THE 12% SOLUTION

Earn a 12% Average Annual Return On Your Money,

Beating The S&P 500, Mad Money's Jim Cramer,
And 99% Of All Mutual Fund Managers…

By Making 2-4 Trades Per Month

David Alan Carter

 Copyright © 2017 by David Alan Carter

Published in the United States by Echo West Publishing.

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Table of Contents

WHY I WROTE THIS BOOK

WHO SHOULD READ THIS BOOK

THE BUFFETT BET
SPY AND TLT – THE FOUNDATION

BUILDING ON THE FOUNDATION

A CASH TRIGGER
BUILDING ON THE FOUNDATION, PART II
THE 12% SOLUTION

OK, BUT DOES AN EXTRA 5% REALLY MATTER?

A WORD ABOUT BROKERS AND COMMISSIONS
A NOTE TO READERS

ABOUT THE AUTHOR

DISCLAIMER
Why I Wrote This Book

Don’t be like me. More specifically, don’t be like the younger me.

I wrote this book because of people like me. Because this is exactly the kind of advice I
wish I had been given nineteen years ago. Back then, I was brimming with confidence
that I would be able to figure out this stock market thing, game the system, power
invest my way into an early retirement. That was in 1998. And in fact, after an initial
period of brutal losses, I began piling up profitable trades and my brokerage account
began to grow -- impressively. Yes, of course, I was a genius.
Then 2000 happened. The Dot-Com Crash. From peak to bottom, the Nasdaq
Composite lost 78% of its value. I went from genius to doofus practically overnight. In
the back of my mind was this thought: squirrel away a set of flatware so that I might be
able to eat with some dignity out of a dumpster.
But in time I recovered. Then the market downturn of 2002 happened. After a few
months of rice and pintos, again I pulled my account up by its bootstraps. Then it was
the collapse of the Chinese stock bubble of 2007. Then the financial crisis of 2007-
2009 (The Great Recession). The European sovereign debt crisis of 2010. The Flash
Crash of the same year. The market selloff of 2015-2016.
Each time I eventually recovered. And each time I listened to more gurus, watched
more CNBC, experimented with more bizarre technical charting patterns and developed
new and improved investment strategies.
And when it was all said and done? After 18 years of countless hours of toil and trades,
stress and sleepless nights, I was only marginally ahead. It was a rare year that I beat
the popular benchmark, The S&P 500. More often, I lagged behind that benchmark –
sometimes far behind.

In 2016, while researching yet another foolproof trading strategy, I stumbled across an
obscure article on the subject of sector rotation. It got me thinking. And the more I
thought, the more a strategy began to crystallize.
I wrote this book because of people like me. Because this is exactly the kind of advice I
wish I had been given nineteen years ago.
Who Should Read This Book

First off, let me state that this book will not appeal to every investor. Nor should it.
There will be those investors who have either stumbled upon or have carefully
researched a fund or combination of funds that have produced a satisfactory level of
returns. To those individuals, my hat’s off to you and I wish you the best of luck.
Others might be active traders who have mastered a system by which they win more
often than they lose, who enjoy what they’re doing, and are building a career for
themselves managing a fast-growing portfolio. To those, Godspeed.
Finally, there are investors who don’t wish to deal with the tax implications of trading
monthly; for some, especially high net worth individuals, a buy-and-hold strategy
assuring only long-term capital gains at tax time is preferable to beating the S&P 500
by a few points. (TIP: Implement the strategy in a tax-deferred or tax-exempt
retirement account.)
So who is this book for? Pretty much everybody else. It’s for those who are just starting
out in stock market investing and overwhelmed with the choices. It’s for those who
have spent a few years moving in and out of individual stocks or mutual funds or ETFs,
chasing returns or following the advice of money managers or market gurus only to be
disappointed at the end of each year.

It’s for those who have money on the line in such risky bets that they can’t sleep at
night. It’s for those who want to be invested but live in fear of the next dot-com bubble
burst or Great Recession when the U.S. stock market lost 57% of its value. It’s for
those willing to sacrifice a little larger tax bite in traditional brokerage accounts (short-
term capital gains vs long-term capital gains) in exchange for up to 5% annually in
additional investment returns.

It’s for anybody who isn’t currently generating an average 12% annually on their
investments, and wants to be. And wants some modicum of assurance that they won’t
get wiped out in the process.

In clear, precise terms, I lay out a blueprint for achieving annual returns that – over the
past 10 years – have outperformed the S&P 500, the gold-standard benchmark for U.S.
stock market performance. And while the most often repeated of investment advice –
past performance is no guarantee of future results – remains valid, the reader can judge
for himself as to the logic behind the strategy, and the likelihood of outperformance
going forward.
To those new at stock market investing, becoming actively involved in the direction
and velocity of your portfolio may seem frightening, like working a lot of moving parts
on a piece of machinery traveling along at an unsafe speed on a road with no guardrails.
I understand this completely, and want you to know that I developed this strategy with
two primary concerns: 1) simplicity, and 2) safety.

I wanted anybody and everybody to be able to follow this plan easily and with simple
tools that are readily available at no charge; no need to lash yourself to onerous
software or be a mathematics genius. And I wanted guardrails firmly in place along the
road. That’s not to say I’ve eliminated the risk associated with stock market investing.
That’s simply not possible, and those who require an absolutely risk-free investing
environment need to look elsewhere. But reducing risk in the form of volatility and
drawdowns (peak-to-trough declines) has been a priority.

Although many if not most of my readers will be new to the stock market, I don’t
intend this book to be an intro into stock market investing. For the basics regarding
selecting a brokerage firm, setting up a trading account, and executing trades, there are
warehouses of books and the Internet at your disposal.

For those new to investing as well as those experienced to the point of frustration, I
welcome you and congratulate you on taking this first step. Together, let’s uncover a
simple and logical approach to investing that automates the decision making,
commands 20 minutes of your time per month, and helps you sleep like a baby during
the most turbulent of markets.
It’s been hiding in plain sight for years. You’re going to kick yourself when you see
how easy this is.

Welcome to The 12% Solution.

The Buffett Bet

When Warren Buffett speaks, people listen. Or do they?

Buffett is an American business magnate, investor, and philanthropist, and considered

by many to be one of the most successful investors in the world. According to
Wikipedia, as of March 2017 Buffett is the second wealthiest person in the United
States with a total net worth of $73.3 billion.

As the Chief Executive of Berkshire Hathaway, the 4th largest company in the world,
Buffett is known for dispensing financial wisdom from time to time. Often, some of
that wisdom comes out in the annual Berkshire Hathaway letter to shareholders.
In the most recent such letter (2017), in a section titled “The Bet,” Buffett revisited a
wager he proposed back in 2007. Buffett bet that he could outperform any investment
professional selecting a set of 5 or more hedge funds over a time span of 10 years.
Hedge funds are investment funds catering to high-wealth individuals and institutional
investors. They often use complex portfolio-construction and risk-management
techniques – and charge high fees for their services.
Buffett’s vehicle of choice for his side of the bet? One single mutual fund that simply
tracks the S&P 500 index.
A single investment pro stepped forward at the time – Ted Seides, at the time the Asset
Manager for the firm Protégé Partners. And the bet was on. The loser would write a
check to charity.

With nine years down and one to go, Buffett looks virtually certain to win the bet. The
fund Buffett picked, the Vanguard 500 Index Fund Admiral Share, has generated an
average annual return of 7.1%. Protégé’s fund of funds has returned 2.2%. That’s a
three to one beat down.
What happened? How could a simple fund that mimics the S&P 500 outperform high-
priced professional money managers with tool bags brimming with proprietary
research and sophisticated trading techniques?

As Buffett explains it, while there are some money managers with the chops to beat the
market in any given year or even several years, those are rare birds. And those who do
win inadvertently sow the seeds of future failure by attracting hoards of new money.
While that sounds counterintuitive, managing a multi-million dollar portfolio is quite
different than managing a multi-billion dollar portfolio.
Those high management fees certainly play a factor. If the S&P 500 returns 8% in a
given year, the money manager charging his clients 2% annually has got to deliver a
return of 10% just to match the benchmark index. Most simply can’t do it, certainly not
year after year for ten years.
Contrary to what money managers would like you to believe, multiple studies have
confirmed that high management fees do not improve returns, indeed they are an
impediment to returns.

So, what advice does Buffett give to stock market novices and mega-rich investors
alike? Not surprisingly, he advises all to buy and hold a low-cost fund that tracks the
S&P 500 index. It works, and he has study after study on his side and will soon have
half a million dollars in winnings to accentuate the point.

But here’s the surprising part: not everyone takes that advice. Some do – typically
those stock market novices with little money to spare. But folks with the kind of money
that can buy a high-fee manager, or those with a little bit of trading prowess or those
easily infatuated with gurus of every stripe are often deaf to the advice.
Why? Gurus know how to lure. It has a lot to do with marketing and promotion. Every
financial magazine touts the credentials of money managers who have beaten the street
at one time or another. There are pages and pages filled with rankings of actively-
managed mutual funds all competing for investor dollars. The corporate machinations
and the ins and outs of top management are fodder for endless glowing articles that are
often lacking in objectivity and read like they could have been written by the corporate
communications teams themselves.

