Earthquakes and Wars Call for Diversification and Tactical Asset Allocation in Investing

03/20/2011 0 comments

Investing for wealth preservation and growth or for retirement purpose is by definition a long term process. In a long term period, experiencing wars, natural disasters and political or social unrests is a fact of life. How to deal with and navigate through these threatening events is pertinent to the success to achieve financial goals. 

As baby boomers are exiting or getting ready to exit the work force, this year suddenly saw many dramatic events unfolding: Japan's earthquake and the still unfolding nuclear power meltdown events, the middle east violence with fear of radical islamic involvement and, this weekend's airstrike by allied forces on the Libyan regime are all pointing to certain tipping points in the world economic and political landscape. The new generations and the baby boomers suddenly find themselves in a world with entangled dangerous events. 

The events certainly made their marks on financial markets: the big swings of the Dow Jones Industrial stocks (DJI) and S&P 500 stocks (SPY) left a dent on the otherwise stubborn euphoric markets. Most risk assets including U.S. stocks (SPY) (VTI), international stocks (EFA) (VEU), emerging market stocks (EEM) (VWO) and REITs (IYR) (VNQ) (RWX) lost ground in the last week. The only standout in the group is commodities (DBC) (GSG). For the week, DBC actually gained 0.78% while gold (GLD) gained 0.11%. For more detailed performance information, please refer to here. 

 
The key to succeed in long term investing lies in adopting sound and consistent (thus long term) strategies in managing one's portfolios. Buy and hold of a basket of major assets with properly calculated risk tolerance is one way. A more maverick way can enhance return with lower risk by adopting some tactical moves in asset allocaiton. Let's first review the following portfolios using a strategic asset allocation (buy and hold among equal weights on risk assets): 
 
A. Three Core Asset ETF Benchmark Strategic Asset Allocation Moderate (US Equity (VTI) (SPY), International Equity (VEU) and Fixed Income (BND))
B. Four Core Asset ETF Index Funds Emerging Markets Strategic Asset Allocation Moderate (additonal Emerging Market Equity (VWO) (EEM))
C. Five Core Asset ETF Benchmark Strategic Asset Allocation Moderate (additional US REITs (VNQ) (IYR) added)
D. Five Core Asset ETF With Commodity Benchmark Strategic Asset Allocation Moderate(additional commodities (DBC) added to the four asset portfolio)
E. Six Core Asset ETFs Strategic Asset Allocation Moderate (include US Equity, International Equity, Emerging Market Equity, REITs, Commodities and Fixed Income)

 
For the week, Six Core Asset ETFs Strategic Asset Allocation Moderate lost 0.34% compared with 0.66% loss of Five Core Asset ETF Benchmark Strategic Asset Allocation Moderate or 0.68% loss of Three Core Asset ETF Benchmark Strategic Asset Allocation Moderate. With the smaller loss of REITs and the commodity performance, diversification does show its advantage during the market stress. 
 
The last ten years experienced two major economic downturns: the technology bubble burst in 2000-2002 and the financial bubble burst in 2008-2009. The pure buy and hold strategy, even with proper diversification, does not shield its portfolios from big loss. A more active portfolio strategy such as this tactical asset allocation strategy (TAA) can be used. The following again compares the five portfolios with 3,4,5,6 assets using TAA. All of them are moderate risk portfolios. 

Portfolio Performance Comparison

Portfolio Name 1Yr AR 1Yr Sharpe 3Yr AR 3Yr Sharpe 5Yr AR 5Yr Sharpe
Three Core Asset ETF Benchmark Tactical Asset Allocation Moderate -3% -32% 2% 16% 4% 28%
Six Core Asset ETFs Tactical Asset Allocation Moderate 9% 67% 10% 78% 14% 96%
Four Core Asset ETF Index Funds Emerging Markets Tactical Asset Allocation Moderate -2% -16% 7% 62% 10% 64%
Five Core Asset ETF With Commodity Benchmark Tactical Asset Allocation Moderate 2% 18% 5% 43% 10% 64%
Five Core Asset ETF Benchmark Tactical Asset Allocation Moderate 6% 42% 7% 60% 10% 63%
 
 
The six asset portfolio with TAA  actually had a slight gain in the last week and it is also positive in the last month. This clearly illustrates that tactical asset allocation over a diverse array of major assets can be effective. 
 
 
The following table shows the trend scores of major assets ending 3/18/2011. 

 

Assets Class Symbols 03/18
Trend
Score
03/11
Trend
Score
Direction
Commodities DBC 14.15% 12.94% ^
Gold GLD 8.86% 9.46% v
US Equity REITs VNQ 5.89% 8.03% v
US Stocks VTI 5.55% 8.03% v
International Treasury Bonds BWX 5.07% 4.04% ^
International REITs RWX 4.27% 6.89% v
US High Yield Bonds JNK 3.74% 4.13% v
Emerging Market Stks VWO 2.97% 4.64% v
Intermediate Treasuries IEF 1.82% 1.16% ^
US Credit Bonds CFT 1.71% 1.71% v
Total US Bonds BND 1.12% 0.97% ^
International Developed Stks EFA 0.87% 3.28% v
Emerging Mkt Bonds PCY 0.57% 1.18% v
Mortgage Back Bonds MBB 0.23% 0.12% ^
Treasury Bills SHV 0.05% 0.05% v
Municipal Bonds MUB -0.9% -1.22% ^
Frontier Market Stks FRN -3.22% 1.01% v
The trend score is defined as the average of 1,4,13,26 and 52 week total returns (including dividend reinvested).

In conclusions, no one has a crystal ball to predict the future. The effective way to cope with major risks for mankind is to adhere to sound portfolio strategies such as asset allocation with diversification and tactical allocation based on prevailing events. 


Symbols:EEM,VNQ,FRN,VWO,IYR,ICF,GLD,RWX,VTI,SPY,IWM,PCY,EMB,JNK,HYG,PHB,EFA,VEU,IEF,TLT,GSG,DBC,DBA,CFT,BWX,MBB,BND,MUB,SHV,AGG ,Exchange,Tickers,(NASDAQ,EEM),(NASDAQ,VNQ),(NASDAQ,FRN),(NASDAQ,VWO),(NASDAQ,IYR),(NASDAQ,ICF),(NASDAQ,GLD),(NASDAQ,RWX),(NASDAQ,VTI),(NASDAQ,SPY),(NASDAQ,IWM),(NASDAQ,PCY),(NASDAQ,EMB),(NASDAQ,JNK),(NASDAQ,HYG),(NASDAQ,PHB),(NASDAQ,EFA),(NASDAQ,VEU),(NASDAQ,IEF),(NASDAQ,TLT),(NASDAQ,GSG),(NASDAQ,DBC),(NASDAQ,DBA),(NASDAQ,CFT),(NASDAQ,BWX),(NASDAQ,MBB),(NASDAQ,BND),(NASDAQ,MUB),(NASDAQ,SHV),(NASDAQ,AGG),

Disclosure:

MyPlanIQ does not have any business relationship with the company or companies mentioned in this article. It does not set up their retirement plans. The performance data of portfolios mentioned above are obtained through historical simulation and are hypothetical.



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