| Investment strategy is a little like religion in the | | | | management accountable for performance, etc. |
| financial advisor community. There are few | | | | When It Works/When It Doesn't Work: |
| situations that would get emotions boiling, fists | | | | Buy-and-hold makes money when investments go |
| flying, and require police action faster than putting | | | | up, and loses money when they go down. |
| a buy-and-hold advocate and a market timing | | | | Therefore, it works well during bull markets and |
| zealot in a room and asking them to resolve their | | | | works poorly during bear markets. For this |
| differences. The truth is that most strategies | | | | strategy to continue to work for the next 30 |
| work some of the time, a few work most of the | | | | years like it did the last 30 years, you have to |
| time, and only Bernie Madoff figured out how to | | | | assume that investments will continue to go up |
| make one work all the time, right up until he got | | | | like they have during a period of economic growth |
| caught. Investment strategies have two major | | | | that was fueled by the Baby Boom generation, an |
| parts: 1) what investments to buy, and 2) when | | | | Energy bubble, a Technology bubble, and a Real |
| to buy and sell. Because I'm an investment | | | | Estate bubble. |
| advisor and human, I have some built-in biases, | | | | Market Timing (prediction-based) |
| but following is an attempt to objectively look at | | | | Market Timing is one of the most loosely-defined |
| several common strategies with a minimum of | | | | terms in the financial industry. There are many |
| sarcasm. | | | | advisors who deride market timing, and yet |
| Allocation Strategies (what to buy) | | | | routinely practice market timing themselves. |
| Strategic Asset Class Allocation | | | | Broadly-defined, market timing is a strategy that |
| Traditional asset classes include stocks, bonds and | | | | makes changes to a portfolio based on predicted |
| cash. These classes are then divided into | | | | market performance. These changes may involve |
| subcategories based on geographic location (U.S., | | | | selling all investments and moving to cash, or |
| developed foreign countries, emerging markets), | | | | simply adjusting the percentage of stocks and |
| company size (small-cap, mid-cap, large-cap), and | | | | bonds because of economic conditions or |
| bond style (treasuries, mortgage-backed, | | | | anticipated market behavior. Prediction-based |
| high-yield, etc). Real estate, commodities, and | | | | market timing bases decisions on an advisor's |
| hedge funds are sometimes added as additional | | | | assessment of future conditions. If high-inflation is |
| asset classes. The idea behind Strategic Asset | | | | anticipated, investments that hedge against |
| Class Allocation is to come up with a portfolio of | | | | inflation would be added. If economic contraction is |
| non-correlated assets that meets an acceptable | | | | anticipated, an advisor might move to a heavier |
| risk profile, and then stick with that allocation as | | | | cash position. |
| the market goes up and down. The portfolio is | | | | Most Common Supporting Arguments: |
| typically rebalanced periodically to maintain the | | | | - By using indicators such as inflation, |
| percentages of each asset class, but mostly the | | | | unemployment, factory usage, etc, it is possible |
| portfolio is left alone. | | | | to anticipate which sectors have a higher chance |
| Most Common Supporting Arguments: | | | | of outperforming in the future. |
| - Easy to set up with mutual funds, which are | | | | My Rebuttal: |
| typically aligned with asset classes. | | | | - Economic indicators work when nothing |
| - Mutual funds provide diversification by owning | | | | interferes with them, but unexpected events such |
| many stocks with professional management. | | | | as government action or national conflict override |
| My Rebuttal: | | | | any statistical probability used for predictions. |
| - Many mutual fund managers tend to favor | | | | - Overweighting some sectors and ignoring others |
| certain stock sectors at the same time, making | | | | adds significant risk to a portfolio. |
| the portfolio less diversified than it appears (e.g. | | | | When It Works/When It Doesn't Work: |
| overweighted in Energy or Financials). | | | | This method is highly dependent on the person or |
| - Most stock asset classes are highly correlated | | | | statistical model making the prediction. If the |
| when looked at over the last decade. | | | | predictions are accurate, this strategy has a good |
| Semi-Objective Opinion: | | | | chance of significantly outperforming other |
| Dividing the stock world by geographic location | | | | methods. If the predictions are wrong, the |
| (U.S. & foreign) or by company size no longer | | | | opposite is true. Because of the large number of |
| results in a diversified portfolio. This has been a | | | | advisors who make predictions, a certain number |
| long-term trend developing and getting worse | | | | will get it right several times in a row, but |
| over the last 20 or so years. As an intuitive | | | | statistically this will not indicate any greater |
| example, when oil drops from $150/barrel to $35 | | | | likelihood that they will continue to be right in the |
| barrel, all energy companies get hurt, whether | | | | future. As mentioned above, unanticipated news |
| they are large or small, based in the U.S. or based | | | | events or government action will instantly derail |
