Reducing risk and enhancing returns through market timing

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.

Categories: PortfolioRetirement

Tags: AllocationKMP MLP StocksPortfolioSWRtiming

32 Comments

David Fleischer · November 10, 2010 at 10:57 pm

Paul,

Very interesting and is something I want to follow up on and try to understand. Would it be possible to outline an example based on actual recent averages of how this works?

David

libertatemamo · November 11, 2010 at 9:54 am

Sure, I could do an ‘implementing the moving avg strategy post’. Good idea. Thanks.

David Fleischer · November 11, 2010 at 12:22 am

Hi Paul,

I went to the link you included (http://www.mebanefaber.com/timing-model/)

I just want to make sure I understand. In the first graph (US Stocks). If I am reading it correctly, the blue line is the 200 day moving average and the black line is the actual monthly close. From approx April 2008 to April 2009, the Average was above the actual which would say we should be out of the market, and from approx April 2009 to April 2010, the average was below the actual which says we should have been in the market… Today the Actual is above the average… so we should be in the market.

Am I understanding this correctly?

David

libertatemamo · November 11, 2010 at 9:53 am

Yep, you got it. In his system you also only look at the monthly closing price of an index, like US stocks, and make a decision based on that. Above the 200 day, you’re in, below the 200-day, you’re out. No need to track the indices every day. He actually looked at that system and it performed no better than the monthly system. I haven’t finished looking at it yet but you can start taking a look at his new ETF he launched, GTAA.

David Fleischer · November 11, 2010 at 9:37 pm

Great. I’ll look into the ETF.

Another question… can the 200 day moving average be successfully applied to individual stocks? Or to different classes of stocks like “mid cap” or “small cap”? Or is it best used on a more macro level?

libertatemamo · November 12, 2010 at 9:42 am

Yes, it can be applied to any class of stocks like small, mid caps, especially if the class has a highly liquid ETF that tracks it. And for almost any asset class there is an ETF for it. I think the exception would be the leveraged ETFs, or inverse ETFs. I think the method also works on popular stocks with good volume. Before using it on an individual stock I would backtest this strategy on that stock. Where I don’t use the strategy is on good dividend stocks. When the stocks are down I want to re-invest those dividends at those lower prices to boost my returns. But that takes a strong stomach sometimes.

David Fleischer · November 12, 2010 at 11:00 pm

Got it. Thanks Paul.

Jim OConnor · November 16, 2010 at 12:42 am

The material you present and what is in Mebane’s paper is very attractive. The devil is in the details. 1. I look at the graph you present and feel that most of the advantage is in the last 12 years or so. That may be in the nature of the graph; I’m not sure. 2. I looked at charts for a number of indexes and etfs. Even using monthend data it looks like there are a lot of whipsaws. The numbers tell you to exit(or enter) the end of this month but then you are going in and out for a couple of months before a good trend develops.
I guess my question is whether there is any solution to this problem or is it just in the short term data I am looking at. I think that any more complexity in the decision rule and one is data mining. I know Mebane is sensitive to this in the paper but I don’t know of enough out-of-sample tests to overcome the doubt.
Very long comment but I really appreciate what you are trying to do. My wife and I fulltimed for 8 years and are off the road for the last year due to health insurance issues. But the quest goes on to survive as full time investors.
Thanks again
Jim

libertatemamo · November 16, 2010 at 2:20 pm

Hi Jim. Thanks for the comment. The graph I posted is a log graph so its hard to judge the magnitude of the changes and the recent year are amplified because of this. I like to look at the actual series of annual returns for the 5 asset class model that are published in the paper. The S&P500 only model is not so realistic I think – how many investors would be 100% in stocks? The strength of the system is in range bound markets or bear markets. The system can underperform in serious bull markets. For me personally, the downside protection is worth the ‘price’ of the system which is more trades and maybe under performance in big bull markets. I’ll take that trade off any day.

And yes, there are some false signals. I think that would be inherent in any purely mechanical strategy. The false signals don’t seem too bad to me. The model and the month end investing keeps the number round trip trades pretty low. That and the lower transaction cost for ETFs recently I think makes this idiosyncrasy tolerable. As far as out of sample testing only time will give us more data. Mebane I think did what he could but there is just not enough data yet. I do like what he’s trying to do though.

8 yrs full-timing is impressive. I find the lifestyle quite addictive, we’ll see how long we do it for. At some point we will get off the road and ‘settle down’ again.

Paul

Jim OConnor · November 17, 2010 at 4:02 pm

Thanks for the reply. I am in agreement but wanted to bring thses points up.
Jim

Del Clark · July 28, 2012 at 2:20 pm

Hi Paul,
I’ve been reviewing this post again in light of recent reference to timing the market. You indicated that you don’t time individual stocks. Could you share some thoughts on which ETFs would be good to “time” to give a balance market exposure?
Thanks. I really enjoy your blog and thoughtful analysis that you share.

libertatemamo · July 28, 2012 at 10:53 pm

Hi Del, the IVY timing model uses 5 ETFs that each represent one of 5 asset classes. They are VTI for US stocks, VEU for Foreign stocks, IYR for Real estate, IEF of bonds, and DBC for commodities. These are the ETFs that the return numbers are based on.

Hope that answers your question.

Paul

Del Clark · July 29, 2012 at 3:14 pm

Thanks Paul. Have you tried applying the timing model? With these ETFs or with another set of assets? Or maybe selling puts/calls on indices for the 5 asset classes?

libertatemamo · July 29, 2012 at 3:47 pm

Del, yes I run the timing model in my and family’s 401Ks. I use the model exactly as it was designed by Mebane Faber which uses the exact 5 ETFs I listed. Its a simple model; you invest in the ETF when its month end price crosses above the 200 day SMAS and you sell the ETF when its monthly end price crosses below the 200 day SMA. YOu do that independently for all 5 ETFs. That’s it. See his site World Beta and I highly recommend his book. Or just read the white paper. He discusses all the details of implementing the model.

Paul

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