Stocks and Bonds Aren’t Enough: You Need Strategy and Geographic Diversification as Well

“You keep using that word. I do not think that it means what you think it means,” Inigo Montoya, The Princess Bride.

The word “diversification” gets thrown around a lot in the investing world. Everyone agrees that it’s important and that everyone should be diversified. The problem is that there’s no one definition of diversification.

Does it mean owning 50 stocks instead of one? Well, yeah. That’s a form of diversification.

Does it mean owning different sectors of the economy? Sure. That’s another form of diversification.

Does it mean owning some bonds as well as stocks? Yep. That’s diversification too.

Unfortunately, that’s about as far as most Americans go on their diversification journey. This is a mistake. Indeed, a mistake that could cost them hundreds of thousands (if not millions) of dollars and leave them broke in retirement.

American investors could improve their returns and, more importantly, dramatically reduce the risk of not meeting their goals by adding geographic and “Strategy” diversification.

Strategy Diversification

So, what the heck is Strategy diversification? (I’m assuming that most people understand what geographic diversification means. Own stuff in other countries!) Strategy diversification simply refers to employing different investment strategies.

For example, the S&P 500 is comprised of big American stocks. That’s a strategy. (Yes, the S&P 500 isn’t anything special. It’s an investment strategy like any other. A pretty good – though not great – strategy, but a strategy nonetheless.) A different strategy might be owning small American stocks. Another strategy might be buying cheap or value stocks. Astute readers might notice that I’m talking about “Factor” investing. (For a discussion of Factor investing, see this, this and this.)

Another strategy might be using a trend screen on your stocks to decide when the odds are in your favor so you stay invested and when the odds are against you so you get out of the market. (For a discussion on the use of a trend screen see here and here.) Using a trend screen is, of course, a very different from the strategy than buy and hold.

(Again, I know that buy and hold has been sold as THE one true way to invest. Heck, I’ve preached it for decades. But the truth is that buy and hold is just one strategy among many. Granted, it’s a very, very good strategy, but like any strategy, it has its strengths and weaknesses. The same is true for using a trend screen.)

Diversification Throughout the Decades

So, let’s take a look at how geographic and strategy diversification has helped investors over the decades, indeed, saved investors in some decades who traditionally use only the S&P 500 and bonds. In this case, we’ll use five-year Treasury bonds for our bond investment.

(Please note that I’m going to use annualized real returns, i.e. how well an invest did after adjusting for inflation. I mean, who cares if an investment makes 10% a year if inflation is 20% a year.)

To represent geographic diversification, I’ll use the MSCI ex-US index. Think of this as the S&P 500 for the rest of the world. For strategy diversification, I’ll use Dimensional Fund Advisors U.S. Small Value Index and a combo of their International Small Cap and International Small Value Indexes.* This will show the impact of investing in small and value stocks. For the trend screen strategy, I’ll use a 10-month moving average trend screen on the S&P 500 where we move to cash when the S&P 500 falls below its 10-month moving average.

Finally, to see how a truly diversified portfolio would have performed, I will include the annualized real returns of a portfolio equally weighted among each investment asset and strategy.

1970s

S&P 500	5-Yr Treasury	MSCI	US SV	Int’l SV	Trend	Diversify
-1.5%	-0.4%	3.5%	6.8%	16.0%	0.9%	5.4%

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

As you can see, the 1970s were a disaster for American investors who lacked geographic and strategy diversification. Both the S&P 50 and Treasury bonds lost you money over the decade. Those negative real returns were a financial death sentence for retirees pulling money out of their portfolio. Had those retirees included international, small and value stocks, they would have been fine.

1980s

S&P 500	5-Yr Treasury	MSCI	US SV	Int’l SV	Trend	Diversify
12.5%	6.8%	16.4%	15.0%	27.0%	11.4%	15.5%

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Well, that’s more like it. Frankly, you almost had to try to lose money in the 1980s. That said, geographic and strategy diversification (small and value stocks) were the clear winner for this decade.

