Picture this: You're an artist, and the canvas before you is your future wealth. The paint? Your assets. Welcome to the world of asset allocation, the art of strategically dabbling your capital across a palette of diverse asset classes. We're going to take you on a journey - the first of many - into the heart of our asset allocation strategy.

Summary

Asset allocation – the strategic distribution of capital across diverse asset classes – plays a pivotal role in determining portfolio risk and projected returns, embodying the systemic risk exposure to market fluctuations. This communique represents the first of a series of detailed reports explicating our strategy for asset allocation, encompassing strategic and tactical allocation, security selection, and rebalancing to optimize risk-adjusted returns. Our focus today lies in elucidating the role of time horizons in asset allocation.  

• Equity markets' cyclical nature manifests bull and bear cycles, the timing of which is inherently stochastic. Historically, bull markets typically yield higher upside and are more protracted than their bear counterparts. The heterogeneous nature of equity returns makes market timing a formidable task, with average returns slightly surpassing those secured through the buy-and-hold strategy.  

Market Timing

Equity performance historically exhibits considerable variance, with investors confronting negative annual returns approximately 28% of the time. Avoiding these underperforming years could exponentially accelerate wealth accumulation. For instance, investing a dollar at the end of 1925 and accurately predicting market performance each year until the close of 2011 would amass a staggering wealth exceeding 230 million dollars. In stark contrast, investing in top-performing small-cap stocks would yield a terminal value of 15,532 dollars, while government bonds would only accumulate to about 21 dollars, clearly illustrating the improbability of such prescient market timing ability.

Drawing a parallel to the experiment of tossing a coin, although stock returns sometimes exhibit a sequential pattern of heads or tails, it doesn't necessarily infer a predictive trend. Each toss of the coin is an independent event, with the possibilities of heads and tails steadfast at an even 50/50. Similarly, the advent and duration of bull and bear markets within the financial arena are equally unpredictable. The fluctuation in stock prices is propelled by the unveiling of fresh information, which in itself is a random process. Thus, it becomes paramount for investors to grasp the volatility inherent in stock returns, and it is through long-term investment that one can effectively participate in the market's yield.

Examining bull and bear market cycles from the past century, barring the three most intense and three most mild bear markets, the downturns ranged from -22.18% to -49.15%. Conversely, excluding the three most bullish and three most bearish bull markets, the upturns ranged from 39.85% to 228.81%. Thus, price movements during bull markets tend to be substantially larger and longer-lasting than bear markets.

Across the span of ten market cycles since the conclusion of World War II, the median bull market has celebrated an uplift of 76.66%, while the median bear market has grappled with a contraction of -27.97%. The lifespan of the median bull market is approximately 2.5 times that of the median bear market – an upturn period lasting 38 months as compared to a downturn period of 15 months. The upward trajectory in bull markets is sufficiently robust to offset losses incurred in bear markets. It's worth noting that even during bear markets, an upward trend can be discerned for about 3 months within every 10-month period.

Suppose that investors missed the eight most lucrative years for large company returns during the 86-year span from 1926 to 2011, opting instead to invest in government bonds during those years. The resulting growth of a dollar invested at the end of 1925 would amass to 202 dollars by 2011's close. Meanwhile, a consistent investment in large company equities over the complete 86-year period would realize a value of 3045 dollars. Hence, the penalty of missing these eight optimum equity return years is costlier than anticipated.

This indicates that the prodigious returns from equities do not accumulate in a steady, homogeneous progression. On the contrary, these returns can be traced back to brief episodes of sudden market vigour. These positive pulses typically manifest when sentiments of pessimism saturate the market. Naturally, these turning points in the market tend to be identifiable only with the clarity of hindsight.

For instance, in late 1990, investors and portfolio managers alike were steeped in pessimism. The equity market was on a downward trajectory, an economic downturn was looming, and the United States was on the brink of the Gulf War. However, in 1991, the total returns on large-cap equities amounted to 30.55%, a significant portion of which was generated shortly after the onset of the Gulf War. Investors who, out of fear, sought to liquidate their stocks and convert their assets into cash missed a prime opportunity for market appreciation. A striking parallel can be drawn between the circumstances of 2023 and those of 1991.

According to research by Jess Chua and Richard Woodward, the ability to accurately anticipate a bull market's onset is more critical than predicting a bear market. If investors fail to forecast the emergence of a bull market over half the time, the returns generated from market timing will trail behind the returns from the buy-and-hold strategy.

The average monthly return from market timing adjustments is 0.96% (annualized 12.1%), slightly higher than the buy-and-hold strategy for equity indices at 0.94%. Despite the efficacy of the market timing strategy, its annual compounded return increment does not exceed 0.3% compared to the S&P 500 index's buy-and-hold strategy. Moreover, the efficiency of market timing demonstrates wide variance among different investors.

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