In the first half of this article, we touched on our “View” of what the next three to five years would hold for us as investors. It will be a rollercoaster in terms of price movements. Expect big rises and big falls as the markets adjust to the tremendous forces that are being unleashed. But like a rollercoaster, do not be surprised that, after all the screaming and hand waving, the ride ends at roughly the same place it started.

Cyclone at Coney Island

We don’t mean to suggest that every asset class will end up exactly in the same place, but rather that that many of the popular indices will show small net returns over the period despite experiencing relatively large amounts of price volatility.

Our proposal is to use a systematic asset allocation method to actively seek out the most promising investments at discrete intervals. We believe the net result will be a superior portfolio performance to a buy and hold strategy of either a diversified or concentrated portfolio. Not even Modern Portfolio Theory would suggest taking on a large amount of risk (volatility) for very little reward, which is exactly what you are signing up for in any Buy and Hold program today.

Testing Five Scenarios

To see how this will work in practice, let’s cast our vision forward and devise five different market outcomes.

From the dire to the euphoric:

  1. Market Meltdown
    Often referred to as the “bomb shelter and shotgun shell” investment scenario, this grim tableau envisions a partial breakdown in the fiat money system that underpins the global economy. The proponents of this outcome have price targets of US$3,000 per ounce and above on gold and are keen to own it in physical form.
  2. Return to the Bear Market
    A number of bears with a flair for charting like to overlay the last three years of the US equity performance on a chart of the Dow through the Great Depression. This group even has a website which updates the various numbers. These sorts would have you buying Government bonds despite the low yields to the exclusion of almost everything else.
  3. “Muddle Through”/”New Normal”
    This is our core assumption: a return to market conditions that prevailed in the US between the late 60’s until 1982. Although broad measures like the S&P 500 showed very little overall growth over the 14 year period in question, there were strong asset allocation trends throughout the period which were investable. Some asset classes will experience multi-year bulls at the periphery but overall, the trend will be subdued compared to the 80’s and 90’s.
  4. Mild bull market with normal periodic corrections
    This scenario can come about in several ways. The most likely would be a sudden and prolonged acceleration of some positive trends (remember the ”green shoots” a few months ago?) which have popped up despite the overall gloom. A less likely possibility is a rapid restructuring of several key emerging markets towards more internal consumption (remember the “decoupling theory”?).
  5. Return of the Great Moderation
    Through a remarkable sequence of events, the global economy rights itself in less than five years, interest rates remain low, inflation never catches hold and productivity gains and/or immigration reform overcome the demographic trends that afflict many countries. Not likely? Perhaps, but more likely than a market meltdown at this point.

How well will an Asset Allocation System work?

In all cases, evaluating a broad range of asset classes makes sense in the early stages. Although in the extreme cases (#1 and #5), one could argue that the value of asset allocation will diminish over time because in the most dire situation, one need only buy hard assets and the ability to protect them. Whereas, in the most euphoric situation, one should, throw caution to the wind and borrow to gain as much risk exposure as possible.

However, in the most likely middle three scenarios, the ability to discriminate between the various asset classes consistently over a long term investment period could mean the difference between meeting your long term financial goals and falling short.

The biggest difference we see between the 14 year period starting in the late 60’s and now is the much broader scope of investment opportunities. In the 70’s, the average US investor was restricted to stocks, bonds, cash, collectibles and real estate. Investing in Europe was available through a small selection of ADRs and more exotic locales like Asia were the stomping grounds of trailblazers like Mark Mobius.

Now, with online trading and securitization (of which ETFs are a small part), a wide variety of asset classes and trading strategies are available to almost anyone with internet access.

The success of any Asset Allocation System will come from two components:

  1. Selecting the assets to be evaluated
    With such a broad range of opportunities, and noisy proponents in every corner, it is more important than ever to make sure that you have defined the scope of acceptable assets that you will consider. The first screen should be designed to exclude inappropriate investments. The second should look to exclude those investments which you would not consider acceptable. And finally, you should check each asset class for ease of entry and exit.
  2. Selecting a Buy Low, Sell High Discipline
    While we are naturally biased towards the Fund King System, there are many systems one can use to trade your investment universe. The three main schools of thought are Growth, Value and Momentum.

The two parts of the exercise are equally important. It does no good to include an asset in your evaluation universe which you would not be willing or able to buy and sell as your Discipline indicated. Alternatively, it will not help your performance if you allow emotions to interfere with your discipline. One easy way for that to happen is “falling in love” with an asset regardless of the fact that your investing discipline suggests it is overvalued and/or has lost momentum. Each system has advantages and disadvantages and there will be times of underperformance. Switching investment disciplines frequently to catch the latest fad is in fact no discipline at all.

Upgrade to the Fund King Website

To assist you with Asset Selection and Investing Discipline, we have added a new component to the Portfolio Select portion of our website. At the top of the My Portfolio section, you will see a button to direct you to the Portfolio Management feature. In addition to your existing portfolio, we have made room for two more portfolios that you can select (#2 & #3) and three that we will be updating to provide you with new ideas. Keep an eye out for the instructions and video which will be updated early this week.


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