A Strategy for Every Market

By TradeSmith Editorial Staff

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Peter Lynch was a legend – an investment pro to remember.

From 1977 to 1990, he ran Fidelity Magellan, which became the biggest mutual fund on the Street. Under Lynch’s stewardship, that fund generated an average annual return of 29% — enough to turn $10,000 into $270,000 by the end of that run.

Lynch parlayed that success into global fame. He authored the mega-bestseller “One Up on Wall Street.” And he popularized the mantra “Invest in what you know.”

This supernova performance is a major outlier in the universe of mutual funds, which are known largely for their lackluster performance.

But there’s a little-known backstory to this tale of wealth creation — one that’s a downright stunner. You’d probably assume that anyone smart enough to invest in Lynch’s fund made a real financial killing.

But you’d be wrong.

Fidelity itself did some research. And the company’s findings were almost as stunning as Lynch’s track record.

Not only did the typical Magellan investor NOT make 29% a year.

They didn’t make anything at all.

That’s right: During a stretch that saw the fund double every two or three years, the average Magellan investor lost money.

And these dismal results weren’t limited to Magellan.

Most individual investors earn far less than the “average returns” of the markets, funds, or individual stocks they own for one simple reason: emotion.

You see, markets are volatile. So are the investments we make. And while we’re all told to “buy low and sell high,” most investors lack the stomach for the whipsawing that volatility inflicts.

Most investors succumb to emotion. They ignore stocks when they’re cheap, experience “FOMO” (fear of missing out) when those shares start to run, and then ride those stocks down to the point of maximum pain (and maximum losses) when those once-hot stocks roll over and fall — and end up selling at a loss.

There are variations of this scenario, but you get the general idea. Besides, all variations end the same way: Instead of beating the market, these folks get left behind.

It’s a mistake that happens more often now than back when Lynch ruled Wall Street. Research released late last year said stocks were experiencing their most volatile stretch in nearly 15 years.

But what if I told you there was an easy way to exit this emotional roller coaster forever?

What if I told you there was a simple investment approach that has returned nearly 10% a year on average for the past 100 years with surprisingly little volatility?

And that you could manage this portfolio in just a few minutes a month?

Though it sounds (almost) too good to be true, I’m here to tell you it’s possible.

It all has to do with an investing mindset I refer to as “portfolio thinking” — a look at how different assets and asset classes work together to create an overall investment portfolio.

The Standard 60/40

The concept of portfolio thinking dates back to the 1950s. That’s when U.S. economist Harry Markowitz showed that investing in a combination of different asset classes — like stocks and bonds — can produce better risk-adjusted returns than you’d get by investing in either one alone.

(A “risk-adjusted return” is just what it sounds like: It’s a measure of how much risk you’re taking to achieve a given amount of return.)

Markowitz’s research ultimately led to the “60/40 portfolio” that’s still recommended by many investment managers today.

This means you’re 60% in stocks and 40% in bonds.

Again, this allocation is usually an improvement over owning either one of those assets alone. It produces far better average returns than a portfolio of 100% bonds, with less risk than one that’s 100% in stocks.

But the approach does have some severe shortcomings.

First, the 60/40 portfolio is still riskier than most investors can comfortably manage.

This portfolio still has the majority of its risk concentrated in stocks, and stocks are historically about three times riskier than bonds. If the stock market tanks, this portfolio is likely to experience a significant hit too.

Second, this portfolio assumes that stocks and bonds are always “inversely correlated.” That’s a fancy way of saying that they generally move opposite of each other. When one does poorly, the other tends to do well, and vice versa.

And that’s not always the case.

In fact, the 60/40 strategy has come under a lot of fire lately for just that reason.

At one point last fall, a 60/40 model portfolio was down a wrenching 20% for the year. And while that mix of stocks and bonds had been a top performer — generating a market-beating 11.1% average annual return for the previous decade — researchers underscored this isn’t always the case.

During the “Lost Decade” at the start of the 2000s, the 60/40 portfolio generated a 2.3% annual return, meaning investors would actually have lost money on an inflation-adjusted basis.

In short, despite its “balanced” reputation, the 60/40 portfolio tends to outperform when stocks do well and underperform when stocks struggle.

At best, we can say that stocks and bonds experience a dynamic correlation over time.

A Billionaire’s Secret

Here is where a man named Ray Dalio comes in.

