Further, we also recommend employing a tactical approach to buying and selling. Rather than defaulting to a “long-term” time horizon and risking a decade of unproductive investing, we exercise a rules-based, quantitative and tactical approach. We aren’t afraid to sell and get out of the way when a trend turns down and then use our rules to define when to get back in. Our process seeks to avoid the occasionally painful co-movement of asset classes rather than assuming (hoping!?) that diversification will save our clients.
Portfolio Positioning
Given the focus of this commentary, it may come as a surprise when we tell you that our strategies sold out of all risk-on classes in October and November, only to buy long government bonds in December. Didn’t we just make the case that the low or negative correlation assumption for stocks and bonds was an unreliable one? It is. Our alternative approach, though is to use rules to observe when an asset class is declining and when it is rising, and to react with discipline to what the markets are telling us.
In October of 2018 as U.S. stocks began to fall, bond prices were falling too—including the “safe” U.S. government bonds.
Our process kept us out of most of that. Then in early December, stocks really began to collapse in what turned into the worst performing December for U.S. stocks since the Great Depression. It was during this period that the flight to quality and into U.S. government bonds began. In this case, the negative correlation was clear and our trend-following process reported it loud and clear.
We don’t make predictions about what will happen to the U.S. economy and its stock market. We don’t rely on assumptions either. We do think it makes sense to build an ark before the rains start. For us, true diversification isn’t holding a risky stock allocation and a low-yielding bond allocation and believing that is enough. Instead, our rules-based approach depends on dynamic and tactical buying and selling to cut out downside risk and participate in uptrends.
Right now, our first buys are in preferred stock mutual funds, which are participating in the upside gains of stocks with less volatility. That said, we will sell these when our rules identify a shift back to the downside. True diversification is a process, not a set of assumptions.
Terri Spath, CFA, CFP, is chief investment officer at Sierra Mutual Funds.