COP Strategy
(Class OutPerformance Strategy)
An Investment Policy/ Strategy
Malcolm (Mal) Williams
January 2006
© 2006 Malcolm Williams
Please, no reproduction or distribution without permission.
Contact: 972.732.8887 / copstrat@sbcglobal.net
Rev 2.1
Summary
This paper describes a dynamic asset allocation investment strategy based on the short-term out-performance of ten to fifteen out of 80 asset classes and implemented with various funds invested in the top classes. This is neither a market timing strategy nor one that predicts markets. A survey of salient literature is provided. The strategy is supported by research studies reported herein and by references to literature. The centerpiece of support is a large software research model that contains the monthly performance of 50 different asset classes over the past 17 years. The model has many control variables which allow examining a host of investment strategy alternatives.
The strategy is:
- Asset class selection pays the most for your effort. Studies show that about 90% of a portfolio’s return is due to class selection. Eighty asset classes are used.
- Short term performance, or momentum, of asset classes is used as the basis of selection.
- Selection is based on “outperformance” of asset classes as opposed to absolute performance
- Funds (Mutual and ETF) are available for each asset class and are the preferred investment vehicle to implement a portfolio.
- Monthly review and action plan.
- Recognizing that this strategy does not avoid sudden, serious market down turns, but the latest research using the COP Research Model does offer great help in managing through such events.
- Staying informed in a time/effort efficient manner.
This paper describes why the strategy works, research results, recent actual results from using the strategy and special accommodations for market corrections. Further research studies are underway.
The recent actual results delivered a cumulative 30 percentage points better performance than the S&P500 over four years. That amounts to over 300% of the S&P return. Research studies, discussed herein, covering 10 and 15 years suggest a greater outperformance might be possible. The research studies show returns over twice that of the S&P over the past fifteen years. This outstanding performance is accomplished with less volatility than the S&P.
The paper was written for three purposes. The first is to serve as an investment policy for the author (in accordance with Charles Ellis’ book “Investment Policy”). The second is to serve as a vehicle for generating discussion with others. The paper also contains considerable investment opinion and literature references to serve the third purpose -- to be educational for family and friends.
Contents
Summary
Introduction
Terminology
Disclaimer
Background
Review of the Best Recent Publications on Investing
Further Background
The Strategy
Simply
WHY this Strategy Works
Asset Class Selection
Use of Short Term
Performance or Momentum
Focus on “Outperformance”
Funds are the Preferred
Investment
Monthly Review and
Action
Market Corrections
Staying informed in a Time/Effort Efficient Manner
HOW this Strategy System Works
Strategy Improvement With The Cop Research Model
Strategy Development Chronology
The
Basic Strategy
Handling
Market Corrections
New
Study Results
More Research
Market Strategy Principle
Portfolio Diversification, Why and How Much
Volatility Risk and Modern Portfolio Theory
Market
Timing
“It
is Different This Time”
Gurus
and how to Handle Sea Changes
Taxes
My Personal Experience With This Strategy
To Be Added
Recommended
COP Strategy
An Investment Policy/ Strategy
Mal Williams
January 2006
Introduction
The principal reason for a written investment policy is to guard against ad hoc revisions and hold to the strategy when short term conditions are most distressing and the policy is most in doubt. It also serves as a basis for periodic review to determine if one’s views are in tack or changing. (Ellis p 55)
In my view, a written strategy statement is a confirmation for my own self that my strategy is more than an ad hoc reaction to the environment. This strategy is by its nature an objective one which further helps to remove my emotion from my investing while capitalizing on the market’s inherent psychology, which is manifest in momentum.
Terminology
The investment industry uses a wide variety of words to describe different asset classes, styles, categories, sectors, segments and regions. This paper will use “asset classes” to cover any and all of these. In every case there are one or more indexes that cover each class; therefore, they are all “investable” using Exchange Traded or mutual funds. The investment industry uses the terms “relative performance” and “outperformance” in many ways. Outperformance is a central term in this strategy and will be used here to mean the superior or top performance of an asset class, relative to the performance of all other asset classes. Herein, performance is measured in terms of the short-term, total return performance over the last 12 months. The term “sea-change” will be used to mean a sudden and significant change in the market. As will be seen, it is more in terms of the number of asset classes that change in the leadership of the market than in the market averages. As a result, the number of asset class leadership changes offers a degree of measurement of the degree of the sea-change.
Disclaimer
I have no, none, <0, nada, professional investment credentials. My academic background includes a Master in Science from UCLA. I am an avid reader and an active investor. I conduct my own research. These are my views from my reading and research which you may share at your risk (or not). In the Background, below, I have included quotes, from others, that the reader will find are in direct conflict with this strategy. I do that just so that the reader will understand that this strategy is not at all like those recommended by these popular, competent authors or the investment community. The reviews below provide a framework for understanding and for contrasting this strategy with conventional strategies. If you do not accept full and complete responsibility for your investment decisions and their consequences, read no farther, this is not for you.
This paper is very critical of the investment community and in particular brokers and investment managers. For the most part the critical points come from books that are highly regarded in the academic community. Obviously, there are people in the investment community who are exceptions.
Background
To provide a background for this policy/strategy statement I will first quote, or paraphrase for brevity, from some of the best books, in my opinion, on investments in recent years. It will only cover books and points that are salient to this policy. [Comments in brackets are mine.] {Comments in braces are my summary paraphrases}. These are all amongst the best books on investment strategy. They are all recommended reading, but I do not agree 100% with all or any of them. There are many more books that are intended for people who want to buy individual stocks. These will not be reviewed because, as discussed, that is an undertaking at which very few can succeed - - actually a foolish quest for all but a dedicated stock picking professional, few of whom have good performance. There are also other good publications listed at the end of this paper as recommended reading.
(Interestingly most Wall Street publications, and even the better books, are like country and western songs, that is: “somebody done somebody wrong” and “I can save you.”)
Review of the Best Recent Publications on
Investing
The Four Pillars of
Investing by William Bernstein (2002)
- The competent investor never stops learning.
- The pattern of annual returns is almost totally random and unpredictable. No one, not the large brokerages and certainly not your broker or investment advisor can predict where the market will be tomorrow or next year. [Why do they try? They are paid very highly to try – it sells very well. Did you ever see one give you their track record?]
- The market loses money about one third of the years.
- Expect at least one, and perhaps two severe bear markets in your investing career. [Since we have just gone through a severe market drop, another is not likely for a long time; however, we are likely to not be through with this bear market. Bull and Bear markets beginnings and endings are like the start and end of recessions; they subjective and are not reliably recognized until well after the event. As discussed later, a bear market has just as many years up 10% as does a bull market. History also shows us that market swings are becoming less severe than in the past, and there is usually some asset class doing well somewhere. As a friend of mine says “there are few ill winds that don’t have a good twist for someone.” See Mauldin’s and Easterling’s books recommended below for the best discussion of bull and bear market characteristics.]
- In the long run bonds are at least as risky as stocks. As pointed out by Jeremy Siegel, “stocks outperform bonds only 61% of the years but they outperform in 80% of the 10 year periods.” [This strategy treats bonds as just another asset class -- use them when they are working.]
- The real value of [understanding] the historical record [of financial markets] is as a gauge of risk not return.
- [Bernstein and others go to great lengths to prove that past performance of mutual funds does not predict future performance. Like others he uses past “long term” performance of 5-years and then looks at the results over the next 5-years. Agreed, that’s using ancient history trying to predict the distant future. Much more later]
- David Dreman’s: The Psychology of Stock Market Success painstakingly tracked the opinions of expert market strategists back to 1929. They were wrong 77% of the time. The worst were the market timing newsletters.
- Since you cannot successfully time the market or select individual stocks, asset allocation should be the major focus of your investment strategy, because it is the only factor... of your risk and return that you can control. {Funds are his recommended investment choice.}
- For 20
years, from 1970, the best performing assets were Japanese stocks,
- Paraphrase: {Managed (as opposed to index) mutual funds should never be used in a taxable account because some of them are very tax-inefficient with regard to distributed dividends and gains. The most efficient funds for taxable accounts are ETFs.} [In my opinion “never” is too strong since managed funds seriously outperform indexed funds in a few categories, however, if your tax bracket is high enough “never” may be right, especially in core market holdings were the markets are quite efficient.]
- Your broker is not your buddy. [A long discussion of the seamy underside of the brokerage and investment management business pointing out that brokers, in fact the whole brokerage firm, are sales people and not competent to recommend investments. They thrive or die based on sales fees. Why else is it that the most common short-hand terms to distinguish between the brokerage industry and investors are “sell side” and “buy side”. Guess who gets sold.]
- Neither is Your Mutual Fund [your buddy]. [More of the same—pointing out that fund management incentives are in proportion to the size of the funds they attract (through promotion), not their performance]. [somebody done somebody wrong]
- The popular media is at best worthless and often dangerous. Paraphrase: {The Forbes Honor Roll of funds .... 1974 through 1998....returned 13.6% before loads and taxes ... while the S&P index fund returned 14.3% with no load and very little taxes.} To whom do you listen? ... the market is your best advisor ... [that is the only advisor used in this strategy]
- The only guidance you need is your self discipline and your overall asset allocation.
- Paraphrase: {In earlier chapters Bernstein thoroughly destroyed the Modern Portfolio Theory tenants that are used by virtually all brokers and investment advisors to establish an asset allocation strategy; and then he proposes his own based on a range of asset class characteristics that are no better supported. His strategy, while based on rational analysis, also has no basis for its predictive power or future validity. He says that all you need are large market stocks, small market stocks, large value stocks, small value stocks and REITS.} [If those were all you had to chose from and you think that a given allocation can last you until he writes his next book, then it’s probably as good as you can get. We will be working on a dynamic strategy with about 80 asset classes to choose from -- listed in Appendix A.]
