Jekyll or Hyde Market

Readers will undoubtedly be familiar with Robert Louis Stevenson's famous tale, The Strange Case of Dr Jekyll and Mr Hyde. The story centers around a well respected (though hardly innocent) physician, Dr. Henry Jekyll, who produces a potion which causes him to transform into a cruel, sadistic, evil Mr. Edward Hyde. Wikipedia asserts that the story is, in fact, "an examination of the duality of human nature (that good and evil exists in all), and that the failure to accept this tension (to accept the evil or shadow side) results in the evil being projected onto others." This article takes the position that markets have a duality of nature that mirrors the personalities of Jekyll and Hyde, and that traditional investment techniques ignore the existence of Hyde, thus inflicting pain and suffering on unsuspecting investors.


It is a foundational principle of modern investment theory that market volatility is utterly random, with major swings up or down interspersed with minor moves with no discernible pattern. This principle is put to use in the construction of trillions of dollars of investment portfolios, and is an argument commonly put forth by large investment firms in marketing and sales material to justify their buy and hold approach. If volatility can not be predicted, they claim, then why try to avoid it?


To supplement this argument, firms and Advisors often show statistics or charts which allegedly demonstrate how missing the best days or months in the market will result in dramatically lower returns. They go on to conclude that these best months are impossible to predict in advance, so investors must be fully invested all the time in order to experience these great returns. However, a simple review of the evidence should cast doubt on the validity of this assertion.


Is It So Bad to Miss the Best Months In the Market?


The chart below (Chart 1) shows the returns to 3 portfolios invested in U.S. stocks from 1870 through 2009. The red line shows the returns to a portfolio which managed to avoid the 10 best performing months over the past 140 years. The purple line shows the returns to an investor who bought and held stocks for the entire period. Note that the investor who missed the best 10 months was left with about $16,000 at the end of the period, versus the buy and hold investor with $85,000. This is the message that many Advisors deliver to clients: buy and hold works because you must be invested during the best periods.


Chart 1. U.S. Stock Market Returns, 1870 - 2009, Excluding Best and Worst Months

Source: Shiller (2009), Butler|Philbrick & Associates


Unfortunately, this assertion does not stand up to the evidence. To whit, the blue line in the chart shows the returns to an investor who managed to avoid the 10 worst months in the markets. This investor earned $563,000 in comparison to the buy and hold investor's $85,000. Perhaps we should be seeking to avoid losses, rather than seeking to maximize our exposure to strong returns...


The most important line on the chart, however, is the green line, which shows the returns to an investor who managed to avoid both the 10 best, and the 10 worst months of the past 140 years. You will notice that the green line tracks the purple line (buy and hold) very closely over the entire period. Amazingly, an investor who is able to avoid the 20 most extreme months, both positive and negative, experiences virtually the same growth as a "buy and hold" investor.


What the "buy and hold" shills inevitably fail to reveal is that the best months in the markets occur directly adjacent to the worst months in the markets. For example, 6 of the 10 best months in the stock market occurred during the Great Depression, 2 occurred during the secular bear market of the 1970s, and 1 occurred during the 2008/2009 market crash. These are long periods where investors would have been much better off in cash than in stocks, despite the intermittent sharp monthly rallies that occurred.


The phenomenon whereby the strongest months and the weakest months occur right next to each other is called 'volatility clustering'. Remember that Modern Portfolio Theory (MPT) is founded on the principle that market volatility is random and unpredictable. Instead, we find that market volatility clusters and is quite predictable. In fact, the best predictor of future volatility is current volatility. This contradiction with the assumptions of Modern Portfolio Theory is just one more nail in the coffin.


Boil and Bubble, Toil and Trouble


It turns out that markets do not transition smoothly and randomly from periods of low volatility to periods of high volatility. The evidence shows that, in stark contrast to MPT assumptions, markets are either very calm, or utterly terrified; further, there is no middle ground. 


There is a term for this type of dynamic, where a system is either in one state or another, that is derived from the physical sciences: phase transition. A simple example of this is when water turns to ice or steam. During this phase transition there is no middle ground; water is either a solid (ice), liquid (water), or gas (steam). In the same way, markets are either calm or terrified.


If markets behaved as Modern Portfolio Theory asserts, then market returns should be distributed according to a standard  bell curve. The charts below show the actual distribution of market returns against the theoretical bell curve expectations of MPT (Chart 2), and the differential between them (Chart 3.). The dotted line in Chart 2. is the standard bell curve; notice that the actual return distribution is much taller in the middle (lots of small returns), and has lots of spikes way out on the sides.


Chart 2. Daily Return Histogram, S&P 500 1978 - 2007 vs. Bell Curve
Source: Mauboussin, 2007


Chart 3. simply subtracts the actual frequency of returns from the expected frequency of returns (subtracts the solid line from the dashed line in the chart above), to show the difference between the two curves. Notice how the market delivers far more small daily returns than the model predicts. This makes sense given the tall spike in the middle of Chart 2. Also notice that the market delivers far more extreme returns than expected by the model, which are reflected in the spikes far out on either side of Chart 2. Perhaps even more interestingly, the market delivers very few days with mid-sized returns. You can clearly see this on Chart 3. depicted as points below the zero line.


Chart 3. Daily Return Histogram: Frequency Difference vs. Bell Curve, S&P 500 1978 - 2007

Source: Mauboussin, 2007


We can deduce from this frequency distribution that markets are almost always in one of two distinct states: calm or panic; kind or cruel; Jekyll or Hyde. Volatility is either very high, or very low, with few periods in between. So where would we find the 10 best and 10 worst return periods on the charts above? That is, where would we find volatility clusters? Clearly they would occur during cruel and crazy Mr. Hyde markets, not during kind, calm Dr. Jekyll markets. So is there a way to identify when markets are likely to reflect Dr. Jekyll (risk is low), and when they are likely to transform into Mr. Hyde (risk is high)?


Diagnosing Panic


Fortunately, it is quite possible to identify when markets are likely to be transitioning from periods of calm to periods of panic, and vice versa. It turns out that one can use a simple 10-month moving average, for example, to signal when a market is vulnerable to such a phase transition. This moving average does an excellent job of dividing markets into states of low and high volatility. When markets trade above the 10-month moving average, average returns to stocks are high, and volatility is well below average. In contrast, when markets close out the month below the 10-month moving average, investors should prepare for a period of high volatility and low returns. Chart 4. shows a simple 10-month moving average against the S&P 500 stock market.


Chart 4. Example of 10-Month Moving Average Line versus S&P 500

Source: Faber (2009)


The following charts divide the market into periods of calm, and periods of panic, and compare returns and volatility during each these periods. We have chosen to draw the 'panic line' at the 10 month moving average, so the blue bars in the charts show returns and volatility when each of the various asset classes is trading above its respective 10-month moving average. The red bars show returns and volatility when markets are trading below their 10-month moving averages.


Chart 5. Returns to markets above and below a 10-month moving average (1973 - 2008).

