Back-testing tactical asset allocation strategies

I’ve long been fiddling around with various mechanical methods of adjusting an almost passive index investing strategy to improve the risk/reward ratio.  This is sometimes known as Tactical Asset Allocation (TAA).  I thought I’d put up some charts of my efforts.

The lines in the charts are for four portfolios:  Cash, with the returns calculated using the average instant access interest rates borrowed from the rather excellent Swanlopark;  The FTSE 100 with dividends reinvested;  A 60/40 FTSE 100/cash split rebalanced each year; Another FTSE 100/cash split which is rebalanced annually using my asset allocation function which is fed with the FTSE 100 real earnings over the period in question.

The first chart shows the portfolios with a single lump sum invested in 1993:

As I’d expect, the cash is safe and predictable but has the weakest returns; FTSE 100 is the most volatile with the greatest returns most of the time; the fixed 60/40 split is somewhere in the middle.  The interesting thing is that by taking note of the value of the stock market the red line has better returns than the fixed split, but with broadly similar volatility.

I think this is very suitable for a ‘conservative’ portfolio and it’s exactly how my wife’s pension is invested.  The most important thing is the small drawdowns, which is how most retail investors measure risk, i.e. how much has it fallen from some previous value.  In the above chart, the FTSE lost almost 40% in its biggest drawdown, the 60/40 split lost 18% (2000-2003) and the TAA portfolio lost 15% (2008-2009).

The next chart shows the returns when the investment was added in 2000, i.e. a bad time to invest in stocks:

As you can see, cash was a much better place to be than stocks if you were putting away a lump sum in 2000, however, the TAA portfolio has recently taken the lead and looks much healthier than the other stock-holding portfolios. 

The next chart shows the benefits of dollar cost averaging, where you invest new money over time.  This means you buy more when stocks are cheap and less when they are expensive:

Although the returns across all portfolios are broadly similar, the volatility is much reduced and given that stocks are now fair to cheap, the portfolios holding stocks are more likely to begin to outperform cash once again. 

Next up is a chart where I’m drawing a pension starting at a somewhat arbitrary 5% of the initial investment, increasing the drawings by the RPI each year:

Here it looks like everyone is happy except the cash holder.  At a real 5%, the cash pension might last 20 years or so.  All the other portfolios are fine… but what if the drawings started in 2000?

I find this very interesting.  The TAA portfolio seems to give the best risk/return ratio of the four portfolios during the investing stage, largely regardless of whether you are investing a lump of capital in one go and then waiting a couple of decades before taking an income or whether you are dollar cost averaging;  It also looks like it will produces the safest capital during the income phase. 

By safest I mean the capital which is most likely to keep paying a real income for the longest period, regardless of when you start the income phase.  So on this evidence, my wife could build up the pension using TAA and continue to use the same strategy once she starts to take an income.

Of course this approach may not produce better results than say a fixed asset split between different geographic regions and bonds, something like US/UK/Japan/Bonds split a quarter each, which is how I used to invest after reading The Intelligent Asset Allocator, but this TAA function is my very own invention and my ego demands that I use it. 

In fact, I think if I ever get bored with the additional effort involved in value stock picking I may well just sit back and rebalance my TAA portfolio once a year and find other things to do with my time.

Author: John Kingham

I cover both the theory and practice of investing in high-quality UK dividend stocks for long-term income and growth.