Why we believe in rules-based investing and dynamic asset allocation.

Why we believe in rules-based investing and dynamic asset allocation.

Why rules-based investing?

Investors have many choices in how to approach investing.  A common approach is to use a passive approach that seeks only to replicate the results of the markets at the lowest possible costs. The assumptions being made with this type of an approach is that the market returns will be adequate to fulfill the investor’s financial goals.

Unfortunately, such an approach leaves much to chance.  The future is after all, unknown.

Several factors come into play when choosing a passive investing approach.  Timing is one.  Institutions are less concerned about this as they view their investment window as perpetual and ongoing. Additionally, institutions often benefit from a constant stream of new investment contributions.

For an individual, however, who must first save and then rely upon those savings to meet their future financial goals, the importance of timing cannot be overstated enough.

The importance of timing.

An investor who had the misfortune to retire in 2000 had a much different experience than an investor who was fortunate to retire in 1982, right on the cusp of one of the greatest bull markets ever.  The first investor would have been in a battle for investment survival.  What the tech crash of 2001-2002 didn’t decimate, the credit crisis and market declines of 2008-2008 probably did.  After a decade, the average return for our unlucky investor would have been 0%…and if this investor was having to sell assets along the way in an attempt to supplement their lifestyle, their results were likely to be worse.  Much worse.

Market results with and without 4% annual withdrawal at year-end for period 1980-1992.

Market results with and without 4% annual withdrawal at year-end for period 2000-2012.

For the investor who retired in 1982, they experienced nearly two decades where the average return was near twice the market long-term average. This investor would have enjoyed the ability to receive a rising distribution from their portfolio and have more than what they started with nearly two decades later.

Two different experiences where the only difference is created by where an investor is in the continuum of market returns.

Since investors don’t get to choose when they get to invest and retire as this is determined at birth, we prefer an active approach that has the goal to minimize downside risks and maximize upside returns no matter when an investor investing.

Our preferred approach is to use a rule-based approach based upon academic research and methodologies that are often used by institutions.   Such approaches also are based upon data…the more the better.  And through the data, we can determine in advance of investing, whether the approach is supported by real-world evidence.

Fortunately, the basis for building rules-based investing can be readily found in the many white-papers and academic research found within finance journals and sites like SSRN. In our own practice, these papers serve the basis for further exploration.

Perhaps one of the greatest benefits for investors when using a rules-based approach is that it leaves less room for human emotions to sabotage their outcome.  Human’s are hardwired with survival skills and cognitive biases that impede their investing success.  And this is not just an opinion as studies consistently show that investors underperform the markets because of behavioral tendencies.

Thus, one of the easiest ways to improve performance is to simply reduce the interference caused by human emotions.

Rules-based investing does this.

We have two important beliefs about investing that define our approach to the rules-based process we use.

First, we believe that downside risk management is critical to an investor’s success.  This is based both on a mathematical truth and the potential impact on investor psychology.

We believe that the investor experience is just as important as the outcome.  While some firms may focus almost exclusively, on generating excess returns, we prioritize the downside risk management in an effort to achieve higher risk-adjusted returns.

It should seem self-evident that one cannot compound their losses; that the only money available to spend in the future is from the compound growth within their portfolio.  Yet, evidence suggests that too few investors, professionals included, pay attention to downside risk management.

Beware of volatility drag.

Given two portfolio, both with the same stated average return, but one with greater overall volatility, the portfolio with the lower volatility will earn more money as it suffers less from what is known as “volatility drag”.

The negative impact of volatility on compound growth.

Let’s consider two mutual funds. Each of them has had an average arithmetic rate of return of 8% over five years, so you would probably expect to have the same ending wealth value. But it is a mathematical fact that the one with less volatility will have a higher compound return.

In other words, the fact that each year’s return carries over to impact the balance being invested into the subsequent year means it’s not enough to merely add up the returns of each year and divide by how many there are, to determine the average rate of growth the portfolio actually experienced. Instead, the actual average return is somewhat lower, to account for the fact that there were both higher and lower returns that compounded along the way. This is known as the geometric mean or the geometric average return.  A portfolio in which downside risk has been managed will do better to create long-term wealth.

