On page 167 of Mebane T. Faber and Eric W. Richardson's book, "The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets" we read, "Our research has shown that returns are lower and volatility is higher when asset classes are below the 10-month moving average." What investor is not interested in reducing portfolio volatility while increasing returns. And possibly more important, reducing losses. This philosophy is what is behind the ITA Risk Reduction (ITARR) model we are testing with the Maxwell and Euclid portfolios.*
The 10-month simple moving average Faber and Richardson discuss in their book is equivalent to the very familiar 200-Day Simple Moving Average. Instead of the 200-Day SMA, I will be using the slightly faster 195-Day Exponential Moving Average (NYSEMKT:EMA) for each asset classes used in the Maxwell and Euclid portfolios. Readers will find a detailed explanation of the EMA elsewhere on this blog. Should I expand the ITARR to other portfolios, the same rules will apply. As a review, here are the ITARR rules. These simple rules can be implemented by any investor.
- Buy Rule: Buy the index ETF when the price of the ETF moves from below to above the 195-Day EMA of the ETF.
- Sell Rule: Sell the index ETF when the price of the ETF moves from above to below the 195-Day EMA of the ETF.
On the Sell Rule, proceeds will be moved to a money market fund or to a treasury holding such as IEF or TLT. After a Buy or Sell move, we do not pay any attention to that ETF (or other investment vehicle) until more than 30 days pass. This "neglect" rule is applied for several reasons. 1) We want to avoid the wash rule. 2) We can avoid TDAmeritrade's high commission fee if we do not trade within a 30-day period. 3) We minimize the whipsaw problem if we neglect the ETF or index fund for 30 days.
In general, we will examine all ETFs held in a portfolio at the end of the month to see where they are positioned. However, assume we are tracking an asset class such as domestic REITs where our investing vehicle is VNQ. While writing this blog, I checked in at StockCharts to observe VNQ as I knew it was getting very close to its 195-Day EMA. On 10/21/2011, VNQ closed at $55.16 while the 195-Day EMA listed at $55.18. VNQ is positioned to move from below to above its 195-Day EMA. Assuming VNQ rises today (10/24/2011) above its 195-Day EMA, we will buy a full position in VNQ and then neglect it for 30 days.