Welcome to the climactic episode of our slow-burning financial thriller: an investment rookie's guide to the simplest, soundest, most consistently successful long term wealth-building strategy any rookie could ever hope to find.
What you will soon have in your possession is a crystal clear method for putting your savings to productive use and ensuring your golden years need not be not spent in poverty or financial dependency. If you are a parent, it's a plan for building a pot of treasure for your children's education and/or a tempting vehicle they themselves can invest in as they grow older.
All this comes in a structure which is child's play to set up and maintain and which offers, at substantially reduced risk, the prospect of making a meaningful long term return.
I realize I am in danger of making the strategy sound too good to be true, so let's look at it carefully.
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SOLID FOUNDATIONS
Having investigated the techniques it employs and seen statistical reviews of its methodology there's no doubt that, from a purely statistical perspective, we're looking at a solid piece of research.
Based on well-established investing principles which are tried and trusted (diversification and trend-following) the strategy has been thoroughly back-tested over extremely long periods of market history and in varied market conditions and produced results which stand up well to statistical scrutiny.
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Source: 'A quantitative approach to
tactical asset management', M. Faber, 2008
The ten worst years of the past century for the
US S&P500 index: the timing method vastly
reduced losses in five cases and in four more
actually ensured the year turned a profit -
including, incredibly, 2008.
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But back-tested returns are one thing, real-world trading is another. Since its original publication, the portfolio has also faced the ultimate real-time test: a once-in-a-century market meltdown.
In the worst bear market for eighty years, the full diversified 'Ivy Portfolio' strategy emerged virtually unscathed, losing a grand total of 0.59% in 2008, the only negative year out of 36 tested since 1973.
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Strategy returns in real time v. buy & hold
(after original publication in 2006 and up until the end of 2008). |
The fact that it put in this strong a real-time performance under conditions of almost unprecedented stress is certainly reassuring.
But I also wanted to look at the plan from a practical perspective; after all you may, like many of my readers, have neither the time nor inclination to follow the market's twists and turns on a daily basis. So is there anything in the construction or running of the plan which is too complex or time-consuming for someone with a busy life or limited market knowledge?
The answer has to be no. The strategy requires zero financial judgement, should take no more than ten minutes per month to administer and is - providing a few straightforward instructions are followed - idiot-proof.
REASSURINGLY DULL
Friends, there's nothing remotely exciting here, nothing new in the various concepts, no extra bells and whistles, computer programmes, subscriptions, telephone advice lines or iphone apps required. Once you've got it, you've got it for life.
The strategy is neither sexy nor risky nor will it get you rich quick. On the contrary, it is resolutely dull and boring and you'll get rich the old-fashioned way: too darn slow.
Now, those of you who've already read and inwardly digested the first two posts will probably be champing at the bit but it's been a while since Part Two hit your screens, so let's take a moment to swiftly re-cap the highlights.
THE STORY SO FAR...
In Part One, we examined the astounding effect of compound returns on your money and saw how, given the right strategy and a decent stretch of time, an investor who seriously exploits this mathematical marvel can build up a substantial pot of tax-free cash.
We investigated a systematic approach originally published in a 2006 Working Paper (then in a Journal of Wealth Management research paper) and subsequently expanded upon in a book called The Ivy Portfolio, in which US money-manager Mebane Faber distilled the principles and methods of the highly successful Harvard and Yale endowment funds into a plan anybody can set up and run without resort to expensive and subjective financial advice.
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Source: 'A quantitative approach to tactical
asset management', Faber, 2008
Different asset classes form
a 'rope' of returns |
In Part Two we began to examine the principles behind it, investigating the remarkable strengths and occasional weaknesses of that great pillar of investment theory diversification; and we saw how the diversified portfolio set out by Faber in 2006 would have proved a true life-saver during the crash of 2008.
Taking a deep breath, we delved into the nitty-gritty of setting up this same type of portfolio - and found that *gasp!* it was not rocket science but actually quite straightforward.