Faber (2009), Butler|Philbrick & Associates


Chart 6. Volatility of markets above and below a 10-month moving average (1973 - 2008).

Faber (2009), Butler|Philbrick & Associates


It should be obvious from the charts that returns (blue bars) are much higher when markets are trading above their 10-month moving averages, while volatility is substantially lower. In fact, on average over the 5 markets tested, calm markets trading above their 10-month moving averages delivered returns over 6 times higher (13.83% vs. 2.19%) than panicky markets, and at just 75% of the volatility (14.35% vs. 18.86%). Further, the average volatility is skewed higher by commodities, which tend to move higher under panicky conditions (wars, blockades, earthquakes, etc.), in contrast with the other asset classes which tend to drop.


I Know It When I See It

"I shall not today attempt further to define the kinds of material I understand to be embraced within that shorthand description [pornography]; and perhaps I could never succeed in intelligibly doing so. But I know it when I see it, and the motion picture involved in this case is not that." 

Associate Justice Potter Stewart, Concurring, Jacobellis v. Ohio, 378 U.S. 184 (1964)

It is instructive to discuss the bipolar nature of markets in the aggregate by contrasting the natures of the two characters (Jekyll and Hyde) via a discussion of average returns and volatility. But it is, perhaps, equally instructive to demonstrate how these different personalities manifest in the market. To that end, the charts below show the S&P 500 stock index during periods where the market is calm and Jekyll-like, and during periods when it is cruel and Hyde-like. The two personalities are unmistakable, even to the untrained eye!


Chart 7. S&P 500 Jekyll Market 1995 - 2000

Chart 8. S&P 500 Hyde Market 2000 - 2003

Chart 9. S&P 500 Jekyll Market 2003 - 2007

Chart 10. S&P 500 Hyde Market 2007 - 2009

Chart 11. S&P 500 Jekyll Market 2009 - Mar 2010

Chart 12. S&P 500 Hyde Market Mar 2010 - Today

It helps to look at charts of actual market behaviour to get a sense for what Jekyll and Hyde markets look like in real time. Note that last chart; it sure has been nice to be in cash during Hyde's recent appearance!


Conclusion


Investment markets have a dark side that is not generally acknowledged by the firms, advisors and consultants who manage portfolios according to the precepts of Modern Portfolio Theory (MPT). In contrast, investment firms and many advisors loudly and confidently assert that investors should own stocks in a fixed allocation through any and all types of markets. In marketing literature, these advisors point to MPT's assertions that market risk is unpredictable and randomly distributed as evidence that investors shouldn't try to time the market.


In examining actual market data, it is clear that markets have two independent personalities, and that investors would be well served to avoid markets when they are panicky and cruel. We see that market volatility 'clusters' around periods of market panic, rather than being randomly distributed, and that these periods of panic can often be confidently identified by using a simple monthly moving average. Investors who take the extra step of identifying the general personality of the markets will likely be rewarded with higher returns and less emotional distress.

The Three Horsemen of Retirement Apocalypse

We have stated many times in past articles that the brain uses facts as factors, but makes decisions on emotion. This article will present some extraordinarily important facts for people approaching, or already in retirement. Unfortunately, the facts alone are unlikely to motivate readers to change their behaviour; for most of us, it generally takes substantial emotional trauma to compel us to change. For example, smokers may continue to smoke until someone close to them is diagnosed with lung cancer. Interestingly, it has been established that even doctors are vulnerable to this type of cognitive dissonance. To whit, the likelihood that a physician is a smoker relates directly to how much their individual specialty relates to the lungs. Respiratory and cardiovascular specialists are least likely to smoke, while psychiatrists and podiatrists are most likely.

In the same way, most investors will not come to grip with the new realities of retirement until it is too late. The investment industry spends billions every year to maintain the illusion of certainty about long-term market returns, and most investors buy into this because it supports their emotional need to feel like they are in control. As humans, we do not handle ambiguity very well, so most of us avoid it where possible, even when it means potentially sacrificing our future. It is not the policy of Butler|Philbrick & Associates, however, to tell our clients what they want to hear. There are thousands of Advisors across Canada who will be happy to accommodate you in this. Instead, we are committed to telling our clients the truth, so that we can make smart decisions today that provide the greatest likelihood of future happiness.

The 3 Threats to Retirement Success

In light of our continuing effort to promote a more scientific approach to managing wealth, this post will focus on the three biggest threats to retirement success. These threats are (drum-roll please):

• The threat of inflation eroding purchasing power
• The threat of living longer (or less long), than you expect
• The threat of poor or negative investment returns, especially early on in retirement

Most investors are aware of these threats, but most Advisors do not effectively address the tug of war that exists between them. For example, most investors would avoid the stock market roller coaster in favour of safe bonds and cash, if they felt this solution would deliver retirement success. Unfortunately, retirees have to deal with the fact that safe assets like bonds do not effectively protect them against inflation. At the same time, stocks carry a significant risk of losses, especially over short time periods like ten years. Chart 1. shows that stocks have delivered between -6% and +20% over 10-year periods during the past 140 years. So what is one to do?

Chart 1. Annualized 10-Year Stock Market Returns, 1870 - 2010

Source: Butler|Philbrick & Associates, Shiller (2010)

Risk #1: Inflation

Inflation occurs when the price of goods and services increases slowly over time. The mechanism by which inflation occurs is actually subject to some debate, but this is less important to retirees. What is important is how inflation can impose significant restrictions on lifestyle over time. 

Inflation can be a difficult thing to wrap one's mind around, so examples are helpful. Postage costs are one good example: in 1950, a 1st class Canadian stamp cost 4 cents. Today, it costs 57 cents + GST to send a letter in Canada. This represents 4.53% per year in inflation over that time period. If we apply the same rate of inflation to a $1.00 bottle of Coke today, that same can would have cost 7 cents in 1950.

The chart below shows how the purchasing power of income declines over time due to inflation. Put another way, the chart shows how a fixed retirement income can purchase fewer and fewer more expensive goods and services. Note that $100,000 will only buy $70,000 worth of goods and services after just 10 years; purchasing power is cut in half after 19 years.

Chart 2. Purchasing power of $100,000 erodes over time due to inflation

Source: Butler|Philbrick & Associates

Most Advisors incorporate some sort of inflation forecast into portfolio return expectations when creating financial plans. This is better than completely ignoring the effects of inflation, but it ignores that fact that inflation also impacts the returns to other asset classes, like bonds and stocks. For example, bonds do especially poorly during periods of high inflation, so a high allocation to bonds would have very negative consequences should inflation accelerate higher. Conversely, stocks do very poorly in periods of negative inflation, or deflation, such as during the Great Depression when stocks dropped almost 90%.

Our methodology does not use a specific inflation forecast. Instead, we use monthly portfolio return numbers based on actual market returns that go back to 1870, and are already adjusted for inflation. This is an important difference, as this method explicitly incorporates the relationship between inflation and portfolio returns, rather than assuming that it doesn't exist. Traditional models assume that inflation rolls merrily along at 3% per year, even during the Great Depression. This assumption has serious implications for investors that are drawing retirement income.