1990s

S&P 500	5-Yr Treasury	MSCI	US SV	Int’l SV	Trend	Diversify
15.3%	4.3%	4.5%	13.5%	0.4%	10.2%	8.6%

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

The 1990s was the S&P 500 decade. It rolled over everything. Geographic and strategy diversification were a drag on performance. However, the equal weight portfolio continued to perform well, showing that diversification works.

2000s

S&P 500	5-Yr Treasury	MSCI	US SV	Int’l SV	Trend	Diversify
-3.5%	3.7%	-0.5%	9.9%	11.0%	5.4%	5.4%

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Ouch! Like the 1970s, the 2000s were an absolute disaster for your typical American investor. The S&P 500 lost more than 3% a year after inflation. Once again, anyone retiring in the early 2000s and relying on the S&P 500 to grow their portfolio found themselves in a world of hurt. Thankfully, bonds picked up some of the slack but likely not enough. But look what saved the day: Strategy diversification. Small and value stocks did fantastic as did using a trend screen to mitigate the crashes of 2000-2002 and 2008-2009.

As usual, the Diversified Portfolio did perfectly fine.

2010s

S&P 500	5-Yr Treasury	MSCI	US SV	Int’l SV	Trend	Diversify
11.3%	1.2%	3.7%	9.3%	4.9%	5.0%	6.2%

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Hmm, the 2010s look eerily like the 1990s. The S&P is blowing away everything. Geographic and strategy diversification are hurting us, but the S&P 500 and U.S. small value stocks are enough to buoy the diversified portfolio’s returns.

True Diversification Works

The lesson from history seems pretty clear. Owning the S&P 500 isn’t enough diversification. Owning the S&P 500 and bonds isn’t enough diversification. Investors need to incorporate geographic and strategy (factors and trend) diversification into their portfolio, or they risk a decade-long period of no returns above inflation.

 

*Dimensional International Small Cap Index from 1970 to 1981. Dimensional International Small Value Index from 1981 to 2019.

Retirement Planning: The Dangers of Thinking the Past Will Look Like the Future

Retirement planning brings together almost every aspect of financial planning: Cash Flow, Tax Planning, Goals, Insurance and Estate Planning. But at the heart of retirement planning is your portfolio and what you hope to earn from your investments.

At some point, you will rely on your portfolio to provide part of your income so estimating what your portfolio will earn is crucial. Estimate too high, and you could go broke. Estimate too low, and you force yourself to work longer than is necessary.

Unfortunately, most people (and even most financial advisors) use historic asset returns as their estimate. At first glance, this makes sense. We have nearly a century of data on some asset classes and almost 50 years for most others. Why not use the historic average? Wouldn’t that be the best guess?

As it turns out, no. Indeed, this may be the biggest mistake you can make.

Why? Because asset classes produce wildly different returns than their historic average, even over long periods of time.

For example, here are the after inflation returns, i.e. real returns, of the S&P 500, Five-Year Treasuries and a portfolio composed of equal amounts of both from 1926 to November 2018:

	Annual Real Return – 1926 to Nov 2018
S&P 500 Index	7.22%
Five-Year Treasury Bonds	2.15%
S&P 500/Five-Year Treasury Bonds	5.21%

Based on data from Returns 2.0

So, if you had a portfolio of 50% S&P 500 and 50% Five-Year Treasury bonds, you would assume that you’d earn more than 5% a year above inflation and plan your retirement accordingly.

But what happens if you retired in 1966? Well, over the next 15 years, those assets and your portfolio of 50% S&P 500 and 50% Five-Year Treasury Bonds would have “earned” this:

	Annual Real Return – 1966 to 1980
S&P 500 Index	-0.12%
Five-Year Treasury Bonds	-1.36%
S&P 500/Five-Year Treasury Bonds	-0.38%

Based on data from Returns 2.0

If you’d used historic averages to plan your retirement, you’d likely be well on your way to going broke.

So, what can we do? Is there a way to know whether we can expect high or low returns from our portfolio? Surprisingly, to a degree, yes.

Nobody can predict the future precisely, but when it comes to long-term (7 to 20 years) expected returns on assets, there are tools that gives us a range of what to expect. We’re not talking about a GPS telling us the exact address; more like a compass pointing us in the general correct direction.

