Monday, July 19, 2010

How to cope in a low-return environment

MarketWatch published an article last week discussing the rise of trend based market timing strategies, compared to the more traditional buy-and-hold approach to investing. I also covered the same issue when I posted that we may have to wait eight years for a new equity bull to begin.

To recap, we may very well be in a secular bear market, where returns are roughly flat as illustrated by the chart of the DJIA below.

Zero return with portfolio volatility?
Let’s do a back of the envelope calculation. The stock market’s dividend yield is around 2% and the 10-year Treasuries yield around 3%. Assume that stocks have no capital appreciation over the next 5-10 years, the expectation of return of a buy-and-hold balanced fund is going to be around 2.5%, regardless how you play around with the asset mix decision.

Don't forget layer on the transaction costs and fees. After factoring in trading costs, which can easily be 1% or more for individuals, and investment management fees (conservatively estimated at 1-2% for an active solution, under 1% for passive solutions), the investor is left with little or nothing to show for his efforts, except for the volatility in his portfolio.

Why not just sock the money into a savings account?

Yield at a reasonable safety margin
To cope with a low return environment, the first-order solution for the buy-and-hold crowd has been to seek out yield. But there is no free lunch here either. Higher yield comes at the price of credit risk and credit risk could blow up in our faces in the current fragile economic environment. Some investment managers have sought to mitigate that with the concept of yield at a reasonable safety margin, which is not a bad solution under the circumstances and the constraints of a fixed asset allocation.

Dynamic asset allocation using trend following principles
My solution, along with some others cited in the MarketWatch article, is to trade the swings. The swings can be considerable – witness the trough-to-peak behavior of stocks since the March 2009 bottom.

I am not alone in my choice of modeling platform. My Inflation-Deflation Timer model is based on trend following principles, as applied to various commodity prices. The MarketWatch article cites others who use similar techniques. Mebane Faber uses similar kinds of principles to limit losses in asset allocation.

Coping with a low return environment is hard. Preserving financial staying power is of paramount importance under these circumstances. For those who believe in the static buy-and-hold asset allocation approach to investing, reaching for yield as a source of stability can be a reasonable approach if credit analysis is done properly. I happen to be in the dynamic asset allocation camp, where I believe the returns can be considerably higher given the likely volatility of the financial markets.

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