Risk #2: Longevity

Longevity risk really refers to two related risks:

1. The risk that you save too little, or spend too much, because you end up living longer than you expect. In this case, you run out of money before you pass.
2. The risk that you save too much, or spend too little, because you end up living less long than you expect. In this case, you make needless sacrifices to lifestyle.

Traditional financial plans use a specific point estimate for lifespan; they usually assume death on a person's 86th or 91st birthday. This is tragically misguided however, as you can see from the table below. Table 1. shows the likelihood that a man, woman, and at least one person in a couple, will live to various ages, assuming that the person/couple has already reached age 65.

Table 1. Probability of Survival at Age 65

Source: The Society of Actuaries RP-2000 with full projection

You will note that the table indicates that 75 out of every 100 couples will see one person in the couple reach at least age 85; 50 out of every 100 couples will see one person live to age 90 or beyond! With this knowledge, it seems foolhardy in the extreme to rely on a plan in which between 50 and 75 couples out of every 100 will run out of money.

If you are uncomfortable with a 50% to 75% chance of retirement failure, imagine instead being able to tailor your plan to minimize your chance of retirement ruin, while maximizing your lifestyle. Butler|Phlibrick & Associates applies a different approach that accounts for the wide range of possible lifespans, and their respective probabilities. Our approach enables clients to tailor their plan to accomplish their individual level of comfort and confidence. As an example, some of our clients are comfortable with a higher chance that they will run out of retirement funds before they pass. These clients may be able to accept as much as a 30% chance that they will have to dramatically cut back on their lifestyle in their later years, in order to maximize current spending. On the other hand, more conservative clients require near certainty that their retirement funds will see them through with comfort to the end.

Of paramount importance, our approach allows us to update clients on exactly how their spending and portfolio performance during each year has impacted their chances of retirement success during annual review meetings. If markets have not cooperated, or if there was unanticipated spending during the year, we will discover that spending needs to be cut back, or portfolio risk needs to be adjusted, in order to move the plan back into an appropriate comfort zone. If on the other hand performance has been stronger than expected, clients may discover they have a surplus of cash. These fortunate clients have the option of maintaining their current standard of living, but enjoying a higher confidence in a successful retirement, or withdrawing a higher income to boost lifestyle expenditures. Image 1. below shows how retirement plans should be tracked over time to ensure clients remain in 'The Zone' to maximize their chances of balanced retirement success.


Image 1: Keeping clients in 'The Zone' during annual reviews

Source: Financeware.com

Risk #3: Poor or Negative Market Performance

You may have noticed that the first two risks are long-term risks. In the face of long-term risks like inflation, investors tend to behave like the proverbial frog in a pot of water that boils slowly. If you place a frog in boiling water, he will leap out quickly, grumpy but unharmed. However, if you place a frog in cool water and then boil it slowly, the frog will slowly die from the heat. In the same way, investors are unlikely to notice the effects of inflation over a period of a few years. Instead, they will wake up one morning many years from now to discover that their money only goes half as far as it used to. Perhaps they can no longer afford their membership at the golf course. Perhaps they are astounded at how much food costs, or how much of their monthly income is consumed filling the tank of their car with gas. Longevity risk manifests in the same way; slowly, and then all at once.

In contrast, market risk is often front and center in people's attention. They are bombarded with stock market prices every evening on the news, and every day in the papers. They receive a monthly statement and obsess over whether the value of their portfolio is higher or lower than in the previous month. Investors celebrate their peaks and grind their teeth at the troughs, mostly cursing the annoying roller-coaster ride of stock markets.

Strangely though most investors, and indeed Investment Advisors, fail to account for the volatility of stocks and bonds when they build retirement plans. Traditional plans are constructed with the inconceivable assumption that markets go up consistently every year. For example, many Advisors assume an 8% rate of return, and that investors will receive this 8% return every year, without fail. We have yet to meet an investor who has experienced the same return on their portfolio every single year. 


Rather, contemporary investors are used to seeing a wide range of returns, especially over the past ten years. Since June 2000, stock markets have lost over 25% of their value after accounting for inflation. This is catastrophic for people in or near retirement. Readers may be interested in reviewing some of our previous posts (click here for an explanation of our Gestalt Architecture), where we demonstrate how we strive to avoid these major long-term losses while still providing substantial exposure to growth assets.

Dr. Moshe Milevsky is a professor at York University School of Business, and sits on the boards of many Canadian and international life insurance companies. He may know more about retirement risks than any other person on the planet. In the following video, Dr. Milevsky discusses the importance of considering market risk, or what he calls 'Sequence of Returns Risk' when formulating retirement plans.

Video 1: Moshe Milevsky Discusses Sequence of Returns Risk

Source: ClientInsights.ca

In his presentations, Dr. Milevsky often performs a thought provoking exercise that illustrates how important it is to address 'Sequence of Returns' risk in retirement plans:

Sequence of Returns Example:

• Couple age 65 with $1,000,000 in retirement wealth
• Couple withdraws $7,500 per month in income from the portfolio
• Annual expected investment return of 7% after inflation

He then introduces the idea of a rotating sequence of returns, where investors receive 7%, -13%, and 27% returns in years 1 through 3, and then the series repeats for years 4 through 6, 7 through 9, etc. He then changes the order of returns to see how this impacts the age at which the couple will run out of funds. This is illustrated in the Retirement Merry-Go-Round below.

Image 2:The Retirement Merry-Go-Round

Source: The IFID Centre

There are 4 unique ways that an investor can experience the returns from the Merry-Go-Round. In the table below, we show how these 4 sequences of returns affect when the couple described above runs out of money (Ruin Age), and how the actual results differ from what would be expected from a traditional retirement plan (the +7%, +7%, +7% example below).

Table 2. Ruin Age Under Different Sequence of Return Assumptions

Source: The IFID Centre

It is important to understand that the couple receives a 7% average return under each of the scenarios in the table above. However, despite the fact that average returns are constant, the order of those returns can impact the age at which the clients run out of funds by as much as 14 years! Poor returns early on would cause the couple to run out of funds in their 81st year, while strong early returns would see them safely through to age 95. The sequence of returns in the example may seem extreme, but in fact the example assumes a volatility of 20%, which is comparable to the historical volatility of stock markets.

You may be wondering whether it is better to have higher returns, or a more predictable sequence of returns. The following example (Table 3.) shows that it is much more important to avoid poor returns early on in your retirement than it is to increase overall average returns. The investor on the right, which receives 8% average returns, but has poor early returns (-12% in the first year), runs out of funds before her 85th birthday. In contrast, the investor on the left earns 7% average returns, but her funds last through age 95 because of strong early returns (+27% in her first year).

Table 3: Is It Better to Receive Higher AVERAGE Returns, or Better EARLY Returns?