As shown in the example above, the geometric return (also known as Compound Average Growth Rate or CAGR) was lower than the arithmetic average return, by about 1.81%, due to the fact that the compounded volatile returns with the early bear market never quite added up to what the straight line return would have been.

Also, portfolios that are not protected on the downside often leave investors feeling anxious and prone to emotional decisions.  Why else did so many investors liquidate stock mutual funds in April 2009 right when the market was making a long-term bottom?

Our second belief is that our preferred portfolio approach should be regime agnostic.  Investors do not get to choose the economic environment or the direction of the financial markets.  Yet, there is often the need for a portfolio to provide a required return regardless.  Portfolios that are adaptive to regime changes can be more consistent in achieving targeted returns and less dependent upon whether or not the investment climate is ideal.   Thus, we favor flexible, unrestrained portfolio policies whenever possible within the framework of a solid rules-based process.

Other benefits to rules-based investing approaches are that it reduces error and creates greater predictability.  Practicing a rules-based approach requires that an investor repeat the same process over and over again.  The markets may change but the process does not.  The biggest challenge can be resisting the temptation to impose one’s personal opinion or investment views and second-guessing the system.  One word:  Don’t.

Focus on the process

Lastly, adopting a rules-based approach forces the investor to focus on the process rather than the product.  We can benefit from the low-cost structure of passive index funds but not rely on the hope that the sequence of returns will be sufficient.  In other words, we can use a predictable, repeatable process to manage an uncertain future stream of information in order to manage to the outcome we desire.  I think most would agree that this is better than leaving one’s financial future to chance.

After practicing such an approach for nearly three decades now, we know this approach works.

And this is why we choose this to be our approach.

Introducing Cornerstone Income.  A Tactical Approach to Income Investing.

Introducing Cornerstone Income. A Tactical Approach to Income Investing.



Traditionally, fixed-income has been the ballast within a portfolio and not a source of alpha.  Yet, with the application of a systematic approach that actively rotates among traditional fixed-income securities, investors can discover a new source of potential return stream that may normally be overlooked.

For investors whose approach is passive,  the expectation of future returns from traditional fixed-income securities appears to be subpar at best.

In this post, I will discuss the background that is the motive for developing the new Cornerstone Income model and then in the next post, I will discuss the model in greater detail.


A Rising Rate Environment. Maybe.

The thesis for rising interest rates hardly needs repeating.

Interest rates have declined from 15% in the early 1980’s to practically zero in the recent past.  We know that this enormous tailwind to fixed-income securities cannot and will not be repeated.  Historically, high and declining nominal interest rates served as a powerful return stabilizer for fixed-income. However, with rates now at all time lows, the stabilizing impact of yield is reduced, and this income buffer may be insufficient to offset losses from rising rates.

At the same time that central banks have suppressed rates globally, they have issued a record amount of new debt that bears with it an ever-rising cost of financing (carry).  Central banks’ attempts to sustain the global recovery have left investors stranded in a low yielding and highly uncertain environment.

Now couple historically low interest rates with an out of control deficit.  In the U.S. alone, the current U.S. federal budget deficit is running $1T dollars and the U.S. debt/GDP is at 104%.  This implies a need to issue bonds to finance the out of control spending.

Typically, more supply (issuance) means higher yields for bonds.  The problem is that bond prices move inversely to interest rates.  As rates rise, bond prices lose in value.  And based upon current rates, a mere 1% increase in long-term Treasury rates could result in a 20% loss in price which would wipe out 7 years of income.

The bottom line is that there is little room left for interest rates to fall, and tons of room for rates to rise, creating an unfavorable risk/reward ratio.

Please note that I am not joining the chorus of analysts predicting that interest rates will rise.  Frankly, I do not know nor does anyone else.  The future is unknown.  I am simply pointing out that fixed-income investing is skewed unfavorably at this time and to invest in this asset class and be successful moving forward is going to take a different approach than what has been done over the last thirty years!

There are certainly arguments to be made that we could remained mired in low interest rates for awhile longer.  Given that the amount of debt in the system at all levels (government, corporate, and personal) is so high, even the slightest uptick in rates will have a drag effect on the economy because of the added cost to servicing the debt not to mention increasing the cost to borrow for homes and other large capital items.

