In Part I, I wrote about my process for making equity asset allocation decisions. Here in Part II, I will introduce my process for risk management.
I know anytime someone says they don’t buy & hold, it is a sin. So yes, I am a sinner.
I do not believe that a 3-Fund portfolio that never makes adjustments is for me. I think the strategy is fine and will work in the long-run, but it is not something I believe in enough to always hold-on, and that is key. No matter the investment strategy, the key is belief in that system. If someone has that, they will fine.
For me, I believe that using economic indicators can help inform my decisions on when or when not to take increased risk. This journey originally started for me when I read Meb Faber’s: A Quantitative Approach To Tactical Asset Allocation paper. This paper began my journey into the wonderful world of trend-following. From there, I read papers and books from AQR to Michael Covel to Jerry Parker and on and on. Trend Following is a simple and intuitive approach to investing in my opinion.
However, there are drawbacks:
- From an emotional perspective, it can be a challenge to lag in bull markets.
- Whipsaw trades can become extremely frustrating.
- It is generally a high-turnover strategy which can become very costly and tax-inefficient.
- Most trend-following techniques employ leverage via futures markets (Something I would not advise to do on your own…I don’t).
About a year and a half ago, I read a great piece on the Philosophical Economics blog, which proposed using a trend-following approach in certain economic environments. Makes sense, and the results back it up. Most importantly though, it eliminates a few challenges that come from a pure trend-following approach.
This new trend model has had an extremely long bias, meaning that going back to 1930 through 2015, this model was fully invested in stocks 85% of time, compared to the simple trend approach which was invested 72% of the time. This alone diminishes three key frustrations:
- Lower tracking error, especially during bull markets.
- Less whipsaw trades.
- Lower turnover, eliminating some costs from trading.
The additional benefit for me is that this strategy just makes more sense. Do not get me wrong, I was already a fan of trend-following, but it was this last piece that set it in stone for me. When an economic indicator is showing that there is a chance we may be in or may be entering a recession, the trend-following component turns “on”. If the economic data looks fine, ignore the trend. Simple.
Not too shabby. Of course, I do not expect these results to be the same moving forward for two reasons:
- The last 20-25 years was an absolutely perfect time for trend-following approaches. We had two very clean and deep bear markets and three very clean bull markets. That will not always be the case.
- More people will undoubtedly be implementing tactical/trend approaches because of their success over the last two decades.
Both of those reasons will cause the premiums of the past to erode. However, I still find this strategy appealing. Even if it provides close to a 0% premium from a return perspective, it provides me with three very valuable possibilities:
- Reduced long-term volatility.
- Reduced max draw-down.
- Something “to do” during bad environments (Very underrated in my opinion).
In my next piece I will layout my philosophy from a vanilla 3-Fund approach all the way to my current approach and philosophy (It only took 3+ years and thousands of hours to cement…).
Have some fun out there!