| in Brazil. However, it is true that an asset class | | | | most statistical models. |
| allocation model is easy to implement with mutual | | | | Market Timing (momentum-based) |
| funds, and the addition of non-correlated | | | | Momentum-based market timing uses technical |
| alternative investments can improve overall | | | | indicators (stock charts and current market |
| diversification. | | | | behavior) to determine whether the market is in |
| Balanced Sector Allocation | | | | a downtrend or an uptrend. Downtrends occur |
| As stated above, a major problem with Asset | | | | when more people want to sell than want to buy, |
| Class Allocation is that the major equity classes | | | | and uptrends occur when more people want to |
| do not behave differently enough to do an | | | | buy than want to sell. Price movement and trading |
| effective job of diversification. Balanced Sector | | | | volume can determine whether there is more |
| Allocation gets around this by diversifying across | | | | buying pressure or more selling pressure at any |
| low-correlated sectors (Technology, Energy, | | | | given time, and the theory behind momentum is |
| Financials, Healthcare, etc). This is not a new | | | | that once a trend is in place, it tends to stay in |
| concept. Just about any portfolio that uses | | | | place. For how long? Until it stops. |
| individual stocks diversifies this way, and the | | | | Most Common Supporting Arguments: |
| strategy can be implemented using either individual | | | | - Price movement and trading volume offer |
| stocks or sector-based Exchange Traded Funds | | | | strong clues about buying pressure and selling |
| (ETFs). | | | | pressure, and whether large institutional traders |
| Most Common Supporting Arguments: | | | | are buying or selling. |
| - Spreading investments across non-correlated | | | | - Institutional traders do not establish or eliminate |
| sectors does a much better job of diversification | | | | entire positions in a single trade, and typically |
| than dividing investments by company size or | | | | spread trading over several days or weeks. |
| where their headquarters happens to be located. | | | | Therefore, trends tend to stay in place for some |
| - Individual stocks and ETFs typically have | | | | period of time once they are established. |
| significantly lower expenses than mutual funds. | | | | My Rebuttal: |
| - Sector allocation can be precisely controlled. | | | | - This makes a lot of sense to me, so I don't |
| My Rebuttal: | | | | typically argue against it. However, it has some |
| - If Sector Allocation is implemented with a few | | | | weak points (see below). |
| individual stocks for each sector, there is a | | | | - Some advisors can go over-board on technical |
| significant amount of company-specific risk added | | | | patterns (head and shoulders, cup and handle, |
| to the portfolio. | | | | shallow birdbath with a floating stick...I made that |
| Semi-Objective Opinion: | | | | one up). These advisors are traders looking for |
| In addition to showing a significant performance | | | | short-term movements. Trends, on the other |
| improvement over the last 10-20 years, Sector | | | | hand, are determined more by a pattern of |
| Allocation passes the "this just makes sense" test. | | | | higher-highs or lower-lows, and it doesn't need to |
| Intuitively, a Healthcare stock and an Energy | | | | be very complicated. |
| stock will do a better job at diversification than a | | | | When It Works/When It Doesn't Work: |
| large-cap Energy stock and small-cap Energy | | | | There are some key components required for |
| stock. The manager of an actively-managed | | | | this system to work. |
| mutual fund is typically doing sector allocation | | | | 1) The method for determining trends must not |
| within a particular Asset Class (e.g. Large Cap | | | | be too early or too late. Stocks seldom move in a |
| Value), but if you own several mutual funds, there | | | | straight line. They typically make a strong move, |
| is obviously no coordination between the | | | | and then rest or pullback. Assuming too early that |
| managers. | | | | a trend is being established or ending will result in |
| Tactical Asset Allocation/Tactical Sector Allocation | | | | jumping in or out during pullbacks or corrections. |
| These strategies are similar, with the difference | | | | Waiting too long or for too many confirmation |
| being that one uses traditional asset classes and | | | | signals will result in missing a good portion of the |
| the other uses stock sectors. In both cases, the | | | | trend. |
| objective is to predict which stock class or area | | | | 2) Investments must be liquid. You must be able |
| of the market will perform better in the near | | | | to act when your system tells you to buy or sell. |
| future, and overweight the portfolio to take | | | | 3) Whether you use Moving Averages, charting, |
| advantage of that market segment or segments. | | | | or any other system to determine a trend, the |
| The basis for determining which asset class or | | | | trend will not always hold. Each system will break |
| sector to invest in or stay out of can be based | | | | down under certain conditions, so the objective is |
| on a computer model, economic indicators, or | | | | to use a system that works under the widest set |
| (more commonly) an advisor's opinion or gut feel. | | | | of conditions and/or breaks down under the |
| Most Common Supporting Arguments (some with | | | | narrowest set. |
| questionable accuracy): | | | | Market Timing (emotion-based) |
