So if I'm understanding correctly, you are essentially asking if active investing makes sense? Of course the tongue in cheek answer is "yes, but only if you can generate Alpha."
You can make allocation decisions based on all sorts of models, but I would first clearly define what your strategy is. Certain sectors will outperform at certain times, but to make money on such knowledge requires the following:
1. You can identify the underlying conditions that cause certain sectors to outperform
2. You can predict when those underlying conditions will occur
3. You can position ahead of other market participants who have the same idea (maybe because they are using the same models/datasets you are, but more likely they have even better models/datasets)
4. You can exit the position at a profit prior to when the rest of market participants attempt to exit their positions
5. You have the emotional/psychological fortitude to execute steps 3 and 4
The above is true regardless of if your time horizon is measured in hours or years. Keeping an allocation is making an active trading decision just as much as changing an allocation is.
I'm not sure it would be classed as active investing? Setting fixed allocations of your portfolio to index funds.
On the surface that makes sense, however there are a lot of underlying assumptions built in to make that true (Jacob points out the demographic assumptions in his article):
1. The market is properly pricing in all risk (Efficient Market Hypothesis)
2. Variability in returns has the same impact on all market participants. If I'm a long-only retail investor, why do I consider upside risk a risk at all?
3. Bonds are less risky than stocks. There are a number of macroeconomic factors that can render this untrue to include inflation, government debt, etc. Look at past year to see how bonds and stocks are correlated in certain macro environments.
Jacob is pushing back (and has been for 15+ years) on the widely held belief in certain circles that in the long term, stocks can only go up and/or are less risky than bonds. It's worth understanding all the unspoken assumptions that have to hold true to keep that belief afloat. This will allow you to determine if/when those assumptions no longer hold true and a change in strategy is warranted.
What's the alternative though? I think as long as the worlds population continues to grow, company's will grow/ become more profitable?
I recommend the Bodie and the econ books from http://earlyretirementextreme.com/start ... sting.html to understand the foundation of CAPM and Cobb-Douglas. It's just a lot easier to understand these things in context instead of using google+"I disagree"-style debate which often misses context.
"That" is your entire definition of risk, presumption that risky assets are priced appropriately, and presumption that there is a linear relationship between risk/returns. You are referencing the CAPM model, which comes with many flawed assumptions that have already been pointed out by Fama-French and others 30+ years ago.
The Fama-French only showed that the CAPM model was incomplete. I don't remember the exact numbers, but they said that something like 60% of the price is explained by the simple model, but when you introduce 2 factors, that brings you up to 85%, and when you introduce 3 more factors, it's something like 95%.
But I certainly don't need all those assumptions to hold true for what I am saying. I am simply saying... there IS a reason why a long term institutional investor would want to hold bonds. All I need is to assume that bonds will be less volatile than stocks. (I certainly don't need the efficient market hypothesis, or a linear relationship between risk and returns I guess I would need "a" relationship)
My motivation for a 20% tilt to small cap value funds was diversification, even more than increasing total expected returns. I already have enough invested in my cap-weighted index funds to live comfortably on a 3% per year drawdown. Now I want to increase the likelihood of that 3% drawdown working out, by diversifying further.
But how to diversify? Apart from just adding more to the index funds? I turned to small cap value, as there seems to be support in the academic literature (including the Journal of Financial Economics) for small cap value helping to smooth returns due to benefiting from risk factors independent of the market risk captured by a total market index fund.
Over the past 1-year period the diversification benefit has been realised. While VTSAX dropped from 120 to 100, AVUV more or less held its own and AVDV only dropped from 66 to 54.
Over the past 1-year period the diversification benefit has been realised. While VTSAX dropped from 120 to 100, AVUV more or less held its own and AVDV only dropped from 66 to 54.
