A new approach to asset allocation seeks to combine equity-like returns with reduced volatility.

As any chart will tell you, an investor looking for the best long-term returns should concentrate on equities, which historically have generated returns that in the long run have been superior to those that can be gleaned from investing in bonds. (Indeed, between 1925 and 2011, investors would have generated returns of 6.6%, annualized, from equities in contrast to 2.6% on their bond holdings.)  The problem, as financial markets remind us forcibly every few years, is that stock markets are much more volatile. Since the outlook for corporate earnings is tied to the business cycle, any shift in the economy results in a change in sentiment with respect to equities — and big, shorter-term movements in stock prices. Any investor who retired in 2008 with a large portfolio in which stocks dominated can testify to the devastating impact of such volatility on their savings and retirement plans.

Is it possible to achieve returns that approximate those that can be earned over the long run by investing in stocks, while maintaining bond-like volatility levels? Certainly, doing away with the business cycle itself isn’t an option. Nor, it seems, do traditional efforts by investors to gauge just when the cycle is about to shift — many of which rely on changes in real GDP, despite the fact that GDP growth forecasts didn’t manage to forecast either the dotcom crash of 2000 or the financial crisis of 2008 — work well in practice. Too often, by the time the GDP forecasts have responded to real world events, it’s too late for investors to rebalance their portfolios.

The solution, as spelled out in the article attached here part of a forthcoming book entitled ‘Profiting from Monetary Policy’ by Thomas Aubrey, founder of Credit Capital Advisory– may well lie in a theory first developed by Swedish economist Knut Wicksell, and modified by Nobel laureates Friedrich Hayek and Gunnar Myrdal. This theory is based on the fact that an increase in profits is the result of higher growth rates on capital or a decline in the cost of capital, while an increase in profits then stimulates fresh credit creation, which in turn becomes essential for companies to further boost their rate of growth of earnings. The article seeks to identify and analyze the turning points in the business cycle that are tied to the return on capital and the cost of capital (the “Wicksellian Differential”) and thus offers investors a set of alternative signals for when it is wise to make a tactical asset allocation shift away from equities in favor of bonds — and vice versa.

For more on this new approach to asset allocation and insight into the returns generated by the model, click here to read the complete study, which is based on extensive use of Datastream charts.