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The Goldilocks Investing NewsletterNo. 2Aug. 30, 2015
An update on the Mama Bear Portfolio

As soon as the book Goldilocks Investing becomes available, this newsletter will be published once a month. For now, the newsletter comes out only occasionally, when we've found something new in the beta-test process that the book is going through.

Today's newsletter is only for people who attended a Goldilocks Investing seminar in Boston or Seattle in the past few months. Please do not reply to this message or forward it to others during our book's pre-publication stage. For more information, visit Goldilocks-Investing.com.

Reallocating the Mama Bear at August’s end
By Brian Livingston

You're receiving this newsletter because you attended one of my seminars in Boston or Seattle and entered your email address at the Web site.

You probably recall the rules for the Mama Bear Portfolio, which I gave away at my seminar:

Step 1. On the first trading day of the month — or any day of the month you choose — check the 5-month returns of a menu of nine ETFs (exchange-traded funds). The process is explained at the end of this newsletter.

Step 2. If you already own the three ETFs (because of a previous month's rankings), do nothing.

Step 3. Otherwise, buy the three ETFs that have the highest 5-month total returns. If any Top 3 ETF has a return lower than cash (SHV), hold SHV in that position instead.

Those rules are still valid. However, the sudden 11% correction that hit the S&P 500 in August has raised questions in people's minds. To provide answers and share some new information, I'm sending you this special update.
Which ETFs should be held in September?

I'm working with a Web developer to create a page at my site that will show which ETFs to hold for the Mama Bear Portfolio at any given time. The numbers will be updated every 10 minutes whenever the market is open. (Two other model portfolios in the book, the Papa Bear and Baby Bear, will also be supported on the Web site.)

In the meantime, today's newsletter is designed to alert you about a rare situation. This involves the fact that the Mama Bear does not buy any ETF that has a 5-month return below T-bills.

This situation occurs only once every five years or so. It can be confusing, so let's refresh our memory of the rules.

Here's the Mama Bear menu and a ranking of each ETF's 5-month return, as of the Aug. 28 close:

                                  5-mo total
Asset class                         return    Symbol   Buy

 
US Treasury bills, 1 to 12 mo.       0.00      SHV     100%
US large-cap stocks                 -3.81*     VONE     —
Gold                                -4.37*     IAU      —
Developed-market large-cap stocks   -4.42      VEA      —
US Treasury bonds, 20+ yr.          -4.76      VGLT     —
US small-cap stocks                 -6.68      VTWO     —
US real-estate investment trusts    -9.23      VNQ      —
Commodities                         -9.87      PDBC     —
Emerging-market stocks             -14.53      VWO      —

————–
*These two "Top 3 ETFs" have a 5-mo. return below T-bills.


If you're reallocating the Mama Bear on the last trading day of the month, you'd sell the previous month's ETFs on Aug. 31 and then allocate 100% of the funds to cash (SHV).

If you're reallocating on the first trading day of the month or any other day, you should check the 5-month returns using the StockCharts.com link that's shown later in this newsletter.
8 out of 9 ETFs have a negative return as of today

Since its high on July 20, the total return of the S&P 500 (SPY) fell to negative 11.9% on Tue., Aug. 25. By Fri., Aug. 28, the index had recovered almost half of its loss, closing at only 6.3% down.

The global contraction, however, has also put the 5-month return of every asset class (other than cash) into negative territory. This is unusual. It's almost always true that at least three asset classes have positive returns.

The Momentum Rule tells us to buy the Top 3 ETFs ranked by 5-month return. However, there's also a Negative Momentum Rule, which will be explained in more detail when the book is released (which is now expected to be in early 2016).

The Negative Momentum Rule says not to buy ETFs with a return lower than cash (SHV). In place of any such ETF, you buy SHV for that position.

For this reason, it might happen that you will hold 34% of one ETF and 66% of SHV, or you could hold 100% SHV, which is the situation we find ourselves in now.

