I love investing, and I love finding the most interesting and optimal way to do it, then keeping an eye on things every day to see how they go.However, I do realize that not everyone shares this goal. Sometimes apretty simple method to do pretty well is what you really want.A good way to avoid losing tons of money in the market is to get outof the market when risks are higher, using some sort of timing system.This post's approach is a bit different: a long/short hedge.Don't get scared---this can be pretty simple too.First, a few words about the stock investment chosen.Let's assume that your target "long" investment is the US stock market.I started with monthly total returns of the S&P 500, as tracked by an ETF (SPY).But, in recent years, I have become a fan of RSP, an ETF which tracksthe S&P Equal Weight index. Same 500 stocks, just weighted equallyrather than by market cap. This performs a whisker better on averagethrough the years. More recently still, PRF has become available, whichdoes a whisker better yet, by buying large cap US stocks in proportion to an estimate of their intrinsic value, rather than their market cap.For example, if stock A has twice as much in the way of book value,earnings, assets, and dividends as stock B, buy twice as much of Aas you do B, without regard to the current market cap of A or B.This avoids buying too much of stuff which is currently overvalued.In any case, this long process was simply to say I've used thebest currently available broad US equity ETF available at each point.I simply spliced the more recent RSP onto the SPY series, then replace that with PRF when it came available. So much for the "long" part.(remember, everything in this post is calculated on month boundaries only).For the short part, the obvious thing is to bet against the average,but that won't do much good since in bad times you'll be market neutral.Shifting some or all of your money into a market short position isthe same as shifting some of your money into cash. Can we do better?Early results say "yes". I like the fund BEARX, the Prudent Bear Fund,which is a US mutual fund (trickier for those of us outside the USto purchase, but not impossible). I have used it off and on since September 2000, and have been very happy. It is actively managed,so, its tracking error versus an inverse index is a bit variable.To the bright side, they do a LOT better than the negative of theS&P 500. For example, their trailing 10 year total return has been+1.94%, versus the S&P's return of +5.14%. Needless to day, +1.94%is a lot better than -5.14%, which is what a perfect negative-marketfund would have given you. If you look up this fund's price historyfor yourself, be sure to include dividends. They get quite a surprisingreturn from the small number of long postions they hold.Now, simply holding an optimal mix of this long/short pair doesimprove risk adjusted returns a lot, but it isn't going to make yourich. My tuning gave an optimal mix of 38% short and 62% long.This gives an annual return of 7.1% a year, which is 1.8% less thanbeing 100% long all the time. However, it makes a profit in over 94%of rolling 12-month periods, which ain't what you get with the S&P at 74%.The worst rolling year goes from -26.4% to -1.9%The worst drawdown goes from -44.9% to -5.9%There are those who might like this smooth ride, and be willing topay a penalty of 1.8% per year for the privilege.But, that's pretty boring. Can we do better?Well, needless to say, it would be nice to be more long in bull marketsand more short in bear markets. Since we are using both long andshort, our timing doesn't have to be very sophisticated at all, sincewe aren't fully exposed to the market any of the time.This is really the key point of this post.So, for a timing signal, I simply check at the end of each monthwhether the current value of my long market fund (after dividends!)is higher or lower than the average of the last 12 month ends.This is calculated as the current month end and the 11 prior ones.Here's the suggested scheme:Market fund at least 1% above its average: 15% BEARX, 85% long US stocks, no cash.Market fund less than that: 30% BEARX, 0% long US stocks, 70% cash.(the extra 1% is a tweak that adds a whisker of performance but isn't necessary)The "optimal" would actually be even more long and less short basedon the backtest period, but I don't really trust this simple timingsignal enough to be 100% long for this discussion. So, I simply forced it to have no more than 85% net long (15% short position) at all times.How well does this work?In short, about 3% better market returns than buy-and-hold with about 37% of the risk.I defined risk as a weighted sum of two downside deviations:one built with an aversion to any negative rolling 3 month period, andthe other with an aversion to any rolling year under 12% return.So, compared to holding my "long US stocks" proxy, you get the following effects.(remember, these are imperfect month-end-only calculations)Annual return goes from 8.89% to 11.95% (+3.06%)The worst rolling year goes from -26.4% to -2.6%The worst drawdown goes from -44.9% to -12.6%Standard deviation of rolling year returns goes from 17.6% to 6.8%Probability of positive rolling year goes from 73.6% to 95.9%Risk metric from two downside deviations goes from 39.94% to 14.7%Now, this relies on the selected timing system being pretty good.If it isn't, your results will be worse. But, if you don't trust thistiming rule that much, it's easy to do a compromise. Any mix betweenthe suggested allocation and the "38% short at all times" strategyis equally valid, and all such blends should improve risk-adjusted returns.Obviously, relying on the active management of a short-bias mutual fund is a bit of cheating. But, it has been a decade, and these guys are pretty good. The fund seems to zoom reliably on sharp market declines, though admittedly they don't tend to hold onto those gains when the market rallies. In short, they seem to do their hedging job, and a bit more.One nice thing about this strategy: though you would have to check theindex against its average once each month, you don't trade often.This is an 11.4 year test. There were only 5 trades in total.Jim
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