PORTFOLIO POINT: A well-diversified portfolio is the best strategy for dealing with bull and bear markets. It’s all about choosing the right products and allocations to handle both.
In my two previous articles I put the case for an imminent secular bull market on the one hand, and a continuing secular bear market, on the other. Each was convincing, but no one can be sure which scenario will win out.
Which begs the question – is it possible to design an investment strategy that will work in both secular bull and bear markets? Can one achieve good returns without the risk of large draw-downs like many investors suffered in 2008?
Avoiding crashes is important, because their financial and emotional trauma can cause us to be too afraid to take any risk thereafter. And without some risk, investment returns may not be enough meet retirement aspirations.
The life cycle of investor emotions
Dalbar Research found that over the past 20 years the typical share investor has achieved only half the return of an indexed share fund. That’s because most investors enter the market cycle late on the way up, and then exit it late on the way down. See the next chart. Financial planners recommend remaining on the roller coaster at all times. It’s called buy and hold. But the more sensible course is to opt for a less traumatic journey that doesn’t have to test one’s wits.
The advice given in this article is general, not personal, because I don’t know your particular financial circumstances or needs. The products mentioned are for illustrative purposes only. Talk to your financial adviser about these strategies and products before using them.
Managing investment risk
There are basically two requirements for growing wealth without drama. They are:
- Manage specific risk; and
- Manage market risk.
The first requires spreading your investment across multiple securities, preferably from separate institutions. Not exposing more than 3% of you portfolio to one company or project makes sense, because if one of your investments fails it won’t leave you destitute. Too often we read the tragic tales of people who lost all their savings by entrusting them to a single organisation that went broke (e.g. Banksia Securities, Trio Capital, MF Global, Westpoint, Fincorp). The easiest way to achieve product diversification within an asset class is through a regulated managed investment fund. The most liquid and least expensive of these are exchange-traded index funds (ETFs) that specialise in cash, bonds, shares, property, precious metals, commodities and currencies.
The second measure involves two parts. First, having a mix of asset classes that ranges from relatively low risk/ low yield (e.g. bank deposits and debt securities) to relatively high return/high risk (e.g. property and shares). See the next chart.
The following chart shows how a portfolio with a 75% corporate bonds/25% equities weighting achieved 97% of the annual return attained with a 75% equities /25% corporate bonds mix over the 12-year period to October 3, 2012. Yet the bond-biased portfolio cut risk (volatility) in half. In other words, it offered a much smoother ride for almost the same result.
The exact asset mix you chose will be a function of your financial needs and tolerance for risk. One popular approach is called lifecycle asset allocation. Take your age (e.g. 45 years old) and allocate a commensurate percentage (i.e. 45%) of your investible funds (e.g. a self-managed super fund) to defensive asset classes (e.g. cash and bonds) with the balance (55%) devoted to more speculative assets (e.g. property, shares and gold). The rationale behind this approach is that the older you get the less risk you should take because you have less time to make up for security failures or market collapses.
Mitigating market crashes
Most financial planners stop at this point, because they have exhausted their standard risk management tools. But market timers take a further precaution to mitigate market crashes.
They argue that it’s possible to reduce the inherent risk of speculative asset classes by trend-following them. Let me explain.
Speculative assets such as property, shares, precious metals, commodities and currencies are very volatile, but they also exhibit price waves – short, medium and long-term trends.
Market timers are slow trend-traders who grow wealth by letting their profits run (when markets rally), avoiding losses (when markets crash) and cutting their losses short (when markets whipsaw). There is considerable empirical research to show that slow trend-trading beats a buy-and-hold approach to indexed funds by delivering higher returns with much less volatility. It should not be mistaken for traditional technical analysis based on pattern analysis (e.g. head and shoulder or pennant formations), which is voodoo.
Examples of crash proofing
While it’s possible to trend-follow bonds, most market timers focus on timing shares and other speculative assets to tame their downside risk. Trend-following is not speculation, but risk management. Its aim is to stay on the right side of a market’s trend by riding rallies and sidestepping (or shorting) busts.
Here’s an illustration from my own conservative timing strategy that uses moving averages and momentum measures to gauge when the Australian All Ords index is trending up (warranting a blue signal to buy a listed share fund like STW) and when its trending down (triggering a red signal to sell STW and move to cash). This did not involve forecasting the market, just trend-tracking it. Note how this approach escaped the worst of the financial meltdown from 2007 to 2009 and the subsequent corrections in 2010 and 2011.
