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Protecting Your Wealth From
Inflation & Investment Losses

Historical Analysis Of A Prudent And Easy To
Understand Approach To Portfolio Management

Study By

Christopher G. Ciovacco

Chief Investment Officer
Ciovacco Capital Management

January 1, 2007



Abstract

An investment portfolio, which is well constructed using a wide variety of asset classes, can produce positive returns under both favorable and unfavorable market conditions without relying on expert timing or accurate economic forecasts from a portfolio manager.


Executive Summary

Study Description:

This study analyzed the hypothetical historical performance of a portfolio management strategy, developed by Ciovacco Capital Management (CCM). The primary objective of the CCM Portfolio Management Strategy is to provide individual investors with a way to protect themselves from inflation while minimizing the probability of incurring portfolio losses during either bear (unfavorable) or bull (favorable) markets in U.S. stocks. The strategy utilizes well-diversified investment portfolios that include exposure to traditional and non-traditional asset classes such as timber, precious metals, and base commodities.

Study Objectives:

  • To test the ability of the CCM Portfolio Management Strategy to produce positive returns in both favorable and unfavorable conditions for U.S. stock investors.

  • To test the margin of safety of the CCM Portfolio Management Strategy by examining hypothetical historical results under conditions where the portfolio manager makes poor implementation decisions.

  • To gain additional insight into the relative importance of the following three factors in terms of their contribution to overall portfolio returns:

    1. The inclusion of the following wide range of investment classes in a diversified investment portfolio:

      • U.S. stocks (married with hedging strategies discussed on page 3)
      • U.S. bonds (varied durations)
      • Physical commodities (such as oil, wheat, corn, etc.)
      • Commodity stocks (energy, base metals, etc.)
      • Timberlands
      • Physical gold & silver
      • Gold stocks
      • U.S. commercial real estate
      • Foreign commercial real estate
      • Foreign bonds
      • U.S. dividend-paying stocks

    2. The accuracy of the portfolio manager's economic outlook, and

    3. The timing of any portfolio allocation adjustments that are made by the portfolio manager.

Major Assumptions:



Summary of Findings

Figure 1

Asset Allocation Study & Portfolio Management Study - Summary of Findings



Conclusions

  1. A portfolio manager's allocation decisions, which are based on the manager's economic outlook, and the timing of those decisions, can add meaningful incremental improvement to an investment portfolio's returns. However, the most important factor in producing consistent positive portfolio returns, under conditions that are both favorable and unfavorable to U.S. stock investors, is the inclusion of the following wide range of investment classes in a diversified portfolio:

    • U.S. stocks (married with hedging strategies discussed on page 3)
    • U.S. bonds (varied durations)
    • Physical commodities (such as oil, wheat, corn, etc.)
    • Commodity stocks (energy, base metals, etc.)
    • Timberlands
    • Physical gold & silver
    • Gold stocks
    • U.S. commercial real estate
    • Foreign commercial real estate
    • Foreign bonds
    • U.S. dividend-paying stocks

  2. Within the study parameters, positive outcomes vs. the S&P 500 Index were produced under various assumptions. The common element among all the positive outcomes was the inclusion of the asset classes above in a diversified portfolio of investments.

  3. The study period (shown in Figure 1 above) is referred to as a full market cycle since it includes both a bear and bull market in U.S. stocks. Even under very conservative assumptions where the portfolio manager makes significant mistakes within the strategy's framework, the widely diversified portfolio of investments was able to produce positive returns and outperform the S&P 500 during a full market cycle.

  4. The limitations of the study, such as only reviewing one market cycle (2000-2006), and the real world application of the CCM Portfolio Management Strategy are discussed on page 2. You can review the limitations and common sense adjustments that must be made by clicking here.



Summary of Portfolio Management Strategy Studied


After performing a detailed study of asset class performance in the previous bear market and current bull market, two model investment portfolios were created; a model economic expansion portfolio and a model economic contraction portfolio. The model economic expansion portfolio combines "all weather" investments that performed well in both bear and bull markets with those that performed well only in bull markets. Conversely, the model economic contraction portfolio combines the all weather investments with those that performed well during a bear market in U.S. stocks. The figure below illustrates how the model portfolios were built.

The Importance Of Asset Allocation In A Diversified Investment Strategy



Summary of Hypothetical Historical Results


The real life application behind this investment approach is to combine elements from the model economic expansion portfolio and model economic contraction portfolio to create a portfolio that best meets the current economic and financial market environment. The historical performance of each model portfolio is compared to that of the S&P 500 under varied assumptions. As shown in Figure 3 below, the model economic contraction portfolio was able to produce positive results for investors during a period where the S&P 500 almost lost half of its value.

Figure 3

Economic Slowdown / Recession / Bear Market Portfolio vs. S&P 500

Figure 4 (below) shows that a portfolio's allocation to the proper asset classes during an economic expansion or bull market gives an investor an opportunity to outperform the S&P 500.

