Tactical Asset Allocation
March 3, 2009
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“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.” - Mohamed El-Erian (Kiplinger’s, March 2009)
2008 was a devastating year for buy-and-hold investors. The classic barometer of stocks, the S&P 500 Index, declined 36.77%, and the normal benefits of diversification disappeared as many non-correlated asset classes experienced simultaneous large declines. Commodities, REITs, and foreign stock indices all suffered losses over 35%.
While many global asset classes in the 20th century produced spectacular gains for individuals who bought and held those assets for long periods, most asset classes also experienced regular and painful drawdowns like those that characterized 2008. Drawdown is an investment’s peak-to-trough decline, and we calculate it here on a monthly basis.
In this century, every market in G-7 countries has experienced at least one period that saw stocks lose at least 75% of their value. The unfortunate mathematics of a 75% decline mean an investor must realize a 300% gain just to get back to even – the equivalent of compounding at 10% for fifteen years.
Consequently, individuals are usually not invested for a sufficiently long time frame to recover from large drawdowns in risky asset classes.
My 2006 article, “A Quantitative Approach to Tactical Asset Allocation,” outlines a trend-following model that uses the S&P 500 Index and four other diverse asset classes, including the Morgan Stanley Capital International EAFE Index (MSCI EAFE), the Goldman Sachs Commodity Index (GSCI), the National Association of Real Estate Investment Trusts Index (NAREIT), and United States government 10-year Treasury bonds.
My simple trading model works in the vast majority of markets most of the time. The results suggest that a market-timing solution is a risk-reduction technique rather than return-enhancement one— an investor just needs an approach that signals when they should exit a risky asset class in favor of risk-free Treasury bills.
Since 1973 the model has delivered equity-like returns with bond-like volatility and drawdowns, and 35 consecutive years of positive returns, including 2008.
For the model to be simple enough for investors to follow and mechanical enough to preclude subjective decision-making, a few features are necessary:
- Simple, purely mechanical logic.
- The same model and parameters for all five asset classes.
- Based only on prices
The resulting system is very easy to grasp. Investors should buy an asset class when its monthly price is greater than its 10-month simple moving average (SMA), and sell when it is less. Further:
- All entry and exit prices are on the day of the signal at the market’s close. The model is only updated once a month, on the last day of the month. Any activity during the rest of the month is ignored.
- All data series are total-return series, including dividends, updated monthly.
- Cash returns are estimated with 90-day Treasury bills, and margin rates (for leveraged models to be discussed later) are estimated with the broker call rate.
- Taxes, commissions, and slippage are excluded (see “practical considerations” section later in the paper).
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