Upgrading Winning Streak Now
at Nine Years and Counting

Investors were tested emotionally by the stock market in 2007. Those who followed SMI's model portfolios were ultimately rewarded, as both Just-the-Basics and Upgrading notched another year of market-beating returns. While the story ultimately provided a happy ending, it certainly wasn't without plenty of plot twists along the way to keep investors guessing.

The big story of 2007 was the return of market volatility. Three distinct waves of fear hit the market in February, July, and November. This volatility felt extreme due to the unusually tame behavior of the stock market the past few years, but closer examination reveals it was really just a return to more normal levels. While 2006 had witnessed a fairly significant summer swoon, it's safe to say that 2007 was the year many investors got reaquainted with the idea of market risk and fear. (SMI web members can review the Editor's Weblog  post from 12/18/2007 titled "Volatile Markets?" for a detailed discussion of this topic and two charts that vividly illustrate that 2007's volatility was fairly typical.)

A second significant subplot in 2007 was the return to prominence of the growth management style after many years of the market favoring value funds. This is vividly illustrated in the category returns table below. Upgrading's strong 2007 returns were clearly helped by our overweighting of growth over value among both small- and large-company funds last year. We expect this trend to continue, which is why we nudged our allocations even further in favor of growth over value for 2008. (For more, see Adjusting Your Allocations For 2008's Market Probabilities. )

Shifting our attention to the long-term track record of SMI's model portfolios in the table below, a number of things stand out. On the bottom line of the table, the size of the gap between Upgrading's annual rate of return and the market's is striking. The failure of the 2000-2002 bear market to damper the long-term advancement of Upgrading's gains is also worth noting. Remember, this was arguably the worst bear market in a generation, and certainly the worst of the past few decades. Yet just five years later, despite staying fully invested throughout the whole bear market, Upgrading's long-term performance record makes the bear market look like a mere speedbump on the road to huge overall gains.

Two factors have been primarily responsible for Upgrading's long-term success. The first is a virtue we preach every month through SMI's Four Levels framework: diversification. Between 2004-2007, Upgrading generated the following annual returns—+17.3%, +12.0%, +17.4%, +14.3%. Very consistent. What's striking is during that period the market shifted completely—from strongly favoring value to strongly favoring growth, and from strongly favoring small-companies to slightly favoring large ones. Yet you'd never realize such a radical transition took place by looking at the bottom-line results of Upgrading.

Here's another way to illustrate the value of diversification. Between 1999-2006, the average small/value fund tracked by Morningstar gained +13.2% per year. The average large/growth gained just +1.1% per year. When one category outperforms the others by such a large margin over an extended period of time, research has repeatedly shown that investors chase that recent performance, piling into what's been hot. So you can bet many investors sold their large/growth holdings and bought small/value—just in time for 2007, when the average small/value fund lost money and the large/growth led all risk categories with the average fund gaining 12.5%. Diversification sometimes feels like the stodgy parent forcing you to eat your vegetables when all you really want is dessert. But over time, it smoothes your results (and emotions!) while allowing major market transitions to occur almost invisibly beneath the surface of your portfolio.

The second factor that is primarily responsible for Upgrading's superb long-term track record is fund selection. The table above illustrates the effectiveness of Upgrading's fund selection process. In every stock category, SMI's recommended funds significantly outperformed the average fund. This doesn't mean that every fund recommendation works out—if only things were that simple! But it does mean that Upgrading's strict selling discipline acts quickly to remove those funds that don't significantly outperform their peers, while allowing those that do to rack up significant gains.

Month by month, fund by fund, Upgrading has established a track record of superior returns. Best of all, as the Full Performance table below clearly demonstrates Upgrading is no "one trick pony" that is only capable of generating superior returns in certain market environments. That's a common criticism of momentum-based strategies. While Upgrading admittedly has its challenging periods, during which we have to patiently wait for the system to respond to a new market environment, the past decade has vividly illustrated its ability to excel in all types of markets: bull, bear, and everything in between.

That's a tremendous comfort at times like these, when so much speculation abounds regarding the economy and future direction of the stock market. SMI readers can look to the past and see that even without any market timing maneuvers or other tweaks, Upgrading was up to the challenge the last time a nasty old bear came to call on Wall Street. Chances are, it will do just as good a job with the next bear market, whenever it arrives.

Mark Biller is Sound Mind Investing's Executive Editor. His writings on a broad range of financial topics have been featured in a variety of national print and electronic media, and he has appeared as a financial commentator for various national and local radio programs. Mark is also the Senior Portfolio Manager of the SMI Funds.

• Overview of SMI's Upgrading Strategy
• Overview of SMI's Just-the-Basics Strategy
• Performance History
• Adjusting Your Allocations For 2008's Market Probabilities 
• How to Make Rational Investing Decisions 
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