So a year ago, I was thinking about how to best leverage all the academic papers that come out showing their research that says x is better than y and that if you apply this or that you will get better returns. Unfortunately, so much of the research is not particularly useful in the real world. So culling through the papers, finding trends and general ideas that do seem to hold up is a bit of a task.
A couple of ideas that seem to be “tried and true” at this point are:
- the benefits of diversification
- the existence & advantage of momentum
- returns are inversely correlated with trading activity
I’ve tried to keep each of these in mind when creating my tactical asset allocation system.
The well diversified portfolio, holding uncorrelated instruments where possible limits portfolio draw-down while increasing returns. However, too much diversification, and you are just holding the market portfolio. So there is a balance. My personal balance is to weight some sectors more than others, and not hold some at all, depending on performance and other variables.
Many papers note the existence of momentum, and that there are lasting and outsized benefits derived from prior performance. The relative strength rotations model I developed, again inspired by Mebane Faber of The Ivy Portfolio fame, more heavily weights the holding of better performing assets compared to lessor. The old adage of cut the losers and let the winners run is a good guide to follow. However, this momentum idea can get very complex very quickly, so limiting it to simple price momentum over a couple of different periods is what I focus on. No double or triple filters, no cherry picking periods, etc. Keep it simple and (relatively) easy.
The return chart to the left is a comparison to the simple 10/40 week moving average crossover compared to the S&P 500 since 2000. Yes this is cherry picking the timeframe, but the best I could do right now. You own the S&P when the 10 week moving average is above the 40 week, and are in cash if the 10 week is below the 40 week moving average. Very simple system, and shows that being in the market all the time can be dangerous.
On a related note, I have a relative strength rotational model for investments that I have created. The image is an example of this type of system. If you’re interested, read more about my tactical asset allocation investment model based on relative strength, good diversification, and market timing stops.
The last item that I saw in research and other brokerage based surveys, are that returns are inversely correlated with trading activities. In other words, more trading hurts performance. I think all the various brokerage ads where they give you tools to trade quicker and quicker from mountain tops and while driving from your mobile phone all point to there being a conflict of interest. They make money on your trades whether you do or not. Once again, balancing this with cutting losers and letting winners run is key.
The last point I want to touch on is all those stock advisers saying if you missed the best 10 days of the market you would only earn half the returns, and since you don’t know when these will occur you always have to be in the market. What they don’t tell you is what would happen if you miss the 10 worst days, or both the 10 best and worst. The last link below explores some of this sales talk and gives you the real story. This is the basis for the timing aspect to my TAA model, which keeps me out of the large declines.
Readers, what do you think about using the latest research to try and juice your portfolio? What about the