Market Musings 141126: Improving returns at lower risk with simple timing models

Market Musings 141126:
Improving returns at lower risk with simple timing models

Even for long-term, patient stock market investors, there comes a point when the stock market falls by a certain percentage, let’s say 5% or 10%, where the question of reducing risk or staying fully invested should be asked.

In this latest September-October stock market pullback when the MSCI All Country World Index fell 6% in US dollars and 4% in euros, many invested heavily in stocks would likely have asked themselves this question.

As of the end of last week, the S&P 500 index was just 3% off its early October all-time high. However for many investors it has probably felt much more severe, given that the median US stock is down nearly 12% and 32% of stocks have fallen by 20% or more. The most popular stocks with US retail investors (as defined by companies in the Defiance Retail Kings ETF) have dropped 28% since the end of September.

Volatility is the price of stock investing

Since 1945, the US stock market has experienced a 10%+ decline from peak on average once every 1.1 years, i.e. nearly every year. The average such 10%+ decline is 13%-14%, although more painful bear markets (defined as a 20%+ drop, which take place every 3.5 to 4 years on average) obviously also occur. Volatile years on average see 2 such market corrections of 10% or more. 5%+ declines from peak are of course even more common, occurring on average somewhere between 3 and 4.6x per year. Simply put, this volatility is the price of investing in stocks for the long term.

Source: JP Morgan Asset Management

In principle, the default answer when stock markets decline by 10% should be to stay invested, on the basic principle that it is “time in the market” rather than “timing the market” that generates long-term compounding of wealth in stocks. But even long-term investors who accept that volatility is the price of investing in stocks for higher returns, still want to avoid the bulk of bear market drawdowns if at all possible.

While no system is foolproof, there are a number of systematic approaches that can boost overall long-term stock market returns by limiting drawdowns when a substantial stock market decline takes place.

Tactical asset allocation with the 200-day/10-month moving average

Investors want in general to be invested in stocks when they are trending…