Uncertain Times Make Investors Jittery, Which Can Lead to Bad Investing Decisions
Global and domestic debt concerns are making economic markets extremely volatile, and investors are scared. After being beaten up by the bursting of the dot-com bubble in 2000, the subprime mortgage crisis in 2007, and the global debt and recession fear crisis now playing out, investors are justifiably fearful about placing their hard-earned coin into companies that may not be around in a couple of years, and many are fearful of losing their nest eggs.
They are facing complex and confusing economic information, and are at a loss over how their portfolios should be properly invested. Should they buy gold? Should they divest their stock holdings and use the cash to stuff their mattresses? Will the market turn around soon and if it does, will they be too afraid to enter and miss out (perhaps again) on the ensuing rally?
Investors today have so many questions they can’t answer, and many have just given up. But do not fear, help is here! There is a way to stay in the game and still get a good night’s sleep. We’ll show you how.
Asset Allocation According to Modern Portfolio Theory: The Pros And Cons
Many wealth managers design portfolios built upon the concepts of Modern Portfolio Theory, or MPT. We’ve discussed MPT many times before, but for those unfamiliar with it, it is a Nobel prize-winning mathematical model which tells you how to best allocate your funds among various asset classes while minimizing risk.
Although MPT has revolutionized portfolio management, it is not without limitations. One of the precepts of MPT is that portfolios must always have funds distributed among the various asset classes, in good times and in bad. It is this concept that can lead to large portfolio losses during market corrections—losses that can take many years, even decades, to make up.
How This MPT Limitation Can Be Minimized
Realizing the risk of loss during downturns, portfolio managers have sought to downplay the MPT approach by offering their own managed services. It seems that each manager has his or her own approach towards curtailing losses and, typically, the approach is labeled as “proprietary” thus making it opaque to the investor as to how allocations are determined and exactly what components make up each asset class. On top of that, firms offering broad asset class diversification products typically charge a hefty load and/or management fee for the privilege of not telling you how your money is being managed.
When a manager claims that her allocation scheme is proprietary, I have to think that by “proprietary” she means “subjective,” because if her model was completely quantitative, she would say so--what’s there to hide? By contrast, we have created a completely quantitative modification to MPT that will save your portfolio from market crashes.
Market Timing Meets MPT
We’ve spent a lot of time and effort in developing an effective market timing model that, when combined with MPT, not only offers you higher overall returns at substantially lower risk but saves your portfolio from the devastation of market crashes. The beauty of this approach is that you need only rebalance your portfolio at most once per month.
Although we use complex mathematics to determine asset allocations, the theory behind the approach is simple. We apply an indicator that is re-optimized every month for each asset class. When the indicator is positive, we allocate funds to that asset class according to what MPT proscribes. When the indicator turns negative, we take the funds that MPT would ascribe to that class and put it into the most risk-free asset class, typically T-bills (or an insured money market). For this article, we will call our Modified MPT model MMPT for short.
How Market Timing Saved the Day
Let’s see how two portfolios, one constructed using the traditional MPT model and one constructed using our market timing model, with the same return objective would have fared over the market crashes from the bursting of the dot-com bubble in 2000 through the current debt and recession fear debacle. Before we do that, though, let’s take a look at the chart of the S&P 500 which shows that the index lost 50% of its value from 2000 to 2002 (dot-com bubble), 57% from 2007 to 2009 (subprime mortgage mess), and 20% (global debt debacle) so far this year (as of this writing).
(Click to enlarge)
Our two portfolios are composed of the same traditional nine asset classes shown below. We are also assuming a target required compounded annual return of 10% which is neither ultra-conservative nor highly speculative. The only difference between them is one enjoys the benefits of market timing, the MMPT portfolio, while the other does not.
The nine traditional asset classes used in this analysis:
- Large-cap U.S. Stocks (S&P 500)
- Small U.S. Stocks (Russell 2000, etc.)
- Long-Term Corporate Bonds
- Long-Term Government Bonds
- Intermediate-Term Government Bonds
- 30-day U.S. Treasury Bills
- Real Estate Investment Trusts (REITs)
- International Stocks
- International Bonds
Both were rebalanced following updated allocations provided each month. Returns from the beginning of 2000 to the end of this July are plotted against each other in the figure below. (The MMPT portfolio returns and stats are given in green; the classic model is shown in magenta.).
(Click to enlarge)
The results show an astounding difference in both returns and risk. The market-timing or MMPT portfolio was not only able to make its required 10% return but it beat it while the classic model could only return a measly 2.5%, hardly better than the average return of a money market. The one positive thing we can say about the classic portfolio is that it was able to beat (barely) the compounded return of the S&P 500 during the same time period. (Click here to see how the same investment in the S&P 500 would have performed.)
- It took five years for the classic portfolio to break even after the devastation caused by the bursting of the dot-com bubble.
- Four years after the beginning of the 2007 mortgage crisis, the classic portfolio still hasn’t been able to climb back to its pre-2007 high.
- The risk as measured by the standard deviation (σ) of portfolio returns of holding the classic portfolio is more than double that of its market-timing counterpart. This fact alone should alarm you.
We have shown that the judicious application of an optimized market timing model to an MPT-constructed portfolio not only results in being able to attain the required return (at least up to a 10% compounded return) but at a substantially lower risk, too. Another great feature of the market timing model is that it does all this without the need for portfolio hedging or other costly risk-reduction techniques such as buying put options – the market timing model acts as its own hedge!
The few minutes a month that it takes to rebalance your portfolio is sufficient to protect your nest egg from the ravages of a market crash. Can your broker or money manager do the same for you?
A few notes:
Gold was not included as a separate asset class in this analysis, because most people do not hold it in significant proportion to the rest of their portfolio. But we might run the same analysis with it if there’s any reader interest.
We were going to go into detail on why the market-timing model outperforms the classic model during market crashes by showing the monthly allocation tables just before, during, and after each crash, but to do so would have made the article much more lengthy and involved. Again, if there’s reader interest, we can provide these data.
It will be interesting to see how the situation plays out during this current global debt/recession fear crisis. When the dust has settled, we’ll update this analysis. I hope your portfolio is mostly in cash or precious metals!
Pat Glenn contributed to this article.