Thursday, May 28, 2009

More on Failures of Standard Asset Allocation Models and Target Funds/Use of Volatility in an Asset Class to Make Adjustments to an Asset Allocation

I have discussed in several posts that a major source for the failure of a standard asset allocation model  is the failure to use the volatility of an asset class as a tool in making allocation decisions. I wanted to illustrate the point with a simple asset allocation scheme that I would never use myself.  I will assume an investor has two assets, the ETFs SPY and IEF.  SPY is an ETF for the S & P 500 and IEF is the ETF for the 7 to  10 year U.S. Treasury. You could also use IYY, an ETF for the total stock market and BND, for the Total Bond Market.  I would add one caveat before I start. I am not set up to run numbers with a computer program, and I therefore can not do these calculations precisely.  I just want to get a general idea about the performance of a very simple asset allocation scheme, which I would never use, that takes into account one additional factor: the risks associated with enhanced volatility.

I will be using the VIX Asset Allocation to make decisions, so I will pretend that I know nothing whatsoever about what is happening in the real world.  Vix Asset Allocation Model Explained Simply With as Few Words as Possible VIX Chart from 2007: Alerts and Triggers Major Disruption of Cyclical Stable Bull VIX Pattern

I will do a simple reversal in the allocation scheme from 60% in SPY and 40% in IEF when the VIX model flashes a green signal, and 60% in IEF and 40% in SPY after the red signal. 

I will start in 2002 first, where the allocation would be 60% in IEF and 40% SPY. I will change the allocation to 60% SPY and 40% IEF on 10/27/2003 when the VIX is showing stability at below 20, after spending several years in an elevated unstable pattern. The VIX closed that week at 16.1, a reading consistent with a bull market pattern. The VIX had been mostly below 20 from early May 2003 with small advances over the 20 demarcation line, and then falling back below 20. I would call this the formation of a Stable VIX Pattern, an investable bull market in stocks under the VIX Asset Allocation Model.   The VIX stays in the stable pattern until a Trigger Event in August 2007.  This would cause a switch back to 60% IEF, and I would just wait to that until the VIX fell below 20 which occurred on 9/17/07.  So this is how the simpleton allocation scheme described above would be done with the VIX Model:

60% SPY 10/27/2003    S & P 500=   1050   
Back to 40% 9/17/07 :    S & P 500     1525
STILL AT 40% 5/27/2009  S & P 500 AT 893 

IEF 40% 10/27/2003: $84.6 (adjusted by Yahoo to $67.85 to reflect subsequent dividends)
CHANGE TO 60% 9/17/07 USING ONLY VIX MODEL: $$83.43 adjusted to $79.68 
STILL AT 60% 5/27/2009: $89.96 

I am not set up to figure returns after reinvestment of dividends or even the impact on return from dividends. Clearly, however, using a volatility model to make adjustments to the stock allocation would have been very useful during this period. 

For the second period of time I will just take the S & P 500 numbers. I discussed this period from 1990 to 1997, and included some charts for  both the VIX and S & P 500 in the following post:  
In March 1991, the VIX is showing a clear pattern of stability in the 14 to 16 range. There is a Trigger Event in October 1997 Yahoo! Finance, so I will wait until the VIX falls below 20 after the Trigger Event to make a change in my simple allocation plan. This happens on 2/8/1998. 

W/E March 14, 1991:           S & P 500 at 373
W/E February 2, 1998:       S & P 500 at 1012 (above where it is now)

It is apparent that a simple model, which takes into account volatility in making asset allocation decisions, would have enhanced returns over a static model which would make adjustments based on age.

All of the foregoing is just an illustration of how an intelligent use of volatility patterns would beneficial.  The actual changes in an asset allocation plan would vary based on each person's own unique profile and situational risks. The simple allocation that I am using here is just for illustrative purposes only.  

Just speaking for myself, which is all that I ever do in these posts,  my VIX model was developed in 2007, and I did shift money out of stocks that year, raising both my cash allocation and my short term bond allocation in a substantial manner. If I had faced situational risks, which I do not, I would have shifted even more out of stocks. My purpose was just to raise funds to invest in stocks later at a more favorable price than prevalent in 2007 after the Trigger Event in August 2007. I am after all a Stock Jock. But, you need to ask yourself this question. Is your asset allocation model which does not account in any way or form for volatility working for you over the past 10 years?  Remember President Reagan's question to voters (framed with a 4 year time reference: US News and World Report): are you better off now than you were 10 years ago? And, would you have been better off if that target fund or financial advisor had made at least some changes in stock and other allocations based on the risks associated with enhanced levels of volatility.


This is a continuation of my discussion about target funds contained in these earlier posts:





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