Cable news shows like CNBC offer up an endless parade of money managers touting
this stock or that stock, and displaying such an in-depth understanding of markets and
economics that the average viewer inevitably concludes that these brainiacs will make
them far more money than passive investing. Viewers are swayed to trade on those
stock recommendations themselves, or hand over their investable nest egg to the
companies those brainiacs represent.

I know of what I speak. I spent 18 years generating subpar returns by hanging on every
stock picking recommendations from the so-called experts, then giving up monies to
mutual funds, then switching those funds around trying to chase returns, and then
returning to frantic trading with my own accounts. Rinse and repeat for 18 years, and
I’ve left a small fortune on the table by not following Buffett’s simple advice.
Ah, the siren song of the rock-star money managers and the TV personalities with their
stock-picking prowess and their one or two years of outrageous returns. Don’t be
swayed into chasing those returns. Over the long run, nothing much beats the
unemotional, low-cost funds that mirror broad-market indices. That would be
something like Buffett’s choice of mutual fund, or ETFs -- Exchange Traded Funds.

But how do they work, and which funds or ETFs are we talking about? Let’s go there.
But first, to summarize…

The Buffett Bet

Takeaways

Study after study has shown that cutting your cost of investing is one of the most
significant things you can do to improve your returns over time.
It’s a rare money manager who can beat the S&P 500 index in a given year, and
even more rare to beat the street multiple years in a row.
While there is a large industrial complex of television and print media that tries to
instill reliance on master stock pickers as the way to go, a simple, inexpensive
fund that mirrors a major market index like the S&P 500 most often wins in the
long run.
Don’t bet against Warren Buffett.
SPY and TLT – The Foundation

In his bet, Warren Buffett’s investment choice for tracking the S&P 500 index was the Vanguard 500 Index Fund
Admiral Share, ticker symbol VFIAX. While this is a mutual fund, the expense ratio (read, management fees) are
quite low by mutual fund standards: 0.09%. So that’s good.
But because it’s a mutual fund, buying and selling shares is subject to the peculiarities of the mutual fund
industry. For example, unlike stocks and ETFs, mutual funds trade only once daily, after the markets close. You
can place your buy or sell order at any time during the day, but the price associated with that trade will be
calculated after the market closes and typically posted by 6:00 p.m. Eastern Time.

In addition, this particular fund can only be purchased through a Vanguard Brokerage Account or a Vanguard
account that holds only Vanguard mutual funds.

SPY, The “Risk-On” Trade

For The 12% Solution, we’re looking for funds with wider availability and a greater flexibility of transaction.
ETFs fit the bill, and in particular the SPDR ETF (Standard & Poor’s depositary receipt exchange traded funds)
that goes by the ticker symbol SPY.

Definitions:
An ETF, or exchange traded fund, is a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund.
Unlike mutual funds, an ETF trades like a common stock on a stock exchange. ETFs experience price changes throughout the day as they are
bought and sold. ETFs typically have higher daily liquidity and lower fees than mutual fund shares, making them an attractive alternative for
individual investors. Because it trades like a stock, an ETF does not have its net asset value (NAV) calculated once at the end of every day like a
mutual fund does. – Source: Investopedia
SPDR funds are a family of exchange-traded funds (ETFs) traded in the United States, Europe, and Asia-Pacific and managed by State Street
Global Advisors (SSGA). Informally, they are also known as Spyders or Spiders. The name is an acronym for the Standard & Poor’s Depositary
Receipts. -- Source: Wikipedia

The SPDR S&P 500 trust is an exchange-traded fund which trades on the NYSE Arca under the symbol SPY. It is designed to track the S&P 500
stock market index. Each share of the SPY ETF holds a stake in the 500 stocks represented by the S&P 500 -- Source: Wikipedia and
Investopedia

From day one of its inception in 1993, SPY has been wildly popular as an investment vehicle. Buying SPY
means buying a stake in each of the 500 companies that make up the Standard & Poor’s index. These are large
cap (large capitalization) companies selected by a team of analysts and economists at Standard & Poor’s.

Collectively, the 500 stocks that make up the S&P 500 are widely regarded as the most accurate gauge of the
large-cap sector of the American stock market and representative of the American stock market as a whole, so
much so that the index has become one of the common benchmarks by which analysts and investors gauge the
performance of everything from individual securities to mutual funds, sector and foreign markets, and money
managers themselves.

So SPY, representing large-cap U.S. stocks, will become a key ingredient of The 12% Solution. In fact, for those
investors content to generate the kind of returns Warren Buffet received during the course of his infamous bet,
simply buying and holding SPY will get you there. Specifically, +7.06% average annual return for the past ten
years (vs +7.15% for Buffett’s mutual fund selection, the Vanguard 500 Index Fund Admiral Class, ticker symbol
VFIAX).

There’s certainly nothing shabby about a 7% average annual return, and in fact with that return you’d be besting
the great majority of money managers, stock market analysts and TV personalities.
But what if we could boost that respectable return with a little bit of tinkering?

One of the first things you’ll notice if you look at a long-term chart of SPY is that it does correlate exactly with
the U.S. stock market (i.e., the S&P 500). That’s both good and bad. Good – when the market is on a tear upward.
Bad – when all hell breaks loose and the bottom falls out of the market.
In the latter camp, a couple of notable bear markets include the bursting of the dot-com bubble in 2000-2002
(over 30 months, the S&P 500 lost 49.1%), and the bursting of the housing bubble in 2007-2009 (over 17
months, the S&P 500 lost 56.4%).

Now, over time, the index and associated ETFs like SPY recovered. And then some. So all is well, right?

Not exactly. If you had been approaching retirement in 2001 or 2008, watching your hard-earned nest egg cut in
half right before you’re handed your gold watch would be devastating at the least. It’s not enough to “know” that
the market would bounce back eventually. If you needed cash from stocks during those down years, for whatever
reason, you’re selling at significant losses. If you’d bought on margin, you could face liquidation.

Even if you don’t need to sell, watching retirement and brokerage accounts evaporate to that extent plays hard on
the emotions of most people. All too many end up selling on panic, taking significant losses, and are then too
afraid to get back into stocks as the market begins to claw its way back up.

So there they sit, with less money than they started, swearing off the stock market and stuffing what little dollars
they have left into passbook savings accounts or mattresses.

It’s hard to blame them. But the stock market is the place to be if you want your money to generate money. And
most people don’t get rich, or even comfortably well off, without their money generating money. But is there a
way to mitigate losses during stock market downturns?

Hedging The Risk

There is. And there’s a term for it: hedging. A hedge is an investment that -- in theory -- reduces the risk of
adverse price movements in an asset. We hedge in many aspects of our life, though most people never look at it
in quite that context.

Home insurance, for example. We pay monthly or annual premiums for insurance that will reimburse us in the
event of catastrophic damage to our home. By protecting our home (and car, and health, and life) with insurance
policies, we are employing the principle of hedging.
Hedging is simply a technique for reducing or transferring risk. Understand, though, that there is almost always a
price associated with a hedge. In the case of homeowners insurance, the price is the monthly or annual premiums
we pay – regardless of whether or not we’ll ever have a tree go through the roof and receive a payout from that
policy.
In the stock market, the cost of hedging usually manifests itself as lower returns than if you “bet the farm” on a
volatile stock or basket of stocks with no such protection.

Hedges can involve derivatives (i.e. options, swaps, futures and forward contracts) based on the underlying asset
in question. OK, that can be complicated. But a hedge can also be an offsetting position in a security that tends to
move in an inverse relationship to the one being hedged. That sounds simpler, and as luck would have it, just so
happens to be the direction we’re going to move in.

Among assets that tend to move in inverse relationship to the broader market (for which SPY represents) are
several that have become commonplace in the tool bags of savvy investors. They include gold, silver and other
precious metals, utility stocks, and bonds. When the stock market as a whole turns south, gold and other precious
metals often – but not always – turn north. When the markets move higher, gold and precious metals often – but
not always – move lower. Ditto with utility stocks.
But notice this isn’t a perfect inverse relationship. During the housing crash and subsequent recession of 2007-
2009, gold and utilities followed the overall market right down into the abyss. Bonds are a bit more predictable
as a hedge against common stocks, with treasuries leading the pack in this respect.
In fact, while there are a number of negatively correlated components of the overall financial market, perhaps
none is more resilient and widely accepted than that of the stock market and bonds (U.S. treasuries in particular).

Let’s consider treasuries in more depth. And in keeping with our focus on simplicity of strategy and ease of
execution, we’ll look specifically at the asset TLT. But first…
Definitions:
Treasuries, or treasury bonds or securities, are debt obligations of a national government. United States Treasury securities, therefore, are debt
obligations of the United States government and are issued to finance the national debt of the United States. Because U.S. treasuries are backed by
the full faith, credit and taxing power of the United States, they are regarded as having little to no risk of default.

The lure for investors is the interest payable on these instruments. Though interest is currently low by historical perspective, primary investors are
guaranteed the return of both their interest and the principal so long as the bonds are held to their maturity.