Valuations, i.e. what you’re paying for an asset, and interest rates do a pretty good job of telling us what range of returns that we can expect over the next decade or so from stocks and bonds. For example, look at this chart from O’Shaughnessy Asset Management showing how much of future stocks returns are explained (R^2) by various valuation metrics – Price to Retained Earnings (PRE), Cyclically Adjusted Price to Earnings (CAPE) and Trailing 12-Month Price to Earnings (ttm P/E).

As you can see PRE can explain around 75% of future earnings from around 15 years out to around 22 years. In my world, that’s about as close as we’ll ever get to predicting the future.

Now, look at this table compiled by Ben Carlson based work by Meb Faber of Cambria Investments showing stocks returns based on different starting CAPE ratios. (The CAPE is simply a long-term Price to Earnings ratio. Instead of looking at one year, it looks at the S&P 500’s earnings over the past decade adjusted for inflation to smooth out earnings ups and downs.)

As you can see, on average, you earn more over the next decade when stocks are cheap than when they’re expensive. It’s not guaranteed. There are times when the stock market is expensive where investors get lucky for the next decade and earn very good returns. And there are times when the stock market is cheap and investors earn fairly low returns. But look at the “Low” scenarios, and you’ll notice the dangers of an expensive market.

When the stock market is cheap, even your worst-case scenario is manageable. But when stock markets are expensive, you face the chance of horrendous returns.

When planning for retirement, assuming that you’ll earn historic returns is dangerous. Valuations gives a decent guide for what range of returns to expect over the next decade or two. You should look at what those valuations are telling you and plan accordingly.

 

 

2018: Investors’ Year Without a Summer

In 1816, Americans living on East Coast Europeans experienced a devastating environmental phenomenon. In what became known as the “Year Without a Summer,” chilly temperatures, torrential rains and thick fog across Europe and the East Coast during the summer months led to failed crops and near-famine conditions.

The cause of the anomaly was the biggest volcanic eruption in human history. On the other side of the world, Indonesia’s Mount Tambora in April 1815 spewed millions of tons of dust, ash and sulfur dioxide into the atmosphere, temporarily changing the world’s climate and dropping global temperatures by as much as 3 degrees Fahrenheit.

Unfortunately, investors in 2018 experienced their own version of the year without a summer, what I’ll call the “Year Without Gains.” It’s officially the worst year on record in terms of the percentage of asset classes that lost money on a dollar-adjusted basis. As the Table 1 from Charlie Bilello at Pension Partners shows, every asset class but cash lost money.

 

 

Granted, the losses weren’t of the magnitude that investors saw in the Great Depression or the more recent Great Recession, but the breadth of the losses was remarkable. There simply was no where to hide except cash.

For those hoping to avoid the carnage with hedge funds or alternative funds, you were out of luck as well. The Barclay Hedge Fund Index was down 5.10% for the year. The Credit Suisse Managed Futures index was down 6.94%. (Managed futures funds use trend following or momentum signals to bet on or against various assets.)

In 2018, it didn’t seem to matter what asset you invested in or what strategy your used. They all lost money except cash.

Interestingly, the historically bad year of 2018 came on the heels of the historically great year of 2017, where every asset class and most alternative strategies made money. Indeed, it was one of the calmest years in history, gently going up month after month no matter what your investments.

So, what are the lessons to be learned?

1. Do not expect the markets to behave normally. Unusual events are, well, normal.
2. Have a plan and stick to it because you cannot predict the future.
3. Sometimes losing less makes you the winner. While Treasury bonds didn’t perform great, they also didn’t lose much money, allowing you to fight another day. (Diversification still works, even in a year like 2018.)

How to Judge an Investment Strategy

“There are no right answers to wrong questions.” – Ursula K. Le Guin

With the demise of most workplace pensions, investing has become an incredibly important job for most Americans. Yet, we’re never taught how to do it. In high school and college, we learn about geometry, ancient Greece, the internal organs of a frog, accounting, you name it. But we’re never taught how to do the one thing that we desperately need to do: Invest our money.

As a result, people muddle through life grasping at straws. But without some basic knowledge on how investing works, you might as well pick a strategy out of a hat. In this article, I hope to shed a little light on what to look for in an investing strategy and how to evaluate them.

