Tag Archives: discipline

Risk Rotation Portfolio: A Strategy For Retirement Accounts

Summary What is the Risk Rotation portfolio? How to construct and manage a Risk Rotation portfolio inside a 401K type of account. How does a Risk Rotation portfolio perform compared to the broad market? What is the Risk Rotation Portfolio? The Risk Rotation (or Asset Rotation) portfolio is not something new. One can find many variations for such a portfolio on the Internet. In the SA community, you can find several articles and contributions on similar and other Asset Allocation strategies by Frank Grossmann , Varan , Joseph Porter and others. In brief, the core principle in a Risk (or Asset) Rotation portfolio is to periodically move (or rotate) assets out of an asset with a higher downside risk to an asset that has lower downside risk and higher upward momentum. Such a portfolio aims to provide much lower volatility and drawdowns while capturing similar (or better) returns as the broader market. Though such a portfolio can be constructed inside any brokerage account, I personally find them more appropriate for retirement accounts. Risk Rotation portfolio for retirement accounts Investing successfully has never been easy. Even for the most disciplined investors, the market’s volatility sometimes takes its toll. The past few months have been an emotional rollercoaster for many folks, especially for those closer to retirement. If your horizon is very long term, this is simply market noise and best be ignored. However, for anyone who is already retired or close to retirement, any sharp correction has the potential to derail their near and medium-term planning. The big question is how do you protect yourself from a market downturn or an outright crisis like the one we had in 2008? Furthermore, most retirement accounts like 401K accounts do not provide the flexibility to buy individual stocks or even ETFs (Exchange Traded Funds). A vast majority of them provide just a handful of funds to invest. So, you cannot select your own dividend paying stocks and follow a DGI strategy. In my opinion, one good option is to construct a Risk Rotation portfolio. In my own experience, and also based on back testing, such a portfolio will provide market-beating returns in most situations while providing a high degree of risk protection. A disclaimer: I am also a believer in DGI strategy, and personally invest the majority of my investible funds in individual stocks that pay and grow their dividends. However, for accounts where I cannot invest in individual stocks, I follow the Risk Rotation strategy for about 50% of such assets. If you are interested in my other portfolio strategies, I publish a ” Passive DGI Portfolio ” and another portfolio that is Income-centric named ” The 8% Income Portfolio ” on SA. How to construct a Risk Rotation portfolio: I believe in keeping things simple so they can be easily followed long term. As an example in this article, I will use two securities (a pair of two securities). This pair can be easily implemented inside a 401k type account with moderate risk. There can be more aggressive pairs or strategies that promise higher returns (with higher risk obviously), but they cannot be easily implemented inside a retirement account. Moderate Risk strategy: SPY and TLT pair SPDR S&P 500 ETF (NYSEARCA: SPY ) is an ETF that corresponds to the price and yield performance of the S&P 500 Index. Almost all of the 401K or retirement accounts would offer something that is equivalent of S&P500 index. SPY is taken as an example to illustrate, but any similar fund or ETF can be used in place of SPY. iShares 20+ Year Treasury Bond (NYSEARCA: TLT ) is a 20+ year Treasury fund and oftentimes provides the inverse co-relation with stocks. One can find something similar to TLT inside a retirement account. If nothing similar is available, it could be replaced by cash or cash-like money-market funds. However, the back-testing results by using cash are not as impressive as with TLT. One reason is that TLT provides some yield and at times meaningful appreciation, but cash provides neither (though money market funds do provide some minimal yield). On the first of every month, compare the performance of each of the two funds with a 3-month (or 65 trading days) look-back period. – Invest 70% of the allocated amount in the fund that has better performance over the last 3 months – Invest 30% of the allocated amount in the fund that has worse performance over the last 3 months – If the look-back period performance has been the same or nearly same, invest 50% in each of the two securities. – Repeat every month, on a fixed date of the month. It can be 1st of the month or any other date. Low Risk strategy: SPY, TLT and Cash For more conservative investors, a strategy that involves adding cash to the basket (SPY and TLT) will work a little better. This