Risk Model for the Average Joe Investor
Two market meltdowns in the last decade have left a majority of the average investors wary of the stock market. The Baby Boomer is even in more trouble. There is an overload of information for the average investor about how or not how to invest. We continue the overload, but attempt to shed a very small light, in a hope to educate investors on possible investment strategies that actually do work and will help to preserve their well-earned capital.
We are in a current bull market, but we are due at some point for a major pullback. We think even the Average Joe investor can manage to avoid big losses in their portfolio with a little reading about this or another risk model. Baby Boomers in general should be interested in protecting their capital at this late stage in their retirement planning.
Timing systems reduced portfolio volatility by approximately 20%, and reduced month-end portfolio drawdowns by almost 50%, which makes for a much smoother experience for investors, and many less sleepless nights. Further, absolute returns were comparable even after accounting for trading costs.
Given that simple systematic investment strategies can deliver much better results during bear markets, and better risk-adjusted results during bull markets, it is difficult to imagine why any small investor would not apply a timing system to improve their chances for long-term investing success.^ Gestalt
We advocate several strategies. One strategy is to implement a Risk Model to assist in your trading plans and goals, for a certain % according to your risk profile. Our Risk Model uses market trends and a model/indicator that checks current short-term market conditions. First you must determine the markets major trend. The trend is the observation of the direction of the market. Is the market going up, a bull market? A down trend or Bear market? Or maybe sideways, where it just can't make it's mind up. The trend of the market normally indicates the direction of most stocks and sectors. 70-20-10 rule of thumb – 70% of a stocks movement is due to the averages, 20% to the sector and 10 % to the individual stock.
We us a 5 week ema crossing over 21 week ema on a S&P500 weekly chart for the primary long –term trend. When the shorter time frame (5 ema) goes either above or below the longer (21 ema) that signals a corresponding buy or sell signal. Used by itself as the only indicator, since June 5 2006 till Sept. 13 2010 you would of had 5 buys and 5 sells.
Red Arrow - Sell Signal - 5 ema crosses BELOW 21 ema
Green Arrow - Buy Signal - 5 ema crosses ABOVE 21 ema
As you can see from the chart you miss a large share of the market downturns. You also miss some of the markets bull run. Late 2007 & early 2008 also gave a couple buy and sell signals fairly close together. Not a perfect model, but nothing is. If you would of been using this in 2008, you would had to of said that it worked great. You could of avoided a large portion of the 2008 market losses, by using this crossover method.
Our Risk Model is based on a Trend Model and the Core Strength Index, which are based on how the markets operate. It has nothing to do with what anyone “thinks” is going to happen, nor is it based on someone’s interpretation of the fundamentals. Why systems based on moving averages are called timing methods, I haven’t figured out yet. We are NOT timing the market. It’s about how we REACT to what the market is telling us.
You ANALYZE the current market trends, EVALUATE the results, REACT if needed (according to your risk profile) . This method takes the emotion out of your investment decisions. Why they call a system based on moving averages a timing the market is beyond me. Implementing a trend-following crossover strategy – has no guess work, no sophisticated technical analysis, and no judgment.
The above chart used alone can be used as a simple - conservative trading platform. Bull or bear markets can last for months to years. The market will have many fairly large ups and down moves and still be considered a primary bull or bear market. If you miss the initial buy signal, or want to buy and sell within the major trend, you need to know what the medium term and shorter term trends are doing. If you don't do a lot of trades you can just use the chart. Use the extra information as a heads up FYI.
It's important to be aware of all three trends. Long term trend changes are first detected in the shorter time frames. This trend model is used for a majority of your market decisions. If the primary long term trend is up, we can be long or neutral (in cash) according to the medium (weeks to months) term trend. Once the long term trend is identified, wait until the medium term trend is moving in the same direction before opening compatible positions.
Short-term (days to weeks) trend information is used in conjunction with the technical analysis of the particular stock you want to purchase, should help you to get optimum execution on entry and exit positions.
Medium-trend changes let you be cautious in market down-trends and aware of buying opportunities in up-trends with improving market conditions. When the medium trend changes up/down use this a opportunity to buy on the dip or take some profits off the table in market downturns. This is usually a good spot to buy back in within strong up-trends with available cash or start to liquidate positions for possible downturns.
In downturns we advocate to sell your top losers and biggest winners. We don't know for sure which way the market will continue so according to your risk profile it may pay to be cautious to cut a % of your losses and take some profits. If the market decides to go back up you may decide to use the cash to buy back in.
The Risk Model is set up to use the Trend Model in conjunction with the Market Core Strength Index (MCSI) for confirming signals AND for information of the short and intermediate term trends strength or weakness for a heads up on possible trend changes. (I said possible) We feel the MCSI should be slightly more sensitive for some market conditions in indicating changes. We analyze 14 market indicators. Our MCSI matrix. Evaluation of the condition (market strength & weakness) of the current market short and medium trends is performed and shown with a easy to read Market Condition Indicator (MCSI).
Long-term trend cross-over to the downside for our risk model in our opinion, means you should be completely out of all market positions and in cash unless you buy a short ETF or know how to use options.
Trend Model Instructions: In any objective trend model, you wait till one of the three trends cross over before you act according to your trading style and portfolio.
1. Identify the current primary long term market trend.
3. Analyze the current trend(s) health condition/strength.(MCSI)
4. If trend model identifies possible actions are needed per your portfolio, respond accordingly.
1. At a minimum, check the 3 trends on a weekly basis.
2. Any investor should be aware of the market's general health for a heads up FYI.
Frequent trader examples in using our market condition indicator:
1. When planning to buy within a primary bull trend, and the market conditions are pointing to a down trend with a weaker short trend, you would wait to open any new positions. Wait for conditions to strengthen the short trend signal or further deteriorate and the trend completely rolls over to the downside.
