A Radical New Approach to Personal Investing - Part 2

For the last 10 years, investors have not made any headway in increasing the value of their investment portfolios, in fact the last ten years (2000-2010) is now commonly being referred to as “the lost decade”. This has led many investors to become disillusioned with the stock markets and their financial advisors.

The following excerpt is taken from a recent post by The American Association of Individual Investors (AAII) does a good job of explaining why this has happened.

“Diversification benefits have become harder to achieve. Increased similarities in the performances of asset classes have raised risk levels and made it more difficult to achieve improved risk-adjusted returns by relying solely on asset class and sector selection skills.

At issue is asset class correlation, a term that describes how close the total return of one asset class (e.g., large-cap stocks) is to that of another (e.g., commodities). A correlation of 1.0 means returns are identical, both in terms of the direction and the degree of the change. A correlation of -1.0 means returns are mirror opposites. The lower the correlation ratio is, the higher diversification benefits are. In a perfect world, you want investments that zig when your other holdings zag.

Unfortunately, the world is far from perfect and correlations are moving closer to 1.0 instead of further away from it. Sam Stovall, Standard & Poor’s chief investment strategist, quantified this shift in a report published earlier this year. This shift means asset classes are now more likely to move in the same direction than they historically have.

The table below shows his calculations.

If you are among those who feel like they’ve been doing everything right but aren’t making any headway, this merging of correlations may help to explain why. As asset class returns have more closely mimicked each other, it has become harder to reduce risk by combining a variety of investments within one’s portfolio. In more blunt terms, a downward move by domestic large-cap stocks now has an increased chance of dragging down emerging market stocks, REITs and commodities with it. Thus, it is harder to hide from the market’s dark side.

The performance bonus from minimizing risk for a given level of return (a key tenant of modern portfolio theory) has also been reduced. This, in no doubt, is driving professional portfolio managers nuts.

As gloomy as this all sounds, realize that diversification still a good thing. As the numbers published by Stovall show, returns are not completely correlated. It’s just that the distance has become considerably shorter than it historically has been”.

I am sure you have seen this merging of correlations when stock markets around the world rise and fall due to the globalization and linking of the world’s economies.

So, what do you do about this?

First, accept the fact that we are in a difficult investing environment.

Second, realize that times have changed and a new approach to how you invest in stocks is required. Based on this point I have written a research paper called “How Value Averaging Adds Value – Achieving Investment Goals in Tough Economic Times”.

Based on the research and investment strategy developed by former Harvard university professor Michael Edleson, I conducted a study with regards to how investors would have done had they used the value averaging strategy to save for their investment goals. In order to conduct the study I created a powerful web-based software system that allows me to back test the value averaging investment method, over any time frame, using historical data for any North American Stock, ETF or US based mutual fund. The program also compares the results of Value Averaging against Dollar Cost Averaging.

The results of the study has revealed that if investors were using the value averaging strategy over a 5 to 10 year time frame, there is a high probability that they would have achieved their savings or retirement goals while outperforming the market indexes. This would have been possible even with the high volatility and declining stock markets over the last 5 -10 years.

In the new year we will look at rolling out a portfolio management service that will teach investors how to use this investment method in order to meet their investment savings goals.

To read the research report click here

To learn about the software click here

Till the next time.