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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.

The Grandma Approach

Summary Don’t be afraid to take a long-horizon approach to investing. Invest in what you know and understand. Always do your due diligence. Introduction Recently I’ve had several conversations with my grandma that caused me to question everything I’ve ever learned about investing. My sweet grandmother is an incredibly intelligent and humble lady. She has the unique ability to light up any room with her infectious smile and unassuming attitude. On Saturdays she spends time at garage sales looking for deals, and on Sundays she attends church, likely praying for the well-being of her rebellious family. Before she retired, she was a communications professor at the University of Texas. What was she not? She is not a financial guru or valuation genius. I don’t think she knows what a price to earnings multiple is, she doesn’t know what EBITDA stands for, and I can definitively say she doesn’t build her own DCF or comps models. Regardless, my grandmother and grandfather took up investing after retiring from professional life. My grandpa primarily is a dividend investor who averages about 4-5% returns year over year on low beta stocks. My grandmother on the other hand has been very willing to take on risk, and she has averaged an absurd 35% average annual return over the last 20 years. In the last year and a half alone she has made a 100% return. When I heard this, I first apologized for spitting out my coffee all over my shirt. Then as I did my laundry, I ruminated over my disbelief and resolved myself to conduct an independent research study on my grandmother. I was determined to know how someone with almost no financial background could so handily outperform some of the most seasoned investment professionals. The Grandmother Approach After hours of discussion, I determined my grandmother has three main criteria when investing She must personally like and use the products or services of the underlying company regularly in her own daily life She doesn’t focus on quick profits, valuation theory, or macro-economic hearsay She buys and holds a stock as long as she likes what the company sells or provides, and she subsequently liquidates her shares when she no longer cares for whatever product or service the underlying company peddles And that’s about it. She might hold a stock forever if she likes what they do. She has no timetables, and she doesn’t really care much about balance sheets. She is a firm focused trend investor with the patience you might expect from a teacher and a mother of three children. You can scoff at her approach, but the truth is she has outperformed the market for the last 20 years. So, for the sake of money, let’s give grandma the credit she deserves and maybe try to learn from her approach. I’m going to go into more detail now about her historical picks, why she decided to buy, and when she finally decided to sell. Hopefully I’ll verbalize an actionable way we too can follow in Grandma’s footsteps. Grandma’s Winners I have decided to include a select sampling of certain stocks she has owned. If this article garners interest, I may choose to included more of her stock picks. It is true that I noticeably am covering a time frame exemplified by ever increasing stock valuations (and possibly artificially inflated returns), though it should be noted that grandma outperformed the market from 2008-2010 as well. Cracker Barrel (NASDAQ: CBRL ) Enter : April 11, 2012 @ 56.20 “Grandpa and I always love to eat at Cracker Barrel when we take road trips. Their service is very good, and the parking lot is always full. Also, Cracker Barrel is always full of people like grandpa and I.” I believe the “people like grandpa and I” comment meant elderly people. After talking to grandma, I did my own due diligence to check if she was correct. The parking lot was in fact completely full, and the target demographic was indeed, shall we say “a little greyer.” I received my chicken and dumplings within 10 minutes, had some coffee, paid for my food, and left within 30 minutes. Granted I visited only one Cracker Barrel in the middle of rural Georgia. However, My grandmother and I reasoned that she had visited around 90 unique locations and assured me her experience was similar each time. 90 of 500 locations within the US is an 18% sample size which frankly was large enough to equal a statistically significant sample group in my own mind. It was official, Cracker Barrel did operate like a well-oiled machine, and my grandma had recognized this fact and capitalized on it. Exit : July 9, 2015 @ 154.65 “I really like Cracker Barrel still, but grandpa has been telling me that the stock is overpriced. Jim Cramer didn’t seem too optimistic either.” It will be hard quantifying a statement like this, but let me try. I believe what she was trying to say is that she felt like she had realized a generous return on her initial investment and was satisfied with what she had returned. When everyone is saying a stock is overvalued, it may be prudent to listen to what they have to say. Result : 171.18% ROI over 3 years and 3 months before a 3.2% dividend. This translates to a 52.67% avg. annual unrealized return without dividend reinvestment. Takeaway : Remember, the grandma approach involves patience, a long horizon, and recognizing solid