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Normal Doesn’t Exist

By Andy Hyer Michael Batnick on “waiting for normal:” These are not normal times investors are living in. The Fed has held short-term interest rates at zero for six years now, a policy experiment never seen before. This has many investors eager to see what happens if and when this returns to “normal.” One of the biggest psychological challenges of investing is that there is always something out of the norm. Take a look at the table below which highlights different times investors had to live through and the extreme performances that accompanied them. I wonder at what point would somebody would have described the times as normal. Next, have a look at the chart below, which shows the S&P 500 return by decade. You’ll notice absolutely no pattern. Understanding how different it always is should be a great reminder why no strategy will work in all market environments. Knowing the limitations to what you are doing- whatever you’re doing- is critical. The ability to stick with your plan during the bad times will determine if you’ll be around for the good ones. So what is an investor to do? I see a couple options: Employ some form of static asset allocation and hope for the best. 25% fixed income, 25% US equity, 25% international equity, and 25% alternatives, and rebalance annually. Employ some type of forecasting to try to be opportunistic in asset class exposure Employ some form of trend-following tactical approach to asset allocation The static allocation approach may ultimately perform okay over long periods of time, but will investors have the risk tolerance to continue with long stretches of an asset class being out of favor / going through severe drawdowns? Maybe. Maybe not. Chances are the forecasting approach will end very badly, as forecasting usually does. The third option makes much more sense to me. Simply systematically deal with trends as they unfold. This is the approach we use with our Global Macro separately managed account, which happens to be our most popular SMA strategy. Thank goodness we gave ourselves as much flexibility as we did with the way that this portfolio is constructed, because this decade has been entirely different from the last one. As one example, consider how well commodities performed in the last decade, compared to the trainwreck that they have been so far this decade. Normal doesn’t exist. A disciplined way to be flexible is the key to successfully navigating the ever-changing financial landscape. The relative strength strategy is NOT a guarantee. There may be times where all investments and strategies are unfavorable and depreciate in value. Share this article with a colleague

Why Countercyclical Indexing Makes Sense

I am totally convinced that low fee indexing is the best way to allocate one’s savings (in fact, my entire company is based around this view). But when it comes to allocating that savings in a specific manner there are virtually limitless options. We know that reducing your frictions is the only way to guarantee higher returns, so it’s imperative that we be tax and fee efficient in our portfolios. But that doesn’t solve the allocation decision, which will ultimately steer our returns . It’s increasingly common for indexers to advocate a market cap weighted methodology. This is the typical “passive” indexing approach. In essence, you buy what the market generates and you never accuse the market of being wrong. So, if you wanted to be a true passive indexer today you’d buy the market cap weighting of global stocks and bonds at roughly 45/55 stocks/bonds and rebalance back to that weighting every year. You don’t deviate from this because the market is always “right” and you just want to take the market return. Easy enough.* But my economic and financial research shows something strange. This “efficient market” view of the system isn’t always right. In fact, investors and economic agents appear to make substantial errors at times. For instance, I calculated the average retail investor’s relative total net asset allocation over the last 30 years and found that retail investors, by being procyclical, are almost always positioned in the exact wrong way during the business cycle: You can see what happens here. Investors chase stocks in bull markets and they sell them into bear markets. And by doing so they end up being underweight stocks early in the market cycle and overweight stocks late in the market cycle when they’re riskiest. This is in addition to the fact that we know that most individual investors perform poorly due to very high cash balances. The most interesting part about this is that doing the opposite of this allocation (inverting the stock/bond allocation) actually generated similar nominal returns as the market cap weighting (8.2% per year vs. 8.9% per year), but improved the risk adjusted returns by a significant margin (standard deviation of 6.4 vs. 13.8). In other words, betting against the procyclical market cap weighting actually generated a better overall return. Most importantly, what this does is better align an indexer’s profile with their exposure to various asset classes over the course of the market cycle. And the beauty is, you can do this in a highly tax and fee efficient manner if you have the patience to actually let the approach play out over time. Of course, you can tweak this sort of an approach in numerous ways. That’s the essence of my approach at Orcam. But the findings are interesting – countercyclical indexing might actually be a superior approach to market cap weighted procyclical indexing. In other words, discretionary deviations from market cap weighting might not be as silly as some indexers portray. * It should be noted that even a static allocation that rebalances is always rebalancing back to imbalanced degrees of risk during the market cycle. That is, a 60/40 is actually a much riskier portfolio late in the market cycle than it is early in the market cycle. This leaves the investor who buys the 60/40 in 2009 owning a much less risky portfolio than the investor who buys a 60/40 in 2007.