A haphazard approach to investing is the default among the investing public. Investors see an array of options from individual stocks and sector funds to annuities, real estate, collectibles, and private businesses, all promoted by middlemen with compelling narratives. It’s easy to throw some money here and some money there, and maybe keep some under the mattress.

The results are on average terrible and at worst, devastating. The table below from JP Morgan (individual investor data from Dalbar) shows that even when good returns are available, few actually get them. Led astray by narratives and emotions, many investors mis-time their allocations, and on par realize net returns barely above inflation.

The passive investing doctrine is solid advice. This is why sages like Warren Buffett and the late Jack Bogle (founder of Vanguard) tell us not to try to time the stock market, but to invest regularly and hold on no matter what.

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For the mass of investors, for whom a message must be simple and consistent, out of all the advice they commonly receive, this will always be among the best: “Save as much as you can, take advantage of retirement plans and tax-advantaged accounts, and don’t sell a share until you’re 65.”

The most nuance the public can handle is to own more stocks when you are young and more bonds as you get older (100 minus your age is a prudent guideline). Clearly, few investors are content to take this advice, because if they were, it would show in their returns.

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Many simply haven’t heard the gospel of passive investing, but others are betrayed by an impulse to achieve better than average results. In light of the above, is it worth it to bother with anything more complicated than a vanilla portfolio of passively managed US stocks and bonds?

Are alternative assets like gold, real estate investment trusts (REITs), foreign stocks, foreign bonds, and commodities worth the complication? Objectively, yes.

A plan that takes advantage of uncorrelated return streams and adapts to changing environments is inherently more robust than a vanilla US stock and bond portfolio.

It isn’t active investing itself that is inherently hazardous, but unstructured active investing – buying gold because you are suddenly worried about deficits, selling stocks because you don’t like the new president, or getting aggressive when the economy looks rosy and then bailing during the next recession.

If active investing were inherently hazardous, the fund managers with the best long-term records wouldn’t overwhelmingly be value investors or trend followers. Haphazardness is our enemy, because an investor without a plan is at the whim of their emotions and whatever narratives resonate with them at that point in time.

A passive indexer may experience volatility in their account, but the discipline to keep adding to their account through drawdowns will keep them on track. Clearly, if you are going to stray from Bogle’s advice, you had better know what you are doing.

How might an investor outperform traditional passive methodologies?

We start with the same assumptions as the indexers: we can’t trust our whims and leave our nest eggs to chance. Our approach must be grounded in intuition and empiricism. This means defining objective rules, because only rules can be tested, and only rules can keep us on track. Below we illustrate some basic rules that go a step or two beyond 100 minus your age, because despite what the gospel of indexing says, it is not always a great time to invest in US stocks. Indexers acknowledge that individuals are fallible, but they turn a blind eye to the aggregate effects of that fallibility. We may go mad singly, but more often en masse.

Now that a century of data can be dropped into a spreadsheet, we can eliminate the mystique of value investing and trend following. It turns out that the greatest investors of older generations weren’t wizards after all, that is, if you consider complexity a requirement for wizardry. What they were was disciplined, and to be fair, their discipline was all the more impressive given that they couldn’t tap a few keys and see a 100-year simulation of returns. They simply had intuitive conviction in the respective wisdom of paying low multiples for steady cash flows, or buying leaders and selling losers. Few are blessed with such abilities, hence the sagacity of Mr. Bogle, and the value of his invention, the index fund.

Embrace better rules

There are good reasons to take a more active approach if it is a disciplined and well executed one. Through such an approach, it is possible to achieve outsized returns and lower downside volatility – and therefore, enhance risk-adjusted returns. In fact, the way to achieve this is to apply the same conviction and discipline as indexers, just in an enhanced manner.

The strengths of an index are no mystery. They are diversification (among stocks at least), a minimal value screen (the Dow Jones Industrial Average and S&P 500 have earnings requirements), and a momentum filter (stocks that decline have their weights reduced and are finally dropped).

These rudimentary rules are enough to keep the indices trending up on a long enough timeline, but there is nothing magical about them. Anyone today can create and deploy rules that better suit their needs. Many of these rules are best applied directly to indices, and if indices themselves are the result of rules, at what level do we consider a process active as opposed to passive?

Example #1: If we invest in the S&P 500, but only when it is in an uptrend – as defined by hard and fast, quantitative rules – we are remedying a serious deficiency – historical data shows that avoiding asset classes that are in downtrends is a reliable way to reduce the risk of large losses, and without such a rule, we ignore this data at our own peril.

Example #2: If, rather than holding just the top 500 stocks in the US by market capitalization (essentially the investment strategy of the S&P 500), we concentrate our portfolio in the top stocks as ranked by trailing price momentum, we would have historically outperformed the index itself. Again – we ignore this data at our detriment.

Example #3: If, rather than building a portfolio exclusively of US stocks, we add diversifying assets like US bonds, foreign stocks and bonds, gold, commodities, and alternative assets like reinsurance, we would have benefited from lower volatility and portfolio drawdowns, thereby enhancing risk-adjusted returns.

All of the major indices were designed for tracking and reporting, not investing, and as such they will ensure that an investor behaves only as sanely those around him.

Surely we should embrace a mechanical process that protects us from the brunt of crashes and allows us to invest when the crowd is selling cheap. In the year 2000, investors were sanguine about high valuations, and in 2009 most were bearish despite much lower valuations. Today again, most investors are clearly comfortable paying nearly 25 times a trailing 10-year average of earnings. Clearly, individuals can benefit from passive processes that cannot be applied in aggregate.

This is what systematic tactical allocators do. They build indices, but rather than building indices for tracking and reporting, they build rule sets for investors who desire better performance, whether that means higher returns or less downside.

Today, the investable universe has expanded far beyond US stocks, transaction costs have dwindled, and computing has made it easy to define and follow an optimal process. As an insider, I can tell you that few professionals even attempt to do this, as gathering and retaining assets is actually easier when you follow the crowd.

Thus, individuals who have the conviction and discipline to follow different rules are likely to find themselves at the top of the ranks. It truly is the best time in history to be an individual investor.

To learn more about building indexed portfolios with better rules, I suggest the following resources as great a great starting point:

• Mebane Faber’s Paper – A Quantitative Approach to Tactical Asset Allocation
• Andreas Clenow’s Book – Stocks on the Move
• Michael Covel’s Book – Trend Following

Brent Hause is a Portfolio Manager, Financial Advisor and Partner at Fortuna Investors, an independent Registered Investment Advisor with an office in South Lake Tahoe. More information is available at http://www.fortunainvestors.com, or by calling (530) 600-2040. No part of this article should be construed as a recommendation to buy or sell securities, or as personal financial advice.