Source: The IFID Centre

Two things should be clear by now:

1. It is extremely risky to rely on a financial plan that does not account for 'Sequence of Returns' risk 
2. It is extremely important to avoid large investment losses, especially early on in retirement 

Fortunately, Dr. Milevsky has provided a framework that allows us to model the risk of poor or negative market returns. His model also enables us to account for the range of potential lifespans and inflation expectations. His framework differs from traditional financial plans in the following ways:

For illustrative purposes, we provide an example of our proprietary model, which is based on Dr. Milevsky's research papers, found here and here. Note the table of inputs in the upper right of the image. The 'Expected Real Return' input is the return we expect on the portfolio, after accounting for inflation. The 'Expected Portfolio Volatility' input allows the model to account for 'Sequence of Returns' risk, while the 'Median Remaining Lifespan' input is related to longevity risk.

Image 3: Sample Sustainable Income Model with Confidence Interval

Source: Butler|Philbrick & Associates

So what happens when we plug some numbers into our model, using assumptions based on actual market returns, and including very conservative fees? The chart below shows the safe withdrawal rate from an all-stock retirement portfolio assuming 4.6% annual average returns (see posts here and here for why we chose this return), and assuming 0.5% in management fees (about what you would pay for a diversified basket of ETFs if you were to manage the portfolio on your own).

Chart 3: Safe Rate of Withdrawal for A Diversified Global Stock Portfolio

Source: Butler|Philbrick & Associates


The chart above demonstrates that, if one were to create a pure diversified global stock portfolio through ETFs, and manage it on one's own, current assumptions would provide for a safe income of 3.1% of current portfolio value. This means that, for every $1million in portfolio value, an investor can take $31,000 per year from the portfolio, adjusted each year for inflation. This is interesting, but unrealistic as most investors would, quite rightly, feel that a pure stock portfolio is too risky in retirement. So what happens if we invest in a balanced portfolio, with 50% stocks and 50% bonds (See Chart 4.)?

Chart 4. Safe Rate of Withdrawal for A Balanced Portfolio

Source: Butler|Philbrick & Associates

Interestingly, the model arrives at the same 3.1% safe withdrawal rate for a balanced portfolio, despite significantly lower expected returns of just 2.18%. This is because we have reduced our 'Sequence of Returns Risk' input by almost 50% by introducing a 50% bond allocation, because bonds are generally much less volatile than stocks. This underlines the importance of accounting for sequence of returns risk, or the risk of poor returns early in retirement.

Conclusion

We hope this article has helped to drive home the importance of explicitly accounting for all three of the major threats to a successful retirement. To reiterate, a realistic and useful financial plan must account for the following three risks:

1. The risk that inflation erodes purchasing power from the portfolio over time 
2. Longevity, or the risk of living longer, or less long, than we expect 
3. 'Sequence of Returns Risk', or the risk of poor or negative returns early on in retirement

Most financial plans today do not account for the wide range of possible outcomes in either of the above variables. Please visit our web site to see how our Gestalt Architecture can deliver higher confidence, flexibility, and a substantially better lifestyle in retirement.

CNBC Appearance

As promised, CNBC went ahead with an interview to discuss some of our team's more troubling findings. Click on the video below to see Butler|Philbrick & Associates' own Adam Butler discuss risky retirement planning, as well as some potential solutions, live on air with host Erin Burnett.

If you have any questions about points made in the video, please feel free to contact us directly by clicking our team photo on the right.

Quirky QWERTY

Parents will be familiar with the age-old question, ‘But why?’, repeated ad nauseum by children everywhere as they try to understand cause and effect in the world around them. My daughter, who is learning to spell, recently stumped me with this question in reference to the alphabetic keyboard on her word game console. She was typing away in the car when she asked, ‘Dad, why are the letters on the keyboard all mixed up?’ I asked her what she meant, and she described how her keyboard didn’t match the order of letters she had learned, namely ‘A, B, C…’. I told her it was because standard adult computer keyboards are arranged differently. This, of course, elicited the ubiquitous ‘But why?’

I decided to do some digging. The standard computer keyboard is arranged in a QWERTY pattern, so named because these letters comprise the top left-hand row of letter keys. This arrangement is actually quite inefficient. It turns out that only 32% of keystrokes for common English words use keys on the second row, while 52% of words use keys on the upper row. Remember, the second row is the ‘home row’, where experienced typists rest their fingers between words. Some very uncommonly used letters, such as J and K are both positioned on the home row.

So why are the letters arranged so strangely? It turns out the keys were configured in such a way to accommodate the mechanics of old fashioned typewriters. Recall that each arm of a typewriter had a small letter on it that, when the corresponding key was pressed, was drawn up to strike an ink ribbon. This left an ink letter on the paper. When the keys were struck in rapid succession however, they would often jam together. So the QWERTY keyboard was laid out in such a way as to slow down the typist to avoid jamming the machine. In other words, the QWERTY keyboard was introduced to offset the mechanical limitations of the original typewriter.

Of course, those mechanical limitations don’t exist anymore with computer keyboards. So why do we keep on using this poor configuration? ‘Buy why?’ As with so many things in life, the answer is simple: ‘Because that’s the way we’ve always done it.’

This got me thinking about how most Investment Advisors approach the investment process. Most Advisors still advocate for an archaic long-term investment approach called ‘Strategic Asset Allocation’, which suggests that an investor should decide on a basic allocation to stocks, bonds, and cash, and then stick with this allocation over the long-term, no matter what. With this approach, a growth investor that meets with an Advisor in January of 2000, at the peak of the technology bubble, will receive the same allocation to stocks as an investor who meets with his Advisor in March of 2009, at the bottom of the recent financial meltdown. Does it make sense that an Advisor should recommend the same allocation, say 70% to stocks, when markets are expensive and future returns are likely to be low (January 2000), as when markets are cheap and future returns are likely to be higher (March 2009)? That’s like recommending sandals, shorts and a t-shirt all year round in St. John’s. It makes sense sometimes, but certainly not all the time!

Most people, if they gave it some thought, would probably conclude that the QWERTY keyboard is not ideal, the same way they wouldn’t recommend that a visitor wear shorts and a t-shirt in St. John’s all year round. Yet Advisors and investors take for granted that a 70% allocation to stocks makes sense in all environments. ‘But why?’

Not surprisingly, the founding fathers of modern investing, like Warren Buffet’s mentor Benjamin Graham, did not adhere to this silly approach. Instead, they used simple but time-tested methods to tell if markets were cheap or expensive, and therefore if they offered the promise of strong or poor future returns. Their preferred method for valuing markets provides a very reliable estimate of future returns to stocks going back as far as 1870. Dr. Robert Shiller at Yale University makes the data to calculate this ratio available to the public, so it is a simple matter to demonstrate what this ratio has meant for inflation adjusted stock returns over time.

In the chart below, we show that investors experience successively worse returns from stocks when they invest in increasingly expensive markets. For example, investors lucky enough to start investing in the 20% of months where markets are least expensive, such as late 1982, 1974, and 1932, received average returns of 11% per year over the following 10 years. However, investors that invested in the 20% of months where markets are most expensive, such as 1929, 1967, and 2000, experienced just 1.7% per year in returns over the following 10-years. Would you knowingly take on the risk of a 70% allocation to stocks if you expected to receive average returns of just 1.7% per year, or might you look for somewhere else to put your money to spare yourself the stress?

