Creating “Market Sensitive” Portfolios
The NAOI knows that change does not come quickly in the financial world. While holding only one Dynamic Investment in a portfolio can be a very profitable decision, NAOI students have shown a strong preference for easing-in to the new dynamic investing approach. This is very easily done with what we call NAOI Hybrid Portfolios that hold both “static’ building blocks and at least one “dynamic” building block. The process and results are illustrated on this page.
The Problem with Portfolios Today
The NAOI sees as a major problem that today’s portfolios are static investments. Designed using an approach called Modern Portfolio Theory (MPT) the goal of these portfolios is to match the risk tolerance level of each investor using asset allocation methods. Then they are meant to be bought and held for the long-term with perhaps a yearly rebalancing to maintain original allocations. They are completely blind to market dynamics and their value drifts up and down with the tides of the market. And they are dangerously vulnerable to market crashes as we saw in 2008-2009.
The NAOI “Golden” Portfolio Building Block
The NAOI solves this problem with what we call the NAOI “Golden” Building Block. This is an NAOI Dynamic Investment that is market-sensitive; capable of changing the ETF it holds based on a periodic sampling of asset price trends. When a Dynamic Investment is inserted into a static MPT portfolio, all of a sudden the portfolio becomes dynamic and market sensitive resulting in higher returns with lower risk. We call portfolios that include DI one or more building blocks MPT-DIT Hybrid portfolios. They will play a dominant role int the future of investing.
A Hybrid Portfolio Example
Below is an example of an NAOI Hybrid Portfolio structure. It has buy-and-hold Stock and Bond components with the allocations shown in the diagram plus a Dynamic Investment (DI) that alternates between a Stock and a Bond ETF based on a periodic review of the price trend of each. No subjective decisions are required to make this change and the process can easily be automated.
Hybrid Portfolio Components
Allocations of the Hybrid Portfolio When Stocks Are Trending Up
The diagram below shows the allocations of this dynamic portfolio when the stock asset class is trending up. The 80% Stock allocation is the sum of the constant 30% buy-and-hold Stock building block added to the 50% allocation of the Dynamic Investment that “senses” that stocks are performing better than bonds.
Allocations of the Hybrid Portfolio When Bonds Are Trending Up
This portfolio is “asset-fluid”. At any one point in time it will hold an allocation of either 80% Stocks / 20% Bonds or 70% Bonds / 30% Stocks. These asset allocations DO NOT depend on the investor’s risk tolerance; they depend on current asset price trends. Dynamic Portfolios strive to hold an asset allocation that at all times is biased toward the asset class that is trending up in price. This is a new and better way of investing as illustrated in the performance numbers shown next.
The Table below shows the annual returns for the test period from 2008 to 2018 of the example Hybrid Portfolio discussed above in the first data row. For comparison purposes the second data row shows the performance of an MPT portfolio that simply buys and holds the same asset classes using the allocations shown. The last two rows show the average annual return of each portfolio along with the Sharpe Ratio which is a measure of how much return is realized for each unit of risk taken - and the higher the better.
It can easily be seen that the performance of the dynamic Hybrid Portfolio was significantly higher than that of the static MPT portfolio. Not only were the Returns higher but the Risk was actually lower as indicated by the increased Sharpe Ratio. Today’s experts will say that performance like this is impossible. And it is using static MPT portfolios. But when a dynamic building block is inserted into the portfolio, it becomes market-sensitive, and this makes a world of difference as the Table above shows.
Two Additional Diversification Factors
The NAOI Hybrid Portfolio’s higher performance reflects the addition of two new diversification elements. Like MPT portfolios, Hybrid portfolios take advantage of both Company and Asset diversification. Both provide vital risk reduction benefits. But that’s all that MPT portfolios provide. NAOI Hybrid Portfolios add two additional diversification elements as follows:
Time Diversification - Because the Dynamic Investment building block reviews, and changes if necessary, the asset class it owns on a quarterly basis, it is time-diversified. MPT portfolios, because the adopt a buy-and-hold strategy is not. Time diversification not only reduces risk it also enhances returns.
Methodology Diversification - The Hybrid Portfolio is also '“methodology” diversified, using both a buy-and-hold strategy for the static building blocks and a buy-and-sell management strategy for the dynamic building block. This diversity reduces risk and enhances returns as well.
Adding new diversification elements to a portfolio is evidence that with the introduction of Dynamic Investments the world of investing has changed at a fundamental level. And positive outcomes seen today as impossible, suddenly become probable.
An Example Hybrid Portfolio Transition Strategy
The Table below shows multiple allocations for each of the building blocks in the example Hybrid Portfolio discussed above with allocation to the Dynamic Investment gradually increasing. The top data row is a 100% MPT portfolio and the bottom data row is 100% Dynamic Investment portfolio. The rows in-between show allocations and performance for Hybrid portfolios that utilize both MPT and DIT methods. For each allocation-set the final two columns show average annual returns and risk for the period from 2008 to 2018.
This chart very clearly shows how even a small increase in the allocation of money to a Dynamic Investment can significantly increase the returns of an MPT portfolio without increased risk. It also shows how investors and financial advisors can transition from MPT to DIT methods in a controlled manner.
The NAOI Market-Biased Portfolio - The Perfect Default 401(k) Investment
The Hybrid Portfolio discussed at the top of this page is called the “NAOI Market-Biased” portfolio. Its allocations are automatically biased toward the asset class that is moving up most strongly in price.
The NAOI Market-Biased Portfolio is the perfect “default” investment for a 401(k) or other type of retirement account. In a tax-deferred retirement account there is no penalty for frequent trading. And its high returns combined with low risk puts today’s default investment - Target-Date Funds - to shame. Add to this the fact that changes to the allocations of this portfolio can be automated with no human judgments involved. This is how a “default” 401(k) investment should be defined.
A Vast New World of Product Research and Development
In the limited space available here, I can only touch on the vast number and variety of configurations that the introduction of Dynamic portfolio building blocks makes available to portfolio designers. NAOI offers DI and Dynamic Portfolio Design Training as discussed at this link. The potential for major competitive advantage for financial organizations that offer MPT-DIT Hybrid Portfolios is off-the-charts.