Keeping a long-term mindset is one of the most difficult challenges investors face.

It’s one thing to say you’re a long-term investor with a long-term mentality. You may want that to be true and may even believe it to be true. But it’s still hard to keep your emotions in check when evaluating the year-to-date column of your brokerage statement (or worse yet, the online portfolio you check daily).

Year-to-date performance is an arbitrary time frame encouraged by media reports, as well as by our own tendency toward short-term thinking. Looking instead at the more relevant recent 12-month period helps put the year-to-date numbers into perspective. Let’s look at SMI’s Dynamic Asset Allocation strategy (DAA) for a current example: From January 2015 through mid-June, DAA turned in a small year-to-date loss. But widen the lens a bit to look back over the 12 months and the picture changes dramatically — from June 2014-May 2015, DAA was up a solid 8.0%.

That number may not knock anyone over, but look at the performance of DAA’s six options during that period: Foreign stocks and Gold were both negative, Cash was basically flat, U.S. Stocks and Real Estate were up in the 10%+ range, and Bonds up roughly half that. Suddenly 8.0% looks pretty good, and the negative emotions that stirred when looking at the 2015 year-to-date return give way to the more rational long-term perspective we’re all seeking to cultivate.

Focusing on calendar-year returns is just one mental blindspot investors face. To some degree, we’re all prisoners of arbitrary “mental accounting” habits. To help escape that trap, SMI regularly spends time presenting historical return data in various ways — expanding the context often helps promote the long-term thinking most investors would agree is desirable.

Delving deeper into the issue of DAA’s 2015 performance, we looked back at other years in the historical research to see if there were any lessons to be gleaned from past years that started similarly. Sure enough, we found some great examples, including one that intersected with another idea we’ve had on the back-burner: looking back at DAA’s flight path through the treacherous 2007-2009 market environment. (Note that these 2007-2009 returns are from our back-testing; DAA didn't exist yet.)

Interestingly enough, all three of those years (2007, 2008, 2009) started much as 2015 has, with DAA either flat or down slightly through roughly the first half of the year. In 2007, before the bull market in stocks had ended, DAA was up a scant 0.6% through July. In 2008, the year of the financial crisis, DAA was down -2.7% for the year-to-date by the end of July. And in 2009, with the bear market ending in March, DAA had only broken even through mid-year.

All three cases resemble 2015’s first-half performance. Yet all three of those calendar years ended with a positive return, two of those three years ended with double-digit gains, and DAA gained more than 31% overall for the three-year period!

A closer examination of this period reveals a few important lessons for DAA investors.

  • Expect some monthly losses.
    Members often confuse DAA’s long-term historical ability to reduce risk with a short-term ability to eliminate losses. If you’ve been surprised to see DAA lose ground within your portfolio over a month or two, you’ll likely be shocked to learn that between 2007-2009, DAA was just one slight monthly gain away from splitting the 36-month period evenly between gains and losses (that single 0.1% monthly gain in March 2009 tipped the scale to 19 monthly gains vs. 17 monthly losses).

    Yet despite the virtual tie between monthly gains and losses, DAA returned 31.1% for the three years overall while many investors lost as much as half their money due to fearfully bailing out of the market in early 2009.

    Clearly, the frequency of gains and losses isn’t the key to DAA’s success. Rather, its ability to maximize gains while minimizing losses has allowed it to generate its outstanding long-term track record. But based on the historical data, we shouldn’t be surprised by a fair number of small monthly losses.
  • Expect some occasional misses will be quickly reversed.
    DAA’s ability to mute volatility in returns doesn’t necessarily equate to low volatility in terms of trading. Six times in those three years DAA bought an asset class and held it for two months or less. And in just the last five months of 2009, five of the six asset classes monitored by DAA were used.

    Why does this happen?

    For the same reason DAA’s monthly returns are so evenly divided between gains and losses. DAA is constantly probing for long-term trends to tap into, but those trends often take time to develop. When the markets are in transition, long-term trends are elusive (because they haven’t been firmly established yet). DAA is designed to take tentative steps toward emerging trends, while keeping its commitment low until the trend is firmly established. DAA allows small, short-term losses as it searches for long-term trends, because the long-term trends produce the big gains that more than offset any short-term losses.
  • Expect DAA to move slowly getting into, or out of, a particular asset class.
    Yes, the system sometimes appears to be overly deliberate in its movements. On these occasions, try to be thankful for all the times DAA’s steady nature didn’t “jump to conclusions” too soon (which is the flip side of the “too slow!” coin), costing you further gains in an asset class that wasn’t yet done with its run.