will also work better during times when both stocks and Treasuries are headed down. This strategy will provide much lower drawdowns, however, at the cost of some performance or overall returns. – On the first of every month, compare the performance returns of each of the three funds with a 3-month (or 65 trading days) look-back period. Performance of cash being taken as 0%. – Invest 60% of the allocated amount in the fund that has better performance over the last 3 months – Invest 30% of the allocated amount in the fund that has second worse performance over the last 3 months – Invest 10% of the allocated amount in the fund that has worst performance of three funds over the last 3 months – Repeat every month, on a fixed date of the month. It can be 1st of the month or any other date. Performance comparison: RRP Strategies vs. S&P 500: (click to enlarge) Image1: Performance/Returns – RRP Strategies vs. S&P 500 The table above shows the performance/returns of the Risk Rotation portfolio (RRP) starting with the year 2006. Row 12: Shows how the portfolio would have performed versus S&P 500 if we had invested $100,000 on January 1, 2006 and remained invested until 10/30/2015. Row 11: Shows how the portfolio would have performed versus S&P 500 if we had invested $100,000 as of January 1, 2007 and remained invested until 10/30/2015. And so on… Notice, except for two starting years (2012 and 2013), the RRP either matches or handily beats S&P 500 with much lower drawdown. The main benefit that stands out is that it moves the portfolio away from the risk in a crisis situation that we witnessed in 2008. I did not go back to the year 2001-2002, but I expect similar behavior. (click to enlarge) Image2: Growth of $100,000 starting on 1/1/2006 – RRP strategy vs. S&P 500. (click to enlarge) Image3: Monthly drawdowns since year 2006 – RRP strategy vs. S&P 500. (click to enlarge) Image4: Maximum drawdown since year 2006 – RRP strategy vs. S&P 500. Risks from this strategy: Let’s consider some potential risks: The first risk comes from the fact that we are seeing the performance comparison based on back-testing results. As the adage goes, past performance is no guarantee of future results. TLT or any other equivalent fund would invest in a treasury based bond fund. In a rising interest rate environment, TLT may have inferior performance compared to past. However, this risk should be mitigated by the fact that we are checking the performance of the two securities every month and switching if necessary. Lack of Diversification: For the stocks component, we are investing in SPY (equivalent of S&P 500), so there is not much exposure to any of the international markets or other asset types like gold or commodities. However, this is partially mitigated by the fact that the companies inside S&P 500 earn a lot of their revenue from outside of the US. Another risk comes from the fact that oftentimes, the performance of this portfolio will be different than the broader market. If it happens to be negative compared to the broader market for a couple of years, the investor may lose conviction and the discipline and may abandon the plan mid-course. This probably is the biggest risk. Concluding Remarks: As they say, hindsight is 20:20. It is hard to predict with any certainty that such a strategy will work as well as it has worked in the past. That’s why it is important to not keep all of your eggs in one basket and depend too much on any one strategy. In my opinion, for the long haul, this strategy should at least match S&P 500 performance with much lower drawdowns, and hence should allow much better sleep at night. I am starting out a sample portfolio with $100,000 initial capital allocated as of November 3, 2015 and will provide regular updates. I plan to publish the performance comparison of the two securities (SPY and TLT) with the previous 3 months’ look-back period on or after the first trading day of every month. This will indicate if a switch of assets is required for the strategy. Here is the relative performance of SPY and TLT as of November 2nd with 3-month look-back period: Price (adj. close) on 11/02/2015 Price (adj. close) on 7/31/2015 Performance/Return Over last 3 months TLT 121.95 121.75 0.16% SPY 210.33 209.36 0.46% Source: Yahoo Finance Since the performance is nearly the same for both, the strategy will invest 50% of $100,000 in each of the two securities. Full Disclaimer: The information presented in this article is for information purpose only and in no way should be construed as financial advice or recommendation to buy or sell any stock. Every effort has been made to present the data/information accurately; however, the author does not claim for 100% accuracy. The portfolio or other investments presented here are for illustration purpose only. The author is not a financial advisor, please do your own due diligence.