There are 4 types of marketable U.S. treasuries categorized primarily by their lengths of maturities:
Treasury bills (maturing at 4, 13, 26 and 52 weeks),
Treasury notes (maturing in 2, 3, 5, 7 and 10 years),
Treasury bonds (which mature in 30 years), and
Treasury Inflation Protected Securities (TIPS) which are inflation-indexed bonds offered in 5-year, 10-year and 30-year maturities.

Marketable U.S. treasuries are issued through regularly scheduled auctions in what is called the primary market.
There is also a secondary market where the already-issued securities are heavily traded by investors and primary
market participants (such bonds are bought and sold through virtually any broker as well as banks and other
financial institutions). This is the bond market for which we’re interested for the purposes of The 12% Solution.

While U.S. treasuries have little to no risk of default, they do come with some risk. Treasuries are vulnerable to
inflation as well as changes in interest rates. As interest rates rise, for example, primary investors who bought
bonds at a lower interest rate suffer an opportunity cost. This is the cost of choosing one investment over another
that would have been more profitable.

In the secondary market, these opportunity costs are factored in. Bond prices in the secondary market rise, for
example, when interest rates drop and vice-versa.
What else can cause bond prices in the secondary market to rise? Fear.

Falling stock prices generally signal a loss of confidence in the economy. Whether that shaken confidence lasts a
day or a week or a year, investors pulling money out of stocks will generally be seeking safer asset classes (big
money abhors cash with its negligible return).

Bonds fit the bill for safety. And all that money moving out of stocks and into bonds has the effect of pushing
bond prices higher. Thus, a negative correlation is born.
But higher bond prices affect the yield (interest rate return) on those bonds, driving that yield lower. As yields
trend lower, bonds become less attractive from a long-term investment point of view. Thus, when stocks begin
their march back up, investors are all too happy to pull out of their bonds and back into stocks – thus driving
bond prices lower, yields higher, and setting bonds up to offer an attractive safe haven in the future when
sentiment sours once again on stocks.
The relationship is not perfect. Any number of factors can and do drive bond prices independent of stock market
sentiment. But chart the two, over the long term, and an unmistakable negative correlation – or inverse
relationship -- is evident.

TLT, The “Hedge” Trade

While all U.S. treasuries share that negative correlation, long-maturity bonds have price swings that most closely
approximate the price swings of the overall stock market. Therefore, let’s consider long bonds as the second leg
of our strategy. Specifically, let’s consider TLT.

Definitions:
TLT is an ETF issued by the company iShares that tracks the Barclays U.S. 20+ Year Treasury Bond Index, a market-weighted index of bonds
issued by the U.S. Treasury with remaining maturities of 20 years or more. By design, TLT is very sensitive to interest rate movements.

Looking at the chart in Figure 1, you can see the relationship between TLT and SPY for the past 12 months. The
most striking evidence of the inverse relationship can be seen in the lead-up to the June 23 U.K. referendum on
whether or not Britain should withdrawal from the European Union (commonly called Brexit). See the left-hand
side of the chart. The U.S. stock market, represented by SPY (in red) sold off sharply in June of 2016, while the
long bonds, represented by TLT (in blue) rose sharply.
This is a good example of bonds acting as a hedge against a stock market selloff.
Notice also that as June progressed into July, investors quickly began to see the stock selloff as an overreaction
and buying resumed. TLT edged downward as investors pulled money out of long-term U.S. treasuries and back
into stocks.
Indeed, from a peak on July 6, 2016, TLT began a slow slide downward as worries over interest rate hikes came
into play, and as stocks generally strengthened in the face of solid earnings and a U.S. political climate perceived
to be positive toward business.

The following 2-month chart (Figure 2) shows in more detail the Brexit vote on June 23 and the immediate
aftermath. You can see SPY plunging 5% that day while TLT soars by an equal amount. In the days that follow,
you can see investors moving back into stocks while TLT – a bastion of the cautious - continues to post gains for
a period of time.
The investor who put money to work on June 6, 2016 and bought only SPY saw his account plunge by 5% just 17
days later. However, that same investor – assuming he kept himself from selling in the panic that was June 23 –
managed to snag a return of 17% by year’s end. The investor who bought on June 6, 2016 but split his purchase
50/50 between SPY and TLT took no hit on June 23 and was likely sipping fine wine and smoking a big cigar
between bursts of braggadocio directed at his friends.
The swagger wouldn’t last, however, as the hedged investor would end the year with a return of 7% (50% of
SPY’s gain of 17%, plus 50% of TLT’s loss of 3%). Thus the cost of a hedge.

So why hedge? Why in the world would anyone go to extra lengths to make 7% on his money when a single
investment in SPY generates 17%? Because the example above is just one snapshot in time. We can take
snapshots all day long that show just the opposite: TLT ahead of SPY at the end of a 12-month period.

Here’s a particularly good example.

Figure 3 charts SPY and TLT for the 12 months leading up to the market bottom of The Great Recession in
March of 2009. Note SPY is down 45% while TLT is up 15% for this particular 12 month period.
Taking a longer view and incorporating the 9 years to date since that market bottom in 2009, Figure 4 shows the
interplay between these two ETFs during market selloffs and rallies.
One favorable aspect of treasuries, from a hedging point of view, is that the assets have been on a long-term
uptrend. Indeed, since TLT’s inception back in July 22, 2002, the ETF has generated an average annual return of
6.76%. In the past ten years, a 7.26% average annual return – actually besting the return of SPY (6.85% average
annual return) during the same time frame.
Although there’s usually a cost associated with the use of a hedge, not always and not for every time frame
considered. In this case, a 50/50 split of SPY and TLT actually enhanced returns over a 10 year period while
reducing volatility (tempering the ups and downs of the market).

Keep in mind that a long-term uptrend can always change. Past performance is no guarantee of future results.
But for now, we’ve made a pretty good case for using bonds as the second leg of our strategy, as the hedging
component. Specifically, long-duration U.S. treasuries represented by TLT.

What Percentage Split?

In our recent examples, we’ve used a 50/50 split between SPY and TLT to provide an easy calculation. But is that
the best ratio of risk asset to hedge? Turns out, it’s real close. Crunching the numbers, a 60/40 mix of SPY and
TLT give you a slight fractional edge over a ten-year period.

Perhaps not coincidentally, that also happens to be the ratio most cited by market analysts as the optimum mix of
stocks and bonds.
Let’s see what that looks like.

Figure 5 illustrates the most recent 10-year performance of a 60/40 mix of SPY and TLT. The green line marked
“Backtest” is the 60/40 mix. The blue line is SPY alone functioning as a benchmark.

Notice that the Total Return for the Backtest is slightly better than the benchmark, although this can change
depending upon the particular 10-year period you are testing. Note that the Volatility is drastically reduced with
the Backtest. This is due to the hedging effect of TLT and the fact that TLT frequently moves in an inverse
relationship with SPY, leveling out some (but not all) of the roller coaster effect of day-to-day market moves.
So we’ve got the foundation laid for our strategy: a 60/40 mix of SPY and TLT. We’ll be tinkering with that in
the next few pages, but for now let’s see how the chapter sums up.

SPY and TLT - The Foundation

Takeaways

Collectively, the 500 stocks that make up the Standard & Poor’s 500 are representative of the American
stock market as a whole. Buying the ETF SPY means buying a stake in each of the 500 companies that make
up the S&P 500 index.
Buying and holding only SPY would have generated an average annual return of 7.06% over the past ten
years, certainly good, but such an account would have experienced considerable volatility and a drawdown
(peak-to-trough decline) of up to 45% in 2009.
In order to hedge the risk inherent in SPY, we’ll add bonds in the form of TLT, a popular ETF that tracks an
index of bonds issued by the U.S. Treasury with remaining maturities of 20 years or more.
A ratio of 60% SPY to 40% TLT is widely seen as optimal, and plays out such in backtesting.
Building on the Foundation

As we’ve learned, SPY is designed to track the S&P 500 stock market index. These are America’s foremost
large-cap stocks, and a pretty safe bet (after all, it was Warren Buffett betting on the S&P 500 in Chapter 1).

But observe the market for any length of time and you’ll notice that not all U.S. stocks move up and down in
unison. There are periods of time when large-cap stocks outperform small-cap stocks. Other periods when
technology-heavy indices outperform everything else (and periods when they underperform everything else).
Likewise with industrial-heavy indices.

Wouldn’t it be nice if we could identify the index poised to outperform its brethren, and buy that index as the
“risk-on” trade in our strategy? Then, when the outperforming index begins to lose steam and another is poised
to take its place, sell the old and buy the new?

Well, that’s the idea behind rotation. This is also a big hint as to where we’re headed with this strategy.

Most often associated with market sectors (areas of the economy in which businesses share similar product or
service, i.e. semiconductor manufacturers or consumer services companies), rotation can also be applied to
broader-market indices.
In short, the idea is that whatever sector (or index) has outperformed recently should continue to outperform for
a period of time (the essence of momentum investing, confirmed by decades of data). When that time is up,
another sector/index that had been out of favor will rise in the ranks to become the outperformer. The investor
rotates from one to the next.

