A number of questions have been raised since Friday's update of Dynamic Asset Allocation that I thought were worth addressing in this broader forum so more people would see the answers. It feels like we've written about DAA a lot, but the reality is the strategy is only just over a year old and SMI readers still don't have much experience with it. It's not like Upgrading, where long-time SMI readers have been through just about every possible scenario at some point with their Upgrading portfolios.
First and foremost, we need to review how the asset classes are chosen each month. Apparently there is some confusion about the returns I post showing the prior month performance of each of the six asset classes. The recommendations for the following month are NOT based on how well each class performed during just the prior month. We haven't disclosed exactly the formula that is used for selecting the asset classes, but as with all of SMI's momentum-based strategies, it is taking a longer view than just the prior month. It's a combination of performance from the prior year, not just the prior month. So don't be confused when the best performing classes from the prior month aren't necessarily the recommended classes the next month. DAA is trying to catch trend changes, not just one-month wiggles.
Along those same lines, when the update post groups the classes into those that were recommended during the prior month and those that weren't, it's simply to make it easy to see what was in our DAA portfolios and what was not. The fact that BLV (bonds) was listed in the group with those that were not recommended in January has nothing to do with its status for February.
Multiple readers have confirmed what we knew would be true from the outset: DAA is simple (to understand), but it isn't easy (to execute). Getting whipsawed on Real Estate a couple times last year, then having to buy long-term bonds when everyone has been saying to flee them — this strategy definitely requires you to trust the signals. I would just point out that these types of emotional difficulties are littered through the back-tested data. Those long-term results are easy to accept (you can review them by clicking the article link near the beginning of this post), but the process of obtaining those returns would have been no less difficult than what we're experiencing today.
Our old friend Paul Merriman — who ran a market-timing advisory business for decades — once said, "In theory market timing is brilliant. In practice, it just doesn't work successfully for most investors." This from someone who spent 30 years in the business as a timer. Many of you know Austin's back story running a market-timing advisory business prior to founding SMI and the trials and tribulations that came from that form of investing for him.
DAA certainly isn't the most pure form of market-timing around, but it still falls under the broad tent. The simple system we're following has worked tremendously well for decades and we've worked hard to minimize the difficulties common to all timing strategies. But some people will definitely struggle to implement this on their own. Some of you are getting a taste of that right now and wondering if this is really for you.
If that's you, there's no shame in admitting this is hard and deciding to automate this piece of your portfolio (see www.smifund.com for details). Better that than second-guessing yourself and worrying every month.
For those who are fine implementing DAA on their own, understand that even this basic version of the strategy is emotionally hard enough for most SMI readers — even without throwing in any more details about the selection formula and other possible tweaks we've researched. We understand wanting to see every last detail — we're that way ourselves. But in this case, we're purposely limiting the information flow to keep this manageable. Even doing so, there's going to be a higher "failure rate" for readers trying to implement this on their own than any other SMI strategy. But again, that's why an automated option exists. If you struggle with DAA, don't ditch the strategy — just change how you get your exposure to it.
Speaking of tinkering and showing all the details...more than one of you have connected the dots between the new bond funds recommended in 2014 for Upgrading and are wondering about using those instead of BLV in DAA. It's not completely without merit — we looked at it before we even rolled out DAA a year ago (among many other combinations and options). Using various combinations of the two new bond funds offers both pros and cons, but I wouldn't suggest it simply because in certain cases, it pushes volatility significantly higher. (There's a reason BLV is part of DAA instead of the Unconstrained fund, and a reason Unconstrained is recommended as part of the Upgrading portfolio rather than BLV. They're different animals and each serves a specific role better than the other.)
Again, this simple DAA system has worked really, really well over time. That's not to say it couldn't possibly be improved. But we encourage you to trust it and keep it simple. Hope these clarifications help!
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