Figure 4

Economic Expansion / Bull Market Portfolio vs. S&P 500

In a perfect implementation of the strategy (see Figure 5 below), the portfolio manager would be invested in the model economic contraction portfolio during a bear market in U.S. stocks and then switch to the model economic expansion portfolio when the bear market ends and a new bull market begins. While accomplishing the "perfect switch" in real life would be nearly impossible, the results are explored to test the best-case scenario of the strategy's implementation. In an actual real world implementation, the portfolio manager will attempt to capture a portion of the best-case scenario returns, which would produce very attractive results.

Figure 5

Beating The S&P 500



Summary of Margin of Safety Scenarios
Manager Implementation Mistakes


The concept of margin of safety is explored by reviewing hypothetical historical portfolio performance when the portfolio manager makes significant mistakes in portfolio weightings based on inaccurate assessment of the current economic and market environment. The results (see Figures 6, 7, & 8) confirm that a properly diversified portfolio utilizing a wide variety of investment classes does provide a reasonable margin of safety even in the context of portfolio manager error.

Figure 6

Manager In Wrong Model Portfolio

Figure 7

Manager In Wrong Model Portfolio

Figure 8

Manager In Wrong Model Portfolio For Entire Study Period



Summary of Margin of Safety Scenarios
Removing The Manager - Static Portfolio


In a separate analysis, margin of safety was examined using a static mixed portfolio, which is simply held for an entire economic and stock market cycle. Under this scenario, we have removed any possible intervention by a portfolio manager to make adjustments to the investment allocation. The model mixed static portfolio is simply a 50%-50% split between the allocations found in the model economic contraction portfolio and the model economic expansion portfolio. This unmanaged buy-and-hold approach still was able to outperform the S&P 500 during an entire stock market cycle. The results show (Figures 9, 10, & 11) that if the original investment portfolio is well constructed, investors need not rely on expert timing or economic forecasts to produce positive returns.

Figure 9

Buy And Hold Approach Still Beats S&P 500

Figure 10

Buy And Hold Approach Still Beats S&P 500

Figure 11

Buy And Hold Approach Still Beats S&P 500

The purpose of this study is not to suggest that using this approach is the only way to successfully invest, but to illustrate that the vast majority of investors could benefit from investing in a widely diversified portfolio or hiring a manager who can build and manage a widely diversified portfolio for them. While the financial markets have proven time and time again that there is no magic formula for investment success, the concept of diversification into a wide array of asset classes, including some with low or negative correlations to U.S. stocks, combined with the concept of tweaking the allocation based on the outlook for the economy and financial markets, appeals to an experienced investor's common sense.



End Of Executive Summary


Protecting Your Wealth From
Inflation & Investment Losses

Historical Analysis Of A Prudent And Easy To
Understand Approach To Portfolio Management



Why This Study Is Important To Investors:
The Concept of "False" Diversification


Let us assume we have a somewhat typical, well-intentioned investor who has a real job and a real life outside of the financial markets, which limits his or her ability or desire to follow the financial markets on a daily basis. This typical investor understands the need to be diversified or to "spread out" the risk in their investment portfolio. To illustrate the concept of "false" diversification, we will also assume that this investor has growth as their primary investment objective. This profile fits many investors between the ages of 20 and 55 (still at least 5 years from retirement). In a genuine attempt to diversify, our typical growth investor builds the following investment portfolio allocation giving them exposure to a wide variety of asset classes and management strategies:

Table 1

Investor Growth Allocation
Large Cap Index Fund14%
Balanced Fund 14%
Large Cap Growth Fund10%
Value Stock Growth Fund15%
Growth Stock Fund14%
Mid Cap Growth Fund5%
Small Cap Growth Fund5%
Technology Fund5%
International Growth Stock Fund5%
International Value Stock Fund 5%
Emerging Markets Growth Fund 3%
European Stock Fund5%
Total100%


This investor may have a false sense of security thinking that they are diversified and therefore, protected against incurring significant losses in their portfolio. Below are the bear market returns with dividends reinvested for actual investments (either mutual funds or ETFs) that fit the investment allocation profile above. Mutual funds with a good performance record vs. their peers were used in order not to skew the results in a negative fashion. The investments below are listed in the same order as the allocation above.

Table 2

Allocation's Bear Market Returns
S&P 500 Index ETF-46.01%
Fidelity Balanced-16.14%
Fidelity Large Cap Stock-51.95%
Putnam New Value-18.86%
ING Growth-61.77%
Janus Enterprise-75.35%
Fidelity Adv Small Cap-45.25%
NASDAQ 100 ETF-79.61%
T. Rowe Price European Stock-44.84%
MFS International Value-31.38%
Templeton Developing Markets-28.74%
AIM European Growth-44.69%
Average Weighted Return-42.49%



Figure 12

Buy And Hold Approach Still Beats S&P 500


It seems reasonable to believe that twelve different growth investments would offer some type of downside protection in a difficult period for U.S. stocks. If you are like many investors, the current bull market has lulled you into thinking that you are diversified. The "diversified" portfolio above would have declined by 42.29% during the bear market. During the same period, the S&P 500 declined by 46.01% (as measured by the dividend reinvested performance of the S&P 500 ETF).

