Combining Multiple Strategies —
The Next Level Of Diversification
By Mark Biller
© Sound Mind Investing | April 2011
For roughly 20 years, SMI has promoted two primary investing strategies. Just-the-Basics is our simplest approach, using index funds in an attempt to roughly duplicate the market's overall returns. Fund Upgrading is our primary strategy recommendation. It is based on the idea that superior performance is possible by shifting your portfolio among various mutual funds in a disciplined manner based on their recent performance "momentum."
Both Just-the-Basics and Upgrading are core strategies, meaning that either is suitable to be used as an investor's primary (or only) strategy. SMI also offers Advanced Strategies that aren't as familiar to many readers. As you'll see, most of these are designed to play a supporting, rather than central, role in an investor's portfolio.
One can be a successful long-term investor simply by using a solid core strategy such as JtB or Upgrading, without adding any other strategies. This is the simplest approach. However, just as diversification between different types of investments can help smooth out the ups and downs of a portfolio, the idea of "strategy diversification" can yield similar benefits.
The primary goal of diversifying a portfolio among different types of investments is to get a mix that "marches to different drummers." For example, we hope bonds will do well when stocks are faltering, and vice versa. Or that our foreign holdings will be up when domestic stocks are down. In this way, we try to smooth our investing journey — and suffer less emotional ups and downs — by always owning something that is performing well.
Diversifying between strategies is based on the same idea. By utilizing different strategies, we hope that when one is having a down year, another might pick up the slack with a good year. There is also the aspect of dealing with specific risks via a supporting "advanced strategy" as is the case with our Optional Inflation Hedges (OIH)  .
The table here illustrates how this diversification idea translates into actual experience. Each colored box below shows the annual performance for one of SMI's five strategies. Our core JtB and Upgrading strategies are included, along with the Optional Inflation Hedges portfolio (OIH) which appears in each issue of the print newsletter.
In addition, two of our advanced strategies, Sector Rotation and Enhanced Just-the-Basics, are also shown. (These advanced strategies are in green, signifying that they require a web membership to access.)
The performance of the U.S. Market, as represented by the Wilshire 5000 index, is provided to give additional context to the data. Each of the past 10 years is shown as a column, starting with 2001 on the far left.
The most important point to recognize from the table is how the relative performance of the strategies varies widely from year to year. It's very common for one strategy to be at the top of the column one year, then wind up near the bottom the next year, and vice versa. Really, the only consistent performer in the table is the U.S. Market, which consistently can be found at or near the very bottom of the table. (That's a good thing, as it means all of the SMI strategies being discussed are providing a better return than the overall market.)
The relative and varied performance shown in the table helps us visualize how combining more than one of these strategies might lead to a smoother investing journey.
For example, let's consider a reader whose core strategy is Upgrading, but who also allocates a small percentage of his or her portfolio to both the Sector Rotation and Inflation Hedge strategies. Moving across the table from left to right, we can see that in 2002, Upgrading and Sector Rotation had significant losses, despite beating the market. But that year, the OIH strategy managed a strong positive gain, helping reduce those losses.
Moving through the next several years, the strategies bounce up and down the columns, until we arrive at 2008 — the next big bear market year. Flipping the script from 2002, OIH was the worst performing strategy in the table. Upgrading was again in the middle of the strategy pack. This time, Sector Rotation took the top performing slot.
By 2010, OIH was back at the top and Sector Rotation at the bottom, with Upgrading again around the middle. Both Sector Rotation and OIH had higher annualized performance for the decade than Upgrading. Combining them in this manner allowed the investor to capture those returns while still managing the annual volatility somewhat.
Here are a few additional observations from the table. JtB has beaten the market in eight of the past 10 years. Not bad for a strategy that only requires about 15 minutes once per year. However, for those willing to put in a little additional effort, Upgrading has been a clear improvement, beating JtB in all but the past two years and more than doubling its annualized performance over the decade.
Upgrading's performance has been pretty consistent relative to the other strategies — you can usually find it right around the middle of the pack. As our example a moment ago illustrated, the other complementary strategies tend to swing more from top to bottom, orbiting the steadier performance of Upgrading.
Enhanced Just-the-Basics, which puts half the portfolio in the traditional JtB funds while Upgrading the other half of the portfolio among a wide range of Fidelity funds on a quarterly (rather than monthly) basis, was a significant improvement on regular JtB. Enhanced JtB is a sort of half step between JtB and Upgrading, both in terms of implementation and performance (Enhanced JtB averaged gains of 7.3% for the decade, while Upgrading earned 8.4%).
For those ready to dip a toe into the Upgrading experience without wanting to have to keep up with their portfolio every single month, Enhanced JtB is a nice option.
It's worth noting that not all of the strategies shown were "live" for the entire decade — some of their performance shown is from our backtesting. While it's normally appropriate to be somewhat skeptical of backtested performance (it's always harder in real time!), in this particular case we're pretty confident the data wouldn't have changed much.
Both Sector Rotation and OIH are such straightforward, mechanical strategies that it's unlikely the real-time results would have changed much from our backtesting scenario. Sector Rotation was introduced to SMI readers as a live strategy in 2003 and its performance since that time has validated its backtested results. OIH is newer, only debuting in 2010. But in its first year, it captured the top performance slot among all SMI strategies, which seems to be a good sign in terms of validating its methodology as well.
Finally, it's important to review some safeguards we've suggested regarding some of the strategies. As mentioned at the outset, SMI's core strategies of JtB and Upgrading (along with the Enhanced JtB variant) are suitable for any portion of a portfolio, up to and including 100%. The OIH and Sector Rotation strategies are not suitable for this type of
We have long suggested that Sector Rotation be limited to a 5%-15% allocation in most portfolios, with perhaps a 20% stake for the younger daredevils among us. The OIH strategy has similar guidelines, with roughly a 20% cap suggested for most investors. At least with OIH, the allocation is spread among four different types of funds. Sector Rotation, in contrast, is normally concentrated in a single, narrowly focused sector fund.
While the often spectacular gains of OIH and SR are tempting, please use these strategies responsibly as "supporting cast members" in your overall portfolio. As happy as they can make you during the good years, they can break your heart just as quickly when things turn south. 
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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. |
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