Dalio is probably the best investor most folks don’t know. He’s the founder of Bridgewater Associates, the largest hedge fund on the planet, with more than $150 billion in assets under management (AUM). And he’s No. 83 on the Forbes World Billionaire Index.

Dalio is also one of the first investors to truly closely study the problems with traditional portfolio strategies. And he made some fantastic insights that have greatly influenced our work here at TradeSmith.

One of his key contributions: a concept known as “risk parity.” He demonstrated that the most successful investors don’t allocate their portfolios based on the amount of money invested in each asset or position. Instead, they allocate their portfolios based on the amount of money at risk in each asset or position.

Dalio also identified four primary market environments — or “seasons” — that move asset prices. These are:

  1. Higher-than-expected inflation.
  2. Lower-than-expected inflation (or deflation).
  3. Higher-than-expected economic growth.
  4. Lower-than-expected economic growth.
He then mapped out the major asset classes by the season in which they perform best, like so:

RISING• Stocks
• Corporate Bonds
• Gold/Commodities
• Gold/Commodities
• Inflation-Linked Bonds
FALLING• Government Bonds
• Inflation-Linked Bonds
• Government Bonds
• Stocks

Dalio combined these ideas of “risk parity” and “market seasons” to create what he called the “All Weather” strategy. He designed it to manage his family’s investments, but he eventually opened it up to his wealthy hedge fund clients as well.

This strategy consists of a diversified, global portfolio of up to 40 different investments, with risk spread equally among the four quadrants we detailed above.

In other words, while it may own different numbers and types of assets in each of the four seasons, it risks an equal amount of money (25%) in each of them.

Don’t Forget Income

The idea behind the strategy is both simple and brilliant.

If there are only four primary seasons that drive asset performance — but it’s difficult (even impossible) to predict when any specific season is likely to arrive — a well-balanced portfolio should be able to perform well in any of them.

Dalio designed the “All Weather” strategy to do just that. And it has certainly delivered so far. Since its inception in 1996, this strategy has generated close to 10% average annualized returns.

That’s virtually identical to the returns of a conventional 60/40 portfolio over the same period. But it has done so with roughly half the volatility and with significantly smaller drawdowns than the traditional portfolio.

And testing that reaches further back underscores its consistency.

From 1978 until March 2022, a hypothetical $10,000 investment in the Ray Dalio All Weather Portfolio would have grown to $520,000. With a compound annual growth rate (CAGR) of 9.34%, the portfolio outperformed its risk (7.94%) by 140 basis points.

Unfortunately, folks like you and I can’t invest directly in Dalio’s portfolio. Bridgewater is no longer accepting new investors in the All Weather strategy, but you needed at least $100 million in investable assets to qualify even when it did. And the specific asset allocation used in the strategy has never been made public.

However, several years ago, in an interview for Tony Robbins’ book “Money: Master the Game,” Dalio did reveal a simple, “do it yourself” version of the All Weather strategy that any investor could follow.

The performance of this “All Seasons” portfolio, as it has since become known, has been impressive as well.

It, too, has generated an average annual return of nearly 10% — this time going all the way back to 1927. Yet it has done so with significantly less volatility — and smaller drawdowns — than either the market or a conventional 60/40 portfolio.

For example, over those 93 years, the All Seasons portfolio suffered just 17 losing years (18%) — versus 25 losing years (27%) in the S&P 500. And the average loss in those years was less than 4%, compared to more than 13% in the S&P 500.

Portfolio allocation isn’t the only thing you have to look at differently because of revved-up market volatility.

You also need to take a new view of income. It’s no longer enough to ferret out CDs or bonds or conventional dividend-paying stocks. The best income investors combine those with a strategy that’s more active — but that also keeps risk at arm’s length.

It’s a change I saw coming, which is why I brought one of the industry’s shrewdest income strategists to the TradeSmith team. This expert has a strategy that can capture additional income on high-quality stocks that anyone would be proud to hold in their portfolio.

It’s a change I saw coming, which is why I brought on one of the industry’s shrewdest income strategists to the TradeSmith team: Senior Analyst Mike Burnick. Mike is always looking for these types of opportunities in Ultimate Income, which you have 24/7 access to as a part of your membership. You can keep up with all of Mike’s updates and alerts by bookmarking this page.