Stocks for the Long Run, Jeremy Siegel, 2002
- Over the long run (since 1801), stocks are by far the best investment, even beating out collectables, real estate, etc. ........ gold is the worst, returning nothing after inflation. From 1982 through 2001, after inflation, gold lost 4.8% while stocks returned 10.5 %, long term bonds returned 8.5% and short term bonds returned 2.8%. The same is generally true of stocks and alternative investments in foreign countries.
- It takes about 20 years to be confident that buy and hold investments will be positive, however, the probability they will be positive is very high at about 10 years.
- There is undeniable evidence that the economy has become more stable over time and this should help stock prices [assuming it holds]. This {and several other factors} means that the average historical P/E of 14-15 is no longer appropriate – the low and even high 20’s are justified as long as inflation stays low and tax policy remains favorable.
- Future [from 2002] long term real returns on stocks should average about 5 to 7%. Inflation should be low. [Therefore, nominal returns should be about 7% to 9%]
- Paraphrase: {Risk is popularly known to be the hand maiden of return – you can’t have one without the other.} [Today’s research has shown that risk, as measured by Beta, is not a predictor of return and that Beta has no predictive value at all.]
- All of this implies that the average investor will do best by diversifying into all stock sectors. [He recommends a relatively fixed asset allocation.]
- The principal motivation for investing in foreign stocks is more complete diversification. [For me it is returns first.]
- In the long run [only] stocks are an extremely good hedge against inflation.
- Business cycle and economic forecasting are notoriously unsuccessful [But it pays so well! -- because the gains are so great if correct]. Despite growing knowledge and an abundance of data, predictions are not getting better. Turning points [especially] are rarely identified.
- Utilize funds as the preferred means of investing. Up to one third of your portfolio should be in small or mid cap funds.
- The evidence in favor of “index” investments in small cap and international stocks is not yet persuasive.
- Small value stocks significantly outperform [long term] small growth and micro-cap growth stocks do the worst of all classes.
- {Very few, if any, individuals have the skills or resources to select individual stocks, especially, over a broad range of asset classes. Funds are much the better investment choice.}
Global Bargain
Hunting, Malkiel and Mei
Investment Policy,
Charles Ellis
- The evidence on investment managers’ success with market timing is impressive – and overwhelmingly negative.
- [This book on the importance of a written policy was targeted at professional investment managers – it can help us all.]
The New Contrarian
Investment Strategy, David Dreman
The average (stock) analyst (between 1982 and 1990) was wrong by 40%.
Contrarian Investment
Strategies, The Next generation, David Dreman, 1998
Rules:
Do not use market-timing or technical analysis
Do not make investment decisions based on correlations [they will change] {all of the major brokerages use correlations for their asset allocation strategy}
There are no ... industries in which you can count on analysts’ forecasts.
Diversify extensively
Volatility
is not risk. Avoid advice based on
volatility.
The (Mis) Behavior of Markets, Benoit Mandelbrot, 2004 (the originator of fractal geometry) (Great for understanding the highly irregular volatility of markets)
{Markets are much more random than believed.}
{Disturbances come in clusters and build on each other.}
{Market disturbances predict more disturbances, but not the direction of the disturbance}
[Does it not follow that lack of disturbances, therefore, predict calm? It is well documented that many of the most severe market disturbances occurred after periods of abnormal calm.]
The Intelligent Asset
Allocator, William Bernstein, 2000
In practical terms it is nearly impossible to find uncorrelated assets. Consequently, we cannot hope for a risk reduction of more than 25% to 30% from diversification.
...the actual correlation of asset returns in severe bear markets is higher than the average correlations... Diversification fails when it is needed most. [This is an extremely important point. See discussion of “down markets” below.]
Unconventional
Success – A Fundamental Approach to Personal Investment, David F. Swensen, 2005
[Investment strategy in brief] ... a well-diversified, equity oriented portfolio using not-for-profit [funds, i.e. ETFs and index funds from Vanguard or equivalent]
[Re: contrarian investment] Investment success requires for more than taking the other side of a market trade.
Another important piece of research on [investing] performance suggests that 100% of returns are derived from asset allocation. [as opposed to timing or individual security selection]
[Dramatically reduce risk of underperformance] by avoiding asset classes that rely on superior active management—{i.e., hedge funds or hot fund managers}.
Diversification provides the free lunch of improved return and risk characteristics, while equity orientation promises the possibility of greater wealth accumulation.
{If you doubt my attacks on the investment community and media (below), read this, very qualified, guy – he makes me seem like milk toast.
Further Background
It is popular with brokers and investment advisors, and their lackey in the media, to disparage mutual funds by telling the public that “very few mutual funds can beat the market” -- that is, do as well or better than the S&P500. What they do not tell you is that very few try. Most are trying to offer alternatives, such as bonds, small stocks and other diversification. Still let’s see, according to Morningstar data (November 2005).
Of all the funds in Morningstar’s data base:
% of %that beat S&P 500
# Total Total Return
3-yr 5yr 10yr
All, Total 21505 100 comparing apples and oranges
All large
cap
All large cap Blend (=S&P) 2183 10 33 31
(Cap = capitalization, a measure of the size of the stocks in the fund)
So we can conclude that only about 31% of all funds are US
equity funds and 78% of these beat the S&P, but, only about 10 percent
really try to compete with the S&P 500.
When you narrow the definition of a fund down to the same as that of the
index, (large cap blend) then the index does beat about 70% of them. Still the
33% is over 600 “large cap blend” funds (or equals) that beat the S&P500. Most important, there are thousands of funds
that beat the S&P500 when their asset class is in favor. Of all
Most asset allocation strategies, that I am aware of, including those in several of the books I recommend, base their allocation on historical correlations between asset classes. The lower the correlation between assets the greater your diversification. Below is a table with some correlations from Morningstar, published in a 1998 article in the Wall Street Journal, for investors to use to select diversified asset classes. The second column has the correlations that Morningstar currently reports. Note that less than 8 years later the change is dramatic.
Class 7-1998
Correlation 12-2005 Correlation
U.S. Large growth to Utilities 39 53
All asset allocation strategies from the investment managers, that I am aware of, also require that you annually “re-balance” your allocation, usually annually, back to your starting allocation percentages. This reduces the amount you hold in what has done really well, because they believe that it is surely about to do poorly, and increases the amount you hold in what has recently done poorly, since they believe they are surely about to do much better. Amongst simple minded fixed strategies this actually works, at least when tax consequences are not considered. Certainly a more dynamic allocation strategy would do better if we had one that works. So, read on.
Think about this industry standard strategy of re-balancing annually and using allocations that are based on long term returns and correlations. Does this sound like a strategy designed for minimum effort on the part of the investment manager – a great strategy for him, or you?
“It ain’t the things that people don’t know that’s the problem. It’s the things they do know that just ain’t so.” --- Will Rogers. “They” just might be the investment industry. For example, (speaking of strategies designed for the broker, not you) according to Rob Arnott (a Nobel Prize level investment researcher in my opinion), the broker’s “classic standard” 60/40 (60% stocks/40% bonds) balanced portfolio is not true diversity. It sounds great – having 40% in bonds for safety. But the dirty little Wall Street secret is that it has a 98-99% correlation with stocks. That means that you get 98-99% of the risk of stocks. Rob’s research tells him that true diversification requires lightly correlated, risky classes, not low risk classes. Pure heresy – brokers can’t sell that. Yet, Rob is highly successful and runs a major research firm.
Almost all independent researchers and investment authors (all of the authors above) will tell you that the average investor (and in fact, other than experts) cannot competently pick stocks or time the market. Their major focus should be on picking an asset allocation and diversification strategy and a strategy to implement the asset allocation in a manner that meets their individual comfort zone with regard to volatility or risk. That is the focus of this strategy.
Mark Carhart, Goldman Sachs Quantitative Research: {A fund performing high one year can be expected to be above average the next year, but only average the third year.}
Mark Hulbert, NYT 7/7/2002: (paraphrased) {Morningstar’s high star rated funds and Louis Rukeyser’s Honor Roll funds, both based on performance of three or more years, have both underperformed the Wilshire 5000 Index by 5.5% and 10% respectively from 1991 through mid 2002.} [I intend to make, and support, the point that short-term performance measurements are superior for judging future performance, but only for the short-term future.]
A CDA Wiesenberger Study (Original 1974 and revised 1992): {The study showed the results of two hypothetical investors--- one who had perfect market timing and one with perfect asset-class selection (using industry sectors) over the periods from 1942 through 1991. Perfect timing outperformed the S&P500 by over 20 times -- wow. Perfect asset-class selection outperformed perfect timing by a factor of 1000 times.}
I get invitations to dinner presentations by investment managers almost weekly. I have attended many. Without exception, they present “canned” strategies based on well outdated principals and analysis. In my opinion, they are not just weak -- they are wrong. It only takes a few technical questions to reveal that there is no in-depth or technical understanding. They are a sales organization that fronts for a correspondent account management firm. They are rewarded by fees. They only know the book and lyrics they have been taught in their training. Unfortunately, to the uninformed, they are very impressive. Furthermore, unless you have several million dollars to invest they can’t afford to do any better – and neither can you -- at finding a competent investment manager.
The Strategy
Simply
This strategy is to select an asset allocation from the top ten to fifteen asset classes that are performing now (last 12 months) from amongst about 80 asset classes (Listed in Appendix A) (Appendix A will be explained later) then to implement the allocation with the currently (again, last 12 months) top-performing funds. This is reviewed monthly and changed if necessary. It uses short-term performance which can be viewed as momentum or inertia. The reasons that this strategy works are provided below. But first, briefly, the strategy is:
- Asset-class selection pays the most for your effort. Eighty, fund-investable, asset classes are used.
- Short-term performance, or momentum, of asset classes is used as the basis of selection of the top-performing funds for investment (e.g., 10 to 15 out of 80).