Transparency

The first thing to look for in a strategy is an overall theory of why it works. What makes this investment strategy tick? Too many investment firms simply tell their clients that they’re moving money from Investment A to Investment B because their economists believe that it’s the right thing to do at this moment.

Well, why is it the right thing to do?

Any changes to your portfolio should fit a larger overall strategy that an investment advisor has spent time explaining to you.

For instance, my overall investment strategy involves “Factor” investing – attempting to capture premiums such as small, value, momentum and quality – in addition to the overall the market premium. (See here, here and here for a primer on Factor investing.)

Recently, I’ve been shifting some of my clients’ portfolios from one mutual fund company to a different fund company. Why? Because I believe the other fund company does a better job of capturing these factors (or premiums), and I can show my clients why.

That move fits my overall strategy and is easily understood by my clients.

Investors should look for advisors who are very clear about their strategy and explain the theory behind why that strategy should work. Indeed, an investor should be able to explain to a friend the basics of their investment strategy. If they can’t, they don’t understand it well enough, which will lead them to give up on the strategy at the first sign of trouble.

Do not trust any “black box” strategy where an advisor basically says, “Trust us. We’re really smart.”

Evidence

There should be reams of studies, papers and journal articles examining your investment strategy. Your investment strategy should have gone through the meat-grinder of open debate among academics and investment practitioners outside of the investment firm that you’re using.

Don’t trust a strategy that has been vetted only by economists and finance experts at one firm. Maybe they used flaw statistical analysis, maybe they cherry-picked their data or start dates, maybe they only examined one market. There are limitless ways that their conclusions could be wrong.

They should be publishing their work for the world to see and pick apart. You should be able to read about the merits of the strategy from people outside the firm.

Real World Implementation

Just because an investment strategy makes senses and looks good on paper, it doesn’t mean that it will work in the real world. Many strategies fail in the real world due to high implementation costs or capacity issues.

Demand that an investment firm or advisor show that a mutual fund or ETF has been able to capture the returns of the strategy in a cost effective way. However, be very careful here, because many investment firms use short-term records to tout funds and strategies. Don’t buy it. You’re being tricked.

Which brings me to the final thing that an investor needs to evaluate an investment strategy. Indeed, this may be THE most important lesson any investor can learn.

Timeframe

I’ll let you in on a little secret: Investors are human beings.

It’s true. And, unfortunately, human beings are evolutionarily designed to be terrible investors. We are our own worst enemy, and if we don’t take steps to stop ourselves, we will sabotage our investment returns.

Now, the list of ways that we hurt ourselves as investors could fill a library wing. (I know because I’m looking at row after row of such books in my office right now.) But perhaps our single most harmful behavior is having too short a timeframe for evaluating an investment strategy.

Investors typically judge a strategy or fund on one to three years performance. And why wouldn’t they? I mean, in the real world, you pretty much know whether a new employee hired will be any good after a year or two. They’re not likely to get a lot better – or worse. The same is true for machines. If my washing machine hasn’t been working that great for the past month, there’s almost no chance it will just get better.

But that’s not the way investing works. Even the best investing strategies of the past have had long periods of horrendous underperformance. For example, from 1998 to the end of 1999, the greatest investor ever – Warren Buffet – saw his Berkshire Hathaway stock fall 49%. Over the same period, the S&P 500 grew 56%. Buffett underperformed the market by more than 100 percentage points over two years!

You can’t judge an investment strategy on one to three years performance. You can’t judge an investment strategy on five years performance. You can’t even judge an investment strategy on ten years performance.

It’s just noise. I realize that this is hard to accept, but it’s a statistical fact.

So how many years do you need to judge an investment strategy? Fifteen years.

Yes, 15 years. Really, you should judge a strategy on 20-year performance, but I’m willing to go with 15 years.

Therefore, anyone showing you 1-year, 3-year, 5-year, or, even 10-year performance numbers is either trying to trick you or doesn’t know what they are doing. And any investor that judges an investment strategy on anything less than 15 years of past performance is using nearly worthless data to make an extremely important decision.

