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Author: RetiredFloridian Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 75379  
Subject: Re: Core retirement investments Date: 8/19/2011 1:53 PM
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For our core account, I invest in a mixture of mutual funds and use a variable hedge based on market conditions. Started doing this when I retired in 1998 and it seems to do well enough to generate sufficient returns for us as well as keep us shielded from the risks of protracted down trends. At the chance of getting a little long winded I’ll take a few minutes here and describe how it all works, in case someone might be interested in the details.

First, the funds. Prior to retiring, I invested in individual stocks, primarily growth issues, and followed them daily. As retirement approached I became less interested in the daily gyrations of stocks and more interested in other pursuits. On the advice of a good friend and retired financial advisor, now deceased, I moved our assets to mutual funds and started looking at hedging and timing. For diversification purposes I picked three core funds: a large cap growth-style fund, a large cap dividend oriented fund, and a small to mid cap fund. This was for half of the assets we felt comfortable exposing to equity investments. The other half I invest in a mixture of sector funds (could just as well use ETFs here, I guess). I follow a dozen broad sector funds and hold five at a time based on an approach I’ll describe in another paragraph below.

Next, the hedge. I spent my share of time trying to develop some sort of market timer, with lots of spectacular failures along the way. I finally got to a point where it made more sense to me to find a stable timing strategy, ignoring the daily and weekly whipsaws. I am more comfortable with a consensus-style timer, so I settled on a four part approach combining market trend, market breadth, valuation, and interest rates. I am forever indebted to my late friend for his invaluable advice here. For market trend I use two methods. (1) Comparing the daily close of the S&P 500 index to a long-term moving average, and (2) Examining the S&P 500 index price action, looking for increasing or decreasing highs and lows. Specifically I compare the index close to the 200d SMA for method (1). And for patterns of highs and lows, I see whether the index maximum high price over the past 80 days is increasing or decreasing. Timer method (3) looks at market breadth. I use the daily difference of the Nasdaq new highs and new lows, and compare the 20d SMA of the difference to zero. Finally part (4) of the timer examines the relationship of the S&P 500 dividend yield to the yield of three-month Treasuries. I subtract the Treasury yield from the index dividend yield and compare the difference to some value which represents an equilibrium level, which for me is -3.50, but can be modified based on risk tolerance. Adding all four parts of the timer together will yield a total of between 0 and 4. This total can then be used to determine the level of hedging to apply against the total fund holdings. The higher the value of the timer total, the lower hedging % is needed. Since I’m fairly risk averse, I use a 25% hedge when the timer has a value of four, 50% when it has a value of three, and 100% when the value is 2 or less. I use a short position in the SPY stock as a hedge. Since our account has enough cash to back up the short position, there are no margin fees imposed by my broker.

Now the sector fund selection. I follow a dozen broad-based sector funds, such as Financial, Utilities, Technology, and the like. Nowadays I’m sure you could just as well use broad sector ETFs instead of the funds, and maybe someday I’ll make the switch. Every other month I calculate the total return of each of the 12 sector funds over the past two months and invest in the five with the best 2-month return. I’ve done some testing over the years, and there are probably better time durations, but I started with the 2-month period for both returns and for a holding period, and it has worked out well enough.

I can almost hear someone asking how this has performed. Well, 1998 was my first year doing all this, and there was a good bit of transitioning and experimenting, so I’ll just leave those results out of the mix. Starting in January of 1999, and calculating through yesterday, the compounded return has been just shy of 11% annually. Nothing to shout about, surely, but a good bit better than the S&P 500 return over the same time. My goal is all this was to get to a place where I didn’t have to worry about individual stocks and to limit my risk at the same time. One way I like to look at risk is to find out what the worst twelve-month return has been, on a rolling basis. The S&P lowest 12 month return was about -45%, whereas my worst 12 month time was just a bit shy of -7%, back in late 2008.

That’s it in a nutshell. There are plenty of more details, such as which months I use for the sector fund rotation. I do that work on the first day of the odd-numbered months. And I rebalance the three core funds at that same time, selling or buying a few shares to start every 2-month period with the same dollar amount in each of them. I look at the timer every few days, and if it makes a sudden rise or takes a sudden dip (such as it did earlier this month) I’ll adjust the hedge accordingly. So far it’s kept us out of the swamp and with enough returns to keep things interesting. I don’t know if it will continue to do as well in the future but don’t see any obstacles to that. By the way, right now the timer is sitting at a total of 2, with only a couple of days to go until it will definitely drop to 1 when the calculation of the index's maximum high over the past 80 days will age off. That means that currently I'm hedged at 100%.

This brings me to the end of something that ended up longer than I expected and I guess that means it’s time to stop writing. I hope this is helpful to someone.
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