How To Create Portfolios That Adapt To Market Changes

This post contains the key ideas from the book, ‘ Survival of the fittest for investors’ by Dick Stoken.

1. Over the long run, most investors( both individual and institutional) fail to beat the market. Investors, on the whole, have a terrible record at forecasting.

2. From 1926-2010:

• 100% equities=9.87% annual return
• 100% intermediate bonds=5.35% annual return
• 100% long-term bonds=5.5% annual return
• 60% stocks/40% bonds=8.6% annual return
• 100% T-Bills=3.62% annual return

3. For the higher return offered by equities, you need to accept regular underperformance and at times excessive losses of more than 20% of our total capital. 60% stocks/40% bonds reduce the risk significantly and reduce the gain only slightly.

4. The stock-market is better understood as a complex adaptive system which are governed by trends rather than a purely logical Newtonian system.

5. Alternative investment portfolios:( 1972-2010)

• 33% Gold/33% REIT/33% Long-term Government Bonds( rebalanced yearly): 11.30% annual return( -8.24% worst drawdown)= Alternate Investment Portfolio
• 50% Gold/50% Long-term Government Bonds( rebalanced yearly):9.96% annual return(-15.36% worst drawdown)
• S& P 500: 10.05% annual return(-37.61% worst drawdown)

6. Passive combined portfolio: (1972-2010)

• 25% S&P 500/25% REIT/25%Gold/25% Long term government bonds( rebalanced yearly): 11.34% annual return ( -11.37% worst drawdown)
• 50% S&P 500/50% Alternate Investment Portfolio( rebalanced yearly): 11.16% annual return(-19.92% worst drawdown)

7. You can modify this passive combined portfolio by going for global equities, global REITs and global long-term bonds( if they are available in an investable form)

8. There are trends in complex adaptive systems and trends changing. If we have a way of identifying trends and trend changes among various asset classes, it may be profitable.

9. The Buy and Sell Portfolio: 

• Buy when DJIA/S&P 500 closes at a 6 month high. Sell DJIA/S&P 500 closes at a 1 year low. Put the proceeds into 5 year treasuries.
• CAGR: 1926-2010= 12.77% ( worst drawdown=-20.30%)( worst drawdown for buy and hold=-64.21%)
• CAGR: 1972-2010=13.84%( worst drawdown=6.09%)( worst drawdown for buy and hold=-37.61%)

10. The Buy and Replace Portfolio:

• Buy Gold when it closes at a 1 year high. Sell gold when it closes at a 6 month low. Put the proceeds in long-term 20 year treasuries.
• CAGR: 1972-2010=16.03%( worst drawdown=-12.7%)

11. The Buy and Sell REIT Portfolio:

• Buy REITs when they close at a 6 month high. Sell REITs when they close at a 12 month low. Put the proceeds into 5 year treasuries.
• CAGR: 1972-2010=14.92%( worst drawdown=-16.56%)
• CAGR for Buy and Hold REITs: 1972-2010=12.01%( worst drawdown=-47.50%)

12. The Active Combined Asset Portfolio:( rebalanced yearly)

• 33% Buy and Sell portfolio
• 33% Buy and Replace portfolio
• 33% Buy and Sell REIT portfolio

• CAGR: 1972-2010=15.58%
• Worst drawdown=-0.68%

13. Leveraged portfolios will further increase the return, except in S&P 500.

Leverage at 2:1( annualised return 1972-2010)

• S&P 500=8.2% ( worst drawdown=-84.20%)
• Active combined asset portfolio=23.06%( worst drawdown=-7.64%)
• Passive combined asset portfolio=14.46%( worst drawdown=-31.41%)
• Alternative investment portfolio=14.27%( worst drawdown=-32.88%)

Leverage at 1.5:1( annualised return 1972-2010)

• S&P 500=8.09%( worst drawdown=-60.42%)
• Active combined asset portfolio=19.42%( worst drawdown=-5.62%)
• Passive combined asset portfolio=12.98%( worst drawdown=-19.51%)
• Alternative investment portfolio=12.93%( worst drawdown=-20.55%)

14. You need to have a crisis plan. If you lose 20% of your money, you should put your money into defensive assets. If you lose 50% of your money, you should become more defensive. Defensive assets include:

• T-Bills
• TIPS
• 5 year treasuries
• 5 year or less CDs at good banks
• Fixed annuities underwritten by a strong institution, if you are over age 60

15. Things to remember when making rational decisions in games of uncertainty.

• Our knowledge is limited. Know what you don’t know.
• Process is more important than outcome.
• Detach yourself from meaningless noise and engage on your own terms.
• Remember you are error-prone. When an error happens, correct it immediately. Remember your errors and don’t repeat it. Use your errors as a learning experience. Don’t view proper decision making as an all or nothing proposition. You just have to make less faulty decisions than others. Build imperfection into your strategy, leaving ample margin of safety.

16. In investment markets, there are trends, narratives ( the stories we tell about what will most likely happen), the error-prone agents( ourselves), misperception of risk and fluctuations. Dealing with these successfully is the key to success.

17. A real bubble is when a market index after reaching a new 20 year( or more) high, then triples from that level within the following 5 year period.

18. If many people follow these strategies, they will cease to work.

19. Things to take away:

• Markets are complex adaptive systems and alternates between order and chaos.
• True bubbles are rare, but when they happen, they can destroy a lot of wealth.
• Trends are important.
• Evolution and the stock market are smarter than you and me.
• Varied asset classes and selection of some of them depending on certain criteria( commodities, currencies and TIPs may be some to think about in the future)
• There are unknowns in every system and each system is born, grows and dies. We do not know where our current system is in its life-cycle.
• Markets can be beaten, but only for a minority and if everyone follows these strategies, then these strategies will fail to work.