In Defense Of Market Timing (Sort Of)

Summary Typical studies that demonstrate why market timing is a bad idea have a fatal flaw: They’re not so much “market timing analyses” as “perfect market mis-timing analyses.” The options market gives us a feel for how to recast the problem. Some practical thoughts on actual pros/cons for market timing. We’ve all seen the studies, and the conclusions are the same: it’s not about tim ing the market, it’s about time in the market (tell that to the Japanese). I’d like to discuss why there are fatal flaws in the classic study put forth to investors, a study which seemingly demonstrates why market timing is a bad idea. But before going further, I would like to point out that I am attacking the typical anecdotal study, not the overall advice. This piece is not an endorsement on market timing. First, I present the typical kind of reasoning that is set forth for why one should never attempt market timing. This is one particular case, but there have been many variations presented throughout the years, and most investors have been exposed to one or more of them. From Horan Capital Investors : Making ill-conceived market moves can reduce the growth of one’s investments substantially. The below chart graphs the growth of the S&P 500 Index from 1990 through June 30, 2015. The blue line displays the growth of $10,000 that remains fully invested in the S&P 500 Index over the entire time period. The yellow line shows the same growth, but excludes the top 10 return days over the 25-year period (6,300 trading days.) By missing the top 10 return days over the 25-year period, the end period value grows to only half the value of the blue line that represents remaining fully invested. (click to enlarge) Chart source: Horan Capital. Wow! Pretty compelling. Missing out on just the top 10 days out of 6300 cuts my total return in half! Market timing must be a terrible idea, right? There are many very legitimate reasons to argue against market timing, and I’ll discuss some of them in the conclusion. But first, let’s dig deeper to see if there’s anything interesting taking place during those 10 “best” days. Indeed, the cumulative return for participating in those 10 best days amounts to 100% – but look at the dates! The dates these earth-shattering returns occurred teach us some valuable lessons. Two of the dates were March 10 and March 29, 2009 – the furious beginning to the new bull market. It would indeed be tough on an investor to miss those dates, as the train was leaving the station. Bull markets often begin with strings of giant gains, and as such there probably should be some plan to get back in if you dumped your stocks and have plans to rejoin. On the other hand, eight of the dates were merely bursts with plenty of room left for the market to fall. If you got out – and stayed out – the day before any one of those great days, for 3+ months, you’d have been very happy that you had missed both the huge rally as well as the ensuing freefall. In fact, if you got out just before the 9/30/08 5.25% gain, you could have stayed out for the next three years and not lost out on a penny of gains, even though 2.5 of those three years were part of the new bull. Big up-days happen when there is outsized volatility. The trouble I have with studies like the Horan study is that they effectively show you what would have happened if you were an absolutely perfect market mis-timer. Now granted, haven’t we all felt like we were perfect mis-timers? I sure have, and I’ll bet you have too. But this study – and multitudes like it – actually quantify for you how costly being a perfect market mis-timer would be: in this case a doubling of your capital. To further understand why the Horan study asks the wrong question, let’s invert it: How much more money would you have if you only missed the ten worst days in the market? Here they are: Missing the worst ten days in the last 25 years for the S&P would have more than doubled your money! Furthermore, nine of those ten times (1997 excluded), you could have gotten out after the bad day, and still have been happy for several weeks or months to come – even though you would have missed some monster rallies along the way (consider how closely the best and worst days are clustered). Taking aside taxes, transactions costs, and the like, if you could side-step the best ten and worst ten days, you would have been better off to have missed both. Participating in all twenty of those spectacular days cost you 7% cumulative of your ending balance. This is likely not just a fluke, as the stock market has long been known to exhibit negative skew, where the log-magnitude of big down-days are larger than for big up-days. The options market lends insight on the matter. (click to enlarge) Look at the VIX prints for the close of each of the prior days. If we plug those VIX levels in for a one-day option price calculator, struck at the close the prior day, we obtain the call price column. I’ll add that there’s a very good chance that the VIX would have been in backwardation during many or all of these dates, and so the actual call premium would likely have been higher still. If you had hedged your SPX holdings by