Vernl

Tactical Asset Allocation, Part I

I find your article interesting and I’d like to see how your approach worked over substantially more time periods. However, I think mean reversion has some statistical issues. Example: you flip a coin that comes up heads 10 times in a row, what do you bet the next flip will be? Trend followers would bet heads ... mean reversion tells us to bet tails. What is the right answer? The right answer is ... it doesn't matter. No one knows coin flipping is random; the next flip has exactly the same odds as any other flip 50/50 heads/tails. The stock market is random and on average over the long term neither a simple trend following or a simple mean reversion analysis will give you the edge. The market is more complicated than that. Mr. Bogel's approach seems to be the wiser approach here. He is basically recommending Modern Portfolio Theory (MPT).

However, I do believe that the way advisors generally apply MPT today could be improved with the result leading to improved risk adjusted returns. First lower costs (per Mr. Bogel) could certainly be achieved with index ETFs. Second, standard deviation should be replaced as a measure of risk, using some measure of downside risk only. Standard deviation considers upside and downside volatility as equally bad. Yet, no investor worries about unusual upside returns. Third, large Growth, large Value, Mid-cap, and small-cap growth/value asset classes have correlations converging on one. This type of diversification doesn’t reduce risk especially in down markets. Investors and their advisors need to focus on a new group of asset classes with truly low correlation.

These are principals being brought to the forefront of academic theory by Behavioral Finance and Post-Modern Portfolio Theory (Post-MPT). For more information on investments using Post-MPT principals visit isectors.com. There you will find examples of managed investment allocation models with a history of outperforming the market using these simple approaches to apply MPT more effectively. In addition, if you’re looking for more on the “science” (financial theory) behind the Post-MPT investment allocation models …read “Practical Applications of Post-Modern Portfolio Theory” also found on the iSectors® website.