- Selection is based on “outperformance” of asset classes as opposed to absolute performance. The best performing asset classes, even in a down market, are not that bad, as will be shown below. The focus on short-term performance and monthly reviews will allow reacting much faster in the event of down markets. “Outperformance” is relative to the other asset classes, and the relative performance of asset classes is a much slower moving measurement than the absolute performance of a class. Furthermore, asset classes, and the funds that represent them, are less volatile than the individual stocks that make up the class.
- Funds (Mutual funds and Exchange Traded Funds (ETF)) are the preferred investment vehicle to implement a portfolio. Choose the best funds in the best classes.
- Monthly review and action. (My experience is that you will not trade excessively)
- Recognizing that this strategy does not solve sudden, serious market down-turns.
- Staying informed in a time/effort efficient manner.
Now you can see the basis for the name of the strategy: Class
Out-Performance Strategy or COP Strategy.
WHY This Strategy Works
1) Asset Class
Selection
The fact that asset class selection, or allocation, is the most important part of any investment strategy is extensively and well documented in literature, research and media. As referenced above, most researchers believe that asset selection is responsible for 90% of your return. A newer study by Ibbotson and Kaplan, published in the January/February 2000 issue of Financial Analysts Journal, again found that 90% of the return (good or bad) of investment portfolios and funds is determined by the asset class selection. Only 10% is attributed to selection of investments within an asset class. This was an up date of a 1999 study by Ibbotson and Kaplan and of famous 1986 and 1991 studies by Brimson, Hood and Beebower. With this level of acclaimed academic research it is difficult to understand why so many people “play” at investing in a random selection of stocks. As Bernstein says, “asset allocation should be your major focus”.
2) Use of Short Term Performance or Momentum
On reading the book “Ubiquity” by Mark Buchanan, I find that historians and social scientists believe that (a) maladjustment is a precondition to all sudden and dramatic changes (e.g., economic disruptions, revolutions and wars) in all communities, no matter the character or size of the community, and (b) the distress from the maladjustments must become great enough to overcome (c) “the greatest of all social forces – inertia.” That is a powerful statement “the greatest of all social forces – inertia.” This explains a lot about investments.
Inertia must, therefore, necessarily, be present in financial market communities, which explains why momentum strategies (like this one) work. In fact it seems almost undeniable that momentum works. It is just a question of how well one can manage to benefit.
Long term performance (3, 5, 10, 20 years) is the basis for virtually every asset allocation strategy used in the investment industry. It is also used to select winning funds. Morningstar uses long term performance to assign their star ratings. The fact is, however, that their 5-star rated funds do not show outstanding ongoing performance as has been thoroughly researched and documented by independent sources. Investment managers crow about this to attract clients, then, do their version of the same thing with no independent verification of their ability to select funds. I am not aware of any studies that show that long term momentum is predictive. A word used in science for momentum is inertia. Inertia better describes human behaviors, like herd mentality, than does momentum. If market momentum is a measure of human behavioral inertia, it seems unreasonable, to me, to expect people to have long term inertia. Six to 18 months is a long term for the newest “hot” investment.
So then, what evidence is there that short term performance works to select investments that will perform well in the near future?
Roger Ibbotson and William Goetzmann (professors at
This issue was also studied by three
The No-Load Fund-X Investment Service uses a short term performance selection model to select specific mutual funds for their portfolio. According to the July 2005 Hulbert Financial Digest, out of over 500 investment advisor letters, No-Load Fund-X is the top (or in the top few) for periods of 10, 15, 20 and 25 years on both the total return and risk-adjusted return rankings. They are in the top rankings for all advisor letters, not just mutual fund focused letters. For the last 5 year and 10 year averages the No-Load Fund-X portfolio has beaten the Wilshire 5000 index by 10% and 20.9%, respectively, per year. That is consistent performance that works. No-Load Fund-X does not examine or rank investment classes, just funds directly. Still, their work validates that short term momentum is a valid way of picking near term investments.
The formula for No-Load Fund-X’s fund ranking score uses a simple average of four of each fund’s short-term total-returns, and is:
(12-mo% + 6-mo% + 3-mo% + 1-mo%)/4 plus bonus points
Bonus points are awarded for being in the top 15 in each of the four periods in the formula. The bonus points are, therefore, also based on short-term outperformance, albeit relative to the other funds.
No-Load Fund-X recommends, and follows in their portfolio, an “upgrading strategy” that has investors trading into the new highest ranking funds and selling those that drop below the top. This is both a momentum strategy and the total opposite of a buy-and-hold strategy usually followed by indexing gurus and major brokerages, and is exactly what is recommended in this policy. In a strong sense it is also an outperformance strategy since they flag top performers regardless of market conditions or the asset class that the funds may specialize in.
One of John Mauldin’s (See Recommended Reading) featured guest papers by James Montier (he is often interviewed in Barron’s) features a research study designed to prove that “value” investing is better (and thus, you need them). His study shows that short term price momentum (he used six month return) does improve your return. Their research shows that for value investments, and most others, there is and increase in return of about 7% and for growths investors it is about 10%. Not a bad day’s work for paying attention to short term momentum, as in the COP strategy.
3. Focus on “Outperformance”
An Ibbotson Associates and Morgan Stanley study reported in
Financial Planning, Feb. 1997, provided a month-by-month bar chart showing when
In their January 2006 Quarterly, Fiduciary Trust International produced a chart showing the monthly outperformance of equities versus bonds from 1987 through 2005. In this chart there were many periods of outperformance of one over the other for periods of a year or more with one 5 year period of stocks over bonds and one two year period of bonds over stocks – essentially the same results as Ibbotson Assoc. above.
For the six years, up until mid 2005 small stocks outperformed large stocks. The long term average of periods when small outperforms large is 5.7 years. A total return bar chart of large cap growth, large cap value, small cap growth and small cap value for the years 1990 through 2005, from Morningstar, shows 7 periods in which a given class was in first or second place for two years or more.
While the S&P was down about 40% in 2000, 2001 and 2002 you could have during that entire period broken even in small caps and made about 10% in small-cap value. After that you would have made even more excess over the general market because small cap continued to outperform.
Therefore, we are focusing on a slower moving wave than the market as a whole, giving use some hope of being in the right class and of having a cushion in market downdrafts.
In December 1995, Fisher Investments published a research paper entitled “Beating the Market with Style (read “asset classes”) Rotation Strategy. From the Fisher paper: “historically the market shows defined periods of outperformance and under performance for given styles...” [these periods offer] “semi-predictable style rotation.” “..there is a large spread between [the performances] of winning and losing styles.” Fisher maintains that if one could only stay in the top four and avoid the worst two, of 6 styles studied; one could beat the market by an average of 3% points per year. This paper started my effort on this strategy and the momentum model. I followed their paper with my own research using Morningstar.
A 2002 paper entitled “Multi-style Rotation Strategies” by Ahmed, Penn State University; Lockwood, TCU; and Nanda, T. Rowe Price, came to similar conclusions to mine and Fisher’s as evidenced by their title and sub title of “The Benefits are Considerable.”
In my study using Morningstar data I knew I would be relying on past performance data to select asset classes. So I calculated the return I would receive if in each full year I invested in the two, out of 6, asset classes that were the two top performers in the prior full year. Therefore I was one year late, every year, for a full year – a worst case. I compared this to the average of having invested in all six classes each year on a current basis. The two top, but one year late, classes beat the overall average by several points. I was sold.
I have misplaced my original study that I did in the late 90’s, so I have repeated the study using 14 asset classes and the 10 years through December 2005. This is provided in Appendix B.
The Appendix B study provides still more outstanding support for the returns that might be made by focusing on asset class selection and on short term outperformance. Examine Appendix B, then go back and read the quotes from Fisher, above, and you will see why he made them since they seem to exactly apply to the data in appendix B. Surely we can gain some advantage from monthly reviews of performance.
The period under study in Appendix B is very interesting
because it contains both the booming late 90’s and the bummer early 2000’s; and
most interesting, the dramatic sea change in favored classes that took place
between the boom and the bust. Note that the One-Year-Late top four have great
results in boom of ’97, ’98 and ’99, easily
beating the S&P; and then completely miss the sea change between ’99 and
2000, and have a disastrous 2000. In
2001 and 2002 the strategy ignores the gurus who claim the old growth will
recover and stays with the conservative investments. The net is that the S&P drops 38% over
2000, 2001 and 2002 while the one-year-late top four only drop about 18%. By the end of 2003 the late-four are back
ahead by 17%, whereas the S&P is still down 20%. The strategy completely missed the sea change
from growth to value assets but caught on fast.
Surely we can catch on faster with monthly reviews and not being tied to
year end data. While monthly data is noisier than annual data, the last 12
months should be the same and is available every month. Note that while the one-year-late top classes
missed the sudden sea change in 2000, they performed reasonably well during the
“trending” down markets of 2001 and 2002 even though in 2002 the S&P500 was
down over twice the percentage it was down 2000 (-9.15% versus -22.12%. The reason was that there was not the sea
change in the type of asset classes that were performing at the top. We will examine this more below under Market
Corrections.
The reason that asset classes have sustained periods of out/underperformance is that there appears to be a herd mentality in favoring various classes. In addition, as Fisher points out there are real reasons associated with the economic cycles and market cycles (and I would add currency cycles) why various classes will out/under perform for a sustained period. Regardless of the reason, relative performance is a slow(er) moving waveform.
No one is able to predict in advance what will outperform or if it will make money, but, everybody tries. In fact, most of the investment advice you see in the media and from brokers and gurus is trying to predict by telling you what is “going” to be hot next, especially in individual stocks. Fisher’s paper stated that their analysis would allow them to predict the next top classes. This COP Strategy does not try to predict. I prefer to call it “taking short term bets” even “educated hope” but I do not assume that it can predict anything.
