They began by noting that the belief that motivates tactical allocation strategies is that a surprise can be foreseen by prescient analysts. With that in mind, they asked the question: “How prescient do you need to be to exploit economic surprises?”
To answer that question, they built a simple model using data from the last 25 years. The economic measure used is the nonfarm payroll.
- They start with a 60% U.S. equity (represented by the MSCI USA Index)/40% U.S. bond (represented by the Bloomberg Barclays US Aggregate Bond Index) portfolio.
- In advance of any positive economic surprise, they increase their equity allocation to 80%.
- In advance of any negative economic surprise, they decrease their equity allocation to 40%.
Not surprisingly, they found that if you had perfect foresight, your returns increased. However, the improvement in returns was just 0.2% per annum—and that’s before even considering trading costs, and for taxable investors, taxes. To break even with the 7.4% return of the benchmark 60/40 portfolio, the investor would have had to be right 75% of the time (again, that is before considering implementation costs).
Given today’s highly competitive markets, the odds against being able to successfully exploit mispricings after implementation costs seem daunting. Yet in a triumph of hype and hope over wisdom and experience, most investors are still engaged in that endeavor.
Vanguard’s research team concluded: “The odds of successfully trading on surprises is low.” They added: “What can seem consequential in the short run is irrelevant to the long-term investor. Short-term surprises are quickly priced into long-term expectations, and these long-term projections have almost no relationship to future returns.” (There is little relationship between economic growth and stock returns.)
I hope you will keep Vanguard’s findings in mind the next time you are tempted to tactically allocate based on your (or some guru’s or money manager’s) forecasting ability. And if you are still tempted, remember that an all-too-human trait is overconfidence in our abilities.
I offer one other suggestion: Start keeping a diary, writing down every time you are convinced the market is going to go up or down. After a few years, you will realize that your insights, unfortunately, are actually worth nothing.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.