Third Quarter Review: Making Up For Lost Time

Following up on its strong second- quarter performance, the stock market kept right on climbing in the third quarter. With back-to-back 16% quarterly gains for the Wilshire 5000, the market is now up more than 50% from its March lows.

Of course, the overall market is still 30% below its all-time highs of two years ago. But at least for the past two quarters, things have been moving in the right direction.

As strong as the market has been in recent months, our historical performance table shows that those following SMI's two main model portfolios — Just-the-Basics and Fund Upgrading — have done even better. Both strategies slightly outperformed the market during the third quarter, and each has a comfortable lead year-to-date as well.

Two factors explain most of the superior performance for these portfolios this year. First, SMI's portfolios each have a healthy allocation of foreign stocks, which have performed very well (the Wilshire 5000 index contains no foreign stocks). And second, both SMI portfolios are slightly more heavily weighted to smaller stocks over larger ones, which is the opposite of the Wilshire 5000 weighting.

In the table below, note the perfect progression of year-to-date returns as you go up the risk ladder in the "All Funds" column. Clearly, risk-taking has been rewarded this year, just as it was punished in 2008.

Now let's move from the short-term to a longer-term view. It will come as no surprise to anyone who has invested in recent years that stocks have failed to hold up their usual bargain of outperforming bonds. Adding bonds has actually boosted performance (as well as boosting stability, which is their traditional role).

You'll see this illustrated by looking from left to right across the "Past 5-Years" row of the historical performance table. Note that total gains for both Just-the-Basics and Upgrading increase as you decrease the stock allocation and increase bonds. This was especially evident in the Just-the-Basics portfolios, and to a lesser degree for Upgraders.

In the 10-year data row, we find the situation for Upgraders reversed — returns were hurt by adding bonds at the expense of stocks. Why is that? It's because Upgrading provided significantly more protection against losses during the 2000-2002 bear market (reflected in the 10-year returns) than the recent bear market (reflected in the 5-year returns). That protection during the first bear market was sufficient to largely offset the need for bonds, a condition that (unfortunately) was not repeated during the more recent bear market — much to the disappointment of Upgraders.

This impact was significant enough that, despite two massive bear markets in the past decade, an Upgrading investor actually lost value by reducing his or her stock exposure over the past ten years. Note that we're not saying you shouldn't have a bond allocation in your portfolio — quite the contrary, if your season of life and risk tolerance dictate it, you most certainly should. If anything, the more-recent bear market illustrates that Upgrading isn't a silver bullet that eliminates the need for smart portfolio diversification between stocks and bonds.

In fact, having a small helping of bonds (say a 20% allocation) would not have dramatically reduced returns over the past ten years but it would have substantially reduced the portfolio's volatility. For risk-averse Upgraders, this is an important consideration.

Many pundits, observing the anniversary of the financial crisis, have written "what-have-we-learned?" type articles recently. One trend within these articles has been to doubt the conventional wisdom of stocks outperforming bonds over extended time frames, since bonds have compared quite favorably to stocks in recent decades. Given the data for the stock market as a whole in recent years, it's a reasonable conclusion.

But it's important for Upgraders to understand that what is true of "the market" is not necessarily true of their specific Upgrading portfolios. As you consider any portfolio allocation changes over the coming months, use Upgrading's performance characteristics and history, rather than general stock market data, as the basis for your decision making.

Mark Biller is Sound Mind Investing's Executive Editor. His writings on a broad range of financial topics have been featured in a variety of national print and electronic media, and he has appeared as a financial commentator for various national and local radio programs. Mark is also the Senior Portfolio Manager of the SMI Funds.

• Second Quarter Review: A Sigh of Relief
• First Quarter Review: Bear-Market Bottom or Just a Bounce?
• Overview of SMI's Upgrading Strategy
• Overview of SMI's Just-the-Basics Strategy
• Performance History
• 2009 SMI Allocation Guide: Weighing The Risks 
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