This strategy approach is simple. Ignore all of the media/brokerages forecasts, and only invest in the asset classes that are actually performing in the short-term momentum model. This is a bet that the momentum of whatever is outperforming now will continue just a little longer. Since we do not invest in individual stocks, we can then count on the relatively slow movement in the change in relative performance of asset classes. Classes of assets also move slower than individual stocks. For example if really bad news hits a stock -- say a semiconductor stock -- many technology stocks can drop quickly. Then it takes time for investors to realize that the problem is going to be wide spread and domino, such that the entire class will eventually drop, but on a more gradual basis.
Appendix B results were so impressive I decided to do a more complete study using virtually all asset classes except the small countries. This is shown in Appendix C. The Appendix C study fully confirms the results of Appendix B
I included the standard deviations in this study. It shows, as one would expect, that investing in 15 is less volatile than investing in just the top 10 and the returns are also a little less.
Looking at the Investing in Top 15 and Top 10 lines, one can see that even in the bad markets of 2000, 2001, and 2002, there were always asset classes that could produce positive results.
It is very illustrative to look at the colored highlights on page 3 of App. C. Note that all of the contiguous years in which each asset class stayed in or out of the top 15. There are very few spots on the table that do not have one color or the other, indicating one-year periods of in or out of the top 15 are not the norm.
4) Funds are the
Preferred Investment
Utilizing funds (mutual and exchange traded) as the preferred investment vehicle is almost as extensively and well documented in the literature (especially scholarly literature) as is the need to first focus on asset allocation. While there are a large number of books that purport to tell you how to select stocks and get rich, I am not aware of a single serious book that does not recommend that the public should use funds and not individual stocks. The fund managers are your “hired gun” stock pickers, providing you a “specialist” in each class. You can’t hope to compete with them.
I recommend that you subscribe to Morningstar Principia. Soon you will find that you can sort out the best funds based largely on short-term performance and risk. Don’t listen to the investment managers/brokers, who try to sell their services by claiming that good past performance does not usually repeat-- but theirs does. Morningstar’s “star” selection system does not work as a sole selection criteria, as Morningstar so states. It is based on long term performance, so use it only as a very low, last level of criteria to select funds. I feel it tells you more about the quality of the fund management. Do not ever buy a fund based on a broker’s recommendations. They do not have training in fund selection, only in selling a fund profitable for them -- you can’t blame them. Do your own selection where the sun shines.
The important point is to select the very best funds, but only after you have chosen the best asset classes to get 90% of your return.
5) Monthly review and
Action
Albert Wang (2001
There is absolutely nothing magic about the year end. There is no reason not to review and change any time you are sure you want to. The only issue is how often you can get a good update on market data and how much time you choose to spend. Once each month is reasonable for the former. Each month you may make no change, minor changes or overhauls. This is an iterative strategy that keeps you adding new high performing classes and dropping those going out of favor. It is also a check on your particular fund selection within a class. Clearly you want to be paying a lot closer attention during market sea changes. For this, on a weekly basis, you can follow the data Morningstar publishes on the net for free (Morningstar.com) and on the results in your personal portfolio (Schwab’s At a Glance page is very useful).
This only works if you have a portfolio performance tracking method that provides you with the performance of each fund and your overall portfolio. One should track returns on a monthly, quarterly, 12-month and year to date basis. Track your returns along with indexes for the same periods, so that you can compare to the market and to alternative classes.
Reading this strategy and the research, one could easily conclude that one might be rapidly trading funds. I don’t. I have several funds that I have had for years. As mentioned before, asset classes maintain their relative outperformance for years at a time.
Still, I am prepared to trade every month and this is a lot of work. It is important work for a life time.
6) Market Corrections
As stated, in following this strategy, you are betting that past short term performance will repeat in the near term future. You are bound to lose this bet at times. Here we will examine the conditions that cause this as well as what kind of down market conditions still allow one to make money with this strategy. Below is a chart showing the performance of the Top 15, the Top 15-one-year-late, and SPY from Appendix C. In addition, it shows the number of asset classes that changed each year.
First a couple of observations: The Top 15 handily outperform SPY except in two years, 1997 and 1998. That was due to the fact that SPY was ranked at #2 and #4 respectively in those years. When something as stable as the S&P is performing so well one would probably not bother to hold 15 asset classes. The top 5 or so would probably offer adequate diversity. Similarly, in 2000, 2001 and 2002 when all asset classes are doing so poorly, one would probably not be holding more than the top 5 or so – notice again that in these shaky years it is the very stable bonds that are performing the best. So in both cases one should do better.
Now note that there are two years, 2000 and 2003, in which there were a large number of changes in the asset classes in the Top 15. In both cases the Top 15-one-year-late falls away from the Top 15 by about 35 percentage points; whereas, in years where there are a nominal number of changes, the two stay closer together. In 1997, 2002 and 2004 were the number of asset classes that change are fewest, the Top15 and Top 15-one-year-late are quite close together.
The message is that the number of asset class changes represents the most important measure of sea changes to the COP Strategy, not the markets performance. This should be intuitive based on the fact that this is momentum-based; however, this is something that can be monitored each month and all months instead of only at the end of each calendar year, as is done in the Appendix C Study. Perhaps, this will prove to be somewhat of an indicator here to bet heavier or lighter.
One last observation on down markets: One can see from Appendix C that the top 10 to 15 asset classes produce positive results for the investors in even the worst down markets. Thus, the problem of down markets is not when to get out and back in, but rather, a problem of being in the right asset classes. It is a tough problem, but the data analysis used in the COP Strategy is a big help and it is void of emotion. Who knows how good one might be? In 2002 when the S&P lost -22%, even the one-year-late study made money. Personally, I feel I am improving in both skill and discipline.
See more specific concepts about down markets below under Handling Market Corrections and Volatility and Risk, and Modern Portfolio Theory.
7) Staying Informed
in a Time/Effort Efficient Manner
Bernstein: The popular media is at best worthless and often dangerous. [The term “financial pornography” came up.]
If you are not interested in individual stocks, you have just eliminated a major portion of wasted reading on the part of investors. I personally only read for general education, trends, the state of the economy and the general market. Keep a world wide focus. This reading is to keep your head up to be more cautious or more aggressive. Keep in mind Siegel: Business cycle and economic forecasting are notoriously unsuccessful. Keep a near-term focus and stay tuned in for change.
I only read about 5% of the Wall Street Journal, 5 % of Barron’s, still, I consider them the best. I read John Mauldin’s weekly economy e-letter and new investment books from what appear to be scholarly sources (and that avoid individual stocks). I read what gurus have to say if they are top notch gurus.
A discussion group is wonderful to stimulate your thinking and education. Don’t invite brokers or investment managers – they are well trained in selling strategies that work for them.
Read every good book on the market. Read none that tell you how to select individual stocks, commodities or derivatives or on timing or technical analysis. Be critical in your judgment of these books, especially if the author comes from the investment industry. Seek out and rely more on scholarly authors and publications. These would include professional peer-to-peer journals as well as academic sources. “It’s not so much what you know anymore that counts ... It is how fast you learn.” – Robert Kiyosaki, author “Rich Dad – Poor Dad.”
Follow the top gurus as you would a discussion group, but, do not follow their advice. All of this staying informed is to help you understand why things work as they do and to keep your head up for changes in the environment.
Books on market psychology have been in vogue for the last several years. The field seems to be aiming at helping investors take advantage of the “emotional other” investors. Right now, I think they best serve to help you not be one of the “other.” While this is not Dreman’s only focus he is one of the old masters.
HOW This Strategy System Works
1) Use short-term performance, or momentum to select from the top 10 to 15 (out of 80) asset classes that are outperforming now.
Just after the first of each month, I produce an Asset Class Performance and Momentum Report from Morningstar’s Principia. This is available 5 to 7 days after the end of the month and about 50 of the asset classes are available on line the morning of the 1st of the month. A sample of this report is provided in Appendix A. There is a Major Asset Classes report and an Individual Country report in Appendix A. There is some deliberate overlap in the two for comparison purposes.
The various asset classes are on the left of each report and near the right is the “momentum” performance ranking measurement in the column labeled APA. The report is further explained in Appendix A. The COP Research Model has allowed me to test several momentum calculation methods. The one I have chosen to use from that study is called APA. This formula was suggested by my son several years ago. I have used APA for a couple of years now.
2) Use short-term performance to select top performing mutual funds in each of the categories you have chosen.
I use Principia which reports on both mutual funds and on exchange traded funds (ETF).
3) Create a diversified portfolio from the top-performing funds in the top-performing asset classes.
a) Build as diversified portfolio as you can from those asset classes that are working now.
b) Don’t be afraid to invest in 15 to 20 different funds or none.
c) Create a portfolio based on your risk tolerance
There will be times when there is virtually nothing that is performing and that looks safe enough for you – stay in cash or don’t be afraid to hold only a few asset classes. The fewer you hold, under 4 or 5, the greater your class risk and the greater need for a substantial portion of your portfolio to be in cash. At other times you may find several asset classes are performing quite well and can give you a reasonably diversified portfolio. In which case, do not be afraid to not hold any cash. Also do not be afraid of building a portfolio of funds that do not meet someone else’s idea of diversification. Diversification into assets that are not performing will do you no good. Almost all brokers will tell you to have some assets is a particular class, say bonds, at all times. If bonds are performing at a low or modest level relative to stocks you still might want to have them for comfort. However, you can not just look at the dividends from bonds when the value or the bonds themselves may be dropping. If the “total” return from bonds is not reasonable, you are losing money in absolute terms and certainly after inflation.
Cash is just another asset class. The Ultra-Short Bond class included in Appendix A is considered as a good surrogate for cash in your planning. If it is working it will rise to the top.
