Come gather round [investors] wherever you roam
And admit that the waters around you have grown
And accept it that soon you'll be drenched to the bone
If your [money] to you is worth saving
Then you'd better start swimming or you'll sink like a stone
For the times, they are a changing.
Ok. So Bob was probably not talking directly about asset allocation. But even so … the message is the same. These are unprecedented times and without an awareness of how to adapt … the consequences for your portfolio may be dire.
What worked for active investing in the past—may no longer provide the same value. Indexing, strategic allocations, and tactical allocations have all been challenged by today’s volatile markets. So gather round and let’s look at the evolution of asset allocation.
Traditionally, active equity managers relied on superior stock selection. And bond managers did the same with decisions on credit duration. But studies have shown only a small few can consistently beat their benchmark over the long term.
An outgrowth from this fact was popularity of indexing. This worked reasonably well during the 1990s and to 2001. And Strategic Asset Allocation (SAA) followed suit—bolstered by heavy promotion from the financial services industry.
But SAA was vulnerable to volatile markets as diverse asset classes became highly correlated. Said differently, asset classes that were distinctly different now began to behave with the same characteristics. They started to converge and investors lost their diversification.
One solution for lackluster strategic asset allocation was to implement a tactical strategy. Tactical Asset Allocation (TAA) shifts cash to the most attractive markets. So investors don’t have to rely on markets going “up” in order to profit.
The only problem is TAA placed great importance on the manager’s ability to forecast market moves. And if the decision was right—profits abounded. But if the decision was wrong—the consequences could be devastating.
Come Gather Round … For the Strategy Is a Changing
Enter modern day Global Tactical Asset Allocation (GTAA) and the approach I have used with much success. GTAA broadens the scope of TAA by including additional asset classes such as REITs, international stocks and bonds, and commodities.
The most important difference between TAA practices and systematic GTAA is … NO FORECASTING. Instead of forecasting—which exposes you to manager error—the system is entirely mechanical. This eliminates all emotional interference and allows for robust testing of the strategy to ensure performance—in both good and bad markets.
One of the most popularized approaches for GTAA was designed by Mebane Faber. And the essence of his approach is he is “long” an asset class when it is trading above its 10 month moving average (10 MA). And when it is below the 10 MA—he moves to cash.
The great part about this approach is its simplicity. There is nothing magic about a 10 period monthly average. In fact, other periods have been shown to work well too.
But the most important aspect of this approach is the “rules-based” system for investing. The “system” defines when an asset class will be held or not. And by defining the rules in advance you increase the mathematical expectation of your returns.
In my own work I’ve used Meb Faber’s research as the basis for additional rules-based models. These models have continued to perform well … regardless of market condition. You can learn more about these models at the Portfolio Café.
And if you want to hear more from Bob Dylan check out the video below.
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