So, what does needing such a long timeframe mean to investors?

First, you have to trust that your strategy will work, and that trust comes from understanding the strategy and knowing its history, i.e. seeing other periods of time where it was struggling but eventually rebounded.

Second, you should consider diversifying so that you’re not relying solely on one asset or stream of returns. For example, with my clients, we diversify by asset class (stocks, bonds, real estate), by factors (small, value, momentum, quality and trend – see here and here for a primer on trend following) and by geography (United States, international developed and emerging markets).

Of course, diversifying means that you never hit the home run. It also means that you will trail more known benchmarks like the S&P 500 periodically, sometimes for many years.

Investing isn’t easy. But you if you look for a strategy that has a transparent, understandable theory behind it, that has been tested both academically and in the real world and that has a solid, long-term track record behind it, you should be in good shape.

The Last Day of World War One: The Final Waste of a Wasteful War

Naturally, I typically write about financial issues, but with the 100^th anniversary of the end of World War I just days away, I wanted to give an account of the final day of that conflict. The reason is simple: The men who needlessly died that morning deserve remembrance.

The First World War doesn’t get the attention of World War II. It’s understandable. WWII was a far more dynamic war with tank and air battles and swiftly moving armies. Countless movies have been made about WWII battles, giving us a sense of what it felt like to be in that war. In addition, if you take Stalin out of the equation, it also was in a sense a “clean” war in that there was a clear good side and bad side.

WWI had none of those attributes. Despite what masterful British propaganda promoted at the time, there was no real good side or bad side. It was established European Powers (Britain, France and, to a degree, Russia) against the upstart Germany that wanted its share of the colonial pie. The war itself – at least on the Western Front – was a grinding stalemate of little movement where soldiers died by the hundreds of thousands to gain less than a mile.

Not very cinematic, which is why WWI is not much remembered, particularly in the United States.

That said, I agree with many historians and writers who believe that WWI more than WWII shaped the world that we live in today. Communism took hold in Russia because of WWI. Britain and France were so weakened by the war that holding their colonies became more and more untenable. The United States emerged as a global power. And, of course, you could argue that WWII was simply an outgrowth of WWI.

Even the current wars in the Middle East were in part – maybe, in large part – created by the work of Mark Sykes, a British diplomat, and Francois Georges-Picot, a French diplomat, who in 1916 carved up the dying Ottoman Empire with little regard for sectarian, tribal and ethnic distinctions on the ground. The result has been endless wars as various groups push for independence or domination.

WWI may not have been the war to end all wars, but it did change the world in ways that we’re still dealing with today.

By the fall of 1918, Germany had failed in its desperate attempt to knock Britain and France out of the war before the Americans arrived in overwhelming numbers. After days of negotiations, an armistice was signed at just after 5 a.m. on Nov. 11. The Germans had wanted it to be an immediate ceasefire, but the Allies demanded the armistice not go into effect until 11 a.m. – the eleventh hour of the eleventh day of the eleventh month.

The Allied generals argued that they needed to wait six hours to start the ceasefire to give them time to inform their commanders in the field. The Germans disagreed, arguing that date of the ceasefire had unofficially been known by both sides – and had been communicated to their field commanders – for two days so there was no need to wait.

The Allied commanders won, meaning the war was effectively over, but it still had six hours until the end was official.

Gen. John “Black Jack” Pershing, the commander of American forces, told his field commanders that the war would end at 11 a.m.; however, Pershing, who was against the armistice, gave no order as to what they should do in the meantime, leaving it to them to decide.

The British high command actually ordered an attack on the city of Mons, site of a stinging British retreat early in the war.

Many high-ranking American officers choose to keep their men relatively safe in the trenches and wait out the artillery fire that both sides were pouring down. However, inexplicably, many commanders decided to launch one final attack.

Maj. Gen. William M. Wright, the American 89^th division’s commander, ordered his troops to take the French town of Steney because the town had “proper bathing facilities” which would remain in German hands until after the ceasefire. Wright’s division suffered 365 casualties, including sixty-one dead, that morning so the general could secure bath tubs, which likely would have been available anyway.