What about income? Selling profitable capital assets provides the same kind of dollars as does a dividend. Invest in what works and take your income from profits of any kind. But, everyone says that taking your income from dividends saves reducing your capital when stocks are down. Actually, only when you are in an environment when bonds are working and stocks are not, otherwise, it is not true. Let real performance, not dogma, guide you.
Be patient; be sure momentum is there. There can be a lot of head fakes that can get you in or out too soon. By the way, no system, certainly not a momentum system like this one, is going to work well when there is a sea change. So stay informed to stay alert and cautious at times. Know full well that you will miss the sea changes for a while and suffer for it. You have to decide how long of a while is tolerable or if you would rather bail out. I expect to bail out somewhere in the down 10% range (for the entire portfolio) and take the hit if there is an immediate bounce back. There is no market wisdom here, just a gut feel for my tolerance to losses.
Baron’s, 5/29/06; Steve Leuthold Group Commentary: “Market inflection points are – almost by definition – hostile to trend-following strategies, even very refined ones like ours ----- There is no tool -- fundamental, technical, psychological or otherwise – that helps one to ride the “fat” part of the trend and then to exit gracefully at the top ---- we do not view this sort of setback as a very steep price to pay in exchange for the opportunity to cash in on longer term group trends.”
By now the reader must understand that this strategy produces a very dynamic asset allocation and that this is in direct conflict with the position of highly respected authors and the bulk of the investment community. The reason that the contrary quotes were placed in the background section was to be sure that the reader understands this.
Can you do it yourself? Unless you have greater than $5M you cannot hire a competent personal investment manager. So you do not have much choice, and yes you can if you study hard enough. Again, it can be the most important work of your lifetime.
STRATEGY IMPROVEMENT
WITH THE COP RESEARCH MODEL
Strategy Development Chronology
As mentioned above, I started developing and using the monthly momentum data model for this strategy in early 1996 following my mini research, using Morningstar’s Principia, which was modeled on and followed a 1995 paper by Fisher Investments. I used the momentum data as one of my inputs over the next several years, but cannot claim to have followed the strategy with the slightest rigor. In fact, in late 2001 I wrote a personal investment policy for my own discipline which did not even mention this strategy. Like many people, 2000 and 2001 was not kind to my investments and this was part of a self introspection of my investment skills. In the process, I noted that in 1999, where there were no large market corrections, the strategy was a big help. I also started a re-examination of the basis for the strategy and decided to follow it more closely. As a result my fortunes improved; and with my increased reading, I became more convinced that the strategy worked.
After “falling off the wagon” and suffering a week year in 2004, I again recognized that I would have been better off following the strategy. I resolved to become more disciplined and in 1995 wrote another investment policy for myself, family and friends who were also following the strategy to some degree. To support that effort I went back and re did my 1996 research. The results looked so good that I did a much larger study. That looked great too. All of this research used 10 years of annual data, which was all that was available on my Morningstar Principia subscription. However, in the real world, I made “monthly” investment decisions based on Principia’s monthly report. I wondered how much better the research results would be if I had monthly data or would they be worse because the monthly data is so much more volatile. So, in early 2006 I bit the bullet and acquired 25 years of Morningstar’s monthly return data for 50 different asset classes. I then wrote a large software research model called the COP Research Model. The results were outstanding –even better than with the earlier research. Additionally, the COP Research Model has a wide range of control variables to allow comparing many different investment alternatives. As one example, from a host of research cases that have been run, I have learned a great deal more about how to handle market corrections (see discussion later).
The COP Research Model
As indicated, the model has a data base using Morningstar’s 25 years of monthly-performance data on fifty asset classes. I only excluded classes such as money-market funds and most muni-bond funds. I then developed a huge software model (using Excel and VBA language). The model contains a control panel in which I can set a wide range of parameters to test investment alternatives or cases. Some of the investment alternatives require additional Excel or VBA code changes.
So what was the result of running a one-month late strategy as opposed to a one-year late? What did the monthly volatility do to results? The research cases showed that it was possible to beat the S&P at much lower volatility, or to really trounce the S&P at the same volatility. About the same return as the S&P could be attained at about 60% of the S&P volatility and, at about the same volatility, the annual return over 15 years was 70% higher than the S&P. The COP strategy in the COP model shows only one down year in the last 15 years; and curiously, that is 1994 where it loses a few percent while the S&P gained a little over one percent. That year is to be examined in further research (was there nothing that gained in that year?). In the 2000 through 2002 market the model dropped a little harder in the first few months, but learned fast and actually made money during that period, whereas, the S&P was down about 40%.
The more asset classes one invests in at one time, the lower are both the volatility and the return. To achieve about the same return as the S&P one would invest in about 40 of the 50 classes at one time. To run at about the same volatility as the S&P (with 70% higher return) one would invest in about 8 of the 50 at any one time. Keep in mind that in certain months all 8 of the classes owned might be the highest risk classes and in other periods some of the lowest risk. Still, the model gives you 15-year results including the 2000 through 2002 market drop. Thus, this strategy allows each investor to choose the level of volatility they want to experience in order to maintain their individual homeostasis. Below are the results of two cases: one in which the investor chose to invest in the top performing 15 classes and one where the investor chose eight.
|
Investment
Asset |
Annual
Total Return %* |
Standard
Deviation
%* |
15-Year*
Return
% |
|
Investing
in the Top 15 Ranked Asset Classes |
17.97** 16.30*** |
11.45** 8.35*** |
1193** |
|
Investing
in the Top 8 Ranked Asset Classes |
19.48** 18.00*** |
14.07** 10.2*** |
1444** |
|
Investing
in the S&P 500 via SPY |
11.38 |
13.96 |
504 |
The COP strategy model, in the first case above, showed a 70% greater annual return than the S&P500 (17.97% versus 11.38%) which compounds over 15 years to 237% of the S&P’s return. In the two above cases the investor has a choice of a lower volatility than the S&P or about the same volatility as the S&P with a much greater return. This is neither a market timing strategy nor one that predicts markets. Rather, it is dynamic asset allocation based on the well researched fact that 90% of a portfolio returns are driven by “asset class” selection rather than individual asset selection. The COP Research Model only used plain vanilla index funds for investment in all classes. Could you do better?
The graph in Appendix D shows the cumulative return for three cases of the COP strategy. One is the return for investing one month late and another for investing 1.5 months late. Both of these curves are for investing in the top 15 out of 50 asset classes. The model allows for a prior case to be kept for comparison with the current case. On this chart, the “compare case” is for investing in the top 8 asset classes on a one month late basis. The other curves show the returns of the S&P, Small Cap Blend, Foreign Large Blend and Intermediate Term Bond single asset classes. This chart has a “log scale” vertical axis. The benefit of a log scale is that it correctly reflects “percentage change” such that a ten-percent change on the right half of the curve is the same size (in inches) as a ten percent change on the left. The curves on a linear chart would look highly volatile on the right because the amount swings in a much bigger number are much larger than on the left, when on a percentage basis, they are the same.
Looking at the chart, first note how the COP strategy return is a smoother curve because it contained fifteen asset classes. Note that in the third quarter of 1997 the COP portfolio takes a steeper drop than the S&P. Looking at the chart you might suspect that it might have contained small cap blend and/or foreign blend because they both dropped sharply. But, the COP portfolio bounces back and seems more like the S&P. That follows because in that period the S&P was on of the top few performers. The next transition occurs in late 1998 and early 1999 where you see the COP portfolio dramatically pass up the S&P looking like it is influenced by holding the foreign blend. Now we get to the long drop of the S&P lasting to the middle of 2002. The COP portfolio, on the other hand, seems now to be following small cap. Starting in mid 2002 COP portfolio recovers faster than does the S&P as does small cap and foreign.
Any multi-asset class portfolio is likely to show a smoother curve than the single asset classes, however, this one also gives a high performance.
Note that the graph shows that the model has a lower return than the S&P in some years, notably 1997 and early 1998. The reason is that the S&P was right at the top in terms of relative class performance. In such a case one might have actually been inclined to load up on mostly SPY (an S&P ETF) and relax. In late 1998 there is a large correction in the S&P which is covered below in Market Corrections.
The exact same data is presented on the next chart in the Appendix but with a linear vertical axis. Notice how it appears to be highly volatile on the right side of the chart. The linear axis is what you will see in most media because they think you are too dumb to comprehend data on the log scale.
The model also was used to study the case where the investor is investing 45 days late instead of 30. This provides more time for decisions after the end of month data is available. These studies still showed that the S&P could be handily beaten.
Subsequently, the model has been used to explore where and how the COP strategy does better and where it did not do as well. In addition, a series of studies have been completed to understand what happens in significant sudden corrections of the market, such as in 2000, 2001, and 2002, and what could be done to improve the strategy. These studies have shown ways to significantly increase the return over the basic strategy. This is discussed below.
Handling Market Corrections
The last edition of this paper contained strong warnings that the COP Strategy was of no value during sudden market corrections. Abandon the strategy -- you are on your own. Now after using the COP Research Model to study ways to react to such corrections, I am completely revising my position in this edition. The monthly COP momentum report will still not be of much value because you have to react too fast to use momentum measurements that are suddenly out of touch with the reality of the correction. Therefore, to react fast you must have a pre-planned or canned plan. The COP Research model tells us how to react in such a correction. I will present the results of the studies and my conclusions below, but first, let me provide some sample background.
There have been two underperformance periods since I started following the COP strategy, and both of them were caused by the same problem. The model suggested getting out of the market, which I did. That worked well in both cases – for a while. However, in both cases I failed to get back into the market in a timely manner.