While there’s certainly a case to be made for rotating in and out of sectors, we’re going to stick with broader-
market indices as they provide a little more stability and thus a little less volatility owing to the fact that such
indices by nature are made up of more diverse businesses. Sectors, while often providing more bang for the buck,
can move faster and arguably require a more hands-on trading approach than we’re advocating with The 12%
Solution.
So, which indices are we talking about? Well, the S&P 500 sets a pretty high hurdle. In order to be considered
within our rotation universe, an index needs to best SPY – at least occasionally. Let’s rule out world or global
market indices, as well as geographic regions and national indices outside the U.S., and focus just on the U.S.
market.

That still leaves quite a few, from indices based on an exchange (like NASDAQ 100 or NYSE US 100) to indices
based on price-weighed or market-capitalization-weighted stocks.

With help from software provided by ETFreplay.com, I crunched out a small handful of contenders that beat SPY
on occasion, and did so over the course of 10 years without negatively impacting the overall returns.

That last part is key: without negatively impacting the overall returns. Every index will beat the S&P 500 at one
point in time or another, but keeping each of those indices in the rotation universe sometimes makes matters
worse over the long term.

Why? Well, some indices are more sensitive to the kinds of economic data that renders them less predictive
when compared to others. Less predictive, volatile, and fraught with reversals in short periods of time. We need
indices that are relatively stable and telegraph trends in a way we can visualize and take advantage of within the
parameters of The 12% Solution. Namely, once-a-month trading.
The following are indices that fit the bill, along with ETFs that mirror each index. Together with SPY, they will
make up our rotation universe.

Definitions:
The NASDAQ 100 Index includes 100 of the largest domestic and international non-financial companies listed on The Nasdaq Stock Market
based on market capitalization. Launched in 1985, the index reflects companies across major industry groups including computer hardware and
software, telecommunications, retail/wholesale trade and biotechnology. It does not contain securities of financial companies including investment
companies. – Nasdaq.com

QQQ - is an ETF that tracks The Nasdaq-100 Index. Managed by Invesco PowerShares.

The Russell 2000 Index is a small-cap stock market index of the bottom 2,000 stocks in the Russell 3000 Index (The Russell 3000 Index is made
up of the 3,000 largest publicly held companies in America as measured by total market capitalization, and represents approximately 98% of the
American public equity market). -- Wikipedia

IWM - is an ETF of U.S. stocks that tracks the Russell 2000 index. In the iShares ETF family.

The Standard & Poor’s Mid-Cap 400, more commonly known as the S&P 400, is a stock market index from S&P Dow Jones Indices that include
U.S. companies with a total market capitalization that ranges from $1.4 billion to $5.9 billion. The index serves as a barometer for the U.S. mid-
cap equities sector, covering nearly 7 percent of the total US stock market. The index was launched on June 19, 1991. -- Wikipedia

MDY - is an ETF of U.S. stocks that tracks the S&P 400 index. In the SPDR family of funds.

Alright, so we’ve got our rotation candidates for the “risk-on” portion of our strategy. They are the ETFs:

IWM
MDY
QQQ
SPY

We’ll be attempting to identify which one of the 4 candidates above is demonstrating the most strength relative
to the others. That is, which of the 4 ETFs is outperforming. That’s the one we’ll buy, of course, under the
assumption that outperformance begets outperformance – at least for a period of time.

What Period Of Time?

And as I alluded to earlier, The 12% Solution involves once-a-month trading. But why not trade in and out of the
contenders on the exact day in which a new leader emerges?

Markets fluctuate constantly. In trying to price thousands of assets in real time, markets (i.e., investors) succumb
to all manner of trending news, crisis headlines, word-of-mouth rumors, the prognostications of analysts and
talking heads, program trading and the deliberate manipulations of professional traders to manufacture market
advantages.

It’s largely noise and has no lasting impact on value, yet that constant noise is constantly affecting asset prices in
the short run. Trying to move in and out of the contenders on the exact day in which a new leader emerges is to
allow noise to control your trades. You’ll end up fattening the coffers of your broker with commission fees, but
not really getting ahead of the game in the end.

Putting some distance on noise -- in the form of time -- allows the truly important information to rise to the top
and begin to have a more relevant impact on asset pricing. Translation: by trading once a month we filter out the
noise and are better able to see the relative strength among the ETF contenders.

But why once a month? Why not once a week, or twice a month? What about quarterly or annually?
Good questions. I asked the same ones. In fact, using data partner ETFreplay.com, I crunched the charts on
rotations timed bi-monthly, monthly, quarterly and annually. Turns out that monthly is the time frame that
produced the highest return.

With our particular strategy, a monthly time frame filters out just enough noise-generated price swings while
still capturing favorable value movements in the top-performing ETFs.
OK, we’ve locked in our trading schedule at once monthly. And for our particular strategy, trading on the last day
of the month demonstrates a slight advantage over the first day of the month, so we’ll be looking to buy the one
ETF that’s outperforming the others in our rotation universe on the last day of every month. But how do we
determine the outperforming ETF?
Well, outperformance requires a time frame in which to judge performance. Call that the “lookback” period. If
we line up a few stocks or ETFs and look back over a day, we can clearly see which stock or ETF outperformed
its peers for that day. Same with a week, a month or six months – we see outperformance for that week, that
month or that 6-month period.
But relative performance based on a lookback of a single day or even a week is not particularly useful to us.

With stock market assets in constant price motion, selecting a time frame in which to judge useful relative
performance is an exercise similar to putting distance on noise. Pick too short of a time frame and noise-driven
price fluctuations rule. Pick too long a time frame, and top-performing assets become less predictable for the
upcoming month.

So what’s the Goldilocks lookback – a time frame that’s not too hot, not too cold?
Crunching the numbers with our data partner for our particular strategy, a 3-month lookback appears to be
optimal. So when we are evaluating the relative performance of the ETFs in our rotation universe, we’ll be using
a 3-month lookback. Specifically, we’ll be looking at 3-month charts.

Charting Relative Outperformance

Here we come to the beauty part of the strategy: charting the relative performance of the ETFs to decide which
one to invest in for the upcoming month. I say beauty part, because it’s simple, it’s effective, and you don’t need
a bunch of sophisticated software and complicated algorithms to calculate.
All you need is a stock chart that provides for simultaneously comparing multiple stocks or ETFs. And they are
quite easy to find.

If you have an account with a major brokerage, you’ve likely got access to such charting tools. If not, they are
readily available on the Web through both paid and free services. For illustration purposes, I’ll be using free
charts constructed from the site StockCharts.com.
Let’s look at the full year 2016. For starters, Figure 6 identifies the ETF that has outperformed during a 3-month
lookback period ending December 31, 2015. Remember, we buy on the last day of the month to hold for the
upcoming month. So Figure 6 identifies the outperforming QQQ as our “risk-on” investment for January, 2016.
Let’s move to the next month. Figure 7 identifies the ETF that has outperformed during a 3-month lookback
period ending January 29, 2016. With SPY as the outperformer, that becomes our “risk-on” investment for
February, 2016.
Let’s move to the next month. Figure 8 identifies the ETF that has outperformed during a 3-month lookback
period ending February 29, 2016. With SPY as the outperformer for the second month in a row (even though they
all showed negative numbers), that remains our “risk-on” investment for March.

Let’s do this one more time and then we’ll summarize the year. Figure 9 identifies the ETF that has
outperformed during a 3-month lookback period ending March 31, 2016. With MDY as the outperformer, that
becomes our “risk-on” investment for April, 2016.
So let’s see what we’ve got for 2016. Here’s how the monthly rotation shakes out for the “risk-on” portion of our
equation.

2016 “RISK-ON” ROTATION TABLE:

And the results of all this trading? At year’s end, our strategy has returned 13.02%. Had we bought and held SPY
alone, we would have seen a 11.86% return for 2016.
So for 2016, the strategy beat the benchmark – by a little. That won’t happen every year. Some years it beats,
some years it lags. But over time, at least over the past ten years, the strategy of buying the outperformer for the
upcoming month has resulted in a significant improvement over a buy-and-hold philosophy, albeit with a slight
increase in volatility and a slightly higher max drawdown.
We can see this in Figure 10. The green line, or “Backtest,” is the monthly rotation of our “risk-on” ETFs played
out over ten years ending in 2016. The blue line is SPY, and acts as a visual benchmark.

All told, the Backtest saw a cumulative return of 161.5% while holding SPY alone would have returned 94.3%.
How does that translate into real dollars? Presuming a $10,000 initial investment, that means the Backtest would
have delivered an additional $6,720 in profit over the 10 years. Were the initial investment $100,000, you’d be
looking at an additional $67,200 just by applying the strategy each month for 10 years.

Note: I’m not including trading fees in this calculation, nor any tax consequences from short-term capital gains.
While those variables certainly need to be taken into consideration, I think you can see that even small
improvements in annual return can make a real difference in net worth over time.