Chart: 10-year returns following an investment in increasingly expensive markets.

You might be wondering whether markets are currently cheap or expensive according to this model. Unfortunately, markets are currently expensive, with valuations in the top 25% of all months back to 1870. A more detailed analysis of the data suggests that the average expected return over the next 10 years is under 5% per year. Investors may want to consider whether they are being adequately compensated for assuming high levels of stock market risk given return expectations in the bottom 30% of all periods since 1870.

Fortunately, investors need not be held hostage to a ‘Strategic Asset Allocation’ if they choose to follow some simple rules that identify whether it is favourable to own stocks, or whether the risks currently outweigh the rewards. We’ll be touching on these techniques, and the evidence that supports them, in future issues. In the meantime, those readers who would like an alternative to their QWERTY keyboard should investigate the Dvorak Simplified keyboard – Google it!

Butler|Philbrick & Associates Featured In the Press

Your humble bloggers were featured in a Reuters story on May 26th discussing how wealthy investors' expectations have changed over the past 18 months.

WEALTH MANAGER-

Wealthy clients looking for plans they can trust

Wed, May 26 2010 

* Wealthy investors have grown more skeptical of advice

* Clients taking matters more into their own hands

* Evidence-backed advice can help keep focus on long term

By John McCrank

TORONTO, May 26 (Reuters) - "Warren Buffett has a great saying, that when the tide goes out, we get to see who's been swimming naked," said Adam Butler, a director of wealth management and associate portfolio manager at Richardson GMP.

When the proverbial tide dropped in the markets in 2007 and into 2008, high-net-worth investors took a much closer look at their advisers, and many weren't impressed with what they saw.

"High-net-worth individuals are beginning to see that the infrastructure underlying the wealth management industry is not as robust as they originally thought," Butler said.

As a result, wealthy investors are increasingly taking matters into their own hands. That can complicate matters for wealth managers if there are no mechanisms in place to counter knee-jerk reactions by clients in times of volatility.

Investors are also shopping around a lot more for new advice, and advisers that have a solid plan to guide clients through the best and worst of times are winning business.

A report from Barclays Wealth this week found that nearly half of U.S. high-net-worth investors are reviewing their portfolios more than they were before the recession, and nearly a quarter are now spending more than five hours a week actively investing their money. Around half of the U.S. respondents, all of whom had over $1.5 million in assets available for investment, also said they think the U.S. and global economies will get worse before getting better.

"They are still looking for advice," said Matt Brady, head of Wealth Advisory, Americas, at Barclays Wealth. "Certainly, I think they are looking for more advice, and also certainly getting much more actively involved in their own wealth management." Brady said clients are looking for quality information they can trust, something that Butler highlighted as well.

High-net-worth clients are actively looking for advisers who offer more than just a "buy and hope" strategy, Butler added.

That led Butler and his colleague Michael Philbrick, co-head of the Butler/Philbrick and Associates practice at Richardson GMP, to look for a more effective way to guide their clients.

COMBAT THE HERD MENTALITY

Over 18 months, they developed what they say is a more transparent approach that they explain to clients from the start, to help remove behavioral biases that can quickly derail financial plans when the market goes sour.

Butler said their plan is based on scientific principles and is rooted in evidence about the behavior of investors and markets. It provides the ability to move out of risky assets when conditions are unfavorable, at a minimal cost, and it has a clear exit strategy to limit the chances of big losses.

"We don't rely on gut checks or gut feel," Butler said. "We rely on 140 years of data sliced and diced that illustrates that some very simple techniques can help people avoid catastrophic mistakes."

Taking emotion out of the equation can eliminate knee-jerk reactions that people are prone to -- like in recent times when traditional market truisms were turned on their head and many investors were selling low and buying high.

"It's like a snake in a glass box in front of you," said Philbrick, a director of wealth management, associate portfolio manager, and branch manager at Richardson GMP.
"When the snake strikes out at you, you inevitably jump back, even though you know, your logic tells you, you are 100 percent safe."

He says clients increasingly look at their portfolios every day, or at least once a week, an approach that is not always productive in terms of the 20-year horizon most people have.
So Philbrick guides his clients back to the system to ease their fears and keep them looking at the long term.

With more and more wealthy advisers looking for new advice, Butler and Philbrick have found that their system not only helps them manage their current clients, but it's attracting new ones as well.

"We are finding we are getting more and more referrals, especially as the economic and market situation becomes more and more ambiguous -- that's where advisers who are thoughtful and have a process really shine," Butler said.
($1=$1.06 Canadian) (Reporting by John McCrank; editing by Frank McGurty and Rob Wilson)

Apparently we attracted some attention at the networks, because we have received an invitation to discuss our approach on CNBC next Thursday morning (June 3rd). Stay tuned.

Edit: Our CNBC interview has been pushed out to June 10th. We'll let you know.

Don't Touch That Marshmallow

Every parent is concerned with whether his or her child has what it takes to succeed in life. We obsess over reading and speaking skills, counting, and how our children interact with us and others in their lives. Parents secretly (or not so secretly) revel in their childrens' achievements, and marvel at their talents and intelligence. What many parents may not understand however, is that their child's talents and intelligence are largely at the mercy of their self control.

Self control refers to a child's ability to discern right from wrong, and to exert control over his or her own actions. Seminal experiments on self control in children were conducted in the late 1960s by a psychologist named Walter Mischel. His first experiments in the field took place in Trinidad in 1955, where he lived in a part of the island that was evenly split between people of East Indian and African descent. In discussions, the East Indians described the Africans as "impulsive hedonists, who were always living for the moment", and the Africans claimed the East Indians "didn't know how to live, and would stuff money in their mattress and never enjoy themselves".

Mischel took children from both groups and offered them a choice: either they could eat a small chocolate bar right away or, if they waited a few days, they would get a much larger bar to eat. Mischel discovered that the ethnic stereotypes did not hold with the 4-year-old children. Instead, he found that variables such as whether the children lived with their father were better predictors of self control. These initial experiments sparked a lifelong interest in the development of self control, and how this personality trait predicts success in school and life.

The Marshmallow Experiment

Mischel is probably best known for his 'marshmallow experiments', in which over 650 4-year-olds were invited, one at a time, into a controlled setting and presented with a tray of treats. Similar to the original experiments in Trinidad, a researcher on Mischel's team told each child that they could ring a bell at any time, at which point the researcher would offer the child one treat, such as a marshmallow or cookie. The child was also told that if he or she waited 15 minutes for the researcher to return, he would be given 2 treats.

The researchers observed and recorded the children on video as they tried to resist the treats. Some of the children covered their eyes, others played with their hair, or played hide-and-seek under their desk. One devious little boy grabbed an oreo, parted it, licked the icing from the center, and neatly placed the cookie back in the tray. The average child resisted the treat for about 3 minutes. A few children ate the treat right away without even ringing the bell. However, about 30 percent of the children managed to resist temptation, and waited for the researcher to return.

