Both of the funds that we’ve recommended three weeks ago, a bond fund and a Mexican stock fund, have done well. We see more potential growth for them and are therefore continuing to recommend them this week.
Monthly Archive for October, 2009
Question: I have been looking to get better returns from my TSP. However, I have trouble following any method without knowing how or why it should work (much like you state in your bio). I could not find any solid reasoning on your site. [Could you please describe your method.]
Response: There is a general framework for making investment decisions called “asset allocation”. This framework is popular with academics because, unlike technical analysis indicators, for example, it has a theoretical basis. However, the framework itself leaves out some details that you need in order to actually implement it. My method is an implementation of asset allocation, in which (I think that) I have worked out these details.
Here is how asset allocation works. Each investment has two characteristics, one called expected return, and the other called risk. Intuitively, here is how they are defined. If you took a large number of unrelated investments with the same expected return, then, on average, they would give you this expected return. Risk is a less clear concept. Usually, risk is taken to mean the standard deviation of logarithmic return, which is also called “volatility”. This is a good definition of risk because it is easy to understand — higher uncertainty in future returns means higher risk. However, the definition has some weaknesses. I have developed another definition of risk which I use in my algorithm.
Both expected return and risk are estimated from historical price data. In other words, mine is a “technical” system — it only uses historical price data. It does not use any “fundamental” information, such as earnings. The argument for technical analysis as opposed to fundamental is well known. Even if you think that fundamental information is relevant, by the time you, the investor, hear of it, a lot of other people have already heard of it and acted on it. Thus, any relevant fundamental information is reflected in the price before you even hear about it. By analyzing price, you can know all the relevant information. Plus, of course, technical systems are easier to test on historical data. Simulated performance is one of several pieces of evidence that your system works. See below for more on this.
(Just to clarify, even though asset allocation is a technical approach, it differs from most other technical analysis systems. Most technical analysis uses indicators, such as moving averages, or chart patterns, or other similar methods. However, there is no theoretical basis for those approaches.)
Since expected return and risk change with time, how to properly estimate them is a very big question. Many asset allocation methods, such as the one used by the Lifecycle funds within the TSP, actually assume that these investment characteristics do not change with time. I think that this is a major mistake.
Just as each investment has an expected return and risk, so does every combination of investments. Asset allocation says to pick the mix of investments that maximizes the expected return while not exceeding a fixed maximum risk. Of course, there is a huge number of investment combinations. Thus, it is not possible to check all of them using a “brute force” approach. However, with a good search algorithm, you can find a mix of investments with a high expected return that does not exceed your fixed maximum risk. That’s all there is to it. 
In my newsletters I give two allocations. The difference between them is that they have a different fixed maximum risk.
Both of the funds that we’ve recommended two weeks ago, a bond fund and a Mexican stock fund, have done well. We see more potential growth for them and are therefore continuing to recommend them this week.
It has been a year since we have launched our TSP newsletter. So let’s take a look at how the newsletter has performed over the past year. Note that what I am discussing here is real, verifiable performance starting on October 15, 2008, the day that the first issue of our newsletter came out. I myself am following the Balanced recommendations in my own TSP account. You are welcome to verify for yourself that the performance that I am describing is accurate.
Over the past year, out Conservative allocation had a return of 7.90%; our Balanced allocation had a return of 17.70%. While these are very healthy returns, it is important to remember that return is not the only measure of performance. Another important performance measure, which we take into account as part of our investment methodology, is risk. One common measure of realized risk is called maximum drawdown (MDD). MDD is the largest drop in equity, measured as a percent. Low MDD implies low risk. MDD for both of our allocations over the past year was just 4.01%.
The fact that the “buy and hold” approach to investing can be very dangerous has recently been brought back to public consciousness. MDD for the C Fund, which tracks the famous S&P 500 stock index, has reached 55.22% earlier this year! MDD’s for the other two stock funds within the TSP are even higher — 57.43% for the S Fund (“Extended Market”) and 60.89% for the I Fund (“Europe Pacific”). Despite the media reporting a recovery, as I am writing this, the three stock funds are still down about 25% to 30% off of their peaks. In my opinion, such huge drawdowns are not acceptable.
It is always important to have a solid investment strategy, especially in risky times like these. I believe that we have such a strategy. Ours is a scientific approach developed by a Ph.D. statistician. We consider not just the return but the risk as well. Our method adjusts to changing market conditions, is fully automated, and tells you exactly what to do. If you find our newsletter helpful, please help us spread the word by telling your friends and coworkers about it. Also, write about us on various blogs and online forums.
Thank you!
Alex, I understand nothing is guaranteed but I just have a “peace” about following you. I’ve read other websites but they feel too business / Wallstreet like. Not bussinesslike or caring, which I get the impression you are.
-K.
Both of the funds that we’ve recommended last week, a bond fund and a Mexican stock fund, have done well. We see more potential growth for them and are therefore continuing to recommend them this week.
Thanks for sharing your TSP and ETF recommendations. I’ve been following both for several months.
-R.R.
Got it. Now that I understand your strategy, I will follow your advice like a little sheep. A happy and grateful little sheep.
- P.V.
I receive your E-mail and love the advice that I receive from it.
- W.B.
Though stocks have been moving sideways for a month, they still have great potential at an acceptable risk. In our Conservative allocation, however, we are keeping almost all our money in the money market, since stocks still do definitely have a noticable risk.
If you are also receiving our ETF newsletter, you might note that, in that newsletter, we’re recommending putting most of the money into bonds. Someone might ask why we’re not doing the same in the TSP letter, by recommending the F Fund. The answer is that though both the F Fund and the fund we’re recommending in the ETF letter are both bond funds, these bond funds are different. The ETF recommendation invests specifically in high yield corporate bonds. Such a specific bond fund is not available in the TSP.
Though investment grade bonds (LQD), which we recommended last week, have lost money over the past week, bonds still do look like a good investment. This week, though, we are switching into high yield bonds, as they have more potential. Stocks continue to be risky, though the risk of Mexican stocks is low enough for us to put some money into them. All investments, including bonds, are now too risky for conservative investors. We are thus recommending all cash in our Conservative allocation.