Additionally, central banks are pulling back in stimulus. The Fed will, albeit slowly, keep raising rates and reducing its balance sheet and the ECB will end QE by the end of 2018. In short: In 2019 there will be a lot less artificial stimulus to go around as the cost of financing is increasing and earnings growth will be slowing down.

Again, this is not about making a forecast but more about addressing the process to how investors approach fixed income securities.

So investors have two options.  Do what has always been done and hope that it works out ok or utilize a process that is designed to manage downside risk should it become necessary.

The choice is yours.

The more important point here is passive fixed-income investing appears very unattractive at this moment in time.  In an asset-class that many investors consider “safe’, the downside risk is high and the current returns being paid to accept this risk are paltry.

The risk-reward equation has become increasingly asymmetric amid rising bond valuations and concerns over reduced market liquidity.

And because today’s coupon yields are so low, bonds have an even greater sensitivity to any increase in yields.

Indeed, in this year alone, many passive fixed income ETFs show negative returns as the 10-Year Treasury has increased from 2.06% to a high of 3.11% over the past 12 months:

Exchange Traded Fund2018 YTD Performance

Further, from an income perspective, the protracted and deepening low yield environment has forced a search for higher-yielding fixed-income assets, leading to an increase in the use of alternative credit. This has pushed investors up the risk spectrum, potentially conflicting with their risk reduction objectives.

Given these facts I believe a tactical fixed-income approach is more necessary today than it has ever been before.

An absolute return fixed-income strategy that focuses on extracting alpha and removing the impact of market performance on the return stream.

A strategy that aims to produce positive returns in all market conditions.

Which is exactly what I have designed for our new Cornerstone Income strategy.

The goal of the strategy is to provide investors with an alternative to making a passive bet with say something like AGG or BND.

The primary objectives are:

  1. Provide income (no miracles here…we ARE in still in a low interest rate environment).
  2. Preserve Capital during market declines and generate gains where possible.
  3. Protect against bond losses during periods of rising interest rates.

In my next post, I will discuss how Cornerstone Income has been constructed and how it might do in meeting these three goals.

Keystone Independent Performance Certification Report

Keystone Independent Performance Certification Report

In rock climbing, it’s vitally important that you have complete trust in both your equipment and your climbing partner.  After all, your life can depend on each.

For equipment, it’s important to make good selections in having the proper clothes, rock climbing shoes, harness, chalk, carabiners, belay device, climbing ropes, etc.

And in choosing a climbing partner, you want one that is experienced and one that you can be confident will make good decisions, especially in a difficult situation.

While your investment decisions may not result in the difference between life and death, who you choose to rely on for investment advice may certainly impact your long-term success.

Just as in rock climbing, it’s essential to not only have confidence in your advisor or investment newsletter, but also the methodology used.

Unfortunately, on the internet, there are too many exaggerated claims of investment performance and promises of riches.  Often we are provided pictures of the so-called gurus pictured with a Gulfstream jet or some exotic sports cars.  None of this speaks to the accuracy of what is being portrayed.

And while there are many good investment newsletters that do try to do the right thing…very few have audited performance records.  Which is why I am pleased to announce that our firm has just completed a multi-month audit process of our flagship Keystone strategy.

Completed by ACA Compliance Group, the report provides for independent performance certification of the Keystone model strategy.  The purpose of the report was to provide potential investors with reasonable assurance that the performance results that we publish are in fact accurate and in line with our described methodology.

Their conclusion was that based on our methodology and their independent testing, that for the period January 1, 2007, through December 31, 2017, that our performance has been recorded in accordance to the criteria in all material respects.  

For anyone who would like to receive a copy of the entire report, we will be happy to send you a copy by sending us your request.

I would also like to point out that while the U.S. Stylebox Rotation Strategy, U.S. Sector Rotation Strategy, World Traveler, and Explorer were not each independently verified separately, it is important to note that those exact strategies are four of the eight modules within Keystone, thus also implying the audited accuracy of those models as well.

