More Support For Disciplined ETF Strategy

What a pleasant surprise it was to see someone else touting the importance of discipline when investing in ETFs. As we've rigorously outlined our ETF investing philosophy in a previous post, I'll say again that the best defense against the market roller-coaster is a strong discipline to stick with your selling points. And Alan R. Elliott of Investor's Business Daily agrees.

Here's an example of how great minds think alike when it comes to ETF strategies: Elliott says to sell a stock once it drops 7% to 8% below your purchase price. We couldn't agree more. That's why we closely follow the 200-day moving average of all our ETFs. If an ETF falls below it, or if it drops 8% off its high without going below its 200-day average, it’s sold. Below is a chart of SPY for the past year. As you can see, last summer it fell below its long-term trend line. Thus if we had owned it, we would have sold it.

Update: We often discuss the importance of having an exit strategy when investing in exchange traded funds (ETFs). Recently, we wrote about a disciplined ETF strategy, using the 200-day moving average. After writing about this, a reader came back with a great question,

"What is the strategy to buy back a stock [ETF] once it dips below its 200-day moving average and was sold?"

By establishing an exit strategy and selling an ETF, this helps protect gains as it appears the trend is changing. When we sell something, we look at the cash generated as a "free agent." In other words, it is free to be used for any investment where a trend is developing, be it an asset class, global region or sector. If no areas show an up trend or momentum, we keep the money in a money market fund.

As you manage your own portfolio, you might feel a need to always have a set amount of money designated to a certain investment (i.e. small-cap, China or commodity). If this is the case, then the cash can be held until that certain investment goes above its 200-day moving average or gains 5% from its recent low.

Thanks for the questions!

Comments

[fingham:]

I don't get it. If you had sold SPY back in July of 2006, you would have missed out on a 24% gain since then (adj close of 122.44 on 7/13/06). The chart is pretty clear and it suggests the opposite of what you recommend in your article. The chart clearly shows that the smart thing to do in July of 2006 would have been to BUY MORE! Or are you suggesting you would have sold SPY in July 06 anyway, and put that money to work in some other asset that was primed to deliver better than 24%? As it is, the data you present in "support" of your recommendation regarding SPY clearly argues AGAINST your recommendation...

2007 Jul 03 02:38 PM

[mitsuo:]

It's refreshing to see Mr. Lydon attempt to add something to an article he's picked up on the web and regurgitated onto us. Unfortunately, his feeble attempt to mesh someone else's ideas in an unholy juxtaposition with SPY was quite lame. Seems like the use of SPY as an example was just so that this article could get published in SeekingAlpha's ETF section!

2007 Jul 03 07:02 PM

[Susan:]

The main problem with the approach of selling when a holding dips 8% from its high is that often when there's a sharp correction, almost all assets become very correlated. In fact, last summer, (May-June 2006) was a classic example where almost all ETFs had a very significant dip, with almost no hiding place to park money and with most exceeding the 8% threshold suggested in the article. Last summer, even "defensive ETFs" like energy, commodities, precious metals, all went down with the emerging market ETFs.

It is not clear whether in that case the author would have liquidated his whole portfolio at the worst possible moment.

Of course, in hindsight we can say that June 2006 was the best time to load up the truck on the ETFs that dipped 8% or more. I'm not sure if the 8% rule was rigorously back-tested with historical data, but I suspect it would have faired pretty poorly as a general "golden rule" to live by,

2007 Jul 03 10:15 PM

[Nidhi Kadalbal:]

Not sure if I can agree entirely ..

However, William O Niel suggests 8% loss for sells in his CANSLIM methodology. But that is mainly for MOMENTUM stocks and not general SP500 though.

creating-wealth.blogsp.../

2007 Jul 04 08:54 PM

[Tom Lydon:]

Thanks for your comments. To further clarify, we did lighted up on most of our ETF holdings during the April-May correction of 2006. And, in some cases we bought back in at slightly higher levels in August when most ETFs went back above their individual 200-day averages. In hindsight it would have been better not to have sold, but as we know, it doesn't always work out that an 8% correction is a buying opportunity. Hundreds of billions of dollars have poured into ETFs since the last bear market (2000-2002). My intent was to get readers to think about their individual exit strategies no rather than later. -Tom Lydon

2007 Jul 06 02:16 AM