Upon reviewing hundreds of hours of observations from these types of experiments, Mischel drew some important conclusions. His initial conclusion was that the children who resisted temptation were experts at what he called 'strategic allocation of attention'. Rather than focusing all their attention on the delectable treat, the children that resisted the treats were more often the ones who covered their eyes, played games, sang songs, or otherwise occupied themselves while they waited. "If you're thinking about the marshmallow and how delicious it is, then you're going to eat it," says Mischel. "The key is to avoid thinking about it in the first place". Mischel was convinced that children with a better understanding of how to focus on something else displayed much better self control behaviour.

How important is this quality of self control? Scientists including Mischel have conducted several longitudinal studies based on the results of the early childhood studies. In reviewing the data from follow-ups, researchers have shown that adults who demonstrated poor self control as children were more prone to higher levels of obesity, and were more likely to have problems with drugs. As high-school students, they are more likely to have behavioural problems at home and in school, and they found it harder to form and maintain friendships. Perhaps most interestingly, the children who waited the 15 minutes for the extra treat scored, on average, more the 200 points higher on their SATs in high-school.

Self Control Can Be Taught

Now for the good news. Though some children naturally exhibit self control more than others, it turns out that the behaviours that support a child's ability to succeed in school and life can be taught. According to Mischel, "What's interesting about 4-year-olds is that they are just figuring out the rules of thinking. The kids who couldn't delay would often have the rules backwards. They would think that the best way to resist the marshmallow is to stare at it, to keep a close eye on the goal. But that's a terrible idea. If you do that, you're going to ring the bell before I leave the room." However, when Mischel and his team taught the kids some simple 'mental transformations', such as pretending that the treat was just a picture surrounded by an imaginary frame, imagining it as a small pet that must be stroked and cared for, or picturing a marshmallow as a cloud, self control improved dramatically. "All I've done is given them some tips from their mental user manual," says Michel. " Once you realize that will power is just a matter of learning how to control your attention and thoughts, you can really begin to increase it."

Parents teach these skills naturally, but it pays to be mindful and actively provide opportunities for children to learn these skills. Mischel provides some helpful advice for parents: "This is where your parents are important. Have they established rituals that force you to delay on a daily basis? Do they encourage you to wait? And do they make waiting worthwhile?" Even simple lessons like not snacking before dinner, waiting until everyone is finished before leaving the dinner table, taking turns with toys, saving allowances, or holding out for Christmas morning can reinforce important qualities of self control. Modeling is important too, especially for young children, so parents should make a show of waiting in line, or passing on snacks or dessert.

Patience and Self Control Are Also Important For Investment Success

This is primarily an investment blog, so I would be remiss if I did not include a lesson for investors. One obvious lesson relates to saving techniques. Clearly it is much easier to save money every month if the savings come out of your account, or off your paycheck, automatically so that there is never an opportunity to spend in to an immediate 'treat'. We strongly advocate this 'pay yourself first approach' to clients who are saving for a specific goal, such as retirement or a child's education, and it has proven its efficacy many times over.

Another less obvious take-away relates to how often a person checks his or her investment portfolio. A portfolio with an allocation to stocks is necessarily constructed to meet a longer term goal, as the performance of stocks is erratic in the short term. However, clients insist on checking their portfolio values on a weekly, daily, or even intra-day basis. This is a very bad idea, as the ups and downs in the portfolio balance out over time, and are meaningless on short time scales. In fact, investors that check portfolios every day will see about 4.5 times as much portfolio variability as investors who check every month. The chart below shows how an investor's anxiety, as a function of the swings he observes in his portfolio, increases exponentially with the frequency of his observations.


Source: Butler|Philbrick & Associates
Note: Graph represents the theoretical increase in observed volatility due to more frequent observations of portfolio value according to the equation: perceived vol (time horizon 2) = perceived vol (time horizon 1) * square root (number of periods in time horizon 2 / number of periods in time horizon 1). The y-axis shows the magnitude of the increase in observed portfolio variability, with annual observations given a factor of 1.
Chart is for illustrative purposes only.

Investors would be well served by performing a great deal of due diligence as early as possible in their investment horizon in order to find an investment strategy that they are confident in, and can commit to over a very long period of time. (Click here, here, and here for evidence that Buy and Hold is NOT a smart strategy to stick with, and click here, here and here for a compelling alternative). Once that commitment is made, investors should follow the strategy with discipline, and ignore the day-to-day media circus and market gyrations, as they will lead to higher anxiety at best, and poor investment performance at worst.

Conclusion

In conclusion, the ability to exercise self control is highly predictive of success in school and life, and is perhaps more important than general intelligence level, as it controls how we channel that intelligence. Children who are taught the skills necessary to shift their strategic attention in order to delay gratification exhibit healthier behaviour and stronger academic performance in high school. Adults who practice delayed gratification are better savers, focus less on the short-term performance of their portfolios, and have a much better chance of achieving their financial goals.

Source: New Yorker Magazine, May 2009.

Harness The Human Condition to Achieve Financial Independence

The last few posts (here and here) have injected a dose of reality into the debate around future return expectations for 'Buy and Hold' investors. Markets have been expensive for over 80% of periods since 1994, and never reached the genuinely low valuations associated with secular bear markets, even at the depths of 2003 and 2008-9. By most traditional measures, stock markets around the world currently range in valuation from above average (UK) all the way up to nosebleed (China). Returns to a buy and hold strategy consisting of global stocks from these lofty valuations are unlikely to be robust, and may actually be negative over the next 10 years or more.

We believe that investors need not be held captive to the common buy and hold doctrine preached by mutual fund companies and banks. These institutions are motivated to keep investors locked into homogeneous mutual funds and managed account products. This benefits banks and fund companies because they are able to charge more for stock mutual funds (or managed accounts) than bond funds, despite abundant proof that most managers add virtually no value. Not surprisingly, the Buy and Hold approach requires the least amount of effort, training, or skill, and offers investors virtually no accountability. It does, however, advocate constant exposure to stock mutual funds under any and every market condition. 

We assert that cap-weighted buy and hold is just one of a variety of broad investment strategies, albeit the one most commonly embraced by adherents to the dominant investment paradigm. Unfortunately for these adherents, the dominant investment theory does a very poor job of describing actual market behaviour, especially over time horizons that are meaningful for most investors. So what is an investor to do?

The Trend-Following Alternative

There are many alternatives to cap-weighted buy and hold, but the strategies that we feel hold the most promise for investors can be broadly described as 'trend-following'. Although trend-following is an investment strategy with strong empirical roots, it is helpful to think of it as a natural extension of actual human behavior. For many years, scientists in disciplines as seemingly unrelated as evolutionary anthropology and modern psychology have demonstrated that humans are prone to the same herding instincts as other animals. When faced with a choice in the absence of trusted information, humans will usually choose to follow the crowd rather than act against it. Many can relate to the experience of choosing a restaurant in a foreign city. Even when presented with several positive reviews of a restaurant from trusted official sources, people will often choose not to eat at that restaurant if it is empty, especially if a restaurant next door is full. They will usually follow the crowd into the busy restaurant, even at the expense of waiting for a table, rather than eat at the well reviewed but empty one.