    In this vein, it’s worth pausing to discuss DAA’s current Real Estate holding. Some members have been frustrated by the fact that DAA has continued to hold Real Estate, even after selling Bonds at the end of May. They reason, correctly, that many of the factors that influence Bonds also are primary factors in Real Estate’s performance (specifically, the movement of interest rates).

    Apart from the fact that DAA doesn’t make changes based on this type of “fundamental” or bottom-up analysis, this line of thought ignores the significantly different performance history of the two asset classes. In Real Estate’s case, DAA moved into that asset class in March of 2014, a full six months prior to Bonds. So while Real Estate and Bonds behave similarly at times, there’s enough differentiating the two that Real Estate’s move began much sooner — and it shouldn’t be a huge surprise that Real Estate might stick around a month or two longer on the tail end as well.

    Also consider that as late as the end of March 2015, DAA investors still had a 24.6% gain in Real Estate, just 2.5% less than its high earlier in the year. Following a poor April, the category was down only -0.3% in May. Putting all that together, it wasn’t necessarily obvious that Real Estate needed to be replaced in June along with Bonds — which leads to our next point.
  • Expect to follow trends, not to lead them.
    The ability to predict movements of these asset classes is extremely limited (to put it mildly). This shouldn’t be a surprise to anyone who has read SMI for long, as our distrust of prediction-based investing is well documented. There are any number of examples of this, even in this short three-year period, but we’ll focus on one to make the point (you can follow the month-by-month details in the chart).

    From February 2008 through May 2009, DAA basically hid in the most conservative allocation that the strategy allows: Bonds, Cash, and Gold (with a one-month exception when Foreign Stocks were added, only to be dumped immediately). When DAA first settled on this portfolio combination, it was immediately rewarded with 2.0% monthly gain; however, DAA then proceeded to lose money in seven of the next eight months! After which it turned around and generated the two largest monthly gains of the entire three-year period in the final two months of 2008. Those two profitable months were then followed by more losses in three of the next four months.

    Despite the losses, it would have been fairly clear at the time that DAA’s portfolio was well positioned as the market at large was suffering much larger losses. Still, the up and down nature of these monthly returns exposes the false idea that DAA is a docile, low-volatility strategy. Is it over the long-term? Absolutely! It essentially negated the worst financial panic in a generation as if it didn’t even happen. But short-term? DAA’s returns were pinging all over the place. Trying to predict what the asset classes or the strategy’s returns were going to do next — even without making any changes to the holdings — would have been futile.
  • Expect DAA to shine in bear markets.
    Evaluating the true effectiveness of a strategy such as DAA requires looking at long time periods — ideally full bull-bear market cycles. Monthly periods are much too short, and even looking at half years, as we did in our initial example looking at 2007-2009, is likely to lead to faulty conclusions. DAA’s performance is often out of synch with the broader market. This is actually a desirable thing, as it adds a tremendous diversification benefit to a portfolio. But it makes the danger of abandoning the approach at exactly the point when it is most needed that much more acute.


Most importantly, this short analysis exposes some of the faulty conclusions that have been drawn about DAA, particularly in terms of its short-term character. Those with the impression that DAA is “safe” in the same sense that a short-term bond or savings vehicle is safe need to understand that DAA has often lost money in the short-term, even while doing exactly what it was designed to do. DAA fell 14.8% between February-October 2008, yet most would evaluate 2008 as the single greatest highlight of DAA’s back-tested track record, given it actually generated an overall gain in 2008 while stocks were losing over a third of their value.

For long-term investors, DAA remains a solid cornerstone upon which to build an effective investing portfolio. There’s good reason we give it the largest share of our “all-weather” 50-40-10 portfolio. Its ability to ferret out long-term trends and ride them to significant gains, while keeping losses firmly in check, is an outstanding combination of attributes. Just don’t confuse these long-term abilities with a promise to eliminate short-term losses or squelch monthly volatility. As long as you understand what DAA is — and isn’t — you’re likely to benefit tremendously from incorporating it into your portfolio.