By Jason Veinot
THE PROBLEM: The Paradigm Has Shifted
Asset Allocation, is based on “Modern Portfolio Theory” (1952)by the Nobel Prize winner Harry Markowitz and is the most widely recognized and popular approach to investing.
This strategy is built on the premise of combining unrelated assets to produce an expected return with the least amount of risk based on historical trends.
And many economists now believe it no longer works.
A good example supporting this belief is the Permanent Portfolio, developed by investment analyst Harry Browne.
This popular approach simplified traditional asset allocation by splitting a portfolio evenly between stocks, bonds, metals (gold) and cash.
From 1983 to 2012, only four years produced a negative return, including no losing years back to back.
But in 2013 and 2014, the strategy produced negative returns even as the stock market was positive both years.
Five factors have created a new paradigm in investing:
1) Bonds Have Bottomed Out
Because of historically low interest rates, bond prices, which move in the opposite direction of interest rates, can go no higher.
Worse, they will now fall when rates move up.
2) Fixed Investments Pay Too Little
Low interest rates mean low yields for cash.
3) 401ks Have Altered the Market
The influx of billions of dollars from millions of U.S. workers has changed the dynamic of the market, leading to the first decade in history (2000–2010) to produce a negative return and see two market declines of 50% or more.
4) Gold Is No Longer a Hedge
With multiple investments available now for trading in gold, it often no longer moves in the opposite direction of stocks.
5) High Frequency Trading
HFT, which relies on computers to invest millions of orders in seconds, now accounts for 70% of all trades, disrupting traditional approaches to investing.
As Harvard endowment manager Mohamed El-Erian said in 2009:
“Diversification alone is no longer sufficient to temper risk. In the past year, we saw virtually every asset class hammered. You need something more to manage risk well.”
Mebane Faber, author of the best-selling book, “The Ivy Portfolio,” wrote a popular research paper entitled “Tactical Asset Allocation.
This paper outlined a simple technique to avoid holding positions in a Bear market through the use of a “Moving Average Crossover” system.
This system is designed to help investors determine when they should be “Risk-On” (in the market) and “Risk-Off” (out of the market).
Based on the idea that the market is never priced accurately, this approach recognizes potential Bull and Bear market trend changes.
A common method to determine when a potential shift may be occurring is by following the price of a stock or index in relation to an “average” of that price.
Had you purchased an exchange traded fund (ETF) of the S&P 500 (Ticker: SPY) in February 1995 and held until now, you would have participated in all of the funds moves up and down along the way.
But if you sold the index and went to cash when the price (blue line in chart above) moved under the average (red line), you may have potentially avoided a portion of the markets downside.
Make Money When the Market Falls
With the availability of multiple “inverse funds” (investments that increase when the market falls), any investor can “short” the market (make money when prices decline.)
Professional investors have used these funds for years but not so with the general public.
Going back to our example, had you purchased an inverse index fund rather than moving funds to cash when prices moved under the average, you would have added the opportunity to potentially profit as the market declined.
However, just like a regular index fund can lose money when the market moves south, inverse funds can also lose money if the market jumps to the upside.
Embrace the New Paradigm
The stock market has changed dramatically over the last 50 years, and yet many financial advisors and individual investors continue to use the same traditional methods that some now consider flawed.
This simplified technical approach to determine when to be “Risk-On” (in the market) and “Risk-Off” (out of the market) is an alternative to traditional methods and may be appropriate for some investors.
Let us know if you would like to understand more about this approach and see if it may benefit your situation.
Jason Veinot is a financial author, former radio show host, and owner of Enhanced Capital, LLC, a consulting firm that helps individuals manage their life savings in the new economy with an active investment approach. Should you have any questions or desire a review of your situation, please contact Jason directly at 231.6622 or firstname.lastname@example.org.