Evidence Investing

 
Asset Allocation 03/25/2010
 
Alright, now that I have got at least something under my belt for each of my topic areas, we can move on to the EVIDENCE for asset rotation (or Tactical Asset Allocation…TAA), which is the real meat and potatoes of this blog.

One quick think I wanted to bring up: you may hear the term Strategic Asset Allocation.  This refers to the following:  “Strategic asset allocation describes the practice of creating a portfolio with a constant or fixed mix of assets designed to fit the investment parameters of the investor.  A key assumption is that those parameters will remain relatively stable over the long term.  In other words, if the investor's long term objectives and risk tolerance are best served by a 60% equity and 40% fixed income portfolio, determined by risk tolerance and return goals, then that will be set as their target portfolio until their return objectives and risk tolerance change significantly. (source)

Tactical Asset Allocation: Uses some sort of prediction model to periodically alter the consistency of a portfolio on an active basis; that is, periodically adjusting holdings and weights of diverse assets based on the current prediction model output.  In other words, when your model tells you a down-turn in equity may be near, your system will allocate toward bonds.

Look at this summary table:
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For more on this, check out this excellent short article from UBS.

”Wait,” you say, “I thought you said you hate prediction and you don’t believe you can tell the future!!”  True, but with some caveats: I don’t believe in paying for someone’s opinion on what is going to happen in the future, and I don’t believe that the markets can be predicted well. I do believe you can have a basic idea where trends are leading and when markets are broadly over/under valued, etc…USING ANALYSIS BACKED BY REAL EVIDENCE!

So let get right down to it and start to answer our core questions:

  1. What’s the evidence behind TAA, in general?
  2. What prediction models work and are evidence based?
In order to answer this best, we need to first talk about our prediction models and then we can see how they fit into the overall TAA frame work.

There are a multitude of prediction models out there, as I am sure you know.  And, despite their claims, only a very few manage to ever beat the market and even fewer (if any) can beat the market on a long-term ongoing basis.  And, that is our goal, by the way: to beat the market.  If you don’t believe you can beat the market, there is no point in trading (commission costs), studying and analyzing (time/opportunity costs)…you might as well throw your money in an index fund and hit the golf course!  (look for a future post on the logic and evidence for an against ‘beating the market’)

So, there are three types of prediction models that I will deal with (so far) in this blog:

  1. Momentum
  2. Selected Technical Analysis (Moving Averages)
  3. Yield Curve
Why these three? Because they have the most supporting evidence, of course!  J

In reality, these are the only prediction models that I have run across that have been significantly studied and which are supported by rigorous and numerous research studies.  If we discover more, we will be sure to let you know…

I am going to devote many future posts to each of these models, so I am just going to give you the definitions of each today…

  1. Momentum Investing: An investment strategy that aims to capitalize on the continuance of existing return trends in the market. The momentum investor believes that large increases in the price of a security will be followed by additional gains and vice versa for declining values. (Investopedia)
  2. Selected Technical Analysis (Moving Averages)-based Investing:  An investment strategy that aims to capitalize on the continuance or change in directional price movements, as defined by a moving average of asset price.  The moving average investor believes that moving averages have predictive qualities and that assets tend to trend on one side of their moving average, and that a moving average cross-over is significant.
  3. Yield Curve Investing:  An investment strategy that aims to capitalize on the positive consequence of changes in the yield curve for assets.  The yield curve investor believes that the yield curve has predictive qualities and that some assets do better in certain yield curve environments.
Next time, we will start in on the evidence for momentum.  
 


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