Friday, September 2, 2016

Investing at Level3, by James Cloonan

James B. Cloonan is the founder and chairman of AAII, a nonprofit organization providing support, education and information to individuals who manage their own investments or who wish to more closely oversee their advisers.

In "Investing at Level3," Cloonan rails against virtually all the beliefs of current theory and practice, claiming that: 
  • It is very possible to exceed the average market returns.
  • Volatility is not an appropriate measure of risk for the long-term investor.
  • Much of asset allocation and diversification is not a 'free lunch' and is overdone at great expense. His book is, at this time, available only through the AAII website.
As to his points, I agree with him on volatility. If you're a "buy and hold" investor with a time frame of 10 years or longer, then the markets ups and downs don't really matter. Risk is defined as the likelihood you'll have the capital you expect when you want it (at some future long term date), not as the perturbations of the market that won't cause you to sell anyways.

I also could imagine agreeing on diversification: the price you pay for adding bonds to an equity portfolio is that you lower the total yield. People do this for the relative lack of volatility in bonds or for the predictable income stream. But if you believe that in the long haul equities will outperform bonds, then Dr. Cloonan is correct. In the US, from 1926 through 2015, stocks gained 9.9%/year and bonds 5.2%. The volatility measure that Dr. Cloonan disdains was 19%/year for stocks and 6% for bonds. Further, the peak to trough draw down in stocks hit 80% and bonds only 16%.

Yet there have been periods of time when bonds have outperformed equities. In the 20 year period 1929 to 1949, and the 40 year period 1969 to 2009, stocks under-performed bonds. Dr. Cloonan doesn't discuss this.

The tough part for me is the first claim, of out-performance, and that is entirely because of the numbers he throws around. Dr. Cloonan claims you can expect a 12% annual return with his passive strategy, and perhaps 17% with his active approach. Further, his expectation of "safe" investments as a mix-in, including Treauries or CDs, is 4% annual return. Credibility shot, on the ground, not able to move.

As of this writing, the definition of risk free return, US 10 year Treasuries, pay 1.57%. CDs can provide a touch more, perhaps 1.6%. Far from 4%. If Dr. Cloonan had provided a bridge between real market conditions and his claim, then perhaps things would make sense. He didn't.

Okay, so in spite of Dr. Cloonan's distinguished background, he set himself up for less credibility than even the inane talking heads on cable financial news shows. Does he have anything to offer?
  • Individual investors with a long term (10+ year) horizon may safely ignore the volatility of the market, and are psychologically better off doing that.
  • A market cap weighted approach to ETFs is less useful in the long term than equal weighting, and Dr. Cloonan pushes the Guggenheim S&P 500 Equal Weight ETF (RSP), and to a lesser extent the PowerShares Russell 1000 Equal Weight Portfolio (EQAL). In fact the data do support that equal weighting (RSP) outperforms cap weighting (SPY). On the other hand, the amount of draw down is also higher in equal weighting, presumably because small cap stocks are more subject to over-reaction in bear markets. In 2008-2009's bear market, RSP was down more than 10% more than SPY. On the other hand, as Dr. Cloonan points out, so what: hold on and you'll do fine in the long term (recovery).
  • Instead of looking at market drops against peak (the definition of "draw down"), Dr. Cloonan suggests one look at drops against expectation. To his example, if your expectation is his 12% return on equities, and the market has run up - giving you a 40% return, and then drops a lot, as long as you're current value is equal to or greater than your expectation line, you're doing great. This seems like a great psychological tool to help people from panic during inevitable draw downs.
  • You can make more than 12% annually over the long haul - that's the "passive" approach for lazy investors. But wait a moment: is that even remotely reasonable? Most folks whom I respect (e.g., Meb Faber, but really there are very many) expect 4-5% net growth over the next five+ years. So let's say that's because they are large cap focused (yes, Faber is actually a world view value balanced with trend guy, so he's already optimizing, but let it go for now), they're missing the better performance of small caps. Is it reasonable to expect this kind of doubled performance outcome? Either the folks who expect more moderate long term growth are dead wrong, or Dr. Cloonan is out on a limb. And given the absence of any commentary in his book supporting the big numbers, and already low credibility, well... you know the answer.
So what to make of this? My takeaway is simple: replace some market cap ETF holdings with equal weighted holdings like RSP, because the long term performance might be superior, if one can withstand the impact of an out-sized draw down over time. The rest of it? Might be brilliant, but might be hogwash, and this book doesn't make it easy to discern.

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