A study published in the December issue of the Journal of Financial Planning calls into question the traditional buy-and-hold approach to investing.
In “Improving Risk Adjusted Returns Using Market-Valuation-Based Tactical Asset Allocation Strategies,” authors Ken Solow, Michael Kitces and Sauro Locatelli demonstrate that a tactical, rule-based investment strategy that accounts for whether stocks are “cheap” or “expensive” can bring higher regular returns than the status
quo buy-and-hold method.
During the past 50 years, investors have been taught that there’s only one reliable way to make money in the stock market: Investors choose a portfolio that balances the returns they want with the risk they’re willing to take and then stick with it, no matter what. Because the market is assumed to continue to grow during the long term, just as it has in the past, the patient investor will be rewarded.
While this remains the establishment view, the market’s performance over the past decade has greatly undercut the assumption that markets always deliver.
In an effort to determine whether changing the balance between stocks and
bonds in response to market shifts can improve returns, Solow, Kitces and Locatelli created a simple, rule-based investment strategy. Beginning with a portfolio of 50% stocks and 50% bonds, in periods when the stock market was overvalued (amongst the top 10% most expensive stock environments), they shifted the portfolio to 40% stocks and 60% bonds. When the market was undervalued (in the 10% cheapest stock environments in history), the portfolio moved to 60% stocks and 40% bonds. They then tested how a portfolio making those tactical shifts would have performed during any
particular 30-year period during the past century, using the actual historical market returns and fluctuations.
The result was clear: “The tactical portfolios achieved higher long-term returns than the buy-and-hold portfolio,” Kitces said. “In fact, the results showed that the strategy of adjusting the portfolio when stocks are cheap or expensive was so effective, adjusting equities up or down by 30% (e.g., from 20/80 to 80/20) was even more beneficial than just adjusting from 60/40 to 40/60; it was even slightly more effective to go all the way from 0/100 to 100/0, although the additional benefit is limited on a risk-adjusted basis.”
The significance of the findings did not go unnoticed. MarketWatch and
SmartMoney both featured the story last week — it was one of their most e-mailed articles — while financial planning industry guru Bob Veres wrote in his December industry Media Review, “[F]rom now on, after this article, the discussion in the profession won’t be on whether it is possible to add value through tactical shifts, but whether it can be done under broader, more common circumstances.”
“For those who claim that tactical asset allocation is no more than a ‘guessing game’ utilizing market timing strategies that cannot succeed in efficient markets, we hope this study advances the notion that active portfolio management can in fact lead to superior risk-adjusted returns, and even an outright increase in long-term return,” Kitces said.
Solow, Kitces and Locatelli are the chief investment officer, director of research and quantitative analyst, respectively, at Pinnacle Advisory Group in Columbia. To read the study, go to http://goo.gl/yLfnp. For more information, visit http://goo.gl/N9E4m or e-mail email@example.com.