Advanced concepts: market "timing" using valuations; how to incorporate very strong convictions into your investment portfolio allocations. Overall I would discourage attempts to time or finesse your target weightings. Once you've decided your risk tolerance, generally it is best to stick to it, and rely on rebalancing to see you through drawdowns. However, there are rare occasions where the is a clear valuation discrepancy in the markets. I definitely do not subscribe to the pure efficient market school of thought. In my opinion, it is an indisputable fact that on occasion asset markets sometimes go to absurd speculative excess valuations; equally, markets also periodically go to panic-driven crisis lows, with incredibly attractive values based on any rational economic measure. Perhaps the most obvious example of a valuation discrepancy is the 1999-2000 bubble in the S&P and technology stocks. Japanese stocks in 1989 were another example - NTT, a single telecoms company, at the time was worth more than the entire Australian stock market. On the cheap side, the Asia crisis caused incredible undervaluation in those markets, ditto the Russian default in 1998. The Brazil and Argentina financial crashes at the start of this decade caused a similarly extreme level of distressed value. US stocks in 1932, or UK stocks in 1974 (where the FTSE was at a P/E of 3.8 and a dividen yield of 12%), were perhaps the most egregious examples of sound blue chip stocks virtually being given away In each of these cases, no rational observer could conclude anything other than that the valuations were way out of whack, driven by insane sentiment excess or panic-driven risk aversion at absurd levels. Therefore, I personally do not think it makes sense to maintain target allocations if one of your asset classes ventures into either insane bubble territory, or ridiculously cheap fire-sale levels. My solution to this is simply to maintain target allocations, but then to slowly reduce (or increase) them, only if the asset class gets to truly ridiculous bubble/bust levels. You can actually manage a lot of this simply by shifting from the growth portfolio to the conservative portfolio. As we saw, 2000-2003 was actually slightly positive for the conservative portfolio. However, I personally would have made stocks an even lower allocation in 2000 than the conservative portfolio's 35%. I think it would even have been acceptable to have no stocks at all, although that is quite an extreme position. If you are going to follow this "bubble avoidance" approach, fading valuation extremes, I would give the following advice. First, make sure it really is a genuine bubble/bust, and not just a slightly expensive or slightly cheap market. Stocks were pricey in 1996, 1997, 1998 and 1999 - selling out then would have been very costly. Asia was cheap in 1997 but still cratered for 1 more year. In the early 1990s, US stocks were expensive on a P/E basis, fooling many into selling. But earnings were at recession multiples, thus the true P/E was misleading - once earnings bounced back, stocks become cheap quickly, and had already moved higher. In 2000 by contrast, earnings were at cycle peaks after a multi-year boom, margins were at record levels, corporate profits as a % of GDP, and market cap as a % of GDP were all at historic highs. Second, scale out (or in) slowly, in steady increments. Don't go from 50% to 0% overnight, like some value managers did in the mid to late 90s. Go from 50% in 1996 to 45% in 1997 to 40% in 1998 to 35% in 1999 and finally 20% or less in 2000 when things went nuts. Third, check sentiment. Is it really a raging bubble, with taxidrivers being multimillionaires, your grandmother raking it in? Or is it just a typical bull market? Do not try to time normal bull markets. Stick to bubbles only. Fourth - try to estimate long-run returns using valuation metrics. For example, at a P/E of 30-35, the earnings yield of the S&P in early 2000 was 3%. That is not exactly a great long-run return for risky stocks, when long-term US treasuries were yielding 7% with much lower risk, and long-term TIPS were yielding 4% *plus inflation*, with virtually no risk at all. It should have been no surprise that bonds performed very well from 2000-2003, whilst stocks got annihilated in the worst collapse for a generation. In 1989-1990, real estate yields were 4-5% - pathetic compared to stock earnings yields, or bond yields at the time. Sure enough, real estate sucked donkey balls in the early 1990s. So, that's my advice for incorporating valuation - use it to reduce exposure and risk during the blowoff period of true valuation bubbles. And you can use it to try to make Buffett-style deep value purchases in truly depressed markets and asset classes. Just avoid "all or nothing" bets as much as you can, make your shifts gradual and conservative, and remember that most of the time, being long investment assets at your target allocations is the best play. Don't be one of those people who sold stocks in 1990 and then never bought back again, still waiting for the next Great Depression and making 2% in T-bills. Remember, even the conservative portfolio has 6% expected returns, and superb bear market protection.