selling a one-day, ATM call against your position, you would have reduced your SPX winnings relative to not hedging at all. But you would have earned 16% in total call premium, and as such the missed opportunity would have netted to 72% rather than 100%. This highlights two big ideas that are each worthy of note. First, if you sold a one-day call just before one of these hall-of-fame days, then you had some terrible luck: you sold a lot of gamma one day before a giant move. But notice that the options market was at least pricing in very large swings in all ten of these cases. Your missed opportunity, while still large, was dampened considerably. Put differently, your missed opportunity was unfortunate, but predictable. Second, I think framing the study in terms of the ultimate unlucky options trader demonstrates just how unlikely being a perfect market mis-timer really is. Think about it: what are the odds that you would sell one-day ATM calls, ten times in your entire stock-holding career, with each instance being met with one the ten best days in the last 25 years? ZERO! But that’s the same likelihood that you would just miss only the ten best days, and nothing else (forget the options). What if you sold a one-day, ATM option every day, including on some of those worst days? Perhaps the 72% you had missed out on would largely (or more-than-fully) be recouped. Conclusion Studies of the Horan variety above are simply not serious studies of market timing. It doesn’t mean that they don’t offer insight, but they give it in a way that clouds a greater reality. Being a perfect market timer would be amazing — but that alone is not a reason to attempt it. Likewise, being a perfect market mis-timer would be horrific, and that alone is no reason why you should avoid it. There are good reasons for avoiding market timing, but they have nothing to do with the study (quite the contrary; I’d argue that the study recommends running to high ground early and waiting for the dust to settle). Here they are: Transactions costs: lots of portfolio churn needs to be carefully considered. You need to think about what the broker, and what the market maker, is earning off your trade. It does not mean you shouldn’t trade, but it is undoubtedly a con rather than a pro. Taxes: tax losses are treated asymmetrically from tax gains, which skews your after-tax risk profile. That is a perfectly legitimate reason to avoid “market timing”. Psychology: This is by far the biggest reason investors shouldn’t time the market. Investors and traders are not the same animal. They have different skill sets, different perspectives, different goals. Traders time the market almost by definition. Most fail, and a few do quite well. Investors should not be market timers precisely because being a market timer has a lot in common with being a trader, and very few investors are good traders. Imagine morphing from being an investor (something you might be good at) into being a trader (something you are probably bad at) at the worst conceivable time. Look at those dates for the best 10/worst 10 days – what a nightmare! Is that the kind of environment where you want to consider shifting away from what you do know toward what you do not know? This is the real reason that investors should not attempt to time the market. Finally, when SHOULD an investor open or close a position in a meaningful way? I mean, couldn’t we describe any buy or sell order market timing of sorts? Is it part of your overall strategy? Do you have a lot of cash – waiting for weeks, months or years to get in, and then when the market falls, you get out? That’s undisciplined selling: that’s an investor acting like a trader. Note from the discussion above that there’s an outstanding chance that your “trade” will go well and you’ll be happy you panicked, at least for awhile. If that’s you, you should be asking: “When do I plan to get back in? Proverbially or literally speaking, what put option will I sell TODAY to lock me into getting back in should the market actually fall that low and I lose my nerve?” On the other hand, maybe you are selling because this is part of your discipline. “Ride my winners, cut my losers.”; “I don’t hang around in high-vol environments hoping for a recovery (they don’t all end with a V-bottom!)”. This is a legitimate reason to “panic” and sell: it’s part of your strategy. While you might be unhappy if the market rebounds, you did the right thing, even if you got the wrong result. Maybe you should tweak your strategy, ex post. Maybe the market is showing you that your strategy has some meaningful flaws that you never considered or took seriously. Reducing your position size – even to zero – could be prudent. It’s one thing when markets are going from bad to worse and it’s part of your discipline. It’s quite another when you never foresaw the eventuality that you’re in, and volatility is heavy on the market. You’ll know this to be the case when you are asking yourself – as an investor – serious questions about your own long-term investing style. You’re not considering “a trade”, you’re considering a change. Best of luck, I hope the bulls need it!

Don’t Invest With Your Convictions. They’re Wrong.