In the first instance, we had a trip planned to
The next instance was in the spring of ’06 when the market dropped in April and May and did not regain its losses until late September, but, it started back up in July. I got out of the market in late April and I was still ahead through August. Again, I did not get back in because of my fear of a market sell off (and again I was listening to gurus) and because the momentums, while positive, were volatile and weak. So while I did pick some winners in that time, it was a miniscule portion of my portfolio and I remained out of the market out of fear of buying in at a high. My expectation was that we will see at least a near recession in ’07 and that the market should soon drop to reflect that. Having missed the run-up in September and October, the jury is still out on whether or not I was wise in expecting a topping and drop later this year. Nonetheless, I have still fallen well behind the S&P to date; when I could have been at least 5 percentage points above the S&P if I had gotten back in quickly. I have now been out for 7 months. Listening to yourself as a guru has to be worse than listening to a highly paid one. In fact, the basis of the COP strategy is to remove judgment/discretion of any kind.
I know exactly what I “shoulda coulda woulda” done in both cases by looking at the data with hind-sight. The question is what “should” I have done using a planned strategy with foresight. First what I “shoulda” done, then, what I have learned in my analysis is strategically correct.
I cannot remember what classes I was invested in 2004; however the drop that spring was not too bad, so I should have moved into something conservative while I was on vacation. In April of this year I was in high risk asset classes and there is no doubt that I should have gotten out of those, but re-entered a few months later in very conservative asset classes, such as large-value.
New Study Results
Using the COP Research Model, I ran many cases to look at all of the significant market downturns and COP model downturns over the 25 years of Morningstar data that I have for the model. For the years covered by the COP model, I looked at each downturn on a month-by-month basis; looking at the amounts of the drops, how they progressed, and what asset classes turned bad and which ones held up. In addition I have a Dimensional Fund Advisors (DFA) publication that has stock, bond and inflation data back to 1926.
Prior to the time frame covered by the COP model, the only significant market setback, after the depression era, was in 1973 and 1974 where the market lost 40%. It is important for the discussion that follows that this market set back was spread over 2 years and that the next large setback was spread over 3 years; 2000, 2001, and 2002. There were a couple of years, prior to the COP model, at about -10%, but they were followed by nice gains. So, even though the COP model does not cover the very important ‘73/74 period, it does cover a similar lengthy decline and several rough years.
Outside of the ’00 through ’02, there were only the following drops.
In mid 1998 the S&P dropped 15.5% and the COP model 11.2%, both in one month, however, both had recovered rapidly in 2 months and went on to a strong growth period. Both full years were positive. Anyone getting out of the market would have been a big loser. We just cannot react that fast.
In 2004 there was a one month drop in the COP model of 6.3%, but, the S&P was only down 4.5%. Both went on to a good year with the COP model beating the S&P.
There were five other cases where the COP model had frightening drops of 4% to 6.5% in a month or two, and in many cases the S&P did worse -- to add to your fear. They were usually followed by a great rebound, but, always a rebound.
Since the depression era markets are discounted as being caused by well known Federal mistakes, and it is presumed that they will not happen again, we are left with only 73/74 and 00/01/02 as indicators of big concerns. I cannot examine 73/74 in detail so I am going to assume that it was somewhat like 00/01/02 and could have been handled in the same way. As further assurance that the COP strategy could have handled ‘73/’74 the same as it did ‘00/’01/’02, I noted in the DFA publication that bonds did great in those years, returning 7% and 8%. So the COP model could have found good asset classes to jump into.
The COP model gained over 50% in the roaring 1999 (I did 57%, so it was realistic), so it was in good shape for the 2000’s. Then in 2000 it initially dropped harder that the S&P with a loss of
10% over two months, but recovered, leveled off and finished the year with a slight gain. It stayed flat in ’01 with a slight gain for the year. In ’02, it gained about 8% and in ’03 it gained over 40%. Now compare this with the S&P which went into a loss for ’00, ’01, and ’02 and did not recover until it had a gain in ’03 of 28%. What happened to explain the difference is as follows:
In early ’00 the COP model was in some highly risky asset classes, such as technology, that had been the winners up to the drop, whereas, the S&P was fairly safe and did not fall as far.
However, the S&P kept falling in ‘00, with many sucker rallies along the way, all the way through 2002. It lost close to 50% total, if my memory serves me correctly. The COP model, however, quickly found the asset classes that were doing well and never looked back. This was a choppy market so the COP model did not make a lot until the 8% gain in ’02. The small gain of the COP model in 00/01/02 is not as important as the fact that it stayed in the market and did not lose.
So what did I learn? I was always of the
opinion, expressed in my COP Strategy paper, that if the market takes a nose
dive I should get out until I understand what is happening and I am comfortable
it is over and I can clearly see what to get into. That is why I was out of the market in the
summer of ’04 and now. In both cases I
was out for over 7 months. I found no downturns
that lasted for 7 months except the rare ’73 and ’00 cases for the S&P but none
for the COP model. Three months is the
longest.
In the study below I have explored using a range of different asset classes as “safe-alternative” classes to jump into in the event of a market decline. You may recognize these asset classes as the ones often mentioned in the media when they report on the “flight to safety” as part of a market correction. There is, of course, no real long term safe asset class; however, there is a knee jerk reaction by investors to jump to these assets when they are worried about a market decline. Below are the results of that study. Note the 15-year average return in the second column and the 15-year total return in the right-most column.
|
Safe-Alternate Asset Class |
15-Year Avg. Ann. Return |
1998 Return Change |
2000 Return Change |
2001 Return Change |
2002 Return Change |
2003 Return Change |
15-Year Total Return ** |
|
Large Value |
18.61 % |
+5.7% |
+1.7% |
+3.0% |
+0.2% |
-2.3% |
1294% |
|
Financial |
18.40 |
+3.9 |
+4 |
-1 |
+0.9 |
-2.8 |
1260% |
|
Health |
19.03 |
+10.5 |
+1.4 |
+7.2 |
-2 |
-2.5 |
1364% |
|
Utilities |
18.37 |
+4.6 |
+1.5 |
+1.2 |
+0.4 |
-3.0 |
1255% |
|
Precious Metals |
20.75 |
+21.4 |
+3.3 |
+7.0 |
+3.9 |
-4.7 |
1692% |
|
Bear Market |
14.63 |
-13.9 |
-1 |
-16.3 |
-6 |
-1.2 |
|
|
|
17.36 |
-1.5 |
-4.9 |
+7.1 |
-8.4 |
-0.2 |
|
|
Intermediate Bond |
17.68 |
-1.1 |
0 |
-0.4 |
-2.7 |
+0.3 |
|
|
|
|
|
|
|
|
|
|
|
* Percent of assets |
|
73 |
47 |
73 |
73 |
47 |
|
|
|
|
47 |
|
73 |
47 |
|
|
|
Base COP Case, No Action, Ttl Return. |
17.97 |
12.29% |
0.6% |
0.65% |
8.25% |
43.27% |
1193% |
|
S&P Total Return |
11.38 |
28.34 |
-9.17 |
-11.87 |
-22.11 |
28.39 |
504% |
* This shows the percent of the assets that were switched into the Safe-Alternate Asset Class. Each figure represents switching for one month only. There were no cases where the model switched into the alternate asset class more than two times or for more than two months at a time in any one year. When the model switched 47% of the assets, it was because the S&P had dropped between 8% and 11% in the last two months. For a switch of 73% of the assets, the S&P had to have dropped at least 12% in the last two months. (These are adjustable variables in the COP research model.)
** For the 15-year study period, the Standard Deviation of the COP strategy always stayed at least 17% below the S&P Standard Deviation of 13.96%.
Now the question raised by this
data is: “How would we have known which “safe-alternate” asset class to switch
into -- or should it be a basket of the top four -- or what?” The table below provides some information to
answer that question. It provides the
rankings of these asset classes in the three months up to and including the 2
months of the market decline which triggered the switch. Since one of my prior studies with this model
has shown that you can beat the S&P by holding a portfolio of the top 25
out of 50 performing classes, we can call a 1 to 25 ranking (in 2 out of 3
months) a winner (W) and those below as losers (L). (Incidentally, holding a
portfolio of the top 25 returned a 15 year average of 14% versus the S&P of
11.4% and at a 28% lower volatility.)
|
Safe-Alternate Asset Class |
15-Year Avg. Ann. Return |
1998 Return Change |
2000 Return Change |
2001 Return Change |
2002 Return Change |
2003 Return Change |
|
Large Value |
18.61 % |
+5.7% |
+1.7% |
+3.0% |
+0.2% |
-2.3% |
|
|
|
L |
W |
W,W |
L,L |
W |
|
Financial |
18.40 |
+3.9 |
+4 |
-1 |
+0.9 |
-2.8 |
|
|
|
L |
W |
W,W |
W,W |
W |
|
Health |
19.03 |
+10.5 |
+1.4 |
+7.2 |
-2 |
-2.5 |
|
|
|
L |
W |
L,L |
L,L |
L |
|
Utilities |
18.37 |
+4.6 |
+1.5 |
+1.2 |
+0.4 |
-3.0 |
|
|
|
W |
W |
W,L |
L,L |
L |
|
Precious Metals |
20.75 |
+21.4 |
+3.3 |
+7.0 |
+3.9 |
-4.7 |
|
|
|
L |
L |
W,W |
W,W |
W |
|
Bear Market |
14.63 |
-13.9 |
-1 |
-16.3 |
-6 |
-1.2 |
|
|
|
L |
W |
W,W |
W,W |
L |
|
|
17.36 |
-1.5 |
-4.9 |
+7.1 |
-8.4 |
-0.2 |
|
|
|
L |
L |
L,L |
W,W |
W |
|
Intermediate Bond |
17.68 |
-1.1 |
0 |
-0.4 |
-2.7 |
+0.3 |
|
|
|
W |
W |
W,W |
W,W |
L |
|
|
|
|
|
|
|
|
|
* Percent of assets |
|
73 |
47 |
73 |
73 |
47 |
|
|
|
47 |
|
73 |
47 |
|
|
Base Case, No Action, Total Retrn. |
17.97 |
12.29% |
0.6% |
0.65% |
8.25% |
43.27% |
|
S&P Total Return |
11.38 |
28.34 |
-9.17 |
-11.87 |
-22.11 |
28.39 |
So now what do we now conclude? Many losers turned into winners, and in 2003 all winners still turned into losers. Also, the W or L choice was a pretty close call in many cases and the last month was often the odd ball. So there does not seem to be any help here in looking at the performance of the alternatives just before and during the dip.
