Reducing Portfolio Risk: A Modification

Includes: RWX
by: Lowell Herr

Investors tend to be more disquieted by portfolio losses than they are elated by portfolio gains. This seems to be how we are mentally constructed. Taking this into consideration, the ITA Risk Reduction model is designed to improve portfolio returns while reducing portfolio volatility or uncertainty.

The following set of risk reduction rules are faster moving than the original set explained in this article.

In the following screen shot we see several sets of moving averages and the price movement for an international REIT, RWX. Using the original set of rules, a sale was called for back in August of 2011 and a buy in late January of 2012. The price differential is not all that great. One does need to keep in mind that risk was lowered when the money was held in a lower risk investment such as a T-bill. When one is out of the market and invested in a "risk-free" treasury, portfolio risk is reduced.

With the new rules articulated below, a sell was called for in late July of 2011 when the price of RWX was close to $39.00. Possible action of a buy and sell happened in late October and early November, depending on when the ETF was examined. This is what we call a whipsaw action. For this reason, we only use commission-free ETFs so fees don't eat into potential profits. It is possible this buy-sell action occurred when the portfolio was in "neglect" mode.

The latest buy signal showed up in mid-January when RWX was priced a little above $32.00. Again, it depends entirely on when the monthly examination period was scheduled. Coming in early adds nearly 6% points to the recent advance.

Here are the new Buy and Sell rules.

Buy Rule: Buy when the first of these two trigger events take place.

  1. Buy when the ETF price moves from below to above its 195-Day Exponential Moving Average (EMA) or
  2. Buy when the 13-Day EMA moves from below to above the 34-Day EMA.

Sell Rule: Sell when the first of these two trigger events take place.

  1. Sell when the ETF price moves from above to below its 195-Day EMA or
  2. Sell whe the 13-Day EMA moves from above to below its 195-Day EMA and go to cash. Cash is defined as money market or the TIP ETF. A 90-Day T-bill is another cash haven.

The first rule in each of the Buy and Sell areas is identical to the original Buy and Sell rules in the original ITA Risk Reduction model. The modification of the original risk reduction model comes with the addition of the 13- and 34-Day EMAs.

As before, follow the remaining rules.

Commission Free ETFs: Use commission free ETFs to reduce transaction costs.

Neglect Mode: After a trade, wait 31 days to avoid short-term trading fees, wash sale rule, and whiplash trading issues. While the rule is 30 days, I prefer to use 31 days so possible errors are eliminated.

Examination Period: Examine each portfolio once a month. This involves checking each ETF in the portfolio or those ETFs one is using as risk reducing investments. After examination, put the portfolio into "neglect mode" for one month.

Disclosure: I am long RWX.

Disclaimer: The RWX example explained above is historical information and is not an indicator of what we might experience in the future. Out-of-sample data or future results will most certainly vary.