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A Few Notes on The 3% Signal

Posted in Strategic Allocation, Volatility Effects

In the introduction to his 2015 book entitled The 3% Signal: The Investing Technique that Will Change Your Life, author Jason Kelly states: “Ideas count for nothing; opinions are distractions. The only thing that matters is the price of an investment and whether it’s below a level indicating a good time to buy or above a level indicating a good time to sell. We can know that level and monitor prices on our own, no experts required, and react appropriately to what prices and the level tell us. Even better, we can automate the reaction because it’s purely mathematical. This is the essence of the 3 percent signal [3Sig]. …Used with common market indexes, this simple plan beats the stock market. …The performance advantage of the 3 percent signal can be yours after just four fifteen-minute calculations per year…” Based on his experience and analyses, he concludes that:

From Chapter 1, “Why Markets Baffle Us” (Pages 33-34): “Some people spend years of their lives striving admirably to improve their skills and performance in a field that defies improvement, the stock market. They experience stress and frustration at each missed cycle, and many don’t discover until late in life that they’ve given too much of their limited time to a hopeless endeavor. …Stock stress can become an all-consuming worry; a burrowing, hollow disappointment at what went wrong; and worse, a realization that you aren’t sure how to fix it without compounding your troubles.”

From Chapter 2, “Harnessing Fluctuation” (Pages 38, 40): “At the end of each quarter, you’ll look at your stock fund balance. If it grew 3 percent, you’ll do nothing. If it grew more than 3 percent, you’ll sell the extra profit and put the proceeds into your bond fund. If it grew less than 3 percent or lost money, you’ll use proceeds from your bond fund to buy your stock fund up to the balance it would have attained if it had grown 3 percent in the quarter. In this manner, you will mechanically extract profit from price fluctuation. …you’ll need just two cheap index funds, one for small-company stocks and one for bonds.”

From Chapter 3, “Setting a Performance Goal” (Pages 57, 62, 76): “I’ve found this 3 percent quarterly rate to be the sweet spot of risk and reward. It’s not so high that we need to take extraordinary measures to achieve it, but it’s not so low that we barely notice the benefit of beating the market. …Our aim is to maximize profits while minimizing activity, and a quarterly pace achieves this aim. …we’re occasionally going to have to manage cash shortages [when the bond fund runs dry]. As long as you can fund them, they’re great opportunities.”

From Chapter 4, “What Investments to Use” (Pages 82, 87, 112): “Small-company indexes outpace the S&P 500 on their own, and we’ll improve their performance even more with 3Sig. …examples use Vanguard GNMA as the bond fund because it was in business back in 2000…Since April 2007, however, cheaper alternatives to Vanguard GNMA have existed, and you should take advantage of them. …The stick-around mode is triggered when the quarterly closing price of SPY falls 30 percent from its quarterly closing price within the past two years. ‘Stick around’ means you’ll ignore the next four sell signals…You’ll exit stick-around mode and resume the regular plan after you’ve ignored four sell signals or two years have passed.”

From Chapter 5, “Managing Money in the Plan” (Page 157): “…regular [cash] contributions will initially go into your bond fund, but half their value will be added to the 3 percent growth target, to draw new capital into the plan. A ‘bottom-buying’ account outside the plan can power signals during rare buying opportunities that require more capital than you have in the bond fund.”

From Chapter 6, “The Plan in Action” (Page 169): “…you can fare pretty well in 3Sig outside retirement accounts by keeping track of when you bought various lots…and specifying that you want to sell lots you’ve owned for more than a year when the plan signals a sale.”

From Chapter 7, “The Life of the Plan” (Page 295): “The 3Sig plan provides a low-stress beacon through the chaos of the stock market.”

From Chapter 8, “Happy Signalling” (Pages 297-298): “The stock market is humanity’s monkey mind writ large…The more enlightened way to navigate the complexity is by letting it all go…letting an unemotional formula tell you what the prices mean you should do, and then doing it.”

In summary, investors may find The 3% Signal an intuitively attractive approach to strategic and tactical allocations of assets among stocks, bonds and cash.

Cautions regarding conclusions include:

  • Backtest periods are generally short for assessment of annualized returns, and extremely short in terms of number of equity bull and bear markets and number of “stick-around mode” measurement intervals.
  • Bond funds are not risk free. They have tended to perform well over the last three decades as interest rates generally declined. Bond funds may not be “safe” or even profitable in a rising interest rate environment.
  • It is difficult to assess the overall performance of the 3Sig portfolio because the effective allocations to stocks, bonds and cash vary and are unknown ex ante:
    • The stock fund targets a 3% per quarter (about 12.6% annualized) return, but this return sometimes comes from transfers out of the bond fund rather than return on the investment in stocks. The quarterly target is suspended during “stick-around mode,” during which there is no target return.
    • The bond fund has no target return.
    • The cash component derives from an occasional need to put “new cash” into the bond fund when transfers to the stock fund exhaust the bond fund. The allocation to cash is difficult to estimate in advance. The return on cash is zero.
  • Any optimization of thresholds such as the 3% quarterly equity return target, the 80-20 base stocks-bonds allocation, the 30 percent bond ceiling for rebalancing and the “30 down, stick around” rule would inject data snooping bias, tending to overstate out-of-sample expectations. Snooping bias can be especially large when the number of signals involved is small (as for “30 down, stick around”).
  • Much research indicates that the equity size effect (small beats big) varies considerably over time. The available sample period may be favorable for the size effect.
  • Backtests generally assume zero trading/dividend reinvestment frictions. No-fee fund trading at some brokers and infrequent (quarterly) rebalancing mitigate this concern.
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