2. When in a strong short term downtrend, the medium trend likely will look to turn down. So instead of any new purchases, you would wait to see if the medium term trend does in fact cross to the down side. If it does, look at a primary turn down and sell signal for a cash hold. The other possible scenario is the medium and shorter trends could reverse to the upside and the primary trend stays intact, negating a sell signal. Long term trend changes are first detected in the shorter time frames.
While this system is far from perfect. (As are all risk models) We urge all investors to use some type of a risk model or plan to preserve some % of your hard earned capital. WARNING: depending on market conditions, either model may give earlier or later signals then the other model. Either model may also generate false signals created by extreme market fluctuations or whipsawing. Our risk model provides objective information that lets each investor decide to doing nothing, hedge, reduce exposure, or go to cash? Our opinion is that this lets us sleep slightly better at night!
Realize that this is only one important part of a total trading system. A plan is needed in how much to buy, when is the best time is to buy and sell, what to buy, etc……
Seeing how everyone, including us, has an opinion. We like to show supporting articles by other authors. Below are three supporting article excerpts and links. We had been using a 5/20 week model and raised it to 5/21 when we ran into the first article.
Please visit out blog for weekly updates. The Risk-Reward Market Report. Educate yourself and take control of your future. Don’t rely on others for expensive advice that won’t protect your retirement.
The phrase "market timing" means different things to different people. To some, it means anticipating almost every short-term zig and zag of the market. Others seek to predict only the major moves. The Portfolio123.com timing model is a bit of the latter, slow to catch the turns, but it has the advantage of giving very few false signals.
The model has two factors.The first is valuation of the broad stock market. It's bullish if the S&P 500 risk premium, defined as S&P 500 earnings yield minus the yield on the 10-year Treasury note, is greater than 1%. Right now, the risk premium is above 3%, a comfortably bullish level.
The second requirement, the one that has triggered the major signals in the recent past, is that the overall consensus earnings per share estimate for the S&P 500 companies must be trending higher. Specifically, this factor will be considered bullish if the five-week moving average estimate is above the 21-week moving average. Presently, this signal is also bullish. We've had some ominous headlines lately, and a conspicuous correction, but thus far earnings estimates continue to chart the upward course that took hold in mid-2009. Read More
2.) Diversification in Time
The Modern Portfolio Theory tells us not to put all your eggs in one basket. The B/H strategy calls for holding all your eggs in one continuous “basket” of time. That sounds like a risky proposition to me. Market timing is not witchcraft. It reduces risk through temporal diversification. There are times to hold, and there are times to fold.
Active investment management with market timing works not by forecasting the future, but by following major market trends. By way of example, let me illustrate how the 6-month MAC system described in Part 1 and Part 2 realizes temporal diversification. Figure 4 shows the difference between $1 investments in B/H and in MAC made in January 2000. How have the two systems performed through the 2000 Internet Bubble
and the 2008 Systemic Meltdown, to June 2009? I’ll let you be the judge. The MAC system doesn’t predict the markets, it follows the trends. It doesn’t sell at peaks or buy at bottoms. But it’s effective in preserving wealth in bear markets and accumulating wealth in good times.
Now you know why the B/H strategy that worked so well in the past has proven so fallible since 2000. The question is whether you believe the secular bull of the past is likely to return after the current recession is over. If you think that the next decades will not match the good fortune of the post-WWII era, you should start looking for an alternative investment approach. excerpt from Moving Average: Holy Grail or Fairy Tale, Author Theodore Wong.
3.) Market Timing Works. Even A Simple Moving Average System can Beat Buy & Hold
As part of our ongoing market timing research, we've done an analysis on moving average systems to prove dead wrong the market "experts" who continually claim market timing doesn't work. The Gleason Report doesn't use moving averages for timing the S&P500 but many investors and advisory services do. Our results confirm that many moving average systems can easily beat buy and hold. There are, however, significant differences in performance over various time periods. The best moving average system we devised is based on a 40/10 week two average model but we'll discuss the results from other intervals too. The conclusion from our research:
The most important point of our analysis is: A simple, mechanical moving average system beats the Buy & Hold of an index fund over 20 year periods and with 30% less risk. Moving Average systems will have periods of poor performance but hold up quite well over time. So, why do so many commentators and so-called experts continually bash market timing when it obviously works?
First, most investors don't have the patience or the confidence to trade the stock market. They panic out of trades when the market moves against them rather than wait for the system's signal. They are probably better off in a mutual fund at least making some money. Second, uninformed investors are the source of profits for mutual funds. It's not the funds job to educate investors about market strategies. Besides, they get a percentage of the assets even if the investor loses money. Many mutual funds have over 100% portfolio turnover each year as they frantically buy and sell stocks. Ironically, they're lousy market timers trading on investor money.
Fact: Most mutual funds underperform index funds in the short term and virtually all mutual funds underperform over any 10 year period. They're held back by trading costs and expenses. The obvious conclusion: Place your assets in an index fund. Optionally, buy some individual stocks or manage a portion of your portfolio with a proven timing strategy.
If you're willing to manage your own money and have self discipline, shouldn't you consider managing the market with some of your money to get much better returns? excerpt from the Gleason Report
4.)Timing the BullOur study demonstrates that simple timing systems can deliver substantial risk-adjusted value to investors, even during periods of very strong bull markets. The timing systems reduced portfolio volatility by approximately 20%, and reduced month-end portfolio drawdowns by almost 50%, which makes for a much smoother experience for investors, and many less sleepless nights. Further, absolute returns were comparable even after accounting for trading costs.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.