2014/06/24 Alan Yong

Investment Strategies for Finance Dummies

Knowing that I work in the field of investment strategies, several friends have asked me, “For people who do not know the markets, what’s the best way to invest?”

I’ve come to a life stage where most of my friends have worked for a few years. They have paid off their student loans and are developing their careers. Most of us are planning to settle down, planning for a wedding, car, property, child etc. And most have gone through the Great Financial Crisis of 2007 as a young adult, and we have a distrust of banks and financial products in general.

The problem is that for all the education we have received over the years, unless you are working in finance, most of us do not have a good sense of how to manage our own money.

Before I share about some simple rule based investment strategies, here are some money management axioms that I live by:

1. Consistency is Key, Not Your Financial Planner

First, consistently applying sound investment principles pays off in the long run. And no, you do not need an investment professional to do that for you (unless you are a high net worth individual who needs tax and legal advice). If financial planners are really that great with money, most of them would have retired young. Second, consistently setting aside money for investment purposes builds up financial discipline and your retirement nest egg.

2. Diversification Matters

Large fund houses manage their money by diversifying across asset classes, sectors, industries, countries, strategies, risk targets etc. Don’t bother stock picking, the odds are against you (unless you have insider information, which is illegal anyway). Most people try to model their stock picks based on Warren Buffett’s style of value investing, but the truth is many of us do not have the time, intellect, and acumen to analyse companies successfully. ETFs are a great way for general investors to diversify their portfolio at a very low cost.

3. Start Early

Albert Einstein is credited with the quote “compound interest is the most powerful force in the universe.” The table below illustrates this concept perfectly. People who can exercise delayed gratification by giving up present consumption for investments (in assets, exercise, social life) will be able to reap manifold returns in the future.

Compound Table

 

Before I go into the strategy, here are some of the rules/assumptions that I’m making:

  • You have a basic understanding of how the stock market works
  • You know what are ETFs (Exchange Traded Funds)
  • Strategy must be low cost, easy to understand, and does not require huge initial investment
  • No short selling

Disclaimer: I am in no way guaranteeing the performance of the strategies listed below. Past results do not indicate future performance. Please exercise caution and prudence before making any form of investments.


 

Strategy 1: Invest In a Stock Market Index

Hedge funds employ some of the world’s best money managers and academics from Finance, Economics, and Computer Science. The top funds at Renaissance, Citadel, Bridgewater manage upwards of $10 billion each and collect high management and performance fees in exchange for strong returns. However hedge funds in general are unable to outperform the market net of fees:

 “The broader market, as measured by the S&P 500 stock index that tracks shares of large corporations, has continued to beat returns from hedge funds considered collectively, the report said. The S&P 500 beat the Hedge Fund Equity Index, with the former climbing 26 percent for the year to date, versus 9 percent rise among equity hedge funds broadly.” – International Business Times

In 2008, Warren Buffett argued that hedge funds do not outperform the market and do not justify the fees that they charge investors. He made a $1 million bet that pits a low cost ETF (Vanguard 500 Index Fund Admiral Shares) against 5 hedge funds chosen by Protégé Partners LLC.

 “With four years remaining, Warren Buffett has a commanding lead in a decade-long bet that put a low-fee stock index fund up against a portfolio of high-priced hedge funds… In a Fortune piece, long-time Buffett friend Carol Loomis writes that after six years the fund Buffett selected for the wager, the Vanguard 500 Index Fund Admiral Shares, was up 43.8 percent at the end of 2013 .” CNBC

SPY Price Series

Caveats

  • Investing in a single stock market index is highly volatile. Over the period from 2000 to 2014, the SPY ETF has experienced two episodes of 50% draw down (once in 2003 and once in 2009).
  • It is extremely difficult to time the market, if you have bought at the market peak of 2000, your investment would have only break even in 2008 (not accounting for dividends), before taking a dive again.
  • One way to mitigate this problem is to use dollar cost averaging; consistently setting aside a sum of money to buy the index ETF every month/quarter. This will bring down the average purchase price of your investment.

Strategy 2: Invest In a Portfolio of Diversified Assets

People who have done Finance 101 in college will have come across Modern Portfolio Theory (MPT). The “Modern” in MPT was simply because the concept of a mathematical way of diversifying risk in investment assets was a new paradigm (in 1950s) of looking at risk and return. Within MPT, we are introduced to the concept of systematic risk (risk which exists throughout a market system, e.g. government default in Argentina, or military coup in Thailand), and idiosyncratic risk (risk which can be diversified away, e.g. investing solely in technology stocks, or worse, a single stock).

