SEEKING THE HOLY GRAIL OF INVESTING / BARRON´S ( RECOMMENDED READING )

Tuesday, June 23, 2009

UP AND DOWN WALL STREET DAILY

Seeking the Holy Grail of Investing


By RANDALL W. FORSYTH

Diversification works over time, if the mix is right.

"ASSET ALLOCATION DOESN'T WORK." That was the proposition being discussed at coffee hour after church services Sunday, which (with rare exceptions) is about as heated a debate as you'll get among Episcopalians.

You can understand the frustration. The bear-market rally in stocks has been offset by a massive sell-off in Treasuries. The devastation in credit markets has been only partially recouped by this year's recovery. Ditto the surge in emerging markets, which still leaves them far below their highs. And for all the hyperventilating about hyperinflation, gold's top tick was made a year ago March when Bear Stearns fell into Chase's arms. As for cash, it merely fulfilled Will Rogers' desire for return of capital over return on capital (though for unfortunate holders of the Reserve Fund, it didn't even meet that criterion .)

Indeed, Barron's recently has been schizoid on the matter of allocating to equities versus bonds. On March 9, the "Stocks for the Long Run" mantra was chanted, to which Keynes' counterpoint is that in the long run we are all dead. And on March 30, the Streetwise column offered data showing stocks did not provide higher returns than bonds over the past four decades.

Describing the past is easy; predicting the future is impossible. Moreover, posing the question of asset allocation as one of flipping a coin between stocks and bonds is plain stupid.
Conversely, combining different asset classes to produce higher returns with lower risks isn't just reasonable, it's common sense. Of course, taken to absurd extremes -- such as, for instance, declaring collectibles such baseball cards an "asset class" worth investing in simply because it doesn't correlate with the S&P -- is idiotic.

Over long periods, diversification among asset classes has produced higher returns with lower risk. But how to get the mix right is a tougher question. And the mix will change over time.

Doug Roberts, who runs Channel Capital Research Institute in Shrewsbury, N.J., has been working on recipes that are both simple yet effective for individual investors who want to put their asset allocation virtually on autopilot. His "Follow the Fed" formula was discussed here about 2½ years ago, "To Enjoy Life, Just Buy Big-Caps" Dec. 22, 2006, which allocated between large- and small-capitalization stocks. Easier monetary policy favors small caps, and vice versa. Adjusting accordingly provided higher returns with a minimum of trades.

Roberts has extended the principal to pairing gold and long-term Treasury bonds. Not surprisingly, he found gold behaves similarly to small caps, doing better when money is easy, while Treasury bonds tend do better when money is tighter, as is the case with large caps.

Over time, he continues, switching between gold and Treasury bonds delivers similar returns to equities. But they do not move in lock-step with stocks, which can help damp the swings of an equity portfolio over time.

Looking at 1996-2008, a period that saw booms and busts in stocks, bonds and gold, Roberts' strategy with gold and 30-year Treasuries returned 9.15% annually, nearly twice that of the S&P 500 at 4.78%, but with about half the volatility. His "standard" strategy -- positioning for easy money when the short-term T-bill rate is lower than inflation (as measured by the trailing 12-month consumer price index) -- required a total of six trades over than time. In dollar terms, $10,000 would have grown $31,229 over that time using the gold-bond system, compared to $22,276 just in gold, $29,589 in long bonds and $18,345 for the S&P 500.

Roberts' standard equity system of switching between big and small caps during that span would have nearly matched just small caps, returning 7.20% per annum versus 7.28% for the S&P 600, but half-again the large-cap S&P 500.

But a 50-50 combination of the gold-bond strategy with the big-small cap strategy not only increased the return, but lowered the risk to two-thirds of just the S&P 500 and less than bonds alone. The 50-50 combination returned 8.86% annually from 1996 to 2008, resulting in $10,000 growing to $30,144.

Roberts then attempted to reduce risk still further by adding simple intermediate government notes to the mix. He found a portfolio consisting of one-third of the gold or long bond portion, one-third in the large- or small-cap portion and one-third in a static 10-year Treasury note portfolio had about the same risk as intermediate notes alone. But the return of the triple play was nearly as great as the 50-50 combo of the bond-gold and small-large-cap strategies, 8.51% annually from 1996 to 2008, which turned $10,000 into $28,911 over that span.

Given the uncertain investment waters, having intermediate government notes as an anchor to windward results in smoother sailing than the bond-gold and small-large-cap pairing. But even a simple-minded, static 50-50 mix of the S&P 500 and long Treasury bonds produced a 7.97% return from 1996 to 2008, 60% more than the S&P alone with 60% less risk.

Right now, money is on the tight side by Roberts' measure, even with Treasury bill rates barely above zero. That's because of the decline in the CPI, resulting in real rates that are positive; thus, long bonds are favored over gold and large caps over small caps. But an uptick in inflation to a mere 1% would put real rates in negative territory as long as the Fed maintain short-term rates near zero.

Rarely has the outlook been so uncertain. Lots of people have strong opinions of what lies ahead. Roberts' method acknowledges that making predictions is tough, especially when they're about the future.


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