Wednesday, January 14, 2015
Kelly, The 3% Signal
Kelly starts with the assumption that the stock market is a zero-validity environment, what is commonly known as a random walk. Outcomes are unpredictable, and both expert and amateur stock pickers are wrong about half the time. Market timers face even tougher odds. In a 1975 study William Sharpe found that “timers need a 74 percent accuracy rate to beat a passive portfolio taking on the same amount of risk.” (p. 25)
Is there any way to beat the market? Yes, the author claims. His solution is the 3% signal. It has six components: “the growth vehicle where we keep most of our capital during our working years; the safety vehicle where we keep a smaller portion of our capital; the target allocation of capital between the growth and safety vehicles; the safety vehicle allocation at which a rebalance back to its target is triggered; the timing of our growth signal; and the growth target.” (p. 37) Although the investor can define his own permutations of these components, the default plan is “a small-company stock fund as the growth vehicle; a bond fund as the safety vehicle; an 80/20 target allocation between the stock and bond funds; a 30 percent bond allocation threshold that triggers rebalancing back to 80/20; a quarterly timing schedule; and a 3 percent growth target.” (p. 38)
As you may gather, what sets this system apart from and makes it superior to most rebalancing plans is the 3% signal. At the end of each quarter you rebalance based on how much your stock fund grew or didn’t—more than 3%, sell the extra profits and put them into your bond fund; less than 3%, use bond proceeds to bring your stock fund up to its target 3% quarterly growth rate.
The author’s research indicates that 3% per quarter is the outperformance sweet spot. This quarterly performance yields an annual return of 12.6%, 26% better than the market’s annual performance of 10% over the past ninety years. (p. 56) And we know how that extra performance compounds.
Kelly carefully describes how investors can put this outline of a plan into action—what kinds of funds they might use, how they might opt to adjust the default allocation as they age, how they can survive market crashes. He even follows three hypothetical investors as they try to navigate the stock market from December 2000 to June 2013. It should come as no surprise that the one who used the 3% signal fared best.
We often hear, and have come to believe, that models beat experts. Kelly offers the individual investor a simple, mechanical model that instills discipline, removes a lot of self-sabotaging emotion, and has a good track record. Will it continue to outperform? Actually, it just might.