A couple of years ago, psychologists at Columbia University performed an experiment to test the power of social herding. They set up an online music exchange, dubbed MusicLab, where over 14,000 participants registered to listen to, rate, and download songs by a variety of bands they had never heard of. Some of the participants saw only the names of the songs and the bands, while others, in what the experimenters called the 'social influence' group, were also shown which songs were most highly rated by others, and/or most frequently downloaded. The 'social influence' group was further divided into 8 separate 'worlds'. Participants in each world could see only the ratings and downloads of others in their world.

One of the researchers, Duncan Watts, explained the setup and their observations in a 2007 New York Times article:

"This setup let us test the possibility of prediction in two very direct ways. First, if people know what they like regardless of what they think other people like, the most successful songs should draw about the same amount of the total market share in both the independent and social-influence conditions — that is, hits shouldn’t be any bigger just because the people downloading them know what other people downloaded. And second, the very same songs — the “best” ones — should become hits in all social-influence worlds.

What we found, however, was exactly the opposite. In all the social-influence worlds, the most popular songs were much more popular (and the least popular songs were less popular) than in the independent condition. At the same time, however, the particular songs that became hits were different in different worlds... Introducing social influence into human decision making, in other words, didn’t just make the hits bigger; it also made them more unpredictable."

So how does this relate to investment trend-following? Trend following recognizes that one of the most powerful forces in human decision making is 'social influence', and actively takes advantage of this human condition. We see trends in fashion, eating, lifestyles, religion, education, child-rearing, baby names, car colours, medical surgeries, traffic, and almost everywhere else you might look in human society. These trends show up in the markets too, first as a recognition of real profits flowing to a company (Nortel), sector (Internet stocks), asset class (commodities), or geographic region (China, India, Brazil), and then as an extrapolation of this trend to infinity.

"It is not the strongest of a species that survives, nor the most intelligent, but the one most adaptable to change." - Charles Darwin

Trend-following systems are designed to find the most popular trends in the market place, and then ride those trends until they end, which they invariably do. These systems are not predictive; they will not tell you what toy, baby name, stock, or asset class will be most popular in a year or 3 years. Instead, they identify where the trends are currently, and adapt to changes. Some react to very short-term trends, like 2 or 3 month rotations in and out of stock market sectors, while others follow longer-term trends that occur over many months and years. Trends occur everywhere, from cotton to corn, stocks to silver, bonds to pork-bellies, and trend-followers trade them all.

Although trend-following systems differ from other investment strategies in a variety of ways, perhaps the most important difference is that all systems have an exit condition. In other words, all systems have a set of conditions that indicate that a trade is not working, and a strategy for exiting the trade in order to minimize losses.

A Scientific Approach

Trend-following systems are predicated on the human condition, but rooted in empirical data. Systems are developed by applying the scientific method to market pricing data, in much the same way as pharmaceuticals are (or should be) developed and tested before being brought to market. A drug development team applies a deep knowledge of human biochemistry and physiology to identify a chemical that may influence one or more important disease pathways. It is then hypothesized that the chemical will influence the presentation of a disease in a certain way, and this is tested empirically. A successful test is one that meets the expectations of the researchers at a certain level of statistical confidence, and with manageable side effects. Once a chemical is shown to work against a disease, researchers work to optimize dosage levels, delivery methods, etc. before attempting to bring the drug to market.

Credible practitioners of trend-following apply a similar approach to create and test their investment systems. Based on an understanding of human behaviour, and a mountainous body of empirical knowledge about the mechanics of markets, systems developers formulate a hypothesis and run tests against real historical market data to test this hypothesis. To avoid a minefield of potential biases, professional system developers test very simple systems and, if they deliver statistically and economically significant results, proceed to optimize their systems by testing the sensitivity of the system to small changes in the parameters. A robust system shows fairly consistent results over a wide band of parametric dispersion, but certain parameters will be more likely to deliver optimal results. Once the system is tested and optimized, it is ready to be put to work with real capital.

Developing A Proprietary System

Our team has been working on a trend-following system that will work well for unsophisticated investors with a meaningful time horizon of 5 to 50 or more years. Besides statistical and economic significance in testing, we limited potential strategies to those that meet the following criteria:

1. Invests only in public stocks or ETFs traded on North American exchanges.

2. Is simple enough to explain to non-professional investors.

3. Acknowledges the behavioral biases of regular investors and makes it easy to stick to.

4. Possesses risk and return characteristics that validate the assumptions of actuarial-style financial planning tools.

Our efforts have led us to several promising systems, but we have focused on one strategy in particular which meets all of the above criteria, and passes tests of statistical and economic significance. Our system applies a combination of simple trend and moving average signals to a basket of global stock, bond, commodity, and real-estate ETFs. The moving average signals tell us whether each asset class is in a strong positive trend, or a weak or negative trend, while the momentum signals tell us where the trends are strongest. When markets show a weak or negative trend, our system sells out and goes to cash until a strong positive trend re-emerges.

Our systems show strong, consistent results across many time periods, and are resistant to time-period biases. We began by investigating results from several promising studies by Asness et al. (1997), Montier (2006), and Faber (2006, 2009) that show persistent outperformance by using momentum and moving average signals independently. The momentum strategies demonstrated extremely strong long-term performance, but are vulnerable to periods of large losses. The moving average strategies presented extremely consistent results with very infrequent, small losses, but returns were unspectacular. We decided to test a combination of the two systems to see if we could achieve strong, consistent returns with lower risk.

Montier (2007) builds on Asness' research to demonstrate that country stock market indices exhibit a very strong momentum effect. Country stock markets that have risen the most over the prior 12 months continue to do so in the following month, while countries that have risen the least in the prior 12 months continue to be weak. The following chart from Montier shows the power of a very simple strategy that invests in 16 of the top performing global stock markets over the past 12 months while going short the 16 worst performing stock markets, with holdings rebalanced monthly. This simple strategy delivered average annual returns of 16% going back to 1976.

Chart 1. Cumulative performance of global country 12-month momentum long-short portfolio.

Source: James Montier (2007)

Results are pro-forma and for illustrative purposes only

A Compelling Solution

Faber (2006, 2009) demonstrated the power of a simple moving average strategy to identify changes in trends among 5 different assets classes: US stocks, international stocks, REITS, commodities and bonds. The asset class allocations advocated by this researcher's strategy echo the allocations used by many of the top university endowments, such as those at Harvard and Yale. These endowments have a very small allocation to bonds, and a large allocation to real estate, global stocks, and alternative assets like commodities and timber. Due to their large size, however, these endowments are necessarily 'buy and hold' investors, as significant short-term changes to their allocations would cause noticeable market dislocations. Smaller investors can utilize Faber's moving average system, also called a Multi-Asset Tactical Asset Allocation system, to move to cash when market trends turn negative, mostly avoiding large losses.