Using a careful selection of inexpensive ETFs in a tax-free (ISA) or tax-deferred (SIPP, IRA, 401k) account, and tending to it only rarely, we could look forward to the prospect of strong and stable long term growth with a truly remarkable reduction in risk and volatility.
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Source: 'A quantitative approach to tactical asset management', M. Faber, 2008
A greater total annualized return than buy-and hold...
with less pain
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THE SECRET OF GREAT COMEDY
Which brings us to the the final, crucial piece of the jigsaw, the piece which separates this plan from any number of run-of-the-mill investment strategies you'll find lining the virtual bookshelves at Amazon or peddled by your local for-hire independent financial advisor.
This is the secret which is going to allow you to sleep easy in your bed when millions of investors (and their advisors) are fretting and sweating over the next market calamity - a prospect which is, I'm afraid, all too real and which I remain concerned awaits us on the other side of our present 'recovery'.
What is this secret? Why, fittingly, it is no different from the secret of great com-
One of the most pervasive, misleading and criminal myths parroted within the broad investment community is that 'you can't time the market'.
This nonsense, propogated and spread mostly by fund managers fearing for their jobs (when their investors jump ship they are regularly pitched overboard) and by financial advisors who need their clients constantly invested so they can extract a commission, is verifiably false.
In fact, when next you need to interview an investment advisor, a great test is to ask whether they think there is any value in market timing. If they spin you the standard line: 'timing the market consistently is impossible' - don't walk, run.
The near-catastrophe of 2008 is an open and shut case for the value of considered market timing, an example of how the ordinary investor can end up being shafted by meekly aquiescing to advice from an industry which, quite literally, feeds off their ignorance.
While there can never be any guarantees in this game (and the risks of putting your cash under the mattress ain't zero either), the timing strategy Faber presents in his paper and which is replicated here, tested on a century of data and on widely differing asset classes, shows that you can - and damn well should expect to - make your gains and hang on to them, even in the most turbulent of times.
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Source: 'A quantitative approach to tactical asset management', M. Faber, 2008
Over a 109-year period, compounded returns from timing the US S&P500 index using the simple methodology presented here not only comfortably beat a buy-and-hold strategy, it achieved those returns with far less volatility and greatly reduced drawdown (maximum loss at any point).
The table above only shows the effects of the timing method on your stock
market gains; when we include the effects of diversification - remember, you will have at least four other asset classes in your portfolio - the combination reduces your overall risk even further whilst boosting your overall returns.
Can you time the market?
Yes you can. |
Timing in this sense doesn't mean taking speculative punts to juice returns in the short term; its greatest value is as a way to keep your hard-earned savings out of the path of a major storm. Used carefully and strategically, timing is nothing more than an insurance policy against disaster. It allows you to sleep soundly and invest with confidence.
My dear reader, what price would you put on that?
PERFECT TIMING*
*almost.
Boredom alert! Many seasoned traders will be extremely familiar with the method I am about to describe and, having learnt it in Trading 101, will have relegated it to the bottom draw in favour of far sexier timing techniques. As they yawn their way through the rest of this post however, I invite you to marvel at the simplicity, practicality and profitability of the following.
Skipping through these three steps, it should take you no more than ten minutes once a month to keep your nest-egg safe and you on the primrose path to a comfortable old age.
STEP 1: CHART YOUR PORTFOLIO
This is something you need only ever do once.
When you initially set up your portfolio, you'll need to create a very simple tracking method for the ETFs you've bought. If you're lucky your broker's website may have a decent charting facility which includes the basic options I'm about to describe but if it doesn't, simply use one of the excellent free services mentioned below.
Assuming you're following the model portfolios I laid out in Part Two, there will be five or six ETFs you'll need to chart individually.
SETTING UP YOUR CHARTS
In the following examples, I show how to set up a chart for one of Faber's Ivy Portfolio picks, an 'All-world ex-US' stock index ETF with the ticker symbol VEU, using the free package at Stockcharts.com.
Here's how it should look in all it's glorious simplicity...
