Upgrading and the May-June Market Correction
Q: My Upgrading portfolio has dropped noticeably more than the broad market recently. What's going on?
A: Let's review the recent situation as of this writing in mid-June. Individual situations may vary due to specific funds owned, purchase dates, etc., so I'm going to use SMIFX as an Upgrading proxy and assume most Upgraders likely had similar results (see Introducing the Sound Mind Investing Fund).
Between January 1st and May 9th, Upgrading (SMIFX) gained 16.2%. By contrast, from the beginning of 2006 through their highs in early May, the S&P 500 gained just 6.2% and the Wilshire 5000 gained 7.5%. Obviously Upgrading produced much higher returns during that earlier period. Unfortunately, Upgrading also suffered more on the way down. From its high to the low on June 13, SMIFX lost 16.1% while the S&P lost 7.7% and the Wilshire lost 8.6%.
Watching Upgrading rise twice as fast as the market, only to fall twice as hard, was a surprise to many readers. That's likely because Upgrading's past volatility hasn't been much higher than the broad market (see Why Investment Returns Must Be Evaluated with Risk in Mind 
). But Upgrading has obviously been significantly more volatile than the market indices so far in 2006.
The primary reason for this has been the difference between Upgrading's allocations and the market indices often used for comparison. Foreign stocks soared early this year and small company stocks continued to race ahead of large company stocks in the U.S. market (see the First Quarter Performance table in Consistency = Powerful Gains for SMI's Upgrading Portfolios — when measuring all funds in the first quarter of 2006, both small-company categories posted returns more than double their large-company counterparts).
In Upgrading, we have 20% allocated to foreign markets this year and a healthy allocation to small-company stock funds as well. The major domestic indices (S&P 500 and Wilshire 5000) don't have any foreign allocation and very limited exposure to small-company stocks. So when foreign and small-company funds soared during the first four months of 2006, Upgrading benefited relative to these indexes. By contrast, when those funds fell in May and early June, Upgrading suffered more as well.
The diversification provided by Upgrading is intended to cushion returns, rather than magnify the ups and downs. But that only occurs over extended time periods, measured in months, if not years. Over short time periods, Upgrading's tendency to outperform is less reliable. That's why SMI has always warned against putting money in the stock market unless you plan to leave it there at least five years. You simply have to give the markets, and specifically Upgrading, time to work. This is the key to Upgrading's historical ability to gain more during bull markets and lose less during bear markets.
Periods like we've experienced recently present a good test of your true risk tolerance and asset allocation. It's one thing to say you have a high tolerance for risk. But when your retirement money or college fund is dropping fast with no end in sight, that is when you really find out your true risk tolerance. If you were seriously upset by the recent losses, the market is probably revealing a disconnect between your perceived appetite for risk and reality. Recognize this revelation as a positive thing and it can make you a better investor.
Most readers who ride out market downturns like this with relative calm probably didn't start out with iron stomachs. But after following Upgrading through repeated rallies and corrections over the years, they've learned to let the system work and not get too high or too low over the returns generated from any short period.
As confidence grows out of experience, it's not unusual for risk tolerance to increase. As that occurs, you tend to view these downturns less as traumatic events to be avoided, and more as opportunities that aid in reaching your long-term goals. I'm not just saying that — I personally bought more SMIFX on June 12th in the depth of the gloom. I've learned that when I'm somewhat apprehensive it's often an opportune time to buy.
Upgrading isn't a silver bullet. Over short time periods, it can underperform the market. So we need to approach Upgrading with the commitment to let it work over an extended period of time. This is especially relevant for newer readers who face the risk of jumping in and immediately losing money. But every Upgrader has to jump in sometime, and after the initial "luck" of your entry point, you can have confidence you're using a system that historically has been very rewarding for those who stick with it. 
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