Most Downloaded SSRN Paper Ever Says You Should Be in Cash

There are two good reasons to take a look this week at the most downloaded paper on the Social Science Research Network. For a start, we're heading into Labor Day weekend, which means it's time for light beach reading. Second, the paper is focused on a market-timing strategy, and this particular market timing strategy current suggests investors should proceed with utmost caution.

Here's Mebane Faber, the paper's author and co-founder of Cambria Investment Management, on Twitter on Tuesday:

In other words a portfolio based on the paper's strategy would be fully invested in cash and bonds last month—no stocks. As Faber noted, that's extremely rare, occurring less than 7 percent of the time. The potentially most worrisome bit is that the last time this happened was in the depths of the financial crisis.

Founded in the 1990s by two financial economists, the SSRN has quickly become a go-to website for a large number of people in the finance industry. The site's concept is pretty simple: It allows authors to upload their academic papers directly to the site for free downloading worldwide, while publishers and institutions have the option of uploading papers and charging a fee for each download.

The most popular paper on the website is Faber's "A Quantitative Approach to Tactical Asset Allocation."

Originally published in 2006 and most recently updated in 2013, his paper has been downloaded more than 150,000 times on SSRN. It focuses on a market-timing technique to help investors smooth volatility in their portfolios while remaining in profitable positions—and protecting themselves should the bubble burst.

Here's an illustration of the problem Faber is trying to solve.

While investing in any of these assets would have produced returns for investors for many years, it would also subject them to the risk of significant periodic "drawdowns" when prices drop suddenly from peaks:

Faber suggests a market-timing solution, or a "risk-reduction technique that signals when an investor should exit a risky asset class in favor of risk-free investments." One particular brand of market timing he suggests works this way: Investors should buy when a security's monthly price is higher than its 10-month simple moving average and sell when the price is less than the 10-month simple moving average.

You can see a comparison of this strategy vs. a buy-and-hold approach in the Standard & Poor's 500-stock index below:

While the timing model did perform slightly better and certainly reduced volatility, it's worth keeping in mind that Faber's approach does not, for practical reasons, take into account such things as taxes and commissions.

In bad years, however, his strategy appears to make a huge difference:

Faber goes on to make a number of other changes, including different levels of diversification, and more aggressive moves such as using leverage. He also uses his Global Tactical Asset Allocation strategy to encompass five global asset classes with equal weightings: U.S. stocks, foreign stocks, bonds, real estate, and commodities. He looked at both a buy-and-hold strategy and a timing strategy by which the portfolio treats each asset class independently and is either long the asset class or in cash with its 20 percent allocation.

The chart below shows the performance of each, both respectable, but the timing portfolio's results show a reduction of volatility all the way down to single-digit levels, along with a maximum drawdown of single digits. Remarkably, the investor would have experienced only one down year of less than -1 percent since 1973, when the analysis begins:

In the paper's conclusion, Faber says investors would be best-served by using his simplest model—avoiding losses via moving averages—or one of his more complex (yet still pretty simple) model portfolios. Nevertheless, a lot depends on how much time investors want to allocate to tailoring their portfolio, as well as what stage of life they are in.

A non-discretionary, trend following model acts as a risk-reduction technique with no adverse impact on return. Utilizing a monthly system since 1973, an investor would have been able to increase risk adjusted returns by diversifying portfolio assets and employing a market-timing solution. In addition, the investor would have also been able to sidestep many of the protracted bear markets in various asset classes. Avoiding these massive losses would have resulted in equity-like returns with bond-like volatility and drawdown

Head here to read the full paper, or take a look at some of SSRN's other top downloads.

You can read Faber's most recent thoughts on timing this particular market here.

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