Why you should embrace market-timing with open arms
The so-called gold standard of investing – the near-universally revered Buy & Hold strategy – has become obsolete in the brave new world of machine-dominated markets.
The value of the equity risk premium (the higher returns from owning stocks rather than bonds or cash) has been in decline for years. The expected risk premium for equities is so small for the next 10 years, that locking into an equity-loaded portfolio is not only inefficient, but actually quite dangerous to your wealth.
If you are going to take risk, make sure you get paid for it
The reason is that an equity-heavy, static asset allocation does not adequately compensate you for the volatility and risk that come with it. You’re not getting paid for the risk you’re taking.
Rigid adherence to a buy & hold asset allocation mix should go out the window forever. We must abandon fixed views of what the future is going to be like. Investors need to be far more flexible than they have in the past and must embrace asset mixes that meet far different economic, capital market, and geopolitical climates.
Unlike the good old days, stocks are no longer guaranteed to outperform bonds in every 10-year period. But they should outperform bonds in the very long run, otherwise capitalism would eventually face the threat of total collapse.
If not buy & hold, what’s the alternative?
What is the alternative to the nearly religious belief in a rigid buy & hold strategy? A recognition of inefficient markets, frequent periods of overdone greed and fear, extreme valuations both above and below fair value, and reversion to the mean, to name just four.
Spikes in market volatility are unavoidable, causing even the true believers of buy & hold to deviate from their policy asset mix, usually with unfavorable consequences. Modern portfolios should include contingency plans for how to deal with volatility spikes. This reduces the influence of emotion when tough decisions must be made in the heat of battle.
The new normal
Geopolitical turmoil and economic storms have become the norm. Equilibrium and orderly markets are myths. We cannot escape the volatility of the short run. Buy & hold investors are required to sit back and take the pain, even if that means their portfolios are under water for years. The worst example of this forced suffering was the infamous crash of 1929. It took 29 years for buy & hold investors to get back to even. I doubt that many of them lived long enough to enjoy that moment of redemption.
The Bipolar Portfolio
One alternative to buy & hold is a “bipolar portfolio” positioned to respond to both good and bad news. It would include an equity core for positive shocks, balanced by a set of hedges for negative shocks. These might include gold, foreign-based instruments that will counterbalance the negative effects of a falling dollar, inflation-protected bonds, and long-dated government bonds to protect against both inflation and deflation.
A good example of a bipolar portfolio is the Permanent Portfolio (PRPFX). This is a decidedly unconventional asset mix, with a heavy exposure to bonds, precious metals, foreign securities, and a dash of equity exposure. The idea is to deliver steady returns in any market environment. But the performance has only managed to match its Morningstar category.
The ZenInvestor Way
The way I and my clients deal with this brave new world is to embrace market-timing with open arms. Let me emphasize that mine is a modified version of the traditional buy & hold approach. It does not require frequent trading. There’s no “all-in” or “all-out” based on short-term zigs and zags in the market. In fact, my modified buy & hold strategy can go for several years without a single change to the portfolio asset mix.
I offer two versions of this strategy. The first is a simple moving average crossover, where the model gives a sell signal when the short-term average crosses below the long-term average. The reverse happens when short-term crosses above long-term on the way back up.
The second is a Recession Overlay strategy that operates quietly in the background while the investor’s primary strategy is at work. The recession model gives a signal when the risk of a new recession is high enough to warrant defensive action. Recessions come along about every 7 years, so this overlay strategy adds very little trading volume.
I have been using these strategies with clients since 2005. On average, it increases buy & hold returns by 20-30% per year. So if a buy & hold portfolio returns 10%, the defensive overlays will increase that to 12-13%.
If you are interested in learning more about this defensive strategy, contact me at email@example.com .