business. Cracker Barrel checked all these boxes for my grandma, so she invested (and committed to regularly eating/monitoring the performance of her company). I believe there is lot to be said for patience and commitment. Starbucks (NASDAQ: SBUX ) Enter : May 31, 2010 @ 13.26 “Grandpa and I go there all the time. I noticed that it was always full of young people, and I like that I can get little gifts. It seems like there are Starbucks everywhere!” This is largely hearsay and un-technical, but as a “young person” I can attest to the fluidity and convenience of Starbucks’ daily operations. This is largely intangible, but they also offer highly convenient free wifi, they pursue environmentally and socially conscious movements, they offer seasonal beverages (ex. hibiscus tea, pumpkin spice latte’s), they employ thousands, and personally (warning the following comment is highly subjective) I think there coffee is pretty good (albeit overpriced). I think personally, Starbucks’s successful high growth, socially conscious strategy has paid off well over the long term. Strictly from Grandma’s point of view though, Starbucks is: popular, convenient, and widely available. Currently Owns : October 31, 2015 (Present) @ 62.57 Recently, I’ve had conversations with grandma in which she has expressed concern about its value. She believes it is almost time to exit, but she does in fact still own all of her shares. She cited reasons such as its 52 week high, Jim Cramer, and (of course) grandpa. To be fair, SBUX is trading at a 35X P/E multiple with a mere 1.02% dividend. SBUX’s domestic growth opportunities are decreasing, and it will be interesting now to see how SBUX pursues global growth strategies. Considering the vast uncertainty regarding Starbuck’s future growth, it isn’t entirely unfair to see why grandma might have a point here. Result : 371.87% split adjusted return, annualized 68.65% return before its 1.02% dividend. I must say, I was blown away when I crunched the numbers. Cashing out would not be such a bad thing at this point. Takeaway : Popularity, patience, and positive customer experience. These key intangible (yet important) metrics indicate a well-run business/investment. There are hundreds of other reasons why Starbucks has been so successful, but for grandma I believe the three I just mentioned sum it up fairly well. Apple (NASDAQ: AAPL ) Enter : Nov, 1 2005 @ 9.69 “Your father bought me a fancy IPOD, but I couldn’t figure out how to use it for the longest time. I saw so many people buying them though that I knew it must be something special. I thought about it for awhile, and I read up on the company before I decided to buy shares.” It’s honestly hard to say she didn’t luck out on Apple. Apple is a fantastic company that has performed incredibly well. Right now I still think Apple is in value territory and could likely continue its seemingly endless upward trajectory (my opinion). I’ll assume she did her research well and realized Apple’s R&D/marketing was a true differentiator. Honestly I’m more blown away that she never decided to sell. Currently Owns : Presently 119.50 Honestly, holding a stock for 10 years seems like an eternity to me. Grandma calls Apple her “cash cow” and has never seen any reason to sell it. I think it’s fair to say that Apple makes just about anything look good. Apple products have transcended into status symbols in many cultures, and you’d be hard pressed to find someone who does not know at least what Apple is. At a current P/E multiple of 13x, you could argue that Apple is value stock still. Result : Split adjusted return 1,300% before 1.78% dividend over a 10 year horizon. Takeaway : If the quality and desirability of a new technology is apparent in the eyes of a grandmother in her 70s, it’s possible that it’s something special. On a higher level, sometimes jumping on the bandwagon, with a long-term horizon in mind, is not necessarily a bad thing. However, it is important to remain diligent and continually research the performance of the business, the products it is offering, and the desirability of its largest cash producing offerings. The One That Got Away: Facebook (NASDAQ: FB ) What Happened? I mention Facebook because my grandma wanted to buy Facebook from the very beginning, and to this day she is angry that she did not. She was convinced (as many were) that the valuation when Facebook IPO’d was too high, so she chose not to buy in. However, Facebook (even at it’s initially high price @ 38.23 in 2012) has seen a 166.73% price appreciation as of today. Tips for Investing Like Grandma Don’t get too caught up in the noise (CNBC, Fox Business, family), instead remain patient and maintain realistic expectations Don’t be afraid to take a long-horizon approach to investing Focus on companies you understand (and like!) Do your due diligence and spend time getting personally invested in the products and services your company offers Conclusion That’s it! The grandma approach to investing takes patience and personal devotion. Just like you would put time into spouses and family members, get invested in the culture and products of the company you own. Forget the “analyst opinions” and the “most recent news” and focus on what the company you own does for the world. Don’t trust me? Luckily, numbers don’t lie and I believe even the most veteran money manager can learn a thing or two from “investing with grandma.”