The fact that the investments above all declined when the S&P 500 declined and that they declined in similar magnitude tells you all these investments have a high positive correlation to the S&P 500. A high positive correlation means when the S&P 500 goes up, all the investments tend to go up and when the S&P 500 goes down, all the investments tend to go down. Now you can see why the term false diversification applies. One of the purposes of this study is to attempt to show that there is a better way to build a portfolio of investments that offers real diversification and an opportunity for improved returns.



Building A Truly Diversified Portfolio
Understanding Asset Class Correlations


If one of your primary objectives is to produce positive investment returns while having a low probability of incurring losses in a reasonable time frame, you must first understand how different asset classes behave in different economic and financial market environments. For the purpose of this writing, the terms economic contraction, economic slowdown, recession, and bear market are used to describe periods of economic weakness, which have resulted in prolonged periods of declining stock prices. On the other hand, the terms economic expansion and bull market refer to periods where the economy is healthy and stock prices are moving higher.

The portfolio management strategy described here attempts to minimize exposure to investment portfolio losses during bear markets in U.S. stocks. Figure 13 below illustrates how different asset classes performed during the last bear market in U.S. stocks. The S&P 500 began a period of significant declines in late August of 2000. As the U.S. stock market began to anticipate an economic recovery, the S&P finally found a bottom on October 7, 2002. The asset classes in Figure 13 are shown in their order of performance during the period. Gold stocks were the biggest winners and U.S. small cap stocks had the worst performance during the period. The data in Figure 13 is taken from the actual performance of specific investments within each asset class. For example, the returns for gold stocks below are those of a widely held gold stock mutual fund. Figure 13 shows returns with dividends being reinvested. Dividend reinvestment explains why the Vanguard 500 Index Fund slightly outperformed the S&P 500 Index. Using the data below, we know that it may be prudent to reduce exposure to holdings in emerging market stocks and small cap stocks when the economy is entering what may be a prolonged period of slowing economic growth.

Figure 13

Asset Class Correlations In A Bear Market





Identifying "All Weather" Investments


Since we are attempting to build portfolios that can be profitable in both bull and bear markets, it makes sense to identify asset classes that were able to produce positive returns in both environments. These "all weather" investments can serve as the core of any well-diversified investment portfolio, which seeks to minimize the probability of investment losses. Within the context of the studied portfolio management strategy, the all weather investments are used as core building blocks to create a model economic contraction portfolio and a model economic expansion portfolio. Every asset class (represented by a single proxy investment) in Figure 14 below was able to produce positive returns during the entire full market cycle, but more importantly, they were able to produce positive returns from August of 2000 to October of 2002 when the S&P 500 (shown in red) was in a serious bear market.

Figure 14

Asset Class Correlations All Weather Investments


Click Here To Continue - Asset Allocation Study

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Chris Ciovacco is the Chief Investment Officer for Ciovacco Capital Management, LLC. More on the web at www.ciovaccocapital.com

All material presented herein is believed to be reliable but we cannot attest to its accuracy. Based on market conditions, CCM may use inverse or short funds to hedge long postions. The information contained herein (including historical prices or values) has been obtained from sources that Ciovacco Capital Management (CCM) considers to be reliable; however, CCM makes any representation as to, or accepts any responsibility or liability for, the accuracy or completeness of the information contained herein or any decision made or action taken by you or any third party in reliance upon the data. Some results are derived using historical estimations from available data. Investment recommendations may change and readers are urged to check with their investment counselors and tax advisors before making any investment decisions. Opinions expressed in these reports may change without prior notice. This memorandum is based on information available to the public. No representation is made that it is accurate or complete. This memorandum is not an offer to buy or sell or a solicitation of an offer to buy or sell the securities mentioned. The investments discussed or recommended in this report may be unsuitable for investors depending on their specific investment objectives and financial position. Past performance is not necessarily a guide to future performance. The price or value of the investments to which this report relates, either directly or indirectly, may fall or rise against the interest of investors. All prices and yields contained in this report are subject to change without notice. This information is based on hypothetical assumptions and is intended for illustrative purposes only. THERE ARE NO WARRANTIES, EXPRESSED OR IMPLIED, AS TO ACCURACY, COMPLETENESS, OR RESULTS OBTAINED FROM ANY INFORMATION CONTAINED IN THIS ARTICLE. PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS.Legal Restrictions and Terms Of Use