For decades, the accepted wisdom for diversifying a portfolio has been to own stocks for growth potential and bonds for stability. The mix between these two was altered depending on an investor's need for growth vs. safety. When Dynamic Asset Allocation was introduced in January 2013, we explained that the primary motivation behind the research was a desire to reduce our reliance on bonds for portfolio stability. (Dynamic Asset Allocation is a Premium strategy available to SMI Premium members. See Dynamic Asset Allocation: An Investing Strategy for the Risk-Averse for a full explanation of the DAA strategy.)

Chart 1 shows why the stock/bond combination has worked so well in the past. Stocks have produced higher average returns than bonds over time, but with greater volatility. Bonds have been the steady stabilizer that offset some of the downside risk of owning stocks. (This 12-year period was selected because it so clearly illustrates this behavior. We chose it in part because it was one of the less chaotic stretches!)

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We believe interest rates are likely to rise from their recent historic lows in the coming years. Rising interest rates mean falling bond prices. That means bonds aren't likely to stabilize portfolios any longer — they could very well sink them! This is the problem DAA was designed to solve.

The first step toward creating the DAA strategy was to identify complementary asset classes that could act as diversifiers to a portfolio. Chart 2 shows the returns of the six asset classes eventually included in DAA. If that chart looks like a mess, that's the point. These six classes zig-zag across each other repeatedly, with some doing well and others doing poorly at any given point in time.

The simplest way to diversify a portfolio using these six asset classes would be to simply add them all, owning some of each class all the time. The results of doing this aren't bad, when you consider that the primary purpose of doing so would be to reduce risk rather than boost returns. Over the past 30 years (1984-2013), the S&P 500 had an annualized return of 11.1%. A portfolio evenly divided between these six asset classes would have earned 8.7%. That's obviously a lower return, but an investor would also have experienced much lower volatility along the way.

DAA takes this diversification idea and adds a timing element to it. Instead of owning all six classes all the time, DAA owns only the three classes showing the best current momentum. By avoiding the worst three asset classes, DAA wins by not losing. Take another look at Chart 2, only this time imagine erasing the three lowest lines at any given point in time, leaving only the higher three lines. This gives you an idea of the impact DAA has on a portfolio.

Chart 3 takes a longer-term view and shows how both of these approaches would have fared over the past 30 years: owning all six asset classes vs. the backtested results of using DAA to move between classes based on their recent momentum. Unlike the "own all six all the time" approach, which had lower volatility but also produced lower returns than the stock market (8.7% vs. 11.1%), DAA would also have greatly reduced risk but done so while boosting returns to 13.4% annualized. Better returns with less risk is a tough combination to beat!

Chart 4 illustrates how dramatic an impact DAA has on a portfolio over time. A $10,000 investment in the "own all six all the time" portfolio would have grown to roughly $123,000 over 30 years. But that same amount invested using the timing mechanism built into DAA ("own only three at a time") would have grown to a whopping $433,000. That's dramatically more than the S&P 500's growth as well (which rose to $234,000), yet with substantially less volatility than the stock market experienced.

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Circling back around to the original challenge of how to effectively diversify a stock portfolio without relying heavily on bonds to do so, consider the following. Since December of 1973 (as far back as the back-tested data is available), there have been 488 rolling 12-month periods (the first period was Jan73-Dec73, the next period "rolled forward" to Feb73-Jan74, etc.). Of those 488 12-month periods, the S&P 500 index of large U.S. companies lost money in only 106 of them. During those down periods, DAA outperformed the S&P 500 in 102 of them. The few times it didn't, it trailed the S&P 500 by an average of only 1.7%. As a diversifier against stock-market declines, DAA would have done an outstanding job over the past four decades! (For information on how to best use DAA within your portfolio, we suggest reading Higher Returns With Less Risk: The Best Combinations of SMI’s Most Popular Strategies.)