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My simple timing chart. Folks, this is all you need. |
US site Stockcharts now offers a large number of UK stocks and ETFs on its platform. Just add the suffix .L to the end of a UK ticker symbol (eg. the FTSE100 ETF from db x-trackers is XUKX.L on Stockcharts). Failing that, for ETFs trading on the London Stock Exchange, the best free charting service I've found which includes the necessary indicators is ADVFN.com. Here's how the FTSE 250 ETF I recommend would look on their site:
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ADVFN.com's are the most comprehensive free charts available for UK investors. Select 'Pro Chart' from the main menu and the above options are presented. I've searched for ticker symbol XMCX, the db x-trackers FTSE 250 ETF. I then selected it to display monthly data over 3 years, added a 10-month simple moving avg (red line) and a 10-month rate-of-change indicator (blue) and set it to display bar charts (highlighted button below). |
Chart each of the ETF's you've bought in the same way. Finally, in your diary be sure to set a regular reminder to check your charts on the last trading day of each month. All done? Excellent - let's start making money.
STEP 2: WHEN TO SELL
On the last trading day of each month, fire up your charting package and check the closing price of each of your funds. Look to see whether the fund's price is higher or lower than the level of its 10-month moving average.
If the price at the end of last month was above its average and this month's price has closed below the average, that's a SELL signal.
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See a SELL signal on the last trading day of the month? That's your cue to call your broker. |
Carry out the same check on each fund you hold. Many months there will be no signals given at all, but when there are you need to act straight away.
Next morning, contact your broker and when trading opens dump any of the funds which have issued a sell signal. It is usually cheaper to conduct transactions online, so you could simply leave any sell orders with your broker overnight for them to carry out first thing next trading day.
Having sold, you're going to then either leave that money sitting in cash with your broker or buy a safe cash equivalent (US Treasury bills or UK gilts. More on this in a moment).
STEP 3: WHEN TO BUY
Last trading day of the month you've checked as usual to see whether the price of each ETF is higher or lower than the level of its 10-month moving average.
If a fund's closing price was below its average at the end of last month but this month's price has closed above the average, that's a BUY signal.
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Don't hesitate when you get a BUY signal, call your broker next day or place an order online. |
The very next morning you need to contact your broker and buy that ETF at the first opportunity, or place an order to do so online.
The amount you invest will be the percentage of your funds currently allocated to that particular ETF, as we discussed in Part Two. So if for example your portfolio requires a 20% weighting in an ETF tracking the FTSE 250 index, and your total portfolio is currently worth £10,000, you would buy a number of shares in that ETF worth £2000 (the broker will work out how many shares are required).
The process is exactly the same for each ETF you hold. My personal twist on Faber's portfolio is, as I showed last time, a sixth fund which tracks the US dollar both long and short*; that portion of my portfolio will therefore always be invested one way or the other (depending on whether the dollar index is above or below its moving average) and need never be in cash.
*Please note, I've changed the indicator parameters and relative portfolio weighting of this asset class since I first published Part Two. The post has since been amended. See chart below.
Here, just for fun and illustration, are charts of my own portfolio ETFs as they stand today, March 3rd 2011:
UK STOCKS (20%)
ALL-WORLD EX-UK STOCKS (20%)
COMMODITIES (15%)
GLOBAL PROPERTY (15%)
US DOLLAR (10%)
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The US Dollar is currently on a sell signal which, in a long and short strategy, means holding the Proshares ultra short dollar ETF, ticker ULE. PLEASE NOTE: I'M NOW USING A 4-MONTH MOVING AVERAGE FOR SIGNALS ON THE US DOLLAR |
UK GOVERNMENT BONDS (20%)
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Bonds are the only asset class currently in cash |
Rather than fall significantly stocks may just track sideways, but either way they'll move some way closer to their 10-month averages; once they do you could either buy in one lump sum (cheaper), or start phasing your money in gradually. In the very long run it should make little difference to your returns, but over the next few months you might sleep easier.
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A LITTLE NITTY-GRITTY
So there you have it. A simple-as-you-like timing strategy which gets you out of your investments when they're rolling over and gets you back in when they're ready to rock.
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| Dow Jones index 2000, timing signals - a whole lotta seein' and sawin' for not a whole lot. |
But what you lose on the swings you more than make up for on the roundabouts...
