From Bogle's Classic to a Robust, Adaptive Trading Model
by David Alan Carter
The 12% Solution started with a nod to the classic 60/40 portfolio, long a staple of passive investors and an idea popularized by Vanguard founder Jack Bogle, who pioneered index investing.
Starting point: 60/40
In a nutshell, the 60/40 portfolio typically invests 60% in "risk-on" stocks, and 40% in "risk-off" bonds. The underlying premise is that both asset classes should make money over the long run. And in the short run, when one asset class "zigs" the other "zags," thereby lessening volatility and reducing overall risk.
This zig and zag is characteristic of asset classes that have an inverse - or non-correlated - relationship with each other, of which stocks and bonds are an example. While there will be times when the two asset classes behave similarly, the drivers that affect equity prices are generally not the same as those that affect bonds.
This zig and zag is characteristic of asset classes that have an inverse - or non-correlated - relationship with each other, of which stocks and bonds are an example. While there will be times when the two asset classes behave similarly, the drivers that affect equity prices are generally not the same as those that affect bonds.
The evolution.
This is where The 12% Solution takes an evolutionary step forward. Spinning off from that static buy-and-hold model, the strategy rotates among multiple ETF candidates representing the two asset classes, each undergoing a monthly relative strength test. Why? Because within the broad equities universe there are categories that will outperform in any given month. Same with bonds: Treasuries may outperform other bonds in any given month, or vice versa, depending on market conditions.
So we test to see which candidates have the greater potential for outperformance in the upcoming month. The winners are bought and held until the process repeats itself the following month. The details, of course, are spelled out in the book.
The classic 60/40 portfolio is a buy-and-hold model. The 12% Solution is a trading strategy. As such, it may incur trading fees (largely nonexistent anymore) and the potential for short-term capital gains taxes (if traded in a traditional brokerage account rather than a tax-advantaged retirement account). Higher returns help offset those potential costs.
The results: outperformance.
While there is no perfect strategy, The 12% Solution was designed to outperform the S&P 500 index over the long run, while providing a greater margin of safety than holding equities alone. To that end, I believe it's been quite successful, and remains a core holding of mine.
Chart: ETFreplay.com
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