Keystone was designed to be a total portfolio solution.  It includes tactical, rules-based exposure to all major global asset classes.  Do it yourself investors will find that it takes as few as 15 minutes per month to follow and implement the strategies.  We are aware too of financial advisors who use Keystone as a central “core” account for their client’s portfolios.

What every investor wants.

What every investor wants.

I was recently asked to speak at a conference hosted by one of the largest financial publishers in the industry.  There were no restraints placed on me….I could talk about anything within my area of expertise.

I mulled multiple possibilities.  Since I didn’t know beforehand the level of audience sophistication, I knew I should try to keep the presentation fairly basic.

The challenge then became, how in twenty-five minutes can I share everything an investor needs to know about rules-based investing?

And more importantly, why should they care?  And why should you care?

As I was preparing my notes and outline, one benefit seemed to stand out more than others.


It was the single word on my second slide.

For me at least, one reason we use models is that it creates a certain degree of predictability. (I will discuss mathematical expectancy in greater detail in a future post)

I think that one reason that people don’t invest who should, is because of the uncertainty that often surrounds investing and the emotional angst caused by the uncertainty.

There are two types of data.  That which is known, i.e. the past; and that which is unknown, i.e. the future.  Everything else is just noise.

None of us are diviners of the future.  Thus all future market data is unknown.  (Which is why “forecasts” are worthless despite investor fascination and interest in them)

Traditional investing advice such an indexing and buy and hope have you accepting the market’s future returns regardless of the outcome.

It’s random.

And it is highly unpredictable.

And psychologically, deep down, there is something unsettling about this.


What if, we placed our focus on strategy.  On process.   After all, that is the only thing we can control.

What if our process managed our major concerns? Meaning…it had the ability to always adapt to the best opportunities at any given time.    And if the “best opportunity” at the time was to be defensively positioned on bonds or cash, so be it.

In essence, we manage the unpredictable stream of future market data with a clearly defined, tested, researched, and predictable process.

How many investors have watched this market from the sidelines waiting for a pullback for better entry?   Thinking all along that “it was too high”.

If however, investors knew that it did not matter…that the investment strategy would protect them should the need arise…then investors could and should invest anytime capital is available.

Unfortunately, many investors approach investing as an all or nothing proposition that is rigid.  And this is where the internal psychological battle begins.   Questions like” what if I’m wrong” or “what if the market declines” and “what if this is a mistake?” take command.  And the result is often paralysis that results in inaction.

Markets adapt and change.  Why shouldn’t your portfolio be allowed to do the same?

Strategic allocation approaches, indexing, and buy and hope do not adequately address the element of predictability.  Consider the following table of historical returns for the market.  Notice that even in 20 year periods of time that the range of returns is from 1.9% to17.9% for the S&P 500.

Does that seem predictable?

And it’s worse the shorter your time frame.

The financial industry is always quick to say that every 20 year period in the market has been positive.  True.  But what it doesn’t mention is the possibility that half of the returns will be below the 20-year average return of 10.1%

If you were estimating on achieving an “average return” to reach your financial goals, there is a 50% chance you will fail.  That after all is the simple mathematics of an “average”.

I ask again if any of this makes investing seem predictable?

What if your timing is unlucky and you earn well below the average?   Success becomes based upon luck and hope that the return sequence delivers what is required.

So we come back to focus on process.  To make sure that our portfolio is allowed to breathe.  To make sure that our portfolio can adapt to new market regimes.

This is why I am so passionate about rules-based investing.  It allows us to program in the ability for our portfolio to maximize profits when times are good and protect our capital when markets start to head south.  Simple mathematical formulas can replace our emotional involvement and provide a predictable process to manage the market, no matter what it throws at us.

In my next post, I will discuss how some of the tools we use can help create an element of predictability.

Tim’s Technical Take – Breathe

Tim’s Technical Take – Breathe

With war rhetoric taking center stage this past week, the geopolitical risk for investors certainly increased.  At times like these, it’s very easy to let your emotions take over your investment plan.

Which is why I love adaptive, rules-based investing.  We can leave out emotions at the door knowing good and well that our portfolio will get adjusted…IF IT NEEDS TO BE.

