This area of the NAOI site describes an innovative approach to investing called Dynamic Investment Theory (DIT). Developed by the NAOI Research Center, this theory produces a new investment type called Dynamic Investments that are capable of automatically adjusting their holdings in response to market price trends. By doing so they have the potential to produce returns that today's experts will say are impossible.
This page discusses Dynamic Investment Theory (DIT). Dynamic Investments are discussed on the second page in this area of the site. And The Amazing Future of Investing book, that teaches the why and how of Dynamic Investments is discussed on the third page of this area.
The Catalyst for Change
The catalyst that prompted the development of Dynamic Investment Theory was the complete and utter failure of Modern Portfolio Theory (MPT) portfolio design and management methods to cope with the stock market crash of 2008. MPT, used by virtually all advisors today, uses asset allocation to design a portfolio to match a client's risk profile. Then investors are told to simply "buy and hold" their portfolios for the long term. As a result, MPT portfolios go up and down with the market without the capacity to take full advantage of uptrends or to avoid downtrends.
A "static" MPT portfolio in a dynamic market is a disaster waiting to happen and it did in 2008. After observing people losing up to 50% of their life-savings as a result of the 2008 crash, NAOI President, Leland Hevner, decided that there had to be a better approach to portfolio design and to investing in general. He formed the NAOI Research Center to find it. And after 5+ years of research he did in the form of Dynamic Investing Theory. An overview of this innovative approach to investing is provided below.
Design Criteria for a New Approach to Portfolio Design
When the NAOI Research Center began its research and development effort to find a better approach to portfolio design we started with a blank slate. NAOI researchers were told to not be constrained by the rules of MPT or any other traditional methods. Rather they were directed to meet the goals that the public had provided to the NAOI when we asked them what they wanted in a new approach to investing. They told us the following:
Simplicity - A primary element in the NAOI Mission Statement is to empower individual investors. One way to meet this goal is is to make investors smarter. Another way is to make the world of investing simpler. NAOI researchers were told to develop a new approach to portfolio design and management that was easy to understand, implement and manage and could be done by individual investors without the help of a financial advisor.
- Capture Positive Returns Potential - In any economic condition there exist markets, market segments and/or asset classes that are moving up in price. Thus there exists positive returns potential somewhere in the market at all times. The new approach must to be able to automatically, without the need for human judgment, identify and capture this potential.
- Minimize Risk - MPT portfolios use asset allocation to reduce risk. This means that at all times an MPT portfolios holds both winning AND losing investments. Asset allocation does reduce risk but it also reduces returns. There are other ways to reduce risk that do a far better job, including stop-loss orders and time-diversification. A new approach should use risk reduction methods that minimize risk without reducing returns potential and, in fact, maximizing it.
- Reduce Human Judgment - Far too much investing activity today revolves around human judgment. Trades are made based on "expert" analysis and market forecasts that are as often wrong as right. There are just too many variables to accurately predict future market movements. Investing based on trusting human judgment opens the doors to bad analysis, emotional reactions, sales bias and just plain fraud. A new approach should replace human judgment with scientific methods and empirical observations as the catalysts for action. It makes far more sense to take actions based on what the market has done, and is currently doing, than based on "guesses" of what it will do in the future. A new approach must be based on this fact.
- Minimize Management Fees - Too much of the public's money today is wasted on advisor and fund fees that provide no observable value-added to the investor. No study has ever shown conclusively that higher management fees consistently result in higher investment performance. A new approach to investing should use Exchange Traded Funds (ETFs) as its primary investment vehicle to keep management fees to an absolute minimum.
After carefully analyzing our public survey results, It became immediately obvious to NAOI researchers that Modern Portfolio Theory could not meet these goals. So we started with a "blank slate" to design a new approach that could.
A Hypothesis and a Theory
To meets the public's goals, the NAOI research team started with the ONLY fact-set that we know about the movement of market prices. They are as follows:
- We know from empirical observations that market prices are cyclical, they move up and down on a periodic basis.
- We also know that different asset classes and different market segments move up and down at different times.
Based on these two observable facts the NAOI research team formed the following hypothesis:
From this hypothesis, NAOI researchers created and tested multiple portfolio design approaches that could meet the public's goals. Following extensive testing and analysis of each investing approach candidate, we found one approach to be optimal. It showed that the proposed hypothesis presented above had a high probability of being true. At that point we transformed the hypothesis into a theory that we call NAOI Dynamic Investment Theory. This theory and how to use it to build Dynamic Investments is thoroughly discussed in The Amazing Future of Investing book written by Leland Hevner and published by the NAOI.
Dynamic Investments and Proof of Concept
Dynamic Investment Theory defines the rules for the creation of Dynamic Investments (DIs). These are investments that are designed to periodically sample market trends and to automatically adjust the investment(s) they hold in an effort to capture positive returns that exist in the market at all times. DIs use primarily Exchange Traded Funds (ETFs) to buy into assets / market segments that are trending up and to sell (or avoid) those that trending down.
As a proof of concept the NAOI team used DIT rules to design a basic Dynamic Investment (DI) that simply rotates between a stock market ETF and a bond market ETF on a quarterly basis. We called in the Core DI. The ETF it bought and held for one review period depended on which is trending up the strongest at review time. We then backtested Core for the volatile market period from 2007 to 2016.
Performance results are presented in the table below. The "Core DI" performance is shown in the top row of the table and for comparison purposes the returns of 50% Stock / 50% Bond MPT, asset-allocation portfolio shown in the bottom row. The "Sharpe Ratio" in the last column is a measure of how much return is obtained for each unit of risk taken and the higher the better. Any Sharpe Ratio over 1.00 is seen as a superior investment.
The performance of this Core DI during this period is absolutely astonishing when considering that it included a major stock market crash in 2008 - a period when the Core Dynamic Investment earned +57% while the stock market was crashing just as hard. Of course this happened because the Core DI quickly recognized the market trends and switched to holding a Bond ETF as Stocks were crashing.
The Superiority of Dynamic Investments vs. Static Investments
The reason that Dynamic Investments produce such stellar returns is that they are sensitive to market changes. They have a built-in capability for detecting market uptrends and to automatically buy ETFs that capture the positive returns from these uptrends.
Thus, Dynamic Investments are both "dynamic" and "intelligent". In contrast, MPT portfolios that employ a buy-and-hold strategy are both "static" and "dumb". The contrast could not be more stark.
The Future of Investing
With the development of Dynamic Investing Theory and Dynamic Investments, the NAOI is confident that we have created an approach that has the potential to significantly change the way we invest at its very core and to "evolve" the entire world of investing. Now we would suggest that you learn more about Dynamic Investments on the next page in this area of the site.