs $4,500 per audit and we’ve completed four audits for a total of $18,000 spent on this process.

Note: For a Limited Time, I/O Fund is offering a $99/year Premium Newsletter plan that provides one actionable stock tip per month and analysis from a top performing, audited team. Click here for more detailsNote: For a Limited Time, I/O Fund is offering a $99/year Premium Newsletter plan that provides one actionable stock tip per month and analysis from a top performing, audited team. Click here for more details

Here are some things we could have done with $130,000 instead of being the only retail site to provide checks and balances to this extent:

• Bought two Tesla Model Y SUVs and painted them with our logo (or even three Model Ys with the new tax credit)
• Traveled the world for a year, all expenses paid, and instead, sent our members a picture from a Gondola in Venice
• Bought a small yacht and sailed the beautiful Bay, and sent our members kitesurfing pictures

Joking aside, accountability is expensive but we feel it’s worth it.

Conclusion

I believe real investors take necessary steps to prove their returns, that they accept the pressure that comes with registering trades in real-time and that they do not expect anyone, under any circumstances, to lower their standards and accept an unverified number in regard to portfolio performance. Due diligence on stocks requires scrutiny, and this same level of scrutiny should be applied to the company you keep in the finance industry. 

To put it simply, the I/O Fund was founded to bring the standards that smart money insists on to the retail investment class. We think retail will be empowered to outperform when their standards are higher on who they follow and what research they read, and when they refuse to accept a lower standard on transparency.

The I/O Fund is wrapping up our annual audit in the month of March, which is a month earlier than our audits were published in the past (you can access our previous audits including here and here and here). We look forward to adhering to the high standards that retail investors deserve. You can look forward to our 2022 performance being published by the end of this month.

Note: For a Limited Time, I/O FundNote: For a Limited Time, I/O Fund is offering a $99/year Premium Newsletter plan that provides one actionable stock tip per month and analysis from a top performing, audited team. Click here for more detailsis offering a $99/year Premium Newsletter plan that provides one actionable stock tip per month and analysis from a top performing, audited team. Click here for more details

The I/O Fund is a publishing company. The analysis, strategies, reports, activity and all other features of our service is provided for informational and educational purposes only, and should not be construed as personalized investment advice. Hedging is an advanced method of trading stocks, sudden losses can occur, and hedging should only be pursued under the supervision of your personal financial advisor.