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The US S&P500 index since 1998. A pretty picture...but only for those who got out in time. On average, staying ahead took less than one call to your broker per year. |
Yes there are more complex methods which can help you get in and out closer to the very peak or absolute trough, but quite often the more sophisticated a system the more variables and the greater the possibility of something going wrong.
This simplest of all methodologies is tried, tested and shown to be effective over many decades of real-time use. World-wide, almost all investors who ever look at a chart use a 200-day (roughly 10-month) moving average to help them make their trading decisions. When price drops below, sellers get motivated; when it rises above, buyers step in. That won't be changing any time soon.
WHAT TO DO WITH YOUR CASH
WHEN YOU SELL
When you get a sell signal and off-load an ETF, your broker will automatically leave the proceeds sitting in your account as available cash. There will usually be some money idle in your trading account unless all your funds are on a buy signal and you're 100% invested.
At some point that cash will be reinvested in the markets; meanwhile there is every reason to want to put it to work earning decent interest. In practice, the rules of your investment vehicle - ISA, SIPP, 401k etc. - will dictate whether that's a realistic option.
For example, UK investors cannot invest the proceeds from sales within their stocks & shares ISA in a normal interest-paying cash account without removing it permanently from the ISA (bad move). Yet it will generally receive pitiful rates of interest whilst sitting idle at your broker, leaving inflation to chip away at its value.
One alternative is to put any cash in inflation-linked UK gilts (government bonds), either buying them directly via your broker, or through an ETF. Unfortunately,
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Over short periods inflation-linked UK gilts are volatile and no guarantee of capital preservation. |
And don't forget you'll pay transaction fees each time you buy / sell gilts, bonds or any equivalent ETF. In some cases, the least-worst option is just to leave your cash right where it is. Should financial conditions deteriorate markedly, keeping it in the safest possible place would become a more pressing concern and buying gilts could then be considerably more appealing.
US investors may be able to buy US 3-month T-bills cheaply within a tax-deferred account. Again, there is currently little or no interest to be had, but there is capital protection. Weigh up the costs of whichever options are available in your particular investment account, and balance those with the benefits of leaving your cash parked temporarily where it is.
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The following section is for those of us who really, really don't like losing. Now, if you don't mind suffering the occasional market disaster, by all means skip to the conclusion below; otherwise, dear reader, please bear with my anal tendencies - it should be worth it.
EVEN MORE PERFECT TIMING*
*kinda.
Perfectionist that I am, I couldn't help but try to improve on the basic method described above because, whilst it has captured every important market low of the past century it has, on one or two significant occasions, missed a pretty important stock market top. Here's one rather notorious example:
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S&P500 1986 - 1989 |
Oops. Missing the top in 1987 cost many investors in the S&P500, literally, a fortune. Almost 40% of the value of the biggest American corporations vapourized in the space of three months. 20% was wiped away in a single day. The total damage was even worse for other indexes, and it was three years before markets were able to fully recover and surge to sustained new highs.
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| 1929 |
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| 1987 |
Is there a way to avoid these calamitous events - or at least minimize the chances of them poleaxing you? Are there any similarities between them, any particular combination of conditions, which could tip us off to an impending catastrophe in advance?
PORTENT OF DISASTER
In a post last summer, I took a detailed look at the very worst stock market crashes of the past century and discovered an essential common theme - historic momentum in the run-up. Stocks in 1929, 1937, 1939, 1987 and 1999 all saw a surge in prices fuelled by rampant speculation which could not ultimately be sustained. Disaster followed.
Sure there have been many times over the years when speculators have run rampant, but when measured objectively, ie. technically on a chart, these few I've noted touched a rare extreme, a buying frenzy unmatched during other periods. Mostly, the end result was calamitous; I call the technical picture 'Chart of the Century':
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Dow Jones Industrials Average (monthly) 1920 - 1946 & Rate of Change indicator |
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Dow Jones Industrials Average (monthly) 1977 - 2010 & Rate of Change indicator |
Above are the two extended periods of market history which included these extreme momentum readings. As you can see, readings of 45 or more on the Rate-of-Change indicator (turquoise line beneath) preceded a major peak in every case.
