The hot potato portfolio has served up average annual returns of 15.2 per cent since 1981 by using momentum to jump into stocks during bull runs and out of them during long bear markets.
Before digging into the hot potato, it is useful to examine its more conservative cousin, the passive potato portfolio, because the passive potato provides the ingredients for the hot potato.
The passive potato invests an equal amount of money in four major asset classes – Canadian bonds, Canadian stocks, U.S. stocks and international stocks. The idea is to take a relatively hands-off approach to the market while minimizing costs with low-fee index funds or exchange-traded funds, or ETFs.
The passive potato delivered average annual returns of 9.5 per cent from the end of 1980 to the end of July, 2022. (All of the returns herein are based on month-end data and the gains of the FTSE Canada Universe Bond Index, the S&P/TSX Composite Index, the S&P 500 and the MSCI EAFE Index. They include reinvested distributions and assume monthly rebalancing, but they do not include fees, taxes, commissions or other trading frictions.)
The passive potato provides a base that can be easily modified to reflect each investor’s individual risk tolerance by leaning more heavily toward stocks or bonds. As it happens, there are several low-cost balanced ETFs that offer roughly similar portfolios. For instance, passive investors would do well to consider the asset allocation ETFs from Vanguard Investments Canada.
In contrast, the hot potato employs a much more aggressive momentum-based strategy. But be warned, it is not suitable for everyone and it should be avoided by novice investors, in particular.
Simply put, each month the hot potato moves all of its money into the single index (of the four used by the passive potato) that gained the most over the prior 12 months.
While the hot potato might theoretically change its holdings each month, the top-performing index tends to keep its lead for many months. That explains why, in practice, the hot potato swapped indexes 1.7 times a year on average from the end of 1980 through July.
The effort produced average annual returns of 15.2 per cent for the hot potato from the end of 1980 to the end of July. By way of comparison, the hot potato beat the passive potato by an average of 5.7 percentage points a year. You can examine the return history of both portfolios in the accompanying graph.
The hot potato’s bountiful returns were achieved, at least in part, by swapping from stocks to bonds in a timely manner during prolonged market downturns.
For instance, the passive potato was crushed after the internet bubble peaked in 2000 when it fell 29 per cent. It got mashed in the financial crisis of 2008 when it tumbled 31 per cent.
The hot potato fared better despite being roasted in those periods. It lost 21 per cent after the internet bubble burst and it fell 10 per cent in 2008, but fully recovered by the summer of 2009 thanks to a switch to bonds.
In the pandemic crash of 2020, the passive potato dropped 13 per cent before bottoming in March, while the hot potato fell 14 per cent. In this case the hot potato failed to dodge the worst of it because of the speed of the 2020 decline.
Similarly, the market tumble this year caused the hot potato some heartburn because bonds failed to provide a safe haven as interest rates jumped from their pandemic lows. The passive potato fell 15 per cent from its high at the start of the year to its low at the end of June while the hot potato fared a bit better with a decline of 14 per cent.
The hot potato is all-in on Canadian stocks for August and it looks as if it might stay that way in September. But U.S. stocks are rebounding and there’s a chance they’ll usurp Canadian stocks by the end of the month. On the other hand, the downturn might not be over and bonds may yet provide comfort should the hard times linger for another year or two.
I have high hopes the hot potato will continue to serve up delicious returns to active investors over the long term while the passive potato delivers solid results for more conservative investors. But the strengths and weaknesses of both options should be fully considered by investors before they dig in.
Norman Rothery, PhD, CFA, is the founder of StingyInvestor.com.
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Norman Rothery