The charts and tables below show how this strategy delivers very consistent returns with minimal losses. Investors would have received better returns than with stocks alone (11.3% vs 10.6%). More importantly however, investors would have experienced positive returns over 98% of all 12-month periods going back to 1973, and never lost more than 3.8% from their peak value at months' end. In contrast, stocks were positive only 76% of the time, and investors had to endure losses of 40% or more on their portfolio.

Chart 2. Mutli-Asset Moving Average Strategy Demonstrates More Consistent Returns

Source: Faber (2009), Butler|Philbrick & Associates (2010)

Results are pro-forma and for illustrative purposes only

Chart 3. Cumulative Returns from S&P500 Buy and Hold versus Multi-Asset Moving Average Strategy

Source: Faber (2009), Butler|Philbrick & Associates

Results are pro-forma and for illustrative purposes only

Given the strong performance of Asness' and Montier's simple momentum-based country allocation system, and the independent strong performance of Faber's simple multi-asset moving average system, we decided to investigate a strategy that combines these two systems. First, we tested a system that combines a momentum strategy with a moving average strategy using U.S. stocks. We tried this first because we had easy access to the necessary data and systems to run the test ourselves. We used a quantitative momentum model to select stocks, and combined it with a simple moving average model as a signal to move to cash. The quantitative model does quite well on its own, but the moving average overlay adds very significant value. Aside from delivering better absolute returns, the moving average overlay dramatically reduces periods of large losses (see blue line versus red and green lines in Chart 4 below).

Chart 4. Cumulative returns of S&P500 'Buy and Hold' versus momentum strategy versus momentum with moving average overlay

Source: CPMS (2009), Shiller (2009), Butler|Philbrick & Associates

Results are pro-forma and for illustrative purposes only

Once we demonstrated that momentum works well in concert with a moving average signal in a strategy using individual stocks, we decided to test a similar strategy using allocations to global stock markets. This is a very simple and investable strategy because of the availability of ETFs that track the performance of over 35 global stock market indices. To implement this test we partnered with one of the most experienced systematic investing teams in Canada, Jason Russell and Nicholas Markos of Acorn Investments. Using MSCI country data going back to 1970, we tested a simple momentum model that invests in top-performing countries, and overlayed a simple moving average system to signal a change in the trend of global stocks. The following table and chart show the results of our non-optimized test.

Table 1. Performance characteristics of Global Tactical Allocation System (All Ex-Dividends)

Top row: Country Index Buy and Hold

Middle row: Country Index with Moving Average Overlay

Bottom row: Country Allocation System with Moving Average Overlay

Chart 5. Comparison of Cumulative Performance

Source: Butler|Philbrick & Associates, Acorn Investments

Results are pro-forma and for illustrative purposes only

Note that the Country Allocation System above, which combines the momentum model with the moving average signal, compounds at over 16% annually versus 6.5% for Buy and Hold. Further, the largest cumulative loss over the period is under 26%, less than half the maximum loss from a buy and hold strategy (56%). The longest period that investors are underwater on their investments is 40 months with the Allocation strategy, about half of the 78 month underwater period for Buy and Hold. Volatility is also less, at 14% annualized versus 15% for buy and hold. Any way you slice it, the Country Allocation System is superior to Buy and Hold.

The Country Allocation System in its current form was only applied to global stock markets. Our next step is to integrate our momentum/moving average system, which has demonstrated such excellent risk/return characteristics for stocks (Chart 4.) and allocations to countries (Chart 5.), into Faber's multi-asset model. We hypothesize that a momentum overlay will significantly enhance risk-adjusted returns versus the existing moving average system for each of the other 3 asset classes.

Maintain Your Lifestyle In Retirement

Buy and Hold is likely to underwhelm over the next decade or so, but investors have alternatives that may dramatically enhance their financial opportunities. Although a low-return environment for stocks is likely to also pull-down expected returns for the strategies we have described above, the historical risk-adjusted performance premium is likely to persist. For example, the current non-optimized Country Allocation System delivered a return premium over stocks of almost 10% per year from 1970 through 2009. Even assuming a 2% management fee, and some performance decay, it is reasonable to assume that this strategy might deliver 5% per year over a buy and hold strategy going forward.

The following charts demonstrate the massive impact that this return differential can have on a retirement plan. If we use a 4.6% expected real return for stocks as derived in this post, and assume that our strategy can deliver an extra 5% per year with slightly lower risk, then Chart 6. describes the potential difference in retirement income. The chart shows the income that can safely be withdrawn from a $2.5 million retirement portfolio under different return and risk assumptions.

Charts 7, 8, 9 and 10 use the 'Risk of Retirement Ruin' model described by Moshe Milevsky in his paper "A Sustainable Spending Rate without Simulation", and illustrate how the safe withdrawal rates in Chart 6. were modeled. The model uses lifespan assumptions for a healthy non-smoking male retiring on his 60th birthday, which is currently another 20 years.

Chart 6. Modeled safe annual income from a $2.5 million retirement portfolio for various strategies.

Source: Milevsky (2005), Acorn Investments, Butler|Philbrick & Associates

Results are pro-forma and for illustrative purposes only

Chart 7. Milevsky Modeled Risk of Ruin for Global Stocks

Source: Milevsky (2005), Acorn Investments, Butler|Philbrick & Associates

Results are pro-forma and for illustrative purposes only

Chart 8. Milevsky Modeled Risk of Ruin for Country Allocation Strategy

Source: Milevsky (2005), Acorn Investments, Butler|Philbrick & Associates

Results are pro-forma and for illustrative purposes only

Chart 9. Milevsky Modeled Risk of Ruin for 50% Bonds / 50% Stocks

Source: Milevsky (2005), Acorn Investments, Butler|Philbrick & Associates

Results are pro-forma and for illustrative purposes only

Chart 10. Milevsky Modeled Risk of Ruin for 50% Bonds / 50% Country Allocation

Source: Milevsky (2005), Acorn Investments, Butler|Philbrick & Associates

Results are pro-forma and for illustrative purposes only

Conclusion

In conclusion, the money management industry, which is dominated by large banks and mutual fund companies, have a vested interest in preaching a buy and hold doctrine. They earn greater profits from keeping investors in equity mutual funds which pay greater fees to these firms rather than suggesting that investors attempt to earn superior returns by using active timing strategies.

We have presented a few alternatives to the buy and hold paradigm, and offered compelling reasons to specifically consider trend-following systems. Trend following strategies operate on the principal that humans are influenced by powerful social factors that manifest in trends in life and markets. The dominant investment paradigm embraced by almost all contemporary investors emphatically denies that this human condition exists, preferring to think of human decision makers as computational engines that operate independently and have a perfect understanding of the odds. By acknowledging the human condition, trend-followers have an opportunity to deliver out-sized performance over time. Further, this superior performance can have a dramatic impact on the lifestyle expectations of retirees.