With that said, I still do like to keep an eye on the markets.  After all, our models must operate within the market environment we find ourselves in, so any insight to market activity, in my opinion, helps provide understanding to model adjustments.  Further, and as I will explain, our attention to the market can help us make portfolio “tilts” which are smaller adjustments within our portfolio.

Clearly, it was not a good week for stock market investors.   The S&P 500 lost 1.4% and the MSCI All World Index lost 1.5%

The beneficiaries of all of this were gold (GLD), up 2.34% for the week, and US Treasuries (TLT), which gained 1.09%.

With that as our background, here are a few charts of interest.

Some of my favorite kinds of charts are that which depicts what is going on beneath the surface of price action alone.  Trends are less likely to be sustained unless the market as a whole is in synch.  And when evidence suggests otherwise, its good for investors to be at least cautious.

On Wednesday of this week, I posted the following chart to my Twitter account.  It is the Bullish Percent Indicator the S&P 500.  What is shows is that the Bullish Percent has been weakening as the market was rising, meaning fewer and fewer stocks have been participating as the market was making new highs.  This generally, is never healthy.

Another way of looking at this in a similar fashion is to measure the number of stocks trading above their 200-day moving average.  If this number is rising, stocks are in demand and generally, prices should be rising.  Conversely, if this number is falling, it tells us that more stocks are succumbing to selling pressure.

What we look for are divergences and recently the market has been rising but the indicator has been falling.

So based upon these market breadth indicators, I believe that investors have reason to be cautious.  By and large, it has been the mega cap and high-quality stocks pushing the popular averages higher.  (And incidentally, exactly how Portfolio Cafe models have been positioned for members)

Price action confirms this view, at least for the near term.

Price action for the S&P 500 SPDR ETF shows prices below the 21-period moving average and also the 8-period moving average has crossed below the 21-period.  According to successful trader John Carter, this set of conditions shifts the short-term trend from up to down, however at this time, price still remains above the long-term moving average.

Where the real damage is being done is in the Small Caps.  Here both the short-term and the long-term trend have turned negative. Small caps have been dramatically underperforming for all of 2017 and there is nothing to suggest this is about to change anytime soon.

This is where, as I said at the beginning of this post, that this information can be useful to make small adjustments to your portfolio.  Personally, when I see what I see happening to the Russell 2000, I would be minimizing my exposure to Small Caps.   This even means I would be minimizing exposure to Portfolio Cafe models that emphasize Small Caps because, in this environment, you are fighting a headwind to do otherwise.

To step back and take a look at the long-term trend, a very simple but effective chart that I like to look at is the Vanguard Total Market Index on a weekly time frame with a 13 and 34 period moving average.   When these cross investors need to pay attention. In 2008, this simple indicator would have gotten you out of the market in plenty of time to avoid the losses that were to come.

The present situation shows we are nowhere close to seeing this pair crossing.

So at the moment, this looks like a short-term correction within a long-term uptrend.  But don’t let that fool you.  That could still mean a 5-10% correction as I see it.

The best-performing markets YTD have been the international markets, so let’s see how they now look.

The MSCI EAFE index shows price action below the 21-period moving average and the 8/21 very close to crossing.  Short-term this is a caution.

The picture is the same for the MSCI Emerging Market Index.

So yes, I anticipate that the correction has further to go.  The market is now in a seasonal period when weakness often occurs – which often shows up when complacency is high, markets are overbought and sentiment is very bullish.  These conditions all existed at the start of last week.

Over 18 months have now passed since a meaningful pullback.

That is the longest period during this bull market.

Looking back over the last 60 years, that is also one of the longest periods without even a 5% correction.

Complacency reigns in the credit market too.  Currently, Euro Junk debt is yielding the same as 10-Year U.S. Treasuries.  This is insane.  Risky assets are being priced beyond perfection.

But please remember.  While technical analysis can provide a view into the market, and warning signs do exist, they aren’t perfect predictors and the future is unknown.  We can only approach the “unpredictable future” with our “predictable process” that never varies.

That is the power of rules-based systematic investing and adaptive allocation.  And it leaves time for us to breathe.