Once the correct investment portfolio is built on day 1 according to your risk profile and preferences (see all previous reference guides here for more insights if needed)...
...how often should you change (or ask your advisor to change) your portfolio as market conditions evolve over time:
=> daily?
=> often?
=> sometimes?
=> never?
Here two financial theories clash.
Buy and hold: a static approach
First, some say that investing is only appropriate and valid when done for the long term.
This basically means that the investor should buy good asset classes at good valuations and leave them there for long enough, ignoring market changes.
Such theory is backed-up, for example, by the fact that the S&P500 (?US equities) have generated average returns for +8% per year over the past 100 years (see chart).
Long term investing would capture those average returns and would in fact suggest that a static approach would be appropriate, on top of limiting trading costs. Buy and hold would then seem to be the most appropriate solution.
You can check some famous static investment portfolios here.
The issue is that some good quality assets like US equities grow consistently over time, assuming they are bought at good value (challenging to know in real time), but other assets do not experience the same journey.
Take a look at the two charts below.
The first chart on the left shows the same S&P500 only in the past 30 years. We can notice that from a peak in August 2000 during the dot com bubble to February 2015 (=> yellow area) that the returns remain negative, meaning that for investors who bought at expensive prices close in the summer of 2000 it would take more than 15 years to get positive returns.
That's a long time to keep losing money. The buy and hold strategy would have not worked for those investors, unless they had an investment horizon longer that 15 years and had nerves of steel to remain invested after major losses over time. Ouch.
The second chart shows another asset class, Japanese stocks, represented by the Nikkei 225 index. We can see that the market has not yet reached its past peak from December 1989 over 30 years ago. Buy and hold also would have not worked for many investors buying in the mid eighties to the mid nineties, and the experience in Japan has remained challenging for many others.
Our take then is that static portfolios work for some, do not work for some others. In general terms, static portfolios can work for patient investors knowing when to buy the right assets at cheap valuations, who know how to hold without panic in periods of volatility. But there are not many Warren Buffets out there.
Moreover, jokes aside, our experience in financial markets working with private bankers, financial advisors and institutional investors is that their end-clients (individual retail investors) constantly judge their portfolio returns in the short term, maximum over one year.
The implications of this typical short-term mentality driven by fear is that static portfolios get changed often when not performing properly, ending with the wrong behaviors of selling loss-making, cheaper assets and buying expensive assets holding up when volatility bites. Ouch, again.
A better proxy solution would be to constantly buy small portions of good asset classes (think S&P500 in US or Stoxx 600 index in Europe) over time, for example on a monthly basis in small amounts, to reduce the risk of buying in bulk at the wrong price. Such technique is called dollar-cost-averaging and can improve the performance of a static portfolio especially in times of higher market volatility.
An alternative solution to the problems highlighted above is dynamic investing.
Change over time: a dynamic approach
Using a professional but perhaps complex vocabulary, we can say that in a static portfolio optimization process, the structure of the investment portfolio in which the investor’s wealth is invested is chosen once and for all at the beginning of the period. In a dynamic optimization process, the structure of the portfolio is continuously adjusted.
In simple words, a dynamic portfolio changes over time.
In other words, dynamic asset allocation is a portfolio management strategy frequently adjusting the mix of asset classes better suited to specific market conditions. The stock and bond components of a portfolio can be adjusted based on where we are in the economic cycle, the health of a specific sector, or investor sentiment.
Does dynamic investing outperform the static approach?
As one of the many available, check here one of the various comprehensive studies done on a balanced portfolio of US equities and US bonds, where a dynamic approach generates higher returns with a comparable risk level vs a static approach, or just see the final results copied below (green column: the dynamic portfolio wins).
Sourcing a practical example from Investopedia, imagine that global equities enter a six-month bear market. An investment manager using dynamic asset allocation may decide to reduce a portfolio’s extensive equity holdings and increase its fixed-interest assets (=government bonds) to reduce risk. That would help returns. Then, if and when economic conditions improve, the manager may increase the portfolio’s equity allocation again to take advantage of a more bullish outlook for stocks.
Get the point?
Implications of dynamic investing
For investors keen to explore an investment approach promising better returns and better diversification over time than a simple static one, dynamic investing would be the right option.
The reality of things is that economic conditions change constantly along the economic cycle, as we have reported in a specific article. The approach of ignoring such changes and investing in a static portfolio could work if we buy the right things at the right price, both elements that tend to be like a lucky draw.
Dynamic investing instead makes you focus and invest in what works best in a specific market environment. Of course, the success of a dynamic asset allocation depends on the making good investment decisions at the right time.
