By now, we have all heard that 90% of investment returns are attributable to asset allocation decisions. It makes sense, too, that if you buy stocks, you’ll get a stock-like return, if you buy bonds, you’ll get a bond-like return, etc. Stocks, bonds and other asset classes don’t offer consistent returns, however. Stocks will do very well during a bull market, but then will perform poorly while bonds may perform far better, as an example.
Asset allocation means picking a set proportion to invest in each stocks, bonds and cash and then maintaining that allocation in an effort to minimize volatility and earn a reasonable return. This is what most investment advice is focused on. It has the benefits of diversification and low maintenance. It is possible, however, to predict which asset class will outperform over the coming months, and trying to take advantage of outperformance is sometimes called “asset rotation”.
The reason asset rotation works is due to short-term momentum. Over the longer term, three to five years, performance tends to revert to the mean. However, over the shorter term, people tend to put stock in and act on inertia. When money starts moving from stocks to bonds, for example, it tends to continue for a number of months. This will depress the price of stocks as supply begins to outweigh demand, and increase the price of bonds as demand increases. If a person can be among the first to detect these movements, they can not only profit from the demand-induced waves, they can also avoid much of the drawdown on the asset class that is falling out of favour.
This works. As markets move faster, it may work less well and cycles may become shorter. But there’s research to show that it works. One example of a successful practitioner can be found at www.decisionmoose.com. An independent review of this strategy can be found at www.cxoadvisory.com. There’s more than one way to profit in the markets, and this is one option. I believe that it presents characteristics of speculation and probably wouldn’t suit my temperament. At the same time, it’s nice to have a big picture outlook on markets, to be prepared to react rationally during a tough environment.
Others who are more active in their trading and assign less value to stability in their investment account may choose to employ this method. What I pointed out with asset allocation holds for strategy as well: sticking with your strategy will bring the majority of gains, whereas the choice of strategy may be less important.
Now that I am aware of this strategy and that it can be very useful for more than just moving out of stocks (or hedging) when the market appears to be turning in favour of bonds, I’ll explore how to implement the strategy (in Canada) next week and whether or not it would make sense to integrate it with value-oriented stock picking the following week.