Monday, March 12, 2007

Consistent Returns

Many investors get sidetracked into large bets on single companies or equity sectors. These bets often come with significant volatility and drawdowns. If you are trying to average 12% per year for 3 years (40.5% total compounded return) a single misstep can make it challenging to reach the goal. As an example, a 7% decline in year 1 requires a 22.9% return in each of years 2 and 3 to reach the average compounded return of 12% for the entire period. This is not impossible but it is certainly more difficult. A 15% decline in year 1 requires a 28.6% return in year 2 and year 3.

With the S&P 500 Index likely returning mid/high single digit returns over the next half dozen years a simpler approach to outperformance would be to make some broad bets on diversified indexes when the opportunities favor investment. First, identify a half dozen or so broad asset classes to track. The general categories could be stocks, bonds, commodities and currencies. Within the stock arena one could consider general indexes such as the S&P 500, Russell 2000, an international index, REITs, or specific sectors such as energy, technology, finance, etc. With bonds you generally only want a long bond fund to invest in when interest rates appear poised to drop or track a few closed-end funds closely monitoring their discount to NAV for opportunities to benefit from a combination of interest rate movements and spread narrowing. We recommend investing in commodities using general commodity mutual funds and ETFs as well as specific sector funds such as gold and oil & gas. Currencies can be easily invested in using a variety of ETFs and mutual funds (such as the Rydex funds). There are ETFs and mutual funds that provide opportunities to profit from inverse movements of the above asset classes if you are so inclined.

Our bottom line: keep it simple by focusing on less than 10 asset classes that resonate with your investment temperament. Follow them and learn about what drives the returns. Analyze if contrarian or trend following commitments seem to work best over time. Then commit 20-25% of your capital to a position that you think can generate a return of 10-15% over a 1-6 month period. If the S&P 500 returns 7% per year and cash returns 5% per year, it doesn't take many correct calls to exceed the market return. In the past year the following asset classes provided these opportunities: TLT (bonds) 4.3%, 11.2%, and 4.7% total return; DBC (commodities) 18.0%, 10.9%, 11.5% and 11.5%; IWM (small stocks) 7.9% and 22.1%; EEM (emerging markets equity) 19.0% and 45.9%; IYR (REIT ETF) 8.4% and 39.3%; RYWBX (weak dollar fund) 17.2%, 6.0% and 11.7%; AWF (international bond ETF) 20.0% total return; GLD (gold ETF) 33.5%, 17.9%, 13.5% and 12.8%; USO (oil ETF) 13.3% and 15.8%. Of course, this is catching the bottom and selling at the tops and we're not suggesting that is possible. But it IS possible to catch of 30-50% of many moves with reasonable consistency. The biggest impediment to success is usually your own lack of patience and/or discipline. Before you attempt this, we suggest you read Mark Douglas' book, "Trading in the Zone".


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