Hi Tim <CAUTION>Long Techie Post</CAUTION>
AIM or other similar stock/cash blends (Ladder/EZM etc.) in part exploit the simple (arithmetic) versus compound (geometric) effects.
As a simple model consider that cash = dividends = inflation = stock capital gain, so in effect the dividend represents the equity risk-premium. Also assume that cash = 5%, so stocks yield 5% dividends and 5% capital growth, 10% total benefit for stocks compared to 5% for cash.
This model holds more true for the UK market where taxation treatment hasn't been biased as much as it has in the US (US taxation favouring paying less in dividends).
Also assume that stock capital prices traverse +21% in each of two years and -21% in the third year (in any order) - an overall average 7% p.a. simple average, but a compound average of 5% (4.97% to be exact).
With 5% dividends therefore and with say a 50/50 overall stock/cash average blend we see yearly TOTAL returns of ((26+5)/2) in two years and ((-16+5)/2) in the third year total returns, 15.5% in two years, -5.5% in the third year, which has a compound average of 8%, compared to buy and hold which compound out to 10% p.a.
Ladder trades - which are similar to AIM trades - add around 1.5% p.a. net additional benefit. Add that 'trading' benefit onto the above 8% and the total rises to 9.5% versus 10% for B&H. This assumes that an overall 50/50 stock/cash blend occurred over the investment period. Where the average stock/cash blend is higher (60/40 stock/cash etc.) then AIM-like starts potentially pacing B&H and at even higher levels (e.g. 75/25 stock/cash) it potential betters B&H on a compound basis.
What AIM/Ladder do is in effect provide near (but slightly lower) equity like returns yet do so via a blend of stock and cash and as such has lower volatility - that lower volatility then helps uplift the compound average closer to the simple average and hence closer to or in excess of conventional buy-and-hold.
Equity like returns, but with reduced correlation to conventional buy-and-hold.
What I personally do is extend this concept further. I use a proportional Ladder to partition the full account, tuning the top and bottom levels of the ladder (points at which the ladder goes 100% cash/100% all-in respectively) such that the central third spans another top and bottom range in which I believe prices will actually range. I then only trade that central 1/3rd using Ladder indicated amounts (not selling anymore if the inner top is breached, not buying any more if the inner bottom is breached). I allocate the top third to conventional buy-and-hold, whilst the bottom third is allocated to a Managed Futures style.
Individually each of the buy-and-hold, central ladder trading based (AIM/Ladder/EZM) and bottom third Managed Futures style have equity like returns, but do so with different correlation's - and hence overall lowers volatility across the set. The collective set therefore has total compound investment benefits that should be higher than conventional buy-and-hold.
In effect its just simple style diversification, with each component having equity like longer term returns, but having low/inverse correlation which reduce the volatility and uplift the compound average closer to the simpler average. That compound based uplift helps compensate (or more) the 'cash-drag' effects contained with the style.
vWave like measures help us gauge how much stock/cash blend to carry in that 'traded' central third component. Effectively increasing the stock/cash ratio during Bull like/potential periods and reducing the stock/cash ratio during Bear like/potential periods. Which potentially helps uplift overall total investment return.
Having a overall structure such as the above helps ensure that we're on the right road using automated reactive based measures/triggers. Beneath that we can tune our stock selections to also help reduce volatility (diversification) whilst maintaining overall average investment benefits - which in turn might help uplift the overall total investment return.
This helps me understand which of the 3 methods to use in the construct of a relative valuation metric
A problem I think you will encounter is that relative valuations tend to reflect short/mid term or single periods only. For example AIM typically will relatively under-perform during Bull periods, but when prices decline then that relative difference closes/reverses (lower volatility). That smoothing has the effect of uplifting the compound average as I've described above.
In order to capture the best picture of the U.S. equity market, one needs an index of at least 2500 stocks
You can capture that measure if you like, but as in more recent times when the vast majority of stocks all move in a correlated downward move then your volatility increases (compound average declines). Perhaps then rather than, as many do, looking too much at stocks/trends in a predictive manner, you might like to instead focus more on style diversification and reactive based money management practice. Securing equity like returns contained within separate low correlated styles will more likely help uplift total returns closer to the (higher) simple average ;>)
Regards. Clive.
Market Data 
Markets 
AI