As this is the first time we’ve looked at summary statistics, there are a few terms that might need explaining.
CAGR, or the Compound Annual Growth Rate, is the mean annual growth rate of an investment over a specified
period of time longer than one year. “The compound annual growth rate isn’t a true return rate, but rather a
representational figure. It is essentially an imaginary number that describes the rate at which an investment
would have grown if it had grown at a steady rate, which virtually never happens in reality. You can think of
CAGR as a way to smooth out an investment’s returns so that they may be more easily understood.” --
Investopedia

The Sharpe Ratio is a formula for examining the performance of an investment or strategy by adjusting for its
risk. For those into mathematics, you calculate an investment’s Sharpe ratio by taking the average period return,
subtracting the risk-free rate (most commonly, the 90-day Treasury bill rate), and dividing that number by the
standard deviation for the period.

If all that makes your head hurt, as it does mine, here’s the thing to remember: when comparing two assets or
strategies against a common benchmark, the one with a higher Sharpe Ratio provides a better return for the same
risk.

SPY Correlation measures the statistical relationship between an investment or strategy and the selected
benchmark, in this case the S&P 500 (represented in our examples by SPY). A SPY correlation of 1.0 means that
the investment or strategy in question moves in virtual lockstep with the S&P 500. A SPY correlation of 0.0
means an investment or strategy has zero relationship with the S&P 500, and price movements in one are
unaffected by the other.

Max Drawdown is an indicator of downside risk over a specified time period. It measures the largest single drop
from a peak to a trough in a portfolio -- before a new peak is achieved. In practical terms, it paints a worst case
scenario for the investor. Maximum drawdown demonstrates how much would have been lost if an investment or
strategy had been bought at its peak value, ridden all the way down, and sold at the low.

If an investment had never lost a dime, the max drawdown would be zero. If an investment lost everything, the
max drawdown would be 100%.
While max drawdown is a backward-looking (historical) statistic, investors are well advised to factor it in when
considering how much pain an investment has caused in the past.

Building on the Foundation

Takeaways
Not all U.S. broad market indices move in lockstep. While over time there is a tendency to converge, in
shorter time frames there are outperformers and laggards. We’ll take advantage of this through rotation.
We’ve identified 4 indices for consideration for rotation: 1) the Russell 2000 small cap market index
represented by the ETF IWM, 2) the S&P 400 mid cap market index represented by the ETF MDY, 3) the
Nasdaq 100 large cap, technology-heavy index represented by the ETF QQQ, and 4) the S&P 500 large cap
broad-market index represented by the ETF SPY.
The time frame most optimal and applicable to our needs is monthly. We’ll be buying on the last day of the
month to hold for the upcoming month.
The ETF candidate to buy is the one that has outperformed its peers during a “lookback” period of 3
months. With readily available charting tools, we can see which ETF has been the outperformer by charting
all 4 on the same chart.
Backtesting confirms the advantage of index rotation over a buy-and-hold strategy.
A Cash Trigger

I’m going to do something now that – for some of you – will short circuit this book. Those ‘some of you’ will be
tempted to read the following, nod knowingly, close the book and proceed to implement the strategy without
further ado. And you’d have my blessing, because what I’m about to do will get you to The 12% Solution.
I’m going to show you how to implement a cash trigger.

You may have heard the expression: ‘The best way to make money is to not lose it.’ That’s more than just a
clever financial bumper sticker. It’s a slogan steeped in truth. While stock market gains magnify stock market
gains through the beauty of compounding returns, the reverse has a magnifying effect, too.

An example. Take a $100,000 account and lose 10%, and you’re left with $90,000. Or lose 30% and you’re left
with $70,000. That’s straightforward enough. Time to make it up through a market recovery, right? Yes, but look
at the gains you’ll need just to recover and get the account back up to breakeven. To go from $90,000 back to
$100,000 requires an 11.1% positive return, not the 10% that caused the setback in the first place.

And to go from $70,000 back to $100,000 requires a 42.9% positive return, not the 30% that cause the setback in
the first place.
In short, the greater the loss, the greater the gain has to be in order to recover the loss. And while investors are
fixated with this return and that return, who’s beating the S&P and which stocks are hitting all time highs, the
ultimate success of any investment plan turns on one simple element: minimizing losses.

A cash trigger does this. And the implementation is quite simple. Each month, when evaluating which of the 4
“risk-on” ETFs to select for the coming period, consider exactly where that top-performer is on the graph. If it’s
above the “0.0%” line, that’s the one you’ll buy, as we’ve discussed. But if it is below the “0.0%” line, if all the
ETFs are trending below the “0.0%” line, then you’ll go to cash.
It’s that simple. The zero percent line on the chart is the cash trigger.

Let’s look again at Figure 7. This was the chart that dictated what our “risk-on” selection was to be for February
2016. Without the cash trigger, we would have bought SPY, as it is the outperformer of the bunch. With the cash
trigger, because all ETFs – including SPY – are trending below the 0.0% line, the strategy dictates that we move
to cash.
How does this cash trigger impact our returns? Let’s go back to 2016. Here’s how the monthly rotation shakes
out, both with and without the cash trigger. We buy…

Month Without Cash Trigger With Cash Trigger

January QQQ QQQ
February SPY SHY*
March SPY SHY*
April MDY MDY
May MDY MDY
June IWM IWM
July IWM IWM
August QQQ QQQ
September IWM IWM
October QQQ QQQ
November QQQ QQQ
December IWM IWM

* Note: Going to cash can mean literally “going to cash” -- selling the asset in question and simply holding cash
in the account. Or, for our purposes with The 12% Solution, it can also mean going into SHY, the iShares 1-3 year
Treasury Bond ETF which is a reasonable proxy for cash albeit with a little bit of upside potential during equity
selloffs.
Large accounts might want to consider SHY during these times, smaller accounts might not return their way out
of trading fees. Investor’s call.
And the results of implementing a cash trigger into our trading? At year’s end (2016), our strategy with the cash
trigger returned 6.3%. But wait – didn’t we get a higher return without the cash trigger? Indeed, we realized a
13.02% return without the cash trigger. What in the world…?

The cash trigger failed to deliver improved results for 2016. In fact, it led to even worse results than having no
such trigger, achieving exactly the opposite of what it was intended. If we go back and look at our 2016 "Risk-
On" Rotation Table, we can see the problem: going to cash (or SHY) in February and March causes us to miss
out on a juicy 6.72% gain that would have been generated with SPY.

In retrospect, a study of the markets, analysts and pundits during the first few months of 2016 had all predicting
an imminent market crash. To wit, this headline in Fortune Magazine: “Analyst: Here Comes the Biggest Stock
Market Crash in a Generation.” Our strategy was predicting the same, hence the move into cash. But the crash
never materialized and markets rallied and it was off to the races – but without our participation for two back-to-
back months. And that security blanket of cash for those two months cost us.

So the cash trigger failed us for 2016. But that was one year. And one year doesn’t capture market cycles nor
does it capture the entire picture of a long-term strategy. Let’s backtest this and see how things would have
played out over 10 years, ending in 2016.

Figure 11 gives us a chart of that time frame, incorporating the cash trigger into our monthly analysis. The green
line, or “Backtest,” is the monthly rotation of our “risk-on” ETFs played out over ten years ending in 2016 and
includes the cash trigger. The blue line is SPY, and acts as a visual benchmark.
The arrows indicate when and where some of the more obvious cash triggers kicked in, sending us out of any
“risk-on” ETF and into the loving arms of cash (or SHY, as the case may be). A month or two of an account in
cash is evident by the green line going flat.
Not only did we substantially boost the compound annual growth rate (CAGR) but we dramatically reduced both
volatility and maximum drawdown by incorporating the cash trigger.
The most dramatic argument for the trigger in the above example was the year 2008. During the depth of The
Great Recession while the S&P 500 crashed and burned to a negative -36.8%, our monthly ETF rotation that
incorporates a simple cash trigger (first arrow, above) lost only -0.6%.
As we’ve seen, though, not every year is going to be a stellar year that will beat the S&P 500 benchmark.
Witness 2016. But if your time horizon is 10 years plus, we’ve made the “risk-on” portion of our strategy a safer
trade while improving overall returns. So safe, in fact, and with overall returns so improved that this will be the
‘close the book’ moment for some of you. And that’s fine. After all, we’ve just generated a 13.3% CAGR on a
10-year backtest.
Stop now and be the envy of Jim Cramer. Or, keep reading and let’s see what happens when we work a bond
hedge into the monthly equation.

A Cash Trigger
Takeaways
The best way to make money is to not lose it. Or stated another way, the ultimate success of any investment
plan depends on one simple element: minimizing losses. A cash trigger addresses this element.
The zero percent line on the chart is the cash trigger. Each month, when comparing our 4 ETFs over a 3-
month lookback, if all the ETFs are trending below the “0.0%” line, then the trade is to go to cash.
While not every year sees an advantage, adding a cash trigger substantially boosts the compound annual
growth rate (CAGR) over time.
Side benefits: a cash trigger dramatically reduces both volatility and maximum drawdown.
Building on the Foundation, Part II

In Chapter 3 we laid the foundation for our strategy: a 60% to 40% mix of “risk-on” equities and bonds acting as
a “hedge.” We initially looked at SPY (mirroring the S&P 500 index) as our “risk-on” ETF trade and TLT (long-
maturing U.S. treasuries) as our hedge.
From there, in Chapter 4, we tinkered with the “risk-on” side of the equation by moving from a buy-and-hold
mindset to a monthly rotation strategy involving 4 ETFs. In Chapter 5 we added a cash trigger to the “risk-on”
side of the equation in order to minimize losses during significant market downturns.