Let’s first dispense with 2003. In January of 2003, the S&P was down a cumulative 11.3% whereas; the COP model was down about 2.6%. It seems doubtful to me that I would have switched to an alternative asset class in February, when what I had was doing so well on a relative basis. The entire 2003 loss for switching to alternate classes takes place in February. Therefore, I do not really think that the 2003 case belongs in this study.
Leaving out 2003 from now on, then Precious Metals seems like the best choice, but I am sure a basket of the top five would do well also, and be much less risky. It is interesting to note, that in any case, you would have been invested in the alternate asset classes for only 8 months out of 15 years. Still I doubt that any of us would put 73% of their assets into precious metals for even one month. With the improvement in the poor months, using precious metals as the alternative, you would expect the overall curve to be smoother and the volatility to be less. But that is not the case. The precious metals class had a dramatic jump up in those months and it is the upside volatility that we are seeing. The precious metals class is mostly gold mining stocks and they are highly leveraged to the price of gold. Using pure gold (like the ETF GLD) would be smoother and much less risky. Using a basket of the top 5 above would be still less risky.
My theory was that if a drop in the market killed all of the momentum measurements, then it would take several months for the momentum trends of the new winners to develop. That does not seem to be the case. I do not know, but maybe, the momentum of the new winners was good enough before the downturn that the measurement transcends the drop.
I now conclude that I should not get out at all unless it looks very serious. Even then, I should look to get back in within three or less months. In ’04 I should have not gotten out at all. I could have shifted into something very conservative for my vacation period, but not out. In the spring of ’05 it appears that it is good that I sold out of my high risk assets, but, I should have gotten back into conservative asset classes within less than three months. Since this case is so recent, and I have the data, I can see, with 20:20 hindsight, that I could have gotten back into Large Value in one month and I would have had a 9% gain while the market as a whole was just getting back to even over the next several months. In this case the “flight to safety” dramatically drove up the large value class.
In looking at all of these downturns on a detailed, month by month basis, I found that
the model eventually found something good, but also, things were not as dire as market gurus try to paint market history (to scare you into buying their services). If you look at the chart that comes at the end of the Appendix D, you can see that the COP model results, during downturns, were not as bad as pundits lead to you expect. I have attached two graphs from the model which shows the same case as in the preceding two graphs except that the asset class “Health” is utilized as the “safe alternate” as described above. The first of these graphs also has a log scale for the vertical axis. So look at the vertical axis as a percentage change axis. Note that the return for this case, which uses Health as a Safe Alternative, jumps up to almost as high as the case for using the top 8 asset classes even though the Safe Alternate was only invoked by the model for 8 months out of the 15 years. Now you can see what a steady-eddy the COP model really is. Compared with the S&P it is almost a straight line. This explains my new conclusion – stick it out or switch to low risk safer alternates. You might want to stay out for a month or so, to be comfortable the drop is settling out, before you re-enter with the safe alternate classes. Never forget “your comfort zone” is an important part of your investment strategy. It is not, however, an excuse to let the gurus scare you – the real market is scary enough. Go with the real market data. Ask, as Sergeant Friday would, “just give me the facts Mam.”
I have read a great deal lately that drives home the point that a momentum-based, quantitative (programmatic) strategy works -- maybe not so perfect that it does not give you occasional heart palpitations, but, better than anything else. This is one of those strategies.
Now, a very conservative investor might ask “if the safe alternate classes are so safe, why not invest in them alone all the time”. To examine this question, I ran several cases with a number of combinations of the safe alternate classes listed above. For the most part the return dropped down to about 8.3% per year and the volatility also dropped but not as much. One case might appeal to the very conservative investor because the volatility dropped to less than half of the S&P whereas the returned dropped to about 7.6% per year, or about two-thirds of the S&P. This case was investing full time in equal values of: Large Value, Financial, Health Care and Utilities.
More Research
The COP Research Model will be used to explore a host of alternate strategies and questions in the research results; such as why in 1991 and 1995 where the COP strategy had such a great year did it still underperformed the S&P substantially and why in 1994 where the strategy return was close to the S&P but still lost money (i.e., was there nothing that was up that year?). On the positive side, what are the explanations for the COP strategy beating the S&P so widely in some years?
Market Strategy Principles
Portfolio Diversification, Why and How
Much
A study on diversification by Ibbotson Associates was reported in Barron’s November 3, 1997. They called the conventional diversification between just stocks, bonds and cash as “dinosaur diversification”. Just by adding small cap, international stock, real estate and commodities to the mix one could design portfolios ranging from conservative to aggressive that all showed better performance and substantially lower volatility.
This strategy uses 80 asset classes. There is very little reliable information
available regarding their mutual correlations and certainly none that are projectable
into the future. History has shown that
the greater the diversification the higher the performance and the lower the
volatility in what might be called “normal” markets. However, when something jolts the market, all
things fall and the core
Following the COP Strategy, you will make your choice of how
far down the asset class performance rankings you wish to invest. Say you choose the top 15 out of the 80. Then you invest in those 15. You certainly may exclude some you are not
comfortable with. For your sense of diversification one has to be content with
the fact that the assets you choose are different in nature as
Carrying cash makes sense for safety if you fear a downturn but not as an asset class to diversify your portfolio. Keeping cash “in case something new comes up” also does not make sense because you need the discipline test to identify something you own that is less attractive than what you want. This prevents ad-hoc, non-integrated, additions to a portfolio.
I have an under 40 friend who follows this strategy. He chooses to invest in the top eight or so of the top 50 even though they may be the higher risk assets. He is willing to accept the higher risks for the higher returns and he has the tolerance to handle the setbacks and go for the next big gain. My view is that he is both young enough and sophisticated enough for such a choice. He proved this when, at a point when he committed to some large cash outlays and needed stability in his assets, he backed way down the risk scale. This illustrates both the need to set your own level of risk and to be aware of times you need to change.
Volatility and Risk, and Modern Portfolio Theory
Investment managers use Modern Portfolio Theory’s (MPT) “efficient frontier” analysis to select allocations of different assets to produce the most reward for the least risk using historical volatility and correlations between various assets. Unfortunately, it has been demonstrated that the historical data does not persist into the future, and according to Markman: “There is no empirical reason to think that they do.” “Historical correlations once thought fixed ... can change almost over night.” “I maintain that it is impossible ...to determine the future correlations between ... asset classes.”
David Dreman, Forbes 12/1/1997: “Although the academic world has renounced modern portfolio theory .... the system is still widely used.” In fact, it is still taught in universities and used extensively by investment managers. A few simplifying assumptions, like those mentioned above plus the assumption of “normal distributions” (i.e., bell curves), made in the beginning of the development of MPT have enabled the development of a truly massive and comprehensive array of mathematical tools for financial analysis. Perhaps because there has been no replacement is the reason it remains in use. Financial Advisor magazine (1/2006) contains a paper by J. Kaplan, Chief Financial Strategist for Smart Financial Advisors, in which he pokes another big hole in Modern Portfolio Theory’s asset allocation theory. He goes on to propose a much better allocation theory he calls MCS. Unfortunately, it still uses none-predictive past correlations, used in MPT, that have been so roundly trounced in academic circles and by people like Dreman and Markman.
From Modern Portfolio Theory came the principal that volatility is the standard measure of risk, from an analytical perspective. In MPT, risk and volatility are synonymous. Robert Markman of Markman Investments states “this became the most widely accepted concept in all of investing. And also the most tyrannical and destructive – and wrong.” In my limited experience I have found that high risk/volatility sectors such as emerging markets and small caps can have lower volatility when they are in favor and returning most to the investor. During the 2005 and early 2006, the volatility of a particular East European fund dropped from 38% to 20% and back to 22% as it went up 61%. Since then it fell off of a cliff and has had high volatility. The point is, that the drop in volatility did not change the basic risk nature of the asset.
Still, asset classes that are “believed” to have high risk
also tend to have high volatility.
Perhaps it is as much the conditioned reactions of investors as it is of
the actual risks. Furthermore, volatility produces anxiety; therefore, for
these reasons, I am willing to consider it as akin to risk. However, I believe that diversity is a better
way to produce lower portfolio volatility than avoiding high performing
volatile assets classes. I presume that
is what Rob Arnott meant when he said that you need “lightly correlated, high
risk assets.” Based on Morningstar’s standard
deviations for my portfolios, they have about the same average standard
deviation as the S&P500, yet their volatility is less. For example, during the third week of January
2006 the market went down over 2% and the NASDAQ about 3%, whereas my
portfolios went down less than 1.3%. Yet
I held several quite volatile classes;
Precious metals or gold is one of the most volatile asset classes and I avoid it; however, that is more because I have yet to hear of any really substantiated rationale for investing in gold. It is my judgment that the volatility of gold is mostly random noise, not economics. In his book referenced below, J. Siegel shows that historically gold is by far the worst possible investment. Other commodities, and commodities as a whole, are also volatile. However, they enjoy sustained periods of up and down markets and outperformance that can be successfully monitored for investment opportunities. Funds have recently become available for commodities.
