The less obvious thing to consider is that as something loses value, something else should gain value by about the same amount as money will flow out of one asset, and either remain in cash or go elsewhere. This doesn’t always translate as more or less goods being produced and consumed as well as inflation and deflationary effects and the expanding and contracting on debt will influence the prices. But the theory is that if inflation occurs, everything goes up, and cash goes down proportionally to the sum of all goods. As resources become scarce standard of living may go down, but investments in food and energy and materials go up.
The conclusion that can be derived from this line of thought is that in order to ultimately preserve the purchasing power and standard of living that your money can buy you, you need to be diversified among multiple asset classes, as this will protect you from dramatic outflows of cash from one asset and into another.
Additionally, it would be wise to rebalance your portfolio to take advantage in inflows into various assets by selling an asset, while also increasing shares to take advantage of cash outflows.
This is more of a defensive way to invest, however if you are somewhat active in rebalancing the portfolio, you can buy stocks lower, sell them higher, and make profit from people that get carried away buying up one asset class, or those that get carried away in selling, while maintaining a safe balance that defends against both inflation (by owning precious metals and commodities) and deflation (by owning cash, bonds, and foreign currency). There are imbalances and uncertainties on every day, and various individual stocks may easily fluctuate a percentage point per day. The more active you are in rebalancing, the more cash you should have on the sides as well as your investments to prevent slippage from fees and to allow yourself the cash to continue to add shares in areas that are down.
In an imaginary world, lets say you own multiple assets and all of these are worth $20 per share which also represents 1 pound of that asset. A pound of cash is $20 which is worth a pound of oil and a pound of gold and will buy $20 worth of stocks. In this imaginary world the total amount of each that exists in circulation is 1000 pounds of each asset exactly, all in circulation and traded.
If 20% is allocated towards each and shortages in oil result in oil going from $20 per pound to $40 per pound as there are fewer pounds to distribute and just as many people want to buy your pound, then your portfolio would become out of balance. Now if people around the world are more willing to pay for oil, that means that either your pound of cash cannot buy as much things as there are now more pounds of cash available to pay for the oil, or it means people are going to sell their bonds or another asset class to pay for it. Lets say they sell their gold. This means there is more gold in supply, they were willing to take less for gold and that’s the way things go. Now Gold might be worth half the amount and is $10 per pound. Everything else went up slightly, meaning your cash percentage went down as a result.
So now what once was 20% allocation each now is 10% cash, 20% bonds, 20% stocks 10% gold and 40% oil. You should then sell half of your position in oil so you have an even distribution, and use half of the proceeds to acquire more gold at a better price. Now if gold returns to it’s $20 per pound, you have 50% more gold, so it’s worth 50% more, even though it’s at the same price you bought your initial stake. Meanwhile, oil could now return to it’s initial price and you could actually buy more and own more than you did before. Everything balances out back where it started, but you end up ahead because you rebalanced your portfolio.
If you assume it is an efficient market which cannot be timed, in the long run everything balances out and returns to normal and the only way you can gain from that is by selling higher and buying lower. Unless something in your portfolio becomes obsolete, even a situation where one asset continues to sell higher and higher (like gold) and another goes lower and lower (like oil), eventually you would own more and more of the asset like oil and less and less of gold. The result is that over time, there is less oil in supply and when the demand returns, you control more of the supply and have more of a monopoly on it. On the other hand, although gold may be scarce to trade, you would still always own some of it as it goes higher, but as it becomes more affordable, you can buy more and more until it becomes scarce again. Ultimately by rebalancing it you should gradually gain shares of the less scarce until it becomes scarce (or at least publicly available oil becomes scarce), and sell shares that are scarce and continue selling as they become more scarce, until others are more willing to sell and it becomes abundantly in publicly available supply again. This imaginary world doesn’t take into account the fact that some assets may be consumed, others may become obsolete, and more stuff is produced, including money in supply but it still illustrates the concept behind this multi-asset strategy, However, the hope is at least these things will balance each other out over a long period of time.
It’s generally smart to wait a fairly significant period of time before rebalancing your portfolio as you can avoid paying too many fees. Additionally, by constantly rebalancing, you miss out on taking advantage of the large price runs by letting your earnings in one area compound, which may especially happen with global trends (of various countries fearing currency collapse and continuing to buy gold and smart investors followed by the public until finally there’s very little demand left to consume any more at the same price) so it’s not necessarily better, even if you can take advantage of regular market fluctuations, as you will miss being more heavily invested in your winners, and you will over invest in your losers which is a riskier strategy than it appears to be at the surface.
Regardless, this strategy allows you to take advantage of the volatility through rebalancing, while having a very defensive portfolio.
In theory, you should be able to ramp up this strategy by adding options, leverage, and perhaps taking a company public and issuing shares so that you can leverage investor capital to take over businesses and use their assets to invest as well. But that works only if this strategy is effective and you are able to manage your money well.
Lets say you have $10,000.
We are going to break this up into 6 asset classes.
1) Precious metals like gold and silver via a precious metals fund like DBP, or the individual ETFs for various metals like gold(GLD) silver (SLV), platinum(PPLT), Palladium(PALL),etc.
2) Comodities like oil via either a commodity fund like DBC/GSG or long individual commodity names like oil (USO), natural gas (UNG), Agricultural (DBA), etc
3) stock index funds like SPY or global etf like the all world fund ACWI
4) Short term bonds etf like SH
5) A Mixuture of Currency ETFs like FXC, FXA, cash in dollers and bet against the dollar via UDN.