Now let’s consider the “hedge” trade, the 40% of our strategy that contributes largely by reducing volatility and
max drawdown of the overall investment. We had left off that discussion with TLT as our pick for a buy-and-hold
hedge. Can we improve on that?

Improving on TLT
We picked TLT, the iShares ETF that tracks a market-weighted index of bonds issued by the U.S. Treasury with
remaining maturities of 20 years or more, because it has a frequent negative correlation to equities (hence, the
“hedge”), and because long-maturity treasuries have price swings that most closely approximate the price swings
of the overall stock market.

But a “frequent” negative correlation doesn’t mean it always reacts in the opposite direction of the stock market.
A number of factors can and do influence U.S. Treasuries, and those influences sometimes drive the bonds in the
same direction as stocks for extended periods. When this happens, treasuries lose their hedge.

And if the direction is down, losses in equities are compounded by losses in treasuries.

To try to minimize these compounded losses, we’re going to approach the 40% of our strategy the same way we
approached the 60% -- by considering ETF options beyond TLT, and developing a rotation schedule that switches
between outperformers.

At first glance, selecting ETF alternatives beyond TLT appears daunting. One online database of ETFs
(ETFDB.com) puts the number of bond ETFs at over 300 and counting. There are ETFs relating to municipal
bonds, corporate bonds, emerging market bonds, government bonds (domestic and international), high-yield
bonds, inflation-protected bonds, preferred stock/convertible bonds, and bonds that sample the total bond
market.

But a lot of these bond ETFs duplicate one another. And most of the others are fairly easy to determine whether
or not they fit our criteria: that they contribute to a rotational strategy that improves CAGR, or lowers volatility,
or reduces max drawdown, or some combination of the three.

While I was hoping for a small handful of candidates from which to rotate, backtesting kept identifying a single
ETF as the optimal counterweight to TLT. Consider it to be a hedge for the hedge. To the definitions.

Definitions:
High-Yield Corporate Bond is a type of corporate bond that offers a higher rate of interest because of its higher risk of default. When companies
with a greater estimated default risk issue bonds, they may be unable to obtain an investment-grade bond credit rating. As a result, they typically
issue bonds with higher interest rates in order to entice investors and compensate them for this higher risk. High-yield bond issuers tend to be
startup companies or capital-intensive firms with high debt ratios. -- SEC

JNK is an ETF that tracks the Bloomberg Barclays High Yield Very Liquid Index. In the SPDR family of funds.
If high-yield corporate bonds have a higher risk of default, is JNK safe as an alternative to TLT? While it’s true
that high-yield corporate bonds (often called “junk” bonds) are riskier plays than treasuries, we have three things
working in our favor.

1. JNK is an ETF, meaning that it’s a basket of bonds; at last count, 959 holdings (as of 07/12/2017). As with
any ETF, there’s a certain safety in numbers.
2. While JNK doesn’t have a 10-year track record (inception date: 11/27/2007), it does have a 9-year track
record. Since the inception date, the fund has averaged a 5.78% annual return vs TLT at 6.4% for the same
time frame. That’s assuming a buy-and-hold, which we won’t be doing. During its lifetime, it has shown a
volatility number slightly lower than TLT (13.7% vs 15.4%) and a max drawdown slightly worse (-38.5% vs
-26.6%).
3. While all junk bonds funds will react negatively to a rise in default rates, we’ll be evaluating the relative
strength of JNK and TLT every 30 days. That should provide us a sufficient window from which to exit if
default rates begin to rise.

Alright, so we’ve got our rotation candidates for the “hedge” portion of our strategy. They are the ETFs:

JNK
TLT

As with the 60% “risk-on” portion of our strategy, we’ll be attempting to identify which one of the 2 candidates
above is demonstrating the most strength relative to the other. That is, which of the 2 ETFs is outperforming.
That’s the one we’ll buy, of course, under the assumption that outperformance begets outperformance – at least
for a period of time.

And as with the 60%, we’ll use a month-to-month trading schedule and a lookback period of 3 months to
determine relative outperformance.

Charting Relative Outperformance

In keeping with our previous examples, let’s look at the full year 2016. Figure 12 identifies the ETF that has
outperformed during a 3-month lookback period ending December 31, 2015. Remember, we buy on the last day
of the month to hold for the upcoming month. So Figure 12 identifies the outperforming TLT as our “hedge”
investment for January, 2016.
Let’s move to the next month. Figure 13 identifies the ETF that has outperformed during a 3-month lookback
period ending January 29, 2016. With TLT as the outperformer, that remains our “hedge” investment for
February, 2016.
Let’s move to the next month. Figure 14 identifies the ETF that has outperformed during a 3-month lookback
period ending February 29, 2016. With TLT as the outperformer for the third month in a row, that remains our
“hedge” investment for March, 2016.

Let’s do this one more time and then we’ll summarize the year. Figure 15 identifies the ETF that has
outperformed during a 3-month lookback period ending March 31, 2016. With TLT as the outperformer, that
remains our “hedge” investment for April, 2016.
So let’s see what we’ve got for 2016. Here’s how the monthly rotation shakes out for the “hedge” half of our
strategy.

2016 “HEDGE” ROTATION TABLE:

And the result of all this trading? At year’s end, the “hedge” portion of our rotational strategy has returned
+10.88%. Had we bought and held TLT alone (our benchmark for the “hedge” half of the equation), we would
have seen a +2.1% return for 2016. So the strategy outperformed the TLT benchmark for 2016.

But that was one year. And as we said before, one year doesn’t capture market cycles nor does it capture the
entire picture of a long-term strategy. Let’s backtest this and see how things would have played out over 10
years, ending in 2016.
Figure 16 gives us a chart of that time frame. The green line, or “Backtest,” is the monthly rotation of our
“hedge” ETFs played out over ten years ending in 2016. The blue line is TLT, and acts as a visual benchmark.
The reason TLT is our benchmark here, and not SPY as before, is because we’re currently dealing with the
“hedge” portion of our strategy. TLT was our initial go-to bond fund, so if we can’t beat TLT over a period of
time, there’s no sense in rotating among different ETFs. Thus TLT is our benchmark when it comes to the
“hedge” portion of our strategy.

Looking back over a 10-year period, not only did our rotational strategy substantially boost the compound annual
growth rate (CAGR) compared to buying-and-holding TLT, but we reduced both volatility and maximum
drawdown as well.

So while not every year is going to be a stellar year that will beat the TLT benchmark, if your time horizon is 10
years plus, we’ve made the “hedge” portion of our strategy a safer trade while improving overall returns.

Building on the Foundation, Part II

Takeaways
Given the wide diversity of bonds and the catalysts that move them, in any given time frame there are
outperformers and underperformers. We’ll take advantage of this through rotation.
We’ve identified 2 bond types and respective ETFs for consideration: 1) the Bloomberg Barclays High Yield
Very Liquid Index (corporate “junk” bonds) represented by the ETF JNK, 2) the Barclays U.S. 20+ Year
Treasury Bond Index represented by the ETF TLT.
The ETF candidate to buy is the one that has outperformed during a “lookback” period of 3 months. With
readily available charting tools, we can see which ETF has been the outperformer by charting both on the
same chart.
Backtesting confirms the advantage of bond fund rotation over a buy-and-hold strategy.
The 12% Solution

From our initial nod to Warren Buffett and his simplest of plans for beating the money managers, we saw how
we could improve results (or at least improve on investment risk) by swapping his Vanguard 500 Index Fund
Admiral Share for a 60% to 40% mix of equities and bonds.
From there, we tinkered with multiple elements of this tried and true formula. We looked at rotating among
multiple stock market indices and bond funds, and found this approach to further improve results. We identified
a 3-month lookback period as the optimal history for determining which ETFs to buy, and monthly trades as
most advantageous in screening out market noise.

We’ve seen the kind of returns generated by each segment of the equation, along with their associated volatility
and max drawdown numbers. What happens when we put the pieces together into a single monthly rotational
strategy?
Figure 17 shows us 10 years of the overall strategy at work. The green line, or “Backtest,” is the monthly rotation
of both our “risk-on” trade and our “hedge” trade. The blue line is SPY, our benchmark.
Over the most recent 10-year period, as the above Figure 17 illustrates, a monthly rotation of both our “risk-on”
trade and our “hedge” trade triples our total return while cutting volatility in half and reducing our maximum
drawdown by more than three fourths.
Perhaps the most compelling argument for the strategy is the year 2008. That year saw the U.S. market
plummeting in the midst of The Great Recession, with the stock market finally finding a bottom in June of 2009.
Figure 18 gives the numbers: 2008 saw SPY (representative of the S&P 500) post a loss of negative -36.8%.
Conversely, our strategy returned a positive +10.9% that same year.
At the same time, you can see that the strategy doesn’t beat the overall market every year, something I’ve tried
to stress throughout this book. Some years it outperforms, other years it lags. But overall, taken with a longer
term outlook, the strategy beats the market and does so with less risk and less of a roller coaster ride.