If one had invested in the top asset classes produced by this strategy in 2000, 2001 and 2002, one would have been invested in some of the safest asset classes available and would probably have at least broken even. However, beware, at other times the top performing classes can all be the historically most volatile and risky -- the kind that all drop together in the event of a market disturbance. You have to be very aware of your tolerance for a big surprise and discount your ability to react smart and fast when selecting the classes for your portfolio. Ken Fisher in his latest book “The Only Three Questions that Count” says “I’d guess that 95% of society has no real clue about their risk tolerance (... it never has been measured...) and you can count me in the 95%.” Obviously it is a tough issue for you and me. Remember in the movie Trading Places when Don Ameche says to Ralph Bellamy “Sell Mortimer!! Sell!!” but there was no one who wanted to buy.
While volatility is not risk, when it strikes on the down side it sure feels like it. It makes one keenly aware how little we know, or can know, about risk and down drafts.
Lord Keynes said that “Markets can remain illogical far longer than you or I can remain solvent.” My view is that one should assume that the market will be illogical over the near term. It is the longer term in which rationality can be found. In a sense, the market can be considered as quite rationally responding to changing data. It is the data that is irrational in that it is constantly reversing, volatile and unreliable. Any guru, who claims that the market is behaving irrational/illogical, is saying that the market just does not see it my way. I have two papers on my desk right now from respected gurus. They both say the market is irrational -- one says irrationally low and the other says irrationally high.
Combining what we took from the book “Ubiquity” that the greatest of all social forces is inertia, Lord Keynes statement is merely a statement that inertia can drive maladjustments for an undeterminable time before the maladjustment distress becomes severe enough to overcome the great social force of inertia. Almost all of the money made in the financial markets is made when the inertia is operational, so you can not live with out it.
Market Timing
Ellis (Nobel Prize in investment finance): “The evidence on investment managers’ success with market timing is impressive – and overwhelmingly negative.”
Still, every time you buy or sell an investment you are making a decision at a particular time. If you find nothing you want to buy and stay out of the market, that is a timing decision and one that was probably right for you, assuming your decision is based on what the asset classes are actually doing and not on gurus, the media, etc.
True market timing is an effort at predictive timing. In this strategy we will only be reacting to the market’s actual momentum and hoping that it will hold, i.e., that the wave will be reasonably slow such that we can react to it. Again, I do not consider my “bet” on short term momentum a prediction.
I intend to get out of anything that is not performing. It is great when I get out of things when the performance has just slowed, but in sudden market changes I have and will lose some money. In 2002 I had about a 25% return in Emerging Market Bonds. By the time I got out it had dropped to about 20%. That was a 20% loss in my profit; however, I am still very happy because they dropped even further. In the months before the last Iraqi war, almost everything went down. You have to decide when you want to ride it out or run for cover. Here is where your reading about the general economy and the general market becomes valuable. People paying attention to the overall economy knew that the Iraqi war would not hurt our economy as seriously as the market dropped; and thus it represented a buying opportunity. There is an ancient saying in the stock market, “buy when you hear the sound of the canons.” What it does not say is that the sound of canons usually scares people out, driving the market down – so maybe we should buy on the echo. You do not have to understand the economy/market; you only have to read enough to understand the “probable” direction we are headed in for the near term to establish your comfort zone for the level of risk you want to take with this or any strategy.
Major corrections do not usually follow gradual sell offs as in the case of the Emerging Market bonds above. In fact they often occur just following an upward spike. Therefore, the COP strategy, as discussed elsewhere, has little or no answers for sudden down drafts. At best it offers one the ability to react faster after the fact.
In my limited memory and experience, asset classes that have been performing well, usually do reasonably well in sudden market up-surges, however, the opposite seems to be true in sudden down surges. This seems particularly true regarding the higher volatility asset classes.
“It is Different This Time”
Every guru tells you that this is one of the most dangerous phrases in the financial community. Why? Because they can read the tea leaves of history and can tell you what will happen now based on their analysis of the past, therefore you need them. My view: it is always different this time. I offer as proof, if it were ever the same then we would often have reliable predictions of the future and some gurus would have great track records. Ever heard of one who had more than their short moment of fame? So, ignore the guru because it will be different this time. If you do not believe me read (below): Mandelbrot, Buchanan, and Bernstein, Peter.
Gurus and how to Handle Sea Changes
There is one thing about the market that is always “the same this time”. There are always a few gurus who call the market right. Unfortunately, there are 100-times more who are wrong. No gurus seem to have the ability to repeat their history or even rhyme. Neal Weintraub, an investment guru, is reputed to have said “You will run out of money before a guru runs out of indicators.” This leaves a big gap in how to trim ones sails in preparation for a sea change since the COP strategy model offers little hope. The COP derivatives may prove to be an indicator to lighten up or heavy up. However, my current view is that I must be prepared to take the hit and use the COP model to help me recover.
Taxes
Financial Planning/ June 1998: A study commissioned by Charles Schwab found
that over a 30-year period the effect of taxes on fund distributions reduced
the advertised returns of actively managed funds by almost 60%. Seems a little
high to me, however, the study did assume near maximum tax rates and the impact
is not insignificant at the lowest rates. Index funds and ETFs are far more
tax-efficient but not 100%.
My Personal Experience with this Strategy (Through
2005)
It is interesting to look at my personal investing history with brilliant hind-sight and relative to the Appendix data. I was just beginning to use the model in 1999, but so excited with how well I was doing that year, and as yet unsure of the model, that I only used it as one more input. I got almost completely out of the market in March of 2000, feeling very smart, and knew that the model was of no use in a sea change, so I followed the gurus, namely one Ed Kirschner of Paine Webber, and got back into the market at the “bottom” in late 2000 to catch the bounce back of the NASDAQ. As a result, my 2000 was a disaster. I did not start using the strategy again until 2002 which was a good year for me, as have been all subsequent years. For these four years, I have beaten a SPY buy-and-hold by 33 percentage points or a cumulative 49% to 16% (or 207% more) starting in 2002. This was in spite of being out of the market for seven important months in 2004 so that I could relax while traveling. (Again, I blame my listening to a guru, this time Tobias Levkovich, for staying out so long after my return (what can I say, I fell off the wagon.)) Had I left the money in SPY during that time I would not have relaxed, however I would have beaten a SPY buy-and-hold strategy by 39 percentage points (instead of 33) for these four years.
In 2003, there were a lot of asset class changes making it a tougher year for this strategy, and surely there must be other good excuses to explain why I did not stick to the strategy as I should have.
To Be Added
How to Follow Your Performance Weekly or Monthly
Recommended
Bernstein, William, The Four Pillars of Investing, 2002. (Great! Source of: “the broker and the mutual fund manager are not your friends”.)
Bernstein, William, The Intelligent Asset Allocator, 2000. (Good! Established him as a leading investment practices author.)
Bernstein, Peter, Against the Gods. 1996. (Great read! Especially if you like the history behind the sciences.)
Dreman, David, Contrarian Investing Strategy: The Psychology of Stock Market Success. (Dreman is considered an intellectual king, or maybe a grandfather, of market psychology and a patron saint of value investing)
Dreman, David, Contrarian Investing Strategy: The next Generation. (The book lives up to its sub title)
Malkiel,
Siegel, Jeremy, Stocks for the Long Run, 2002 – (Outstanding primer on the market, but be critical. No one invests for the long run, least of all those over 50. One noted economists comment was that “in the long run we are all dead.” Too little attention to pitfalls and to investing in secular bear markets, still a must read.)
Ellis, Charles, Winning the Loser’s Game, 1998 and 2004 or later. (Nobel Prize winner for investment theory) Source of importance of documenting your strategy – the genesis of this document.
Friedman, Thomas, The World Is Flat, 2005 (A must read until the last third or so where he decides he knows how to fix the world’s problems.)
Mauldin, John, Bull’s Eye Investing, 2004 (Great for understanding market behavior—perhaps the best, but not intended for help on specific investing.)
Mauldin, John, Weekly
E-Letter, free @www.2000wave.com.
Fantastic!! Current!! Stimulating! Depth! -- broad perspective, great
references. It is not just his opinions
as he more often provides and contrasts alternative views of others, provides frequent
reviews of books and provides reprints of better papers. Clearly expressed opinion with ample humility
balanced by extensive references to alternative views. This is my definition of a gentleman writer –
I am a strong admirer, but of course, he is just one of many gurus who are
trying to sell you a service. To subscribe to
John Mauldin's E-Letter please click here:
http://www.frontlinethoughts.com/subscribe.asp)
Easterling, Ed, Unexpected Returns, 2005 (Great for understanding market behavior, but not intended for help on specific investing. Reports his own unique and extensive research. Whether you read his book are not, go to his web site, www.crestmontresearch.com, for some great market charts.)
Malkiel,
Mandelbrot, Benoit, The (Mis) Behavior of Markets, 2004, (This book will not directly help your investing, but you will understand that you had no idea how extreme and unpredictable market volatility can be. He also explains why to distrust Modern Portfolio Theory and the market experts, which is probably what he intended. This is why his work is invaluable.)
Buchanan, Mark, Ubiquity, 2000, (This book will give you a much better personal feel about why markets are unpredictable and about how you should view the risks. It turns out that market corrections are a very natural thing related to the basic nature of man and the world environment and will never be something man can forecast.)
Covel, Michael, Trend Following, 2006, (This is a good book to help one understand what trend following is (the same as momentum used herein, however, the users consider themselves to be traders) and how trend following has been very successfully used by a few high performing investment management firms. Unfortunately, it does not provide any specifics to help individuals. It is one more of those “you need us” books, full of more than the usual amount of puffery. It is not clear, however, it appears that some of these firms did not perform as well as did the COP Research Model, but of course, theirs was real performance.)
David F. Swensen, Unconventional Success – A Fundamental Approach to Personal Investment, 2005, (Swensen is the ultimate, even legendary, success as an investment fund manager. He is the chief investment officer at the Yale endowment fund and has a fantastic 15-year track record. This is the tour de force on what is wrong with personal investment managers, the media and brokers, and particularly with the mutual fund industry. If you want a near couch-potato investment plan, this is probably as good as it gets.