Sporadically, up and down the Western front, American, British and French troops attacked to the astonishment of the defending Germans who assumed that both sides would stay in their trenches until 11 a.m. Indeed, many German machine gunners shot over the heads of the oncoming Allied soldiers in an attempt to warn them off without killing anyone. It didn’t work, and they lowered their aim.

By the time of the ceasefire, the needless human toll was horrendous. A conservative estimate of American casualties is 320 dead and 3,240 seriously wounded. The French had casualties – dead and wounded – of 1,170, while the British casualties totaled around 2,400. The Germans suffered 4,120 casualties that day.

In total, casualties on both sides amounted to more than 10,000 men – more than the total casualties inflicted on both sides on the D-Day invasion of Normandy in WWII!

The last soldier to die in WWI was American private Henry Gunther. With just minutes left in the war, Gunther alone charged a German embankment near the French town of Verdun. According to reports, the Germans frantically tried to wave him off, but as Gunther closed to within grenade range, the Germans were left with no choice but to open fire. Gunther died at 10:59 a.m.

The senseless and cruel killing and maiming of thousands of men on that day was a microcosm of a senseless and cruel war and should not be forgotten.

Setting Expections: What is Normal Stock Market Behavior

In times like these, I like to remind myself that scary drops in the stock market are normal. Turmoil in the stock market is normal. Mental pain from being a stock market investor is normal.

For some odd reason, we human beings expect the stock market to be nice. It’s not. It’s mean. And thank goodness for that. If the stock market was nice, like CDs or a money market account, it would earn what CDs and money markets earn. Try amassing enough money to retire on what you earn in your money market account.

In my opinion, the key to being a successful investor is having the right expectations. Without understanding what is normal, you will make decisions based on incorrect assumptions about the market, usually leading to huge mistakes.

So, what is normal for the stock market?

Well, big drops in the market are normal. Look at this table compiled by Ben Carlson at the blog “A Wealth of Common Sense.”

S&P 500 Daily Moves	% of Trading Days
-2% or more	2.1%
-1% to 2%	7.7%
0% to -1%	36.4%
0% to 1%	43.5%
1% to 2%	8.2%
2% or better	2.1%

Data from Jan. 1, 1950 to Feb. 5, 2018. Compiled by Ben Carlson.

As you can see, the stock market spends about 10% of its days getting clobbered. (Heck, the stock market loses money on almost half of all trading days.) Daily losses of 2% or more happen around five times a year on average. In addition, in an average year, you can expect around 20 days where you lose between 1% and 2%. Combined, you can expect around 25 trading days a year where you lose 1% or more of your stock investment.

What’s more, stock market losses (and gains) tend to cluster so you can expect to get hit by those big losses over the course of a couple of weeks, not nicely spread out over the year.

For example, Ben notes, in August of 2011, the last time the S&P had a down day of 4 percent or more, the index fell by more than 4 percent on three separate days in the span of a few weeks. There was even a period of four consecutive trading days with a combination of gains and losses exceeding 4 percent.

Even over longer periods of time, the market has some wild swings. According to research by FactSet, a financial research company, from 1978 to 2017, the S&P 500 had market corrections of 10% or more in 22 out of 40 years or 55% of the time.

That’s right, folks, you can expect a 10% or more drop in the stock market every other year. In other words, 10% or more declines in the stock market are normal.

Whether you’re looking at the stock market on a daily basis or over the course of an entire year, volatility is the name of the game.

Now, let’s look at the real scary times: Bear markets. (We’ll define a bear market as a market decline of 20% or more.) According to Yardeni Research, since 1928, there have been 20 bear markets with an average loss of 37.3%.

That’s a bear market every 4.5 years!

(In case you’re wondering, our last bear market ended nearly 10 years ago, so we’re well past due for another.)

Now, let’s recap what is normal stock market behavior so we can set our expectations correctly:

1. Daily declines of more than 1%
2. 10% declines every year or two
3. Nearly 40% declines every five years or so

Of course, normal doesn’t mean enjoyable. Going to the dentist is normal but also uncomfortable.