Let’s pull it all together and summarize the mechanics of our strategy that generates average annual returns of
12%. Actually, we generated 14.4% annually as per Figure 17, but I like 12% because it’s conservative. I’d rather
under promise and over deliver than the other way around.
So, here’s how it works…

The “Risk-On” Trade

Once a month, on the last day of the month, we will chart the relative performance of 4 index ETFs to decide
which one to invest in for the upcoming month. The ETFs for our “risk-on” trade are as follows: IWM, MDY,
QQQ, SPY.
We chart their relative performance by using an online stock chart that provides for simultaneously comparing
multiple stocks or ETFs – either the stock chart that is incorporated on the Web pages of your brokerage account,
or one that is readily available through both paid and free Web services. For illustration purposes throughout this
book, I’ve used free charts constructed from the site StockCharts.com (specifically, their “Perf Charts”).

Once the ticker symbols of the 4 ETFs are entered into the chart, and a 3-month time frame selected, the
outperforming ETF will become evident: it’s the one whose graph line is uppermost on the chart as of today’s
date. That’s the ETF we will buy to hold for the following month until the process repeats on the last day of the
following month.

As this represents our “risk-on” trade, it commands 60% of the account (or 60% of the amount you allocate for
the strategy). So, we’ll allocate 60% to this fund.
IMPORTANT REMINDER: Should none of the graph lines make it above the 0.0% line, this portion of our
account (or strategy allocation) goes to cash. This is called our cash trigger, and helps to prevent large losses in
the “risk-on” trade. So before selecting the outperformer of the bunch, make sure it is above the 0.0% line.
Otherwise, hold cash in 60% of your account.
The “Hedge” Trade
Once we’ve finished with our “risk-on” trade, we’ll turn our attention to the “hedge” portion of our strategy.
Using the same comparative chart, we’ll remove the equity ETF ticker symbols and replace them with the ticker
symbols for our 2 bond funds, namely JNK and TLT.
We’ll repeat the same process, and select the outperforming bond ETF for the 3-month lookback period. That’s
the ETF we’ll buy to hold for the coming month until the process repeats.

As this represents our “hedge” trade, we’ll allocate 40% to this fund.
NOTE: No need for a cash trigger here, as backtesting has shown no advantage. Which makes sense, as the very
definition of a hedge is an investment that reduces the risk of adverse price movements in an asset.
In the event relative performance testing determines that we keep the same ETF(s) as the previous month, then
the only trade necessary is that which rebalances to maintain a 60/40 mix of “risk-on” and “hedge” investments.
And if the imbalance is slight? Forget rebalancing, save the trading commissions, and just let the ETFs ride.

And Then?
Once the trades are executed, step away from the computer and try not to let the daily market noise lure you into
further trading. Approach it once a month, make the trades dictated by the strategy, then let the strategy do the
heavy lifting. The results we’ve shown through backtesting are predicated on once-monthly trading. To trade
more frequently or less frequently is to strip the strategy of its value.

Trade once a month, then go live your life.

OK, But Does an Extra 5% Really Matter?

This book lays out a plan for achieving a 12% annual return – on average – in the stock
market. The skeptic might say that one can already achieve 7% with no effort
whatsoever (or more precisely, 7.1% as per Warren Buffett’s mutual fund choice in
Chapter 3). And by ‘no effort whatsoever,’ the skeptic means buy-and-hold. Buy one
mutual fund, hold it, boom: 7.1% average annual return over ten years.
So why, asks the skeptic, should we give up that bird in the hand in return for a lousy
5% extra per year? Especially when that extra 5% requires us to pull ourselves away
from the television for 20 minutes per month to execute big league trades on the
frightening web pages of a discount stock broker?
Indeed. What difference does 5% make in the grand scheme of things? And is it worth
the trouble? Well, let’s load the following table with some data.

Warren Buffett’s Mutual

The 12% Solution
Fund Choice
Starting Balance $5,000 $5,000
Annual Contributions $1,200 $1,200
Years Contributed 40 40
Annual Return 7.1% 12.0%

Let’s assume we’re starting with an investment of $5,000. To that initial investment,
we’re adding $100 per month, or $1,200 per year. Let’s also assume we’re young and
hip and happening, and we’ve got 40 years to play around with this. Yes, 40 years is a
long time. But if you’re 25 years old now, 40 years puts you at age 65. Consider this a
retirement plan. The annual returns we’ve plugged in are backtested returns for the
previous 10 years.
As we’ve learned, past performance is no guarantee of future results, but we’ve got to
go with something.

We’re comparing Warren Buffett’s choice of mutual funds (buying and holding the
Vanguard 500 Index Fund Admiral Share,) with The 12% Solution. The difference in
annual return is almost 5% (technically, 4.9%). So how does that 4.9% difference stack
up over the years?

Warren Buffett’s Mutual

Year The 12% Solution
Fund Choice
2017 $5,000.00 $5,000.00
2022 (plus 5 years) $13,962.26 $16,435.13
2027 (plus 10 years) $26,586.32 $36,587.72
2032 (plus 15 years) $44,377.94 $72,103.49
2037 (plus 20 years) $69,448.42 $134,694.40
2042 (plus 25 years) $104,775.68 $245,000.97
2047 (plus 30 years) $154,555.97 $439,398.83
2052 (plus 35 years) $224,702.26 $781,994.29
2057 (plus 40 years) $323,546.66 $1,385,764.56

At the end of 40 years, following The 12% Solution and the assumptions we made
earlier delivers an additional $1,062,217.90 to your account. That 4.9% annual
difference means you’re a millionaire at the end of the exercise. Without the 4.9%? Not
so much.
Note that we’re not accounting for trading fees and commission, nor any additional tax
bite for claiming short-term vs long-term capital gains (for those trading in a
traditional, taxable brokerage account). These certainly need to be taken into
consideration. But I think you’ll agree we’re still talking about a significant difference
in the payday at the end of 40 years.
Let’s look at it another way. Take that additional $1,062,217.90 generated by the
strategy and divide that by 40 (as in years) and you get $26,555.44. That’s the income
you’ll be receiving for each of the 40 years that you work the strategy. Having put up
$5,000 just once, and then adding $100 per month to your account, the strategy returns
over $26,000 a year.

That’s like having a second job that requires 20 minutes of work per month and pays
$26,000 a year. Of course there’s one condition: you’ve got to wait 40 years for the
payday.

So what difference does 5% make in the grand scheme of things? And is it worth the
trouble? Each prospective investor will have to decide that for themselves.

To those who see the difference, decide it’s worth the trouble, and have patience, I wish
you wealth.
Note:

I am offering a monthly service that does the chart work for The 12% Solution, and
provides readers with the resulting buy/sell signals via email. It’s a free service to
purchasers of this book.

If interested, send me an email at trendline@webstreetproperties.com and say “sign me

up for the free monthly signals to The 12% Solution.” I’ll make sure you get on the
subscriber list. --David
A Word About Brokers and Commissions

If you’re new to stock market investing, you’ll need to set up and fund an account with
a stock broker in order to buy and sell ETFs. While the mechanics of that is beyond the
scope of this book, I wanted to take a moment to address brokers in general and their
trading commissions relating to ETFs.
Brokers can be broadly categorized into Full Service and Discount/Online. Because
you’ll be identifying the ETFs you wish to buy and sell each month, there is little need
for a Full Service Broker. These companies specialize in providing personalized service
and investment recommendations for their clients – and they charge accordingly.

Save yourself the big bucks and learn how to execute buy and sell orders. That way you
can take advantage of Discount/Online Brokers. The learning process is
straightforward, and every Discount/Online Broker has online tools to educate you and
guide you through the process.
Know that competition is fierce among the online brokers. Trading commissions have
dropped into the $4.95 to $6.95 range with a number of the major online brokers. Even
better, there is a trend to offer commission free trades on select ETFs. This is certainly
worthwhile to investigate, since commissions and fees can erode investable funds and
returns.

But be careful: not all online brokers offer commission-free ETF trades, and many that
do have terms that may not be suitable to our needs. For example, many that offer such
commission-free trades do so only if you hold the ETF for an extended period. To sell
before that date is to incur magnified commissions, sometimes $20 or more.

This is called an early-redemption fee, and in smaller accounts they can suck the life
out of returns pretty quickly.

Here’s a quick overview of some of the leading discount/online brokerage firms and
their policies regarding commission-free ETF trades. Terms can and do change, so
check the current status with any prospective broker before signing up.

Charles Schwab
Offers: Over 200 ETFs with zero trading commissions.
Early Redemption Fee: None.
 Enrollment: None.
Summary: Schwab ETF OneSource offers over 200 ETFs with no trading
commissions and no early redemption fees. That’s the good news. The bad news?
Those 200+ ETFs include none of the ETFs on our monthly rotation list. Yes, there
are available ETFs that are vaguely similar in makeup to most on our list, both
proprietary to Schwab and from 3rd party providers. But in keeping with the axiom
“there is no free lunch,” don’t be surprised to find higher net expense ratios
associated with “OneSource” ETFs, as well as thinner trading volumes that can
sometimes lead to investors paying fractionally higher prices than they otherwise
might in comparable ETFs with higher trading volumes. You’ll need to weigh the
pros and cons of “commission-free” trades with Schwab’s ETF OneSource.