It is important to have a pool of diversified assets in your investment portfolios to reduce the idiosyncratic risk that you are exposed to. Buying 10 US company stocks across industries might offer some form of diversification, but why stop at 10? Why not buy across countries? Why not buy other asset classes such as government bonds, corporate bonds, real estate, and commodities?

Until recently, it was difficult for retail investors to get exposure to these asset classes. With ETFs, it is now possible to trade these asset classes like shares. I provide a sample list of ETFs which are fairly diversified. This is definitely not the best combination of ETFs for an investor who seeks diversification. Many ETFs are only listed in recent years and these ETFs do not have enough historical data to do the following illustration.

Symbol Full Name Underlying Asset
EEM iShares MSCI Emerging Markets ETF Emerging Markets Equities
EFA iShares MSCI EAFE ETF Developed Markets (Ex US, Can) Equities
SPY SPDR S&P 500 US Equities
IYR iShares U.S. Real Estate ETF iShares U.S. Real Estate ETF
GLD SPDR Gold Shares Gold
AGG iShares Core U.S. Aggregate Bond ETF US Bonds
IEF iShares 7-10 Year Treasury Bond ETF US Govt Treasury

Equal Allocation

 

Equal Weight Allocation and ETF Performance

Equal Weight Allocation and ETF Performance

This equal allocation strategy (black line) has a compounded annualised return of 8.4%, an annualised volatility of 14.2% and a maximum drawdown of 34.7%. This is significantly better than buying a single SPY ETF, both in terms of return and risk profile. While some ETFs are more volatile (Gold/GLD and Emerging Market Equities/EEM), this is balanced by the less volatile ETFs (such as US Bonds/AGG and US Treasury/IEF).

Caveats:

  • This is the theoretical performance of allocating equal dollar capital to the seven underlying ETFs. In real world, this performance will differ slightly due to rounding of contracts. Let’s assume that we allocate $1000 equally among these seven underlying (for a total portfolio of $7000). The price of IYR on 1st May 2001 is $77.46. This will work out to purchasing 12.9 IYR contracts. We can either round to the nearest integer (13) or round down (12) in order not to exceed our investment budget. Either way, both 12 or 13 contracts will not have the same performance as 12.9 contracts.
  • The above illustration is the nominal value of $1 invested from May 2005 until May 2014

Strategy 3: Invest In a Portfolio of Diversified Assets Tactically

This strategy is based on a paper written by Mebane Faber, titled: “A Quantitative Approach to Tactical Asset Allocation”. Faber wrote this paper in 2007, and updated it in 2013 after the Great Financial Crisis. The strategy has held up well out of sample, through the crisis, and managed to provide good returns using simple trading rules. This is an easy paper, and I highly recommend a reading to understand the background and various intricacies of the strategy. Building on the idea of allocating our portfolio across diversified assets using ETFs, I now introduce a simple trading signal known as the Simple Moving Average.

I modified his strategy slightly as follows:

  • Calculate the 120 day Simple Moving Average of the daily close prices of the above 7 ETFs
  • Rebalance the portfolio on the first day of every month
  • If on the last day of the preceding month the close price is above the 120 SMA, there is a signal to buy the ETF this month.
  • If on the last day of the preceding month the close price is below the 120 SMA, there is a signal to sell off any existing position of the ETF this month. (No short selling)
  • If there are buy signals for any ETFs, allocate weight to them based on the baseline weight allocation.
  • All excess unallocated weight gets allocated to US Treasury ETF (IEF)

GTAA Allocation

Strategy Explanation:

  • We want to allocate across diversified assets, however we do not want to be holding assets that are losing money.
  • We use the 120 day (6 months) SMA as a simple trading signal to determine if we should be holding a certain ETF. This is the simplest form of trend following (assets that perform well in recent history tend to perform well in the near future).
  • US Treasury ETF provides stable but low returns and is a good hedge against more volatile asset classes (e.g. Gold). When other ETFs are not performing, we allocate more money to US Treasury.
  • I set aside 5% of my investment capital in cash, as a buffer for contract rounding requirements.
  • Trading costs + slippage is assumed at 0.5% per transaction.
Global Tactical Allocation and ETF Performance

Global Tactical Allocation and ETF Performance

This tactical asset allocation strategy (black line) has a compounded annualised return of 8.0%, an annualised volatility of 6.9% and a maximum drawdown of 8.4%. While the strategy return over the same period is not significantly different, we have managed to reduce our returns volatility by 50% and maximum draw down by 75%.

 

Overview Chart

 

 

For those who are interested to look into the strategies that I have described above, you can download the excel spreadsheet that I used.

 * Featured photo by Flickr user: Anthony Quintano

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If it were easy

everyone would be doing it