| - The advisor has a track record of picking the | | | | This is not a strategy that is typically planned for |
| winning sectors. | | | | or entered into intentionally, and is the form of |
| - When in a bear market, it's better to be in | | | | market timing most often practiced by those |
| bonds, cash, or defensive sectors (e.g. healthcare). | | | | who swear they hate market timing. Many |
| - It is possible to time the market, it's just that | | | | practitioners of this strategy consider themselves |
| most people do it wrong. | | | | to be buy-and-hold investors, but they end up |
| My Rebuttal: | | | | moving to cash when the pain gets too great or |
| - There are enough advisors trying new things | | | | the market is too scary. Typically, this happens |
| that, statistically, some will be right on their | | | | after a significant loss is already on the books, |
| predictions. When this happens, they get their | | | | which actually makes this a form of momentum. |
| own radio show. When they're wrong, you never | | | | The rationale is that if my investments have |
| hear about them. | | | | already lost money, they may continue to lose |
| - Unpredictable events or government intervention | | | | money. The problem is that if emotion or fear |
| can make any prediction completely worthless. | | | | drives the sell decision, then the decision to get |
| - Overweighting some sectors and ignoring others | | | | back in is typically based on "feeling better", which |
| adds risk. | | | | almost always happens at a higher price than the |
| Semi-Objective Opinion: | | | | sell price. |
| In order to significantly beat the market, you | | | | Most Common Supporting Arguments: |
| have to take some additional risk, and this | | | | - Not too many people are active proponents of |
| strategy does that. When called correctly, this | | | | this strategy, but a lot of people practice it. |
| strategy can make huge gains. It can also lose a | | | | My Rebuttal: |
| significant amount of money while everyone else | | | | - Not much to rebut, other than pointing out that |
| is making money. By picking the right sectors or | | | | you can't call yourself a buy-and-hold investor if |
| asset classes at the right time, it is possible to | | | | you move to cash or change your stock allocation |
| make money in practically any environment. | | | | when the market gets scary, and no one should |
| However, similar to flipping a coin and trying to | | | | use this method as an example to "prove" that all |
| get "heads", I'm not sure past success is a great | | | | market timing systems are doomed to failure. |
| predictor of future success. | | | | When It Works/When It Doesn't Work: |
| Buy and Sell Strategies | | | | This strategy seldom works, and is the reason |
| Buy-and-Hold | | | | that the vast majority of investors buy when the |
| A pure buy-and-hold strategy involves buying a | | | | market is high and sell when the market is low. It |
| high-quality investment such as stocks or a | | | | doesn't matter which strategy you use; just |
| mutual fund, and then holding the investment | | | | about anything is better than basing investment |
| through highs and lows until either your | | | | decisions on emotion. |
| investment objectives change or you find out the | | | | Disclosure (my bias) |
| investment is not as high-quality as you thought it | | | | I use a Balanced Sector Allocation strategy using |
| was. The rationale is that the overall market goes | | | | low-correlated ETFs, and momentum-based |
| up over time, and you don't want to miss a big | | | | market timing. The objective is to participate as |
| up day in the market by holding cash. | | | | much as possible in uptrends, and avoid as much |
| Most Common Supporting Arguments (some with | | | | of the downtrends as possible. This requires a set |
| questionable accuracy): | | | | of rules that makes the decision points |
| - The majority of market gains occur on a | | | | unemotional. A Balanced Sector Allocation |
| relatively few number of days, so if you miss one | | | | guarantees participation in the hottest trending |
| of these days, your returns will be significantly | | | | sector at any given time, but with a mechanism |
| less. | | | | to get out of a sector when it starts heading |
| - "Time in the market" is more important than | | | | back down. |
| "timing the market". | | | | Weak Points: |
| - Warren Buffet is a buy-and-hold advocate. | | | | Because it takes a little while for a downtrend to |
| My Rebuttal: | | | | show itself, sell decisions will never happen right at |
| - Missing the worst days of the market is far | | | | the top of a trend. The same holds true for |
| better than catching all of the best days. | | | | uptrends and buy decisions. If the market gets |
| However, since no timing system exists that | | | | indecisive and swings far enough that it keeps |
| misses only the best days or misses only the | | | | looking like uptrends and downtrends are forming |
| worst days, both situations are ridiculous and using | | | | but no follow-through happens, a condition could |
| them as arguments stretches the definition of | | | | occur where losses are exaggerated. This would |
| integrity. | | | | be a very specific and narrow set of conditions, |
| - Warren Buffet does not "buy-and-hold" like you | | | | and I have other checks that attempt to minimize |
| and I would, unless you have the resources to | | | | this condition, but it still exists. |
| buy a company, install the management, hold the | | | | |