While I focus on local markets, there are other market timers who specialise in international markets. Three in particular are readily accessible in Australia. They are MAN Investments – AHL Alpha (AUD), Winton Global Alpha Fund, and Aspect Diversified Futures – Class A. Interestingly, each of these funds can be traced back to MAN’s AHL, which was created in 1987. They use quantitative trend-following models to trade in over 100 markets worldwide, using share, bond, interest rate, currency and commodity forward and futures contracts. Using derivatives, leverage and shorting is not without risk, yet each fund withstood past market crashes. See the charts below.
Lessons in risk management
So, in summary, how can one prepare for a future boom, crash or combination of both without boarding a roller-coaster?
First, don’t put all your eggs in one basket – diversify against specific security and institutional risk.
Secondly, choose an asset allocation commensurate with your age. With the debt securities component, avoid long-dated fixed coupon issues (even if they are government bonds) and high-yielding hybrids since they are most vulnerable to a market correction should interest rates rise from their current historic lows.
Thirdly, minimise market risk further by considering trend-following methods such as trend-trading signals for Australian equity ETFs (and from 2013 gold ETFs) and managed futures hedge funds that trend-trade international markets.
A hypothetical all weather portfolio
The end result for say a 60-year-old person using a life cycle asset allocation might look as follows:
Cash: either bank term deposits (e.g. UBank) or an exchange-traded cash fund such as BetaShares Australian High Interest Cash ETF (ASX: AAA) – 15% of total assets.
Debt Securities: an ETF with a short average duration such as Russell Australian Select Corporate Bond ETF (ASX: RCB) and/or a portfolio of inflation-linked, floating-rate and short-dated fixed interest coupon bonds constructed by a bond broker – 45% of total assets.
Total Defensive Assets: 60%
Domestic Speculative Assets: an Australian exchange-traded equities fund such as the SPDR S&P/ASX 200 ETF (ASX: STW) or SPDR MSCI Australia Select High Dividend Yield Fund (ASX: SYI) risk managed using a conservative timing strategy – 20% of total assets.
Foreign Speculative Assets: spread between international managed futures hedge funds that trade in a host of foreign markets using trend-following principles – Man Investments (via its Australian office), Winton (via Macquarie Bank) and Aspect (via Colonial First State) – 20% of total assets.
Total Speculative Assets - 40%
Such a portfolio would have provided a profitable and smooth ride over the last five years. That’s no guarantee of future performance, though pedigree counts.
The permanent portfolio
Finally a word on a more radical approach to managing an uncertain future devised by the late Harry Browne, author of Fail-Safe Investing, and described in the latest issue of the AAII Journal. It argues that the economy is always transitioning between four states, namely:
- Recession and
Owning the following assets can deal with each of those states and thereby provide a powerful diversification of risk. I have added an Australian ETF that corresponds with each asset class.
- 25% stocks (prosperity) – say SPDR’s STW.
- 25% bonds (deflation) – say Russell’s RCB.
- 25% cash (recession) – say BetaShares’ AAA.
- 25% gold (inflation) – say ETFS’s GOLD.
You buy these assets all at once and hold them at all times. Being a “permanent portfolio” means it does not time the market and is completely passive. Yet it produces both low turnover (hence lower taxes) and low volatility, which means a lower chance of catastrophic losses (and stress).
For high net worth individuals not bothered with a lifecycle asset allocation, such an all weather portfolio might have appeal. In America over the last five years it delivered an 8% annual return versus 6.8% for a well-known Vanguard income fund and 2.8% for the average of all domestic balanced funds.
In my view Browne’s Permanent Portfolio should be further de-risked by trend-trading the stock and gold components using conservative strategies.
Let the debate begin
So there you have it – possible strategies for enjoying booms while avoiding busts. But before you embrace any of these ideas, discuss them with your investment adviser. If they’re sceptical, ask why they won’t work and what’s their strategy for seeking good returns while limiting downside risk?
Let the discourse begin, because the standard financial planner’s mantra that “it’s time in the market, not timing the market” has worn thin. Ask anyone who got burnt in 2008.