In an earlier post on risk management I discussed various methods of managing downside risk in a portfolio. One method I mentioned was a momentum strategy based on moving averages. Most would call such a strategy a market timing strategy even though that brings up a lot of negative connotations despite the fact that it works amazingly well. In today’s post I’ll discuss my favorite trend following system, how it has performed in the past, and how you can take advantage of it to reduce your risk.
I’m sure you’ve heard it before a million times – ‘you can’t time the market’, buy and hold is the best long term strategy to produce wealth, the market is efficient, 90% of mutual funds fail to outperform the market, etc… There is a lot of truth to these statements and a lot of data to support these claims. I don’t want to go into those here. Its not necessary. The fact is that despite the data most investors do try and time the market. Most investors can’t implement a true buy and hold strategy. Why? Emotion. Or more technically because of our behavioral biases. We get scared out of down markets and we chase up markets often to our detriment. And in happens across all asset classes, not just stocks. Morningstar, measures investors returns (actual returns posted by investors) versus the posted asset class returns on a periodic basis. Here is what they found most recently, investor returns in the last decade:
Across all asset classes investors under perform the respective asset classes. So, despite all the prescriptive advice, investors can’t tame their emotions. This is devastating especially to retirement portfolios. This is yet another reason that everyone needs to have a risk management strategy that deals with the reality of behavioral biases. A mechanical strategy like a trend following moving average strategy fits this bill nicely.
Momentum strategies, aka trend following strategies, work, despite what the die hard efficient market academics say. There is a great deal of fundamental work that has been done in this area and it consistently shows these strategies outperform. I’ve looked into many of these and my favorite by far is one based on the 200-day moving average of an asset class. Mebane Faber at World Beta has done a lot of work in this area and it is his strategy that I outline here. His paper, ‘Tactical Momentum Based Investing‘ is where the data in this post is from. The basics of the strategy are simple; you have a diversified portfolio of asset classes, then you get long an asset class when its above its 200 day moving average and you exit the asset class,going into cash, when its below its 200 day moving average. That’s it. The holding into various asset classes takes advantage of the benefits of diversification, while the moving averages prevent you from losing too much on the downside and get you back in when the trend is up. The strategy works across all asset classes by improving risk adjusted returns. Here are the results of this strategy versus buy and hold from 1973 to 2008 for a portfolio diversified among five assets classes; US stocks, Int’l stocks, bonds, real estate, and commodities.
And here are the portfolios statistics versus buy and hold.
So, you get higher returns, less volatility, and more importantly much lower drawdowns. How much different would you have felt in 2008 if your overall portfolio was down a worst case 9.53% versus 35.98%! I bet you would have had a bit less anxiety particularly if you were a retiree relying on portfolio withdrawals to fund your lifestyle.
Another great aspect of Mebane’s system is that it is easy to implement and low cost. It uses highly traded low cost ETFs and is only updated once a month. Most investors would have no problem implementing such a system. Mebane has also recently launched an ETF that specifically implements this strategy. That would be an even easier option as well. I’m currently looking into the details of his new ETF.
In summary, for investors who don’t have the time or inclination to invest in individual stocks this is a great way to invest, particularly for retirees looking to limit the downside, and keep those pesky emotions at bay. And I have an inkling that such a strategy would allow for a higher SWR in retirement (something I’m researching now).
Update, Nov 12 2010: The Kirk Report had a great interview with Mebane Faber. Read it all here.
Full Disclaimer - Nothing on this site should ever be considered advice, research or the invitation to buy or sell securities. These are my personal opinions only.