E*Trade
Offers: Over 100 ETFs with zero trading commissions.
Early Redemption Fee: Yes, up to $19.99.
Enrollment: None.
Summary: No trading commissions on 100+ ETFs. That’s the good news. The bad
news? Sell one of those ETFs in less than 30 days and you’ll incur a “short-term
trading fee” of $19.99. Note: None of E*Trade’s commission-free ETFs match the
ones on our monthly rotation list. Yes, there are available ETFs that are vaguely
similar in makeup to most on our list. But as per Schwab, don’t be surprised to
find higher net expense ratios as well as thinner trading volumes on some of these
alternatives. You’ll need to weigh the pros and cons of “commission-free” trades
with E*Trade.

TD Ameritrade
Offers: Over 100 ETFs with zero trading commissions.
Early Redemption Fee: Yes, $19.99.
Enrollment: Required.
Summary: No trading commissions on 100+ ETFs, two of which match the ones
on our monthly rotation list (the bond funds JNK and TLT). That’s the good news.
The bad news? Sell one of those ETFs in less than 30 days and you’ll incur a
“short-term trading fee” of $19.99. Note: The remaining ETFs on our monthly
rotation list are not included among TD Ameritrade’s commission-free ETFs. Yes,
there are available ETFs that are vaguely similar in makeup to most on our list.
But don’t be surprised to find higher net expense ratios as well as thinner trading
volumes on any alternative. You’ll need to weigh the pros and cons of
“commission-free” trades with TD Ameritrade.

Fidelity
 Offers: Over 90 ETFs with zero trading commissions.
Early Redemption Fee: Yes, up to $12.95.
Enrollment: None.
Summary: No trading commissions on 90+ ETFs, including 70 funds from the
world’s leading ETF provider, iShares. One of these funds matches the ones on our
monthly rotation list (the bond funds TLT). That’s the good news. The bad news?
Sell TLT in less than 30 days and you’ll incur a “short-term trading fee” of up to
$12.95. Note: The remaining ETFs on our monthly rotation list are not included
among Fidelity’s commission-free ETFs. Yes, there are available ETFs that are
vaguely similar in makeup to most on our list. But don’t be surprised to find
higher net expense ratios as well as thinner trading volumes on any alternative.
You’ll need to weigh the pros and cons of “commission-free” trades with Fidelity.

I’ve only included 4 of the leading brokerage firms offering commission-free ETF
trades. There are others you can explore.
Remember, even though a brokerage firm doesn’t have the ETF you want on their
commission-free list, you can still buy and sell the fund (albeit for a commission).
You’ll have to decide whether it’s worth trading alternatives to the ETFs we selected
for our monthly rotation in order to snag free commissions.

If you’re tempted, start by comparing 1, 3 and 5-year returns for both your target ETF
and the commission-free alternative. Your broker should have such information on
their research pages. If not, such information is accessible on multiple free sites such
as Yahoo Finance (https://finance.yahoo.com).

And while commission-free trades are certainly nice, watch out for those early-
redemption fees.
A Note to Readers

Thank you for reading The 12% Solution. I sincerely hope you found it worth your
attention and dollar.
Gaining exposure as an independent author relies mostly on word-of-mouth, so if you
have the time and inclination, please consider leaving a short review on Amazon or
Goodreads. Your thoughts are important and I would be honored to have you share
them.
-- David Alan Carter
About The Author

Growing up in the Southwest, author David Alan Carter was taught

from an early age to work hard and protect what you’ve got. The
former came naturally. The latter, protecting what you’ve got (i.e.
money), took some twists and turns throughout the years before he
finally got the hang of it.
One particularly gut-wrenching turn: The Great Recession, when his stock portfolio
plunged along with his dreams of a carefree future retirement.
“That was a watershed moment,” Carter recalls. “Like many others, my attitude toward
investing would be forever changed.”
Cut to present day 2017. With now 20 years of investing experience ranging from buy-
and-hold to swing trading to high-frequency day trading, Carter has distilled those
lessons learned into simple, testable and repeatable trading strategies that can benefit
anyone interested in making money -- and keeping money -- in the stock market. The
12% Solution is the first in a coming series on investing and personal finance.
_____
Trader
Author, Publisher, former Newspaper Columnist
B.S. Business Management, Oklahoma State University
Disclaimer

NO FINANCIAL ADVICE
The entire contents of this book, as well as any associated websites (media), are
provided for educational, informational, and entertainment purposes only. We (the
author, editors and publishers) are not securities brokers/dealers and we are not
financial advisers, analysts or planners. We are neither licensed nor qualified to provide
investment advice. The information contained within this book is not an offer to buy or
sell securities. Nothing within these pages or on associated websites takes into account
the particular investment objectives, financial situations, or needs of individuals,
therefore should not be construed as a personal recommendation. WE ARE NOT
SOLICITING ANY ACTION.

DO YOUR OWN DUE DILIGENCE

The information provided is not intended as a complete source of information on any
particular company, investment, asset or market. An individual should never make
investment decisions based solely on information contained within our book or
associated media (or any book or website, for that matter). Readers should assume that
ALL INFORMATION PROVIDED REGARDING COMPANIES, INVESTMENTS,
ASSETS OR MARKETS IS NOT TRUSTWORTHY UNLESS VERIFIED BY THEIR
OWN INDEPENDENT RESEARCH.

INVESTING IN SECURITIES IS HIGH RISK

Any individual who chooses to invest in any securities should do so with caution.
Investing in securities is speculative and carries a high degree of risk; you may lose
some or all of the money that is invested, and if you engage in margin transactions your
loss may exceed the amount invested. Before acting on any analysis, advice, trade
triggers or recommendations, investors should consider whether the security or strategy
in question is suitable for their particular circumstances and, if necessary, seek
professional advice. You must decide your own suitability to trade. YOU ASSUME
ALL RISKS AND COSTS ASSOCIATED WITH ANY TRADING YOU CHOOSE TO
TAKE.

PAST PERFORMANCE NO GUARANTEE

Trading results can never be guaranteed. The information provided in this book and
associated media regarding the past performance of any security or strategy is only
representative of historical conditions in the marketplace, and is not to be construed as
a guarantee that such conditions will exist in the future or that such performance will
be achieved in the future. The price and value of investments referred to in this book
and associated media, and the income from them may go down as well as up, and
investors may realize losses on any investments. Past performance is no guarantee of
future results. Future returns are not guaranteed, and a loss of original capital may
occur. ONLY INVEST WITH MONEY THAT YOU CAN AFFORD TO LOSE.

DIFFERENCES IN PORTFOLIO PERFORMANCE

Readers should be aware that numerous variables including timing of trade, trading
commission, slippage and execution issues, may result in actual portfolio performance
to differ measurably from modeled and backtested strategy performance.

RELIABILITY OF DATA
The contents of this book and any associated media -- text, graphics, links and other
materials -- are based on public information that we consider reliable, but we do not
represent that it is accurate or complete, and it should not be relied on as such. This
book and associated media may contain inaccuracies, typographical errors and other
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author does not warrant the quality, accuracy, reliability, adequacy or completeness of
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omissions in such information and material. Opinions expressed herein are the author’s
opinions as of the date of publication of those opinions, and may or may not be
updated.

NO WARRANTIES
The 12% Solution does not guarantee or warrant the quality, accuracy, completeness,
timeliness, appropriateness or suitability of the information or of any product or
services referenced. The author assumes no obligation to update the information or
advise on further developments concerning topics mentioned. This book may contain
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ADDITIONAL RISK DISCLOSURE STATEMENT FOR SYSTEM

TRADING
The 12% Solution develops a rules-based portfolio investment strategy that makes
extensive use of hypothetical or simulated performance results. Pursuant to the
Commodity Futures Trading Commission (CFTC) Rule 4.41(b): Hypothetical or
simulated performance results have certain inherent limitations. Unlike an actual
performance record, simulated results do not represent actual trading. Also, since the
trades have not actually been executed, the results may have under- or over-
compensated for the impact, if any, of certain market factors, such as lack of liquidity.
One of the limitations of hypothetical performance results is that they are generally
prepared with the benefit of hindsight. In addition, hypothetical trading does not
involve financial risk, and no hypothetical trading record can completely account for
the impact of financial risk in actual trading. For example, the ability to withstand
losses or adhere to a particular trading program in spite of trading losses are material
points which can also adversely affect actual trading results. There are numerous other
factors related to the markets in general or to the implementation of any specific
trading program which cannot be fully accounted for in the preparation of hypothetical
performance results and all of which can adversely affect actual trading results. NO
REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY
TO ACHIEVE PROFIT OR LOSSES SIMILAR TO THOSE SHOWN.

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To the fullest extent of the law, we (the author, editors and publishers) will not be liable
to any person or entity for the quality, accuracy, completeness, reliability, or timeliness
of the information provided within this book and associated media, or for any direct,
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howsoever caused, that may arise out of or in connection with the use or misuse of the
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