The SPDR Dividend ETF Is A Very Interesting And Strange Choice

Summary SDY offers a dividend yield of 2.44% which is high for most ETFs but not so impressive for a dividend ETF. The individual holdings offer some dividend champions, but there are some allocations I could do without. The sector allocations aren’t bad, but there are a few changes I’d like to see in that area. The SPDR Dividend ETF (NYSEARCA: SDY ) is an interesting dividend ETF. I’ve been looking at dividend ETFs lately to decide which ones are designed the best. Expense Ratio The expense ratio is .35%. In my opinion, that is not very good. I’m very frugal on expense ratios and would love to see this under .20%. Holdings Investors should always look to the holdings as part of the process in making the decisions. The allocations here are fairly interesting. I see holdings that I love and holdings that I don’t. Realty Income Corporation (NYSE: O ) has an incredible track record that should put it on the radar for any income investor. To be fair, perhaps it should be on the radar for all investors since the total returns have been so solid. When I covered Realty Income Corporation before, I opted to explain how the high valuation of the company was creating an inherent advantage in being able to fund acquisitions through issuing new equity. It is a complex situation, but Realty Income Corporation has a competitive advantage through raising the dividend 81 times. That isn’t a typo; this monthly dividend champion has an incredible track record. On the other hand, this is also an equity REIT, so it could create some tax complications for investors that want to hold their dividend ETFs in taxable accounts and just live off the dividend yield. The same problem with the REIT status is present for National Retail Properties (NYSE: NNN ). If you don’t mind having the equity REITs in your dividend ETF, this isn’t a problem. The REITs offer some great diversification to the traditional corporate allocations and they carry nice dividend yields. Just do your own research on how the tax situation will impact you as an investor. On the other hand, I’m not so bullish on seeing a heavy weight for AT&T (NYSE: T ) because I’m concerned by the level of competition in the sector. I expect that the problems will be resolved eventually, but there could be some substantial damage to earnings over the next couple of years. Sector Allocations The next chart breaks down the sector allocations across the entire ETF: I’m not huge on seeing an enormous weight given to financials. At 25%, this is getting to be a pretty huge allocation and it will have a significant impact on the performance of the portfolio. I’d rather see this be a little lower so the other allocations could be higher. The real challenge for me in assessing their allocation to the sector is looking at which companies are producing the allocation. Equity REITs are classified as financials and I’m not complaining about those allocations. The problem for me is that as we get outside the top 10, several of the financial allocations are to banks or insurance companies. I don’t mind having some money allocated there, but I’m not so sure I would want 25% of the portfolio to go there. Consumer Staples and Utilities On the other hand, we have consumer staples as the second allocation and it comes in with nearly 15% of the portfolio which is nice for maintaining dividends when the economy is staggering. The utilities are running almost 12%, which is better than average for what I find in ETFs, but I’d still like to see the allocation be even higher. The combined weighting of 27% is pretty good, but I’d still like to see it being higher. Energy I wouldn’t mind seeing the energy allocations being a bit higher. Oil has been punished pretty hard, but I still like the huge dividend champions like Exxon Mobil (NYSE: XOM ). XOM is representing 1.55% of the portfolio with another 1.9% in Chevron (NYSE: CVX ). Those are two of the companies I would want for the energy allocation, but I’d like to see that part of the portfolio running closer to a range of 7% to 12% rather than 3.45%. Conclusion This is an interesting dividend ETF. It has some great positive features but there are also some significant weaknesses in my opinion. The allocation to those equity REITs is great as long as there are no tax concerns for the investor. If that isn’t a problem, then the allocations for the ETF are pretty solid. I’d still like to see lower weights towards banks with higher weights towards energy and the combined allocation to utilities and consumer staples.