If you must time the market: Ok, I don't recommend this for investment accounts, but if you must do it, here are some tips: 1) Restrict your "timing" to shifts from the aggressive to the conservative portfolio. Think the S&P has further to fall this year? Ok, go conservative. Don't go 100% cash, please. Even if you are right this time, next time you'll be wrong and watch the S&P soar 40% without you. 2) If you are convinced there's a bubble in one asset, don't go cash - try to find other higher-return assets that are fairly valued or cheap. In 2000 it was much better to have on a spread of bonds, REITS, and commodities than to go into t-bills. 3) Consider using a separate trading account for your "market calls". After a few years, compare the results. If your trading is outperforming, then just keep doing it and eventually your trading account will dwarf the investment account. If you are the next George Soros, you won't suffer from keeping a disciplined steady invested account on the side - in fact it will provide diversification and low-stress acceptable returns to go alongside your more volatile trades. 4) If you really can do something like picking panic lows, avoiding vicious 15% short-term corrections add so on, then consider using options to hedge instead of liquidating your investments. And as soon as your "edge" has gone, remember to go back to your normal investment allocation. Do not stay in cash waiting for a "buy signal" - one feature of investment assets is that they can often end a bear market and start drifting upwards, without providing any buy signal at all. Consider stocks since March 17th - the rally has caught many by surprise, whereas the steady investor was dollar cost averaging and rebalancing into the Bear Stearns panic with wise S&P purchases at discounted prices. 5) You can't make long-term returns without taking some risk. Rather than try to eliminate risk entirely, rely on diversification, regular savings contributions, and rebalancing to mitigate the effect of bear markets. One safe way to "market time" is to make larger than normal contributions once stocks are down a lot. 6) Look at other attempts to time the market. Ben Graham was bearish on stocks in the 1950s because he thought them expensive - they soared for 15 years. Julian Robertson missed the 1998-2000 bull run. Peter Schiff and Bill Gross were bearish at the 2002-2003 lows, missing a 100% appreciation in 4 years. Larry Tisch had New York University's endowment almost entirely in bonds during the 1980s and 1990s, losing billions in opportunity costs. Jim Rogers was bearish on the S&P from 1995 to 2000. Next occasion you think it's time to make that "gutsy" go 100% to cash/gold/bonds call because the S&P is up a few hundred points over the last 12-18 months, consider the market timing disasters these guys fell victim to. Remember - you can always shift to the conservative portfolio, and earn a probable 6% with pretty low risk. At least then if the bull continues, you got 35-45% in equities and REITs to claw back some performance. With 100% in t-bills, if you are wrong then you have diddly squat - and don't think you can just buy back stocks at prices 20, 30, 40% higher than where you sold out a year or two ago. Most likely you're gonna become a perma-bear, 100% in cash for the next decade whilst more rational investors steadily double and triple their capital with moderate risk. Do you really want to end up like Bill Bonner, David Tice, Jim Grant and everyone else who missed 2 decades of 15%+ returns on stocks? Ok, that's all from me for now. I hope you've found this thread useful. Feel free to comment, criticize constructively, or make suggestions. Most importantly, if you don't have an investment program, get working on one now - the sooner you start, the better.
Steve - options as a whole are a slight negative sum proposition, from an investment perspective. I would recommend that if you want to reduce risk, you just use a more conservative portfolio, like the one I suggested earlier, rather than get involved with options. Unless you have a genuine market edge, then the expected return from any options position is zero minus commissions and spreads (which are high for options straddles). Just use the conservative portfolio and you will minimise your risk while still beating an all cash/bond portfolio.
One way to do this is to stick a 200 SMA on the chart of the indice that you are invested in. If the indicie is above the 200 SMA you should be Long. If the indicie is below the 200 SMA you should be in Cash.
Here's how it looks for GLD (gold) ... the concept is applicable to any ETF that would compromise your portfolio. This would allow you to take advantage of the upmoves (capital growth) and hold onto your gains during the individual market downturn (preservation of capital). I know it sounds simple (to us), but if all of those "dot comers" had applied this simple technique, they would be sitting pretty instead of singing the "I used to be rich" song.
Excellent topic... Cutten, thanks very much for writing up your thoughts. Yale University is one of the world's best asset managers. They achieve excellent risk-adjusted returns. They describe their approach in their annual report: http://www.yale.edu/investments/Yale_Endowment_07.pdf Some of their success is from hiring bright people to actively manage certain investment areas. That part is (very) hard to duplicate. But they do other things that are not as hard to duplicate -- such as their disciplined diversification, statistical and analysis methods, etc.
Check out the 'FundCreator' tool created by Harry Kat at Cass Business School in London: http://www.fundcreator.com/ FundCreator is very interesting product used to better manage portfolio risk and return. It creates portfolios of futures contracts with pre-defined statistical characteristics -- such as 0 correlation to stocks and bonds, X% maximum monthly drawdown, pre-defined % volatility. This allows investors to create an ideal diversifier.
But ..... 4K euro for a license, 0.03% per month of fund NAV, and $20M minimum recommended fund size.