Outperforming the Market While Reducing Risk

Most investors want to enjoy the high, longterm returns provided by equities, but they can’t stomach the volatility of the stock market. In the bear market of 2008, the S&P 500 lost 60% of its value. This is too much for people who need to rely on their investment portfolios for retirement.

GOAL/ OBJECTIVE:

To provide longterm gains that beat the market averages with less volatility than the overall market, and significantly less draw down during bear market corrections.

BASIC APPROACH:

Use low cost, unleveraged, Exchange Traded Funds (ETFs) that track the broad market indices as investment vehicles. Invest in bull market ETFs when the 9 month moving average (9MMA) is trending up, and bear market ETFs when the 9MMA is trending down.

HISTORIC RESULTS:

Ignoring dividends and trading costs, a buy and hold investment in the S&P 500 of $100,000 starting in 1995 would be worth $295,000 at the end of 2011. An investment in unleveraged S&P 500 bull and bear ETFs based upon the trend of the 9MMA would be worth $678,000.

The largest draw down during this period would be 60% for the S&P 500 buy and hold strategy. The maximum draw down for the trend following technique would be 25%.

BACK TESTING:

The 9MMA trend following strategy has been rigorously back tested for the Russell 2000 and the NASDAQ Composite from 1995 to present, and for the S&P 500 from 1980 to present. Some other time periods were checked on a less rigorous basis, to see if the method holds up during significant recessions; notably, the DOW 30 during the late 1920s and the 1930s, Japan’s Nikkei 225 during the late 1980s and 1990s, and the S&P 500 around the time of the 1974 bear market. In each instance the 9MMA trend following method yielded better results than the market averages, with smaller draw downs, and less overall portfolio volatility.

REFINEMENTS:

While developing this strategy, I noticed a number of refinements that could potentially improve longterm returns, or reduce risks. For example, in March 2009 the S&P500 went down to $670, but the 9MMA trend following technique indicated staying short until June, when the S&P 500 was at $930, before switching to bull market ETFs. I know there are a number of techniques and indicators that could improve the timing of these bare/ bull decisions. However, I have not been able to back test these theories in enough detail to ensure they should be adopted in the overall strategy. I’ll include the results of back testing these refinements in a later article. Some of the things I’ll look at include:

- Using MACD and Relative Strength indicators for timing the bull/ bear switch

- Employing multiple indices to get a head start in trend turning points

- Using leverage during the fat part of bull market trends

- Using multiple indicators to identify market trends

- Enlisting weekly charts to identify trend changes faster.

- Etc.

The goal will be, to back test the most promising ideas and incorporate enhancements to improve performance and reduce risk, and to keep the overall strategy simple while limiting the number of buy/ sell transactions.