 

Trend Following: Not a Unicorn, But a (Potentially) Useful Horse

In my last article, I introduced the investment strategy of trend following – and my reluctance to believe in it. In the end, the evidence was too overwhelming for me to ignore. A trend following screen on stocks did appear to reduce an investor’s risk (especially of big market drops) while achieving similar returns as a buy-and-hold strategy.

But I couldn’t shake my suspicion that something wasn’t quite right. One of my core beliefs (perhaps “the” core belief) is that investing strategies that enhance your returns (or give you equal returns at lower risk) over simply owning an index fund should cause pain. If they don’t cause investors pain and investment advisors to get fired, everyone would use them, and they would disappear.

Where was the pain in trend following? How could following this strategy get me fired?

Then it hit me. I was looking at the numbers of using trend following, but I wasn’t looking at the human experience for investors over the long run. From that angle, I realized that trend following is a pain train; it’s almost designed to get me fired. (I was beginning to warm up to trend following.)

First, a trend screen on stocks doesn’t work most of the time. (Hmm, maybe you can’t time the market.) Yeah, getting out of stocks when they started to trend down was great in 2008 and 2009, but what about in 2011 when the S&P 500 fell 16% over several months – triggering our trend screen and moving the portfolio to cash – only to shoot right back up to new highs while we sat in cash waiting for the trend screen to signal the “all clear” to move back into stocks.

You can see in the chart below how the trend screen would have caused us to sell just as the market bottomed out and to buy back into the market after missing a large run up in price. We ate all of the downturn but missed a good part of the rebound.

 

For Illustration Purposes Only

Similar market moves – known as “whipsaws” – happened again in 2010 and 2016.

By its nature, trend following is a defensive strategy. As soon as trouble starts to appear, it moves you to cash and waits until the coast is clear before going back in. It’s geared to avoid the big crash. But that protection comes at a price: You will miss out on gains during bull markets when stock downturns are temporary hiccups on the way to new highs.

In essence, a trend screen is like an insurance policy: It pays off big during a disaster, but during good times, you’re out the cost of the premiums. Over time, they even out.

We can see this by breaking down the annualized returns of two portfolios over the last decade. The first portfolio used a 10-month moving average trend screen to decide when to be in the S&P 500 index and when to be in cash. The second portfolio simply bought and held the S&P 500 index.

 

	2008-2017	2008-2009	2010-2017
Trend Following	9.38%	11.61%	8.83%
Buy-and-Hold	8.37%	-10.75%	13.76%

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index.

 

The returns are exactly what you’d expect to see. The trend following portfolio did a great job during the bear market of 2008 to 2009 but has solidly trailed a buy-and-hold strategy during the bull market. Taken together, the overall annualized returns were fairly similar.

While I’m sure that investors would have been glad to have the trend following portfolio during the dark days of the Great Recession, I’m not sure how many investors would be willing to put up with the subsequent eight years of underperformance.

Trend following seems to have the same downside as other factor premiums (small, value and momentum): Long periods of underperformance that the vast majority of investors are not willing to accept.

It also has an added psychological hurdle: It looks like market timing. And perhaps it is, though it’s a strange type of market timing in the sense that it openly acknowledges that it doesn’t work most of the time.

Those caveats aside, trend following has a number of inviting attributes. First, it does seem to generate similar long-term returns as buy-and-hold but at less risk. Second, it complements buy-and-hold extremely well. Just as stocks and bonds pair nicely because they often do well when the other is doing poorly, trend following typically does well right at the time that buy-and-old is doing poorly (bear markets) while buy-and-hold portfolios typically do well when trend following portfolios struggle (bull markets).

Despite my early hesitations, I’ve come to believe that allocating a portion of an investor’s portfolio to a trend following strategy can be a useful addition.

However, I also believe that this strategy is not for many (maybe even most) people. For some (and do I understand this group), the feeling that they’re timing the market will never let them feel comfortable with trend following. For others, the fact that it doesn’t work most of the time will frustrate them into quitting the strategy. And, of course, for many investors, the long periods of underperformance relative to a benchmark will cause them to abandon the strategy before it can work.

As always, the best investment plan isn’t the plan that earns you the highest rate of return; it’s the investment plan that lets you sleep at night and that you can stick with during the inevitable periods of poor performance.