Investment Strategy 10: The Small-Cap Defensive Investor Tactical Asset Allocation Strategy

This strategy is inspired by Benjamin Graham’s Investment Strategy for the Defensive Investor.

Benjamin Graham wrote in ‘ The Intelligent Investor’- the best book on investing ever written: The investor should divide his funds between high-grade common stocks and high-grade bonds. He should keep a minimum of 25% in stocks and a minimum of 25% in bonds at all times. The basic split is 50% in stocks and 50% in bonds. If stocks have gone down a lot , you can increase stocks to 75% and if you thinks stocks have gone too high then decrease stocks to 25%

I have written earlier about the defensive investor tactical asset allocation strategy using large-cap stock ETFs and treasuries.

It is known that small cap stocks and value stocks have had higher returns when measured over long durations of time. You also have to remember that there have been extended periods when small cap and value stocks have lagged the broad market. Small cap stocks also have higher bid-ask spreads and we do not know whether the premiums will persist into the future.

Nevertheless, if we have a strategy of investing in small cap and value stocks, we have a chance of getting a higher return. Now if we use the principles of Graham we can cut down our risk as well.

The small-cap defensive investor tactical asset allocation strategy is as follows:

  • The basic split is 60% in stocks and 40% in bonds at the start of an year. If you start investing in the middle of a year, then use the same split (60% stocks, 40% bonds)
  • The stock part is divided into two groups: US Small Cap Value (30%) and ex-US Small Cap(30%) The bond component comprises of 5 year US treasuries.
  • After one year, if each of stock groups( i.e.US Small Cap Value or ex-US Small Cap) all have positive returns, then keep the same split( US Small Cap Value (30%) and ex-US Small Cap(30%) and 40% Treasuries )
  • If a particular stock group has a negative return for a year, the for each year of negative return, increase by 10% and decrease the amount of treasuries by the same amount.
  • If that stock group later has a positive return, then decrease the allocation by 10% each year till you get back to 30% for each group.
  • You don’t decrease the percentage of stocks in each group to less than 30%, even if you think the market is high.

Some ETFs you can use for the different asset classes are:

The returns from following such a strategy are as follows:

  • Annualised return 1972-2012: 13.66%, worst year 2008: -18.27%. Worst 10 year annualised return is 9.33% for the year ending 2002.
  • If you invested 1/2 in each of the stock ETFs, your annualised return from 1972-2012: 14.63%, worst year 2008: -39.89%
  • The annualised return from 1972-2012 for 30% US SCV, 30% ex-US Small cap and 40% 5 year treasuries is 12.55% with the worst year being 2008(-21.1%)

This is a very good strategy for defensive investors. You participate in all the major stock markets of the world and you take advantage of Mr. Market as well.

The detailed returns and how the strategy is implemented is shown in this spreadsheet.