CPM Investing LLC - Research Publications
The goals of Focused 15 Investing are to
We follow the adage that says, buy low and sell high. But instead of buying low and selling high based on the price of the asset class index, such as the Dow Jones Industrial Average, we buy low and sell high on our proprietary Market Resilience Indexes (MRI) for each asset class. The MRI are an important part of the process we use to create the target weights in the model portfolios published each week and to determine when to rotate out of one asset class and into another.
Modern Portfolio Theory + Rotation
In general, investment practices today are heavily influenced by modern portfolio theory, and there is good reason for this. The thrust of modern portfolio theory is that you benefit by diversifying your account across multiple asset classes. By doing this, you can get higher return for less variability than you would by investing in just one asset class.
As a hypothetical example of this concept, assume that you have 60% of your retirement account allocated to stocks. Stocks have a high long-term rate of return, which is beneficial. But they also have high variability of price levels and rates of return, which are not beneficial. High variability is not beneficial because the price level might be unusually low when you need to use the money in your account.
These two dimensions of return – long-term return percentage and the variability of shorter-term returns – can be combined into a ratio that gives us one number to compare investments. This is the Return-to-Variability ratio. It is calculated as the longer-term return divided by the variability of short-term returns. Both figures are annualized, and the higher the ratio, the better. It is a useful summary statistic for evaluating the level of return achieved and the level of variability that must be endured to get that return.
The chart below shows a long-term rate of return for stocks of 8%. But the variability—which is measured as the standard deviation of weekly returns on an annual basis—is quite high, at 17%. The return-to-variability ratio is 0.47. This means that stock prices go up and down a lot compared to the return that accumulates over the long term.
The sample portfolio in the image above has a 40% allocation to bonds. Bonds have a 4% annualized return in this example and have a level of variability of 7%. Bonds typically have a lower long-term rate of return, but the variability is lower as well. The return-to-variability ratio for the bond asset class is 0.57.
The correlation between stocks and bonds is low and is sometimes negative, which means that when stocks go down, bonds go up. In this way, bonds provide a diversification benefit to the portfolio – bonds reduce the overall variability of the portfolio. By combining these two asset classes – stocks and bonds – into your retirement account, you can get a higher return than if you held 100% of your account in bonds, but a level of variability that is quite a bit lower than if you held all your account in stocks. The weighted average return of these asset classes is 6.4%.
The weighted average variability of these asset classes is 13.0%. Yet, because these asset classes have a low and sometimes negative correlation to one another, the actual variability is less, at 10%. This gives the portfolio a higher return-to-variability ratio than either of its two asset classes separately. That means that when we combine these assets, we get a higher rate of return for the variability we must endure by selecting assets that are not correlated to each other. This is one of the key benefits of modern portfolio theory.
Focused 15's Approach
Focused 15 Investing uses modern portfolio theory, but we also actively rotate among the asset classes to shift out of the asset class that is most likely at the peak of its price cycle and into the asset class that is at the trough of its price cycle, which reduces losses. While both standard industry practice and Focused 15 Investing portfolios use asset class rotation to some degree, our shifts are more dramatic.
If we look at the major asset classes of stocks, bonds, and cash, investment approaches using modern portfolio theory will have relatively stable allocations to each class: typically 60% in stocks and 40% in bonds, plus or minus, say, 5 percentage points, depending on current market conditions. Our model portfolios hold both stocks and bonds and benefit from diversification as described above, but we also seek to reduce the variability of the asset classes through active rotation. Instead of stocks having a variability of, say, 17%, we rotate out of stocks when they are vulnerable to declines and this results in a variability of less than 17%. When we combine modern portfolio theory with loss avoidance, we get a much-improved return-to-variability ratio. I’ll give examples of this in later articles.
A key point for now is that our model portfolios are diversified across stocks and bonds, but the weights of the asset classes change over time. Our model portfolios will have stock allocation ranging from 0% to 100%, bond allocation from 0% to 100%, and cash allocation from 0% to 100%. Compared to most other investment approaches, Focused 15 portfolios will be more aggressive; that is, they will have a higher allocation to stocks in resilient times for the stock market and be a lower allocation in vulnerable times.