The fear of the ignorant investor

Millennial investors face a unique problem. Many started their careers after the portfolio-slashing 2008 recession, and have only seen a bull market as an active investor.

Sounds like a nice problem to have, right?

But here’s the challenge, we all know there’s something coming in the markets. We don’t know when, why, or how bad, but we know it’s coming. And regardless of the hundreds of investment books out there telling you how to “beat the next bear market,” only time will tell if our resolve is strong enough not to sell at the bottom.

If you’re like me, you probably know older investors on both side of the fence. There are those that held through the entire recession, licking their wounds, and putting off their retirement by a few years. And there were those who lost their life savings by trying to time the market, and ended up selling at the bottom.

Trend Follow Betterment

In this post, let’s review an investment approach that aims to capture the benefit of smart buy & hold investing AND trend following to reduce drawdowns and increase returns.

We will cover:

  • Research behind the methods used
  • The benefits of the chosen methods
  • How to easily implement the strategy in minutes per year

This will be an exciting one, as this is an investment strategy that truly sets out to be an all-weather, long term investing approach. Let’s start with the trend following method first:

The trend is your friend!

Mebane Faber is a prolific investor, blogger, and entrepreneur. He is someone you want to follow. He published a white paper called A Quantitative Approach to Tactical Asset Allocation in 2006 that used easy, practical trend following strategies. If an investor began using this strategy in 2006, he would have almost completely avoided the pain of 2008-2009. He later updated the post to show how his strategy would have performed during the crash. Very impressive:

Source: Mebane Faber Research
Source: Mebane Faber Research

I encourage you to read all his white papers to fully understand his methods and the behavioral finance explanations for why they work. But in a nutshell, his strategy:

The 4 steps to Meb Faber’s Trend Following System

  1. Starts with a broad universe of global asset classes. A simple example would be his 5 asset class universe of:
    1. US Stocks
    2. Foreign Stocks
    3. Real Estate
    4. Bonds
    5. Commodities
  2. Select a “lookback” period of 3-12 months, where you measure the performance of each asset class based on their total performance (price increase + dividends).
  3. Every month, rank the performance of each asset class, and invest in the top few asset classes, assuming they trade above their 10-month or 200-day moving average. A good rule of thumb is to take the best performing 40% of the possible asset classes. So if your universe has 10 ETFs in it, you would select the best performing 4 every month.
  4. Rinse and Repeat.

There are several benefits to a system like this:

  1. It has historically outperformed buy and hold strategies significantly (19.1% return per year vs 9.9% for buy and hold)
  2. It is systematic and mechanical, which should help us avoid the traps of fear and greed.
  3. It is based on a strong foundation in human psychology (herding mentality, anchoring bias, etc) which provides the investor confidence that this strategy should continue to work as long as humans are involved in the market. Check out Thinking Fast and Slow to gain a better understanding of behavioral economics!

 

Now let’s add a smart buy & hold portfolio…

This strategy has specific goals for its buy & hold portfolio. Low cost. Global. Home country bias free. Value tilted. Smart on taxes. Mebane recommends his own Cambria Investment’s fund GAA (named for “Global Asset Allocation”) which is a great option. However, for my implementation, I have chosen Betterment for several reasons:

  1. Betterment’s tax loss harvesting feature is extremely attractive and makes it a great option for taxable accounts
  2. To maximize tax efficiency, place all stocks in taxable accounts, and save your bonds for retirement accounts (tax location)

 

Let’s combine it into a great portfolio

So what is the best way of combining these different portfolio methodologies into a comprehensive investment strategy? Let’s assume we have investments spread across both taxable and retirement accounts, starting with an overall $100,000

  1. Select your trend following vs buy and hold allocation. Let’s assume 50/50. So we have $50,000 in trend following, and $50,000 in buy and hold.
  2. Select your desired buy and hold asset allocation between stocks and bonds. Let’s assume 50/50 Stocks/Bonds. So we have $25,000 Stocks and $25,000 Bonds.
  3. Invest the $50,000 of trend following strategy in retirement accounts to avoid the tax implications of short term trading.
  4. Place the $25,000 stock portion of your buy and hold in your taxable betterment account, set to 100% stock allocation. This will maximize your tax-loss harvesting opportunity by realizing short term losses.
  5. Place the remaining $25,000 of bonds wherever they fit, but preferably in tax exempt. This will of course depend on where your funds sit.
  6. Rebalance your trend portfolio monthly
  7. Attempt to balance your strategies back to your desired allocation on an annual basis.

 

This will give you a rock solid portfolio. Not only is it likely to outperform over the long term, but it will comfort you no matter what’s going on in the markets. If you’re in a bull market, you’ve got a good portion of buy-and-hold that is riding the wave. If you are plunging into a bear market, your trend strategy has side stepped it.

This will reduce your long term volatility, and definitely help you sleep at night.

 

In the next post, I’ll show you exactly how to implement several trend following strategies using nothing but Google Sheets.

So what do you think? Can trend following and buy and hold both fit in a single portfolio? Let me know below!