6) Short real estate via REK. You can certainly be long this name and short banks, or long this name and do without shorts. I just think that since there are investors that already have a lot of money tied up into their own home or living arrangements which will increase in price that this is smart. If you own a house I would suggest REK, if you pay rent and live at an apartement building or have a lease on a house, I suggest RWX(long real estate). The logic is that if you own a home and prices go down it will impact your finances, but if you have a hedge via short real estate you may be able to protect yourself a little bit. If you pay rent on the other hand, increase in real estate prices and available credit will likely increase the rent you pay, so you can hedge the higher rent payments by being long a real estate ETF.
If you would prefer to start with a slight bias because you have a macro economic view that you believe to be accurate, you may, however, if you are going to execute this strategy evenly and take the assumption that you have no clear edge, you should take 10,000/6 or $1666.67 per asset class. Since in this example our capital is somewhat limited, we are only going to own one name per asset class with the exception of owning cash along with the currency etf.
$1666.67 Precious Metals (DBP)
$1666.67 Commodities (DBC)
$1666.67 Stocks (SPY)
$1666.67 Short Term Bonds (SHY)
$833.33 Short the dollar against other currencies (UDN), $833.33 and long cash
$1666.67 Short real estate (REK)
Edit:Due to inefficiencies via shorting the market and being long instruments that short the market, this has been modified. Instead of shorting real estate, the money should be added to various currencies. This way you have 50% in assets that benefit from inflation (metals, commodities, stocks) and 50% in deflation (bonds, dollar, other currencies) so you have an even balance.
Now in this mock portfolio we will try to emulate it as best as possible. We actually don’t really need a case study for this since we can instead back test effectively.
Lets say the plan is to rebalance every 4 months. Bonds will not be rebalanced as they don’t move much anyways. We have to make sure we dont’ start tracking this strategy before the ETFs listed above existed. So we will start from Jan of 07.
This experiment/case study/backtest will error on the side of more cash then listed. If you can own somewhere between 54 and 55 shares, 54 shares will be owned, even if the value for 54 shares is $1500 while the value of 55 is $1670. In order to track from 07 we will substitue UDN of FXC and 1/2 the position size of SRS for REK. This will also result in additional cash. Additionally the first month SRS will not be owned as it was not available for trading until Feb of 07.
SRS would have to be rebalanced much more often to take advantage of the volitility, or else it would have to be sold at the extremes. So we will automatically sell half if it is up 50%, and the remaining if it is up 100% during a single period.
Since SRS is based upon leverage, it probably will be an ineffecient vehicle, so we will also test without using it as well.
So after testing it with SRS, I could not really come to much of a conclusion, other than it’s a good method to protect your wealth and it seems to have upside.
Here is the information:
Allocation approximately:
DBP, DBC, SPY, SHY, all 16.67%
FXA and SRS 8.3%
Remaining in Cash
Starting capital $10,000. Rebalancing takes place every 122 days or about once every 4 months.
First period from 1/1/2007 to 5/3/2007 68 shares of DBP 73 shares of DBC 11 shares of SPY 2684.63 cash, 10 shares of FXA and 0 shares of SRS were held. Total value $9,972. (after $7 per trade of 5 trades)
I won’t tell you the exact amounts that were rebalanced, but I may upload an XLS doc or post it on google docs later on.
After end of first period, total value 10321.13
5/3/2007-9/2/2007
Total value 10561.13
9/2/2007-1/2/2008
Total value 11515.63
1/2/2008-5/3/2008
Total value 11936.13
5/3/2008-9/2/2008
Total value 11111.63
9/2/2008-1/2/2009
Total value 10414.63 (SRS rebalanced twice)
1/2/2009-5/4/2009
total value 10414.63
5/4/2009-9/3/2009
total value 10319.63 (SRS sold half)
9/3/2009-1/3/2010
total value 10791.48
1/3/2010-5/5/2010
total value 10607.98
Although it was volatile, the results never declined below the starting capital. Not necessarily the best investment strategy in the world, and it is clear that the investment in SRS was not an effective substitute even if sold at the extremes. However, this is a return on the total portfolio with expenses (as opposed to ignoring cash and only including the investment portion and ignoring expenses), and is a very defensive strategy that aims to protect against losses more so than seek gains. Considering the market volitility and downtrend in 2008 and considering the total return on the S&P over that same period decreased, and the SPY decreased by over 17%, I would say that this is a reasonable defensive strategy. This isn’t designed to win any stock picking contest or anything. It’s not designed to try to time the market. Sure, you could point out that DBP went from 24.25 to 40.60 over this 3.333 year period, or that FXA went up from 79 to 92.50 putting 100% into these stocks would have better results, but that’s making an irrational assumption that you could time the market, and that you will always be right. However, if you do believe that you could have seen the rise in gold coming, you could have actually still used the same strategy only with different allocation. Perhaps 25% precious metals and 25% commodities and 25% austrailian dollar and only a small portion of bonds, S&P, cash and SRS would have been prudent while still allowing you to capitalize. Additionally, perhaps not rebalancing the portfolio as much so that you can let your winners run and not reinvest in the winners will result in better gains. Actually, as it turns out, you only gain under 4% over the entire time without rebalancing as opposed to over 6% with rebalancing even after fees.
Up next, I will share the results without SRS.
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