The stock market’s long-term average annual return masks a hard reality: Returns can vary widely from one year to the next. Even one year’s return can be misleading, with intra-year moves hitting more extreme highs and lows than an unsuspecting investor might imagine.
That’s why it’s so important to follow a strategy that not only has the potential to deliver the returns you need, but that comes with an expected level of volatility you can live with. Formula One champion Niki Lauda’s advice about racing applies just as well to investing: “The secret is to win going as slowly as possible.” And that’s a good description of what investors following SMI’s Dynamic Asset Allocation strategy have experienced this year.
A wild ride, but not for all
When 2020 draws to a close, the stock market’s volatile path will be one for the history books. During a shocking 16 trading-day stretch, from February 19 to March 23, the S&P 500 plunged –34%. Never before has it fallen so far so fast.
The market had been inching upward since the start of the year, giving investors the impression that the nearly 11-year bull market would continue.
However, as a mysterious virus took hold in China and quickly turned into a global pandemic, rattled investors ran for the exits. Most people with money in the market hardly knew what hit them and no one knew when the worst would be over.
At the same time, investors following SMI’s Dynamic Asset Allocation strategy experienced far less turmoil. After beginning the year as aggressively positioned as the strategy can be — in U.S. stocks, foreign stocks, and real estate — DAA’s mechanical indicators dialed things back in February, replacing foreign stocks and real estate with gold and bonds. At the beginning of March, it went further, replacing U.S. stocks with cash. As a result, investors following the strategy avoided much of the pain, losing just –11.8% from its peak to trough, a small fraction of the overall market’s decline.
And keep in mind, there were no subjective decisions for investors to make — no guessing about how much wider the COVID-19 virus might spread or how much further the market might fall. All that was required was to trust the system and make the trades it called for.
A remarkable rebound
After the market hit bottom on March 23, the S&P 500 came roaring back, gaining +58% through the end of August. Did that leave DAA’s 2020 returns behind? No. From January 1 through August 31, the S&P 500 was up +9.7% whereas DAA was up +12.6% — and as the chart below shows, those returns came via a much smoother path.
While it’s true that DAA’s +19% gain since March 23 pales in comparison to the S&P 500’s gains, the fact that DAA is still in the lead can be explained by what we refer to as “the brutal math of market downturns.” In essence, big losses require even bigger gains just to get back to even. For example, the market’s –34% loss earlier this year required a +51.5% gain to get back to its February 19 level. On the other hand, DAA’s –11.8% loss required only a +13.4% gain.
In that light, it’s easy to see that avoiding catastrophic losses is as important — if not more important — as taking full advantage of market gains. That’s why we often summarize one of DAA’s main benefits as “winning by not losing.”
This year has also demonstrated one of DAA’s perhaps least understood or appreciated benefits. While DAA is rightly thought of as a defensive strategy, defense doesn’t always mean moving to the sidelines at times of market stress. In fact, DAA is never more than one-third positioned in cash. The other two defensive asset classes, gold and bonds, often gain when stocks are in decline or struggling for direction. That’s exactly what happened this year.
In March, U.S. stocks fell –11% while DAA’s gold position gained +3%. Then in April, as stocks came bounding back, gaining nearly +14%, gold was up another +9%. (For many DAA investors, the peace of mind of continuing to be defensively positioned at a time of so much ongoing fear and uncertainty was worth even more.) Following small gains in May and June, fueled in part by replacing cash with U.S. stocks, DAA took off again in July on the strength of its continued position in gold. In August, when stocks cooled down a bit, gaining just +5%, DAA gained even more, once again thanks largely to its one-third position in gold.
Click Graph to Enlarge
The priceless value of peace of mind
This year has provided long-term investors with a healthy reminder that “the race is not to the swift” (Ecclesiastes 9:11). While we’d all love to see our entire portfolios generating Sector Rotation-like average annual returns, few of us would be comfortable with the volatility required to achieve them. Far better to build a plan based on a realistic rate-of-return assumption, and importantly, a plan likely to maintain a level of volatility you can live with.
That’s why, for those who are new to SMI, especially older and more risk-averse investors, starting out with DAA as your only strategy may be appropriate. However, over time, we encourage most SMI members to transition to a blended portfolio, such as our 50/40/10 approach (50% DAA, 40% Fund Upgrading, and 10% Sector Rotation).
One of history’s lessons is that good times don’t last forever and neither do bad times. By offering improved returns vs. Upgrading-only or DAA-only, while being less risky than the overall stock market, we believe blended portfolios like 50/40/10 offer the best combination of profit and peace of mind, no matter what’s happening in the economy.