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| Dow 1946 - 1982 & Rate of Change |
We hit an extreme reading on the Rate of Change indicator in December 2009.
BETWEEN ROC
AND A HARD PLACE
In my post last August, I described a simple method for dealing with these unique conditions which I shan't go into again here. For anyone who wants ultimate protection against major market shocks I believe it remains a sound strategy; it successfully navigated our own wild stock market waters in 2010 and, according to the simple rules, finally gave an 'all-clear' and buy signal last December.
For illustrative purposes, here's the process in brief. For comprehensive details please check out the complete post.
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DANGER AT ROC 45 USE OF THIS SIMPLE TECHNIQUE WHEN THE RATE-OF-CHANGE INDICATOR HIT 45 WOULD HAVE ALLOWED INVESTORS TO AVOID ALL THE MOST DESTRUCTIVE STOCK MARKET SHOCKS OF THE PAST 90 YEARS. |
As I go to post, a correction... In the chart above, the topmost text box should read:
"Identify a two-month low. A two-month low (a low during the current month which is lower than any price in this month or the previous month) formed in January" etc.
I have to admit I am concerned that the intervention of the Federal Reserve may have distorted the market to such an extent that this technique might not protect us so well in 2011.
As I detailed here, it's likely that the only reason we've broken up through last April's highs is due to major US banks, hedge funds and financial institutions rushing out to buy stocks on the back of an implicit guarantee provided by the Fed.
That guarantee runs out on June 30th, when Ben Bernanke is due to turn off the spigots having supplied $600bn of ready cash to the banking system.
Much of this cash has found its way to the big banks' trading desks and via loans into the coffers of hedge funds, who have stormed into speculative instruments such as industrial metals, agricultural commodities like wheat, corn and cotton and, overwhelmingly, hot US stocks of the ilk of Apple, Netflix and Baidu.
THE YAWNING CHASM
After June 30th, unless the great US public steps in to fill the $600bn gap left by the Fed, purchases of stocks, bonds and commodities will fall dramatically during the summer of 2011.
Astonishingly, a huge number of economists and commentators (including the bearded sage himself) are taking the surge in stocks as a sign that things are getting back to normal. This is the market's equivalent of the Viagra delusion: take a tab and the results may look impressive - but remember, that rise ain't down to you.
Regular readers over the past eighteen months will know (boy, will they know) my view that we're only in the first phase of a profound and drawn-out downturn. After such a relentless levitation from the 2009 lows, most market prognosticators, politicians, economists, and even friends & admirers have turned rampant bulls and are now betting against me.
Of course I could be wrong, but it won't be too long before we find out: I suspect the true test of my theory is set to come at the back end of 2011.
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CONCLUSION
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| 'IVY PORTFOLIO', TOTAL YEARLY RETURNS VERSUS BUY-AND-HOLD, 1973 - 2008 Source: 'A quantitative approach to tactical asset management', M. Faber, 2008 |
I'm happy to hand over that trust. By taking a bold step out of the subjective world and into the objective and systematic, I am required to check my opinions at the door. The whole point of following a plan such as this is to remove all pre-judgement, all dogmatic belief, all emotion, eliminating human error as far as is possible from a process in which our emotions are almost always our worst enemy.
The history of the past two hundred years shows that investing is essentially profoundly simple, as long as you remember three simple rules:
- Buy smart
- Buy low
- Hold for a long, long time
This plan makes all three steps automatic.
Now, we're grown-ups here and know perfectly well that nothing in the crazy world of money can ever come with a guarantee. But I do think this strategy gives an investor - any investor - the best possible shot at coming out a long term winner. And that's why it forms the backbone of my own retirement account.
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Congratulations! If you've battled all the way through episodes One, Two and Three of The Compleat Investor you've now made it through to the final credits and deserve a prize. My great hope is that you're starting to believe you might actually have one:
a practical investment plan anyone can follow, that really works.
Good luck!
