## How market timing saves an MPT-allocated portfolio

I’ve been receiving numerous inquiries into the Stock Market Cook Book’s portfolio analytical tool, the SMC Analyzer, which is a powerful software tool that applies proven market timing strategies to Modern Portfolio Theory (MPT). Although Analyzer results have been discussed in previous blogs (see 5/12-13/09, 7/07/09), I feel that some of the points made earlier need to be reiterated.

One of the most frequently asked questions is this:  How did a portfolio based on market timing perform during the recent credit crisis as compared with a traditionally long-only MPT portfolio? Although I’ve already answered this question in the May articles, I decided to update the results to this July and take an in-depth look at how both portfolios would have been allocated on a month-by-month basis beginning in July 2008.

Modern Portfolio Theory (MPT) in a nutshell
Briefly, MPT tries to maximize returns given a certain level of risk. It attempts this by allocating a portion of one’s portfolio over a spectrum of asset classes, each with varying degrees of inter-correlation. For example, an MPT-allocated portfolio would most likely contain the asset classes from both large and small-cap domestic (US) stocks, US government and corporate bonds, real-estate (typically in the form of REITs), and international stocks and bonds. Commodities such as precious metals and oil are also popular asset additions. (Hedge funds can also play a role in portfolio diversification.)

MPT attempts to achieve the desired return via the robustness (that is, the degree of return versus the associated risk) of a particular asset class combined with the degree of correlation (or rather, un-correlation) among the other candidate asset classes. It’s a complex mathematical model for which Harry Markowitz won the Nobel Prize. So far, the theory works well over a very long time-frame, but it does dismally over short, volatile periods because of the requirement that it always must be long in the asset classes determined by the model.

Not so for the SMC Analyzer!

How the SMC Analyzer is different
The SMC Analyzer uses a market timing oscillator that is specifically optimized to each asset class. When the oscillator is positive, it will tell you to be long that asset class; when it turns negative, you’ll be instructed to either go short (if that is what you selected and if that asset class is “shortable”) or else move into the safety of T-bills or another risk-free asset.

So, how did both of these approaches compare over the past year?

Portfolio comparison
Below is a chart that graphically depicts how a traditionally MPT-allocated portfolio would have fared compared with a market-timed portfolio as determined by the SMC Analyzer. In the latter portfolio, it was assumed that when the oscillator for that asset class was negative, those funds that would have been designated by MPT for that asset class would be put into the safety of Treasury bills. In both portfolios, a compounded annual return of 10% is assumed.

You can see that the tradition portfolio failed miserably—not only could it not yield a positive return but the investor would have been down 26% and at a huge risk of nearly 27%. Note, too, that the maximum draw-down was a whopping 45%, on par with the major averages.

However, had you been in a market-timing adjusted portfolio, not only would you have realized a positive return, but also at greatly reduced risk and without any significant draw-down. This is truly amazing!

To see how these differences in results were achieved, let’s look at the asset allocations recommended by MPT for each portfolio on a month-per-month basis. The top table gives the recommended allocations for the traditional MPT portfolio while the bottom portfolio gives the recommended allocations for the market timing portfolio.

Observations
Here are several observations derived from the above tables:

1. The risk, as measured by the standard deviation of possible returns, is less than half that in the market timing model.

2. The reason that MPT failed so miserably during the recent downturn is because it is looking towards the longer term and it figures that the only way the portfolio will ever be able to achieve a 10% return is by being long in the highest risk (as well as the highest returning) asset classes, i.e., stocks.

3. In contrast, the SMC Analyzer saw that the market was heading down and re-allocated the monies apportioned to Small-Cap Stocks into the safety of Medium Term Government Bonds and T-bills. It wasn’t until March of 2009 that the stock oscillators began to turn positive indicating it was safe again to invest in those asset classes.

4. You can also see that in order to achieve the monthly asset allocations as recommended by the market timing model involves significantly less trades, a plus for those investors who are worried about commission costs eating into their portfolio profits.

Summary
I hope this exercise will put to rest many of the questions that have been raised about the SMC Analyzer’s market timing model. For further information regarding the SMC Analyzer, take the features tour or test drive the Analyzer for yourself. Both are located in the left-hand column of the home page, www.stockmarketcookbook.com.