Summary Investors overestimate their knowledge of financial markets. Realized returns of individual investors substantially lag benchmark results. There is no clear evidence of persistence in mutual fund returns. Most investors have some kind of view on today’s stock and bond markets. It’s only natural. Financial media is everywhere. Investment news and opinions are delivered to our smartphones as soon as they are written. While the bandwidth of financial information has expanded dramatically, its noise to signal ratio remains stubbornly high. Buy Gold! Metals are dead! The Stock Market is too high! The Market has room to run up! The reality is that almost no one knows. And it’s virtually impossible for John Q Public to identify those few who do know. This newsletter talks about investor convictions and their impact on financial outcomes. The Big Picture One way to evaluate the success of individual investor sentiment is to take a look at aggregated performance. How is everybody doing? As a group … very poorly. DALBAR is an independent consultancy that reports annually on the success that individual investors enjoy relative to various financial benchmarks. In effect, they measure the ability of the public to time movements into and out of mutual funds over long periods of time. There is a lag between expectations and performance. For the 30 years ending 2014, average equity and bond fund investors massively underperformed their respective benchmarks – the S&P 500 and Aggregate Bond Index. Why is the Investor so Wrong? There are two basic explanations for the lag. Investors repeatedly demonstrate tendencies injurious to financial health. Collectively, they lurch from euphoria to panic – based on recent market performance. In fact, investor performance lags are largest during periods of heightened market volatility. These general conclusions deserve some anecdotes. Gallup and Wells Fargo conduct a quarterly survey on investor sentiment by interviewing over 1000 individuals with stock market exposure. They distill the responses into an index of overall market optimism. It reached its apex in January 2000 – 2 months before the dotcom bust. The sentiment index reached its nadir in February 2009 – one month before what has become the 3rd longest bull market in American history. So much for investor convictions. It has been my experience that investors overestimate their own ability to maintain rationality in the face of market turbulence. The aggregated date supports this view. According to a Wells Fargo/Gallup survey conducted in early February, 76% said they were either very or somewhat likely to take no action during market volatility. Yet investors exited the equity markets en masse in late 2008. The second problem with investment outcomes are the products themselves. The mutual funds that investors choose to implement their beleaguered strategies also fall short of the mark. Fund companies spend fortunes to convince the public that their portfolio managers can beat the market through astute security selection or tactical asset allocation. These superstars get paid well. Data compiled by Morningstar indicates that the cost structure of mutual funds has remained high in the new century. The average US equity mutual fund still charges 1.25% annually. Given the secular decline in bond yields, this resilience of high fees is especially surprising in the fixed income space. Fees in the average bond fund now exceed 25% of the yield to maturity of the ten year Treasury bond – up from 13% a decade ago. Have the expert fund managers delivered? The aggregate data tells us no. In fact, actively managed mutual funds lag the performance of a corresponding index by an amount that is not significantly different than the expenses they charge. A reasonable response to this result might be that mutual funds cannot beat the average because they are ultimately competing against themselves. It’s up to individual investors or their investment consultants to identify the “best of breed” managers in each asset class. A foundational approach in this effort is the evaluation of past performance. Again the data throws cold water on this theory. Past performance demonstrates virtually no persistence across a wide range of equity mutual fund asset classes. Top quartile performers depart the top quartile at the rate faster than predicted by random chance. If returns were completely random from year to year, there would be a 25% likelihood that a dart throwing manager could return to the top quartile. Doesn’t work that way as selected data from S&P Dow Jones indicate in the table below. Is There a Better Way? There is a corollary to the rather pessimistic findings of the previous section. If moving assets around is a destructive behavior, then keeping them in place is a better option. Long term performance of the major classes has been sufficient over the last ten or even hundred years to deliver comfortable retirement outcomes to most serious investors. Sure, it’s no guarantee that the public financial markets will continue to serve as stores of value. But stocks and bonds are about the best option the investing public has. A qualified investment advisor can play a constructive role here. Besides the technical ability to craft and implement an investment plan, a key advantage is the discipline that investors gain to stick to the plan amidst the financial noise that is sure to follow. Vanguard estimates that behavioral coaching is worth about 1.5% to investors each year. Based on a Vanguard study of actual client behavior, we found that investors who deviated from their initial retirement fund investment trailed the target-date fund benchmark by 1.5%. This suggests that the discipline and guidance that an advisor might provide through behavioral coaching could be the largest potential value-add of the tools available to advisors. Although the financial markets have suffered few reverses over the past six years, rest assured that market panics will follow at some point. Consider the wisdom of Meir Statman, Professor of Finance at Santa Clara, who wrote the following in the Wall Street Journal near the nadir of the recent financial crisis when investor sentiment was stacked against the stock market. Don’t chase last year’s investment winners. Your ability to predict next year’s investment winner is no better than your ability to predict next week’s lottery winner. A diversified portfolio of many investments might make you a loser during a year or even a decade, but a concentrated portfolio of few investments might ruin you forever. Consistency will get you there. Have the courage NOT to act on your own beliefs. It will be worth it. (click to enlarge)