Alpha Power Investing Newsletter


December 17, 2010

Unnecessary Risks II

In my last newsletter I explored some of the consequences of the primary rule of investing: take no unnecessary risks. If you remember, I showed how an investor could make higher returns over time by taking less risk than someone invested continuously in the stock market.

To prove my point, I constructed three indexes, using the Dow Industrials, the S&P 500, and the S&P MidCap 400. I called these indexes the Alpha Dow, the Alpha 500, and the Alpha 400. The Alpha Dow and the Alpha 500 were constructed by holding the stock indexes from November 1 through April 30 each year, then holding the Barclays Capital Intermediate Treasury Index the other six months. The Alpha 400 was constructed by holding the S&P MidCap 400 from November 1 through May 31, then holding the Barclays Capital Intermediate Treasury Index for the remaining five months each year. These indexes were compared to the continuously held indexes.


As you can see, the Alpha indexes, which have 40%-50% less exposure to the stock market each year, have outperformed their continuously invested counterpart indexes by a wide margin over the past ten years. This past decade has, however, experienced two bear markets, which the Alpha indexes have managed to sidestep for the most part.

Since the S&P MidCap 400 Index is about to celebrate its 30th anniversary in January, I thought it might be instructive to look at the 29 ¾ year record of the Alpha 400 and compare it to the S&P 500. This 29 ¾ year period contains a 20-year bull market and a 10-year sideways market, so the performance of the Alpha 400 during two different investment environments can be compared to the S&P 500.

I chose to compare the Alpha 400 to the S&P 500 for several reasons. First, the S&P 500 is the benchmark index for about 90% of U.S. diversified mutual funds. Second, we know that over rolling five-year periods, most mutual funds fail to outperform this index. We also know that over ten-year periods, about 80% of funds underperform this index. Third, research has shown that the average investor in mutual funds chases performance, resulting in returns that are much lower over time than the funds themselves. Therefore, the average investor has long-term returns much lower than the S&P 500.

That being said, here are the (almost) 30-year performance details for the two indexes:


Looking at the growth of $1.00, we can see that the S&P 500 at the end of 3Q-2010 stands at a cumulative return which is less than the cumulative return at the end of 1999. Over the same time period, the Alpha 400 has gone from $38.35 to $144.57, an increase of about 270%.

How did this happen? A look at the Down Market/Up Market Capture ratios tells the story. Over the past ten years, the Alpha 400 has captured just 26% of the market's losses, while enjoying 95% of its gains. Over the 29 ¾ year period, the Alpha 400 captured just 21% of the market's losses, while capturing 69% of the gains.

When the so-called "investment experts" tell you that you must take more risk to get more returns, please realize that this proposition is simply not true. My own view is that the reason Warren Buffet is one of the richest men in the world as a result of his investment skills is that he has learned how to take less risk than the average investor through the application of superior information and discipline. The Alpha 400, although applying a very different kind of discipline, exploits a recurring causal mechanism which is based on human psychology, and therefore, a constant factor in the investment equation over time. The knowledge of this factor is valuable information and is proven in the long-term history of the Alpha 400.

To discover the cause of the long-term "skewing" of stock market returns into the 6-7 month annual "power zone", both in the U.S. and in over 30 other developed markets globally, read our brochure on the Mid-Cap Power Index Managed Account at the Programs and Performance section of our website at www.alphaim.net.

Sincerely,
Jerry Minton, Ph.D.
President
1-877-229-9400, Ext. 11




© 2010 Alpha Investment Management Inc.

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