That's difficult and requires investment skills and resources not available to the casual investor. In fact, critics of the dynamic approach say that actively-managed, dynamic portfolios are not only costlier to run than static portfolios (on higher trading costs) but also tend to be much more labor-intensive.
Fair?
Let's dive deeper into the fund management industry's practices and thus some of the most interesting insights from this article.
If we look at the way active fund management companies manage their blockbuster funds, we can learn that they deploy significant resources, in terms of number of analysts and researchers, technology and market access, to dynamically buy and sell on a daily basis bonds and stocks within specific focused strategies.
What we mean is that dynamic investing is done within a specific section of the market, for example within emerging market bonds, or global equities. This approach allows them to work within a specific asset class with known behaviors (say global equities), while offering superior expertise in selecting what single stocks or single regions can perform best in any given moment.
You can spot an issue here: dynamic investing is done within an asset class (let's call it "dynamic type 1") and now throughout all asset classes ("dynamic type 2").
This is because the clients of fund management companies, clients who are professional investors that go from financial advisors to private bankers to investment consultants to to complex institutional clients (let's call them all the middle managers here), love to select and buy a specific expertise within a specific area of the market, not to do it themselves (lacking skills or access or time), but then they can decide themselves how to compose the final asset allocation of the entire portfolio of their end clients, and justify their fee.
A-ha!
No scandals here, that's cool enough if done properly.
The issue for the end client is when these middle managers promise to dynamically manage the end-client final asset allocation and then they don't, if not for a quarterly rebalancing, which is typical.
As a consequence of the role of these middle managers, investment companies do not tend to build and dynamically run many investment funds freely allocating through stocks, bonds and other asset classes (= "dynamic type 2").
Those multi-asset propositions would be the holy grail of investing if done property across the economic cycle, but middle-managers often do not like it, often cannot buy them (as they do not control the risk limits of the asset allocation) and sometimes fear that they would be ultimately replaced by these flexible propositions.
Let's say that retail customers/end-clients with the DIY hat...
...or enlightened financial advisors capable and happy to mix their own asset allocation framework with some external dynamic ideas, would be open to the idea of investing via a dynamic proposition of type 2.
Then, what's next?
A first option would be to search for multi-asset, fully dynamic propositions at major active fund management companies, as the ones proposed by the likes of Allianz, Fidelity, M&G, or Pimco. The talent of a specific fund manager would hopefully shine through in a specific market environment, while it is typically harder to find a consistently positive net return over time.
A proposed innovation
Here at Monetharia we are building what we call adaptive investing. In other words, we are building a dynamic investment system ready to self-adapt, powered by AI and human experience, designed to perform in any market conditions:
=> the system observes and understands what is going-on in markets
=> as market conditions change, our portfolio will automatically change and adapt
=> aiming to deliver great performance in any market environment
Did we report that critics say that proper dynamic investing can be labor-intensive?
Well, we have designed a powerful systematic engine, supported by AI algos, that can observe and spot opportunities in markets in any moment.
Do systematic signals fail when the economic cycle turns?
This is when our team of economists will leverage our tools to spot a pivot in the cycle and adapt the portfolio accordingly.
Did we also report that dynamic solutions suffer from excessive trading activities?
Well, our dynamic portfolio will only buy and sell passive ETF funds in the desired asset classes, minimizing trading activity in single bonds and stocks.
Conclusion
Some financial experts predicate on the qualities of static portfolios, while others prefer dynamic solutions.
While static portfolios are much easier to implement, they usually fail to offer the correct diversification required when the economic cycle changes. Their success also depend on buying at cheap valuations, something that is not always easy to do. If dollar cost averaging can help, the diversification risk remains.
Dynamic portfolios can theoretically perform better across different market environments, but only if trading the right assets at the right time, with the right (extensive) resources and avoiding excessive transaction costs, something that is also hard to achieve.
At Monetharia we are building an adaptive investing system led by a systematic investment engine, powered by software rules and AI, that is supported by human skills to identify changes in the economic cycle. With the capabilities from the best of both worlds and the ability to act on passive funds to reduce transaction costs, we believe we are offering a very new, successful investment solution for retail and wholesale customers alike.
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If you are learning about investing, here's a good list of solid readings:
US, available via Amazon.com
Cycles: the science of predictions
Principles for dealing with the changing world order
Principles for navigating big debt crises
Ray Dalio's principles: life and work
Unconventional success: fundamental guide to investing
SPAIN, available via Amazon.es
Nuevo orden mundial by Ray Dalio
Crisis de gran endeudamiento by Ray Dalio
Invertir en bolsa a largo plazo
Estrategias de diversificacion
All pictures are sourced via pexels, unsplash or freepik