Both the Momentum Rule and the Negative Momentum Rule are based on research by CXOAdvisory.com, a research site that calls this portfolio the Equal-Weight Top 3. The approximate performance of EW Top 3 since real-time tracking began in 2006 through July 2015 is shown in the following table:

                                   Annualized   Maximum
Portfolio                            return     drawdown

 
EW Top 3 (no Neg. Momentum Rule)     13.84%      -16%
EW Top 3 (with Neg. Momentum Rule)   13.55%      -10%
SPY (S&P 500)                         7.70%      -51%


The Negative Momentum Rule has come into play in only two calendar years since 2006:

1. The EW Top 3 with no Negative Momentum Rule shows (in the table above) a slightly higher annualized return: 13.84% rather than 13.55%. That's because strictly holding the Top 3 ETFs (even though some of them briefly displayed negative returns) wound up performing a little better in 2011 than holding cash during the affected part of that year.

2. The EW Top 3 with Negative Momentum Rule had a smaller maximum drawdown of only 10% rather than 16%. That's because of a time in 2008 during which the portfolio held cash, not gold (which faded).

One of the goals of Goldilocks Investing is to keep our losses small during crashes. We get good results overall by preserving as much of our gains as possible during bear markets, and then enjoying "gentle shadowing" of the S&P 500 during the subsequent bull market.

We know that a well-diversified portfolio will never beat the S&P 500 when that index happens to be the strongest asset class. But we can easily beat the index when it's crashing. (A drawdown of only 10% to 16% is much better than the index's 51% loss in 2007–2009!)

To be sure, the added protection of the Negative Momentum Rule comes at a cost. There's a slight reduction in the annualized return expected from the Mama Bear Portfolio.

I think this is well worth it. People hate buying ETFs that are going down. By avoiding doing so, we'll suffer less agony at stressful times.
Don’t place market orders when the market is closed

As we discussed at my seminar, informed investors ignore opinions — especially their own — about what the market is going to do next. Mechanical investors, which we are, simply follow the rules, producing better results than guessing.

The numbers above may influence you to sell your other ETFs and buy SHV on Monday. If so, you should be reminded of another rule (which will be more fully explained in the book). Many investors already know about this rule, but it's worth repeating.

If you place a "market order" when the market is closed, you're agreeing to accept whatever price a market maker gives you at the open. If there's an imbalance of buy and sell orders when the market opens, the price you get can be far worse than you expected.

Some "armchair investors" found this out the hard way on Mon., Aug. 24. Within the first few minutes of trading, the so-called PowerShares S&P 500 Low Volatility ETF (SPLV) was down as much as 45% from Friday's close. The highly liquid SPY (which tracks the actual S&P 500) was down only 6.6% at that point.

According to numerous sources, many investors had panicked about the correction, placing market orders over the weekend to sell. The trading volume of SPLV on Monday was about five times above average. The 5-minute chart below from an article at ETFdb.com illustrates the problem. (Friday is on the left and Monday is on the right.)
SPLV dropped 45% in the first few minutes




Because of the crush of weekend sell orders, the NYSE imposed Rule 48 before Monday's open. This eliminated the usual requirement that security prices be immediately announced. The measure helped market makers to function, but it also kept traders from knowing how to price ETFs. Many traders quit buying or simply offered especially low bid prices to protect themselves from losses.

Individuals who naïvely placed market orders over the weekend were hit with a loss of up to 45% — plus the decline that had made them panic in the first place!

The ETF adjusted back toward the level of the S&P 500 index within 60 minutes, as normal trading reasserted itself. But the damage was done. The mini-crash also affected many other "smart beta" ETFs: Guggenheim S&P 500 Equal Weight (RSP), PowerShares S&P 500 Dividend (SDY), etc.

The first 60 minutes of trading is called "amateur hour." This is because market makers can sometimes charge excessive prices to armchair investors who foolishly place market orders when the market is closed.

The solution is to only buy and sell securities 60 minutes or more after the market opens. If you can't place trades during working hours, I recommend that you use a "trading window" at FolioInvesting.com ($4 per trade). With Folio, you can place an order at night and have it automatically execute at 11 a.m. Eastern, when amateur hour is safely past.

The Mama Bear menu uses some of the largest and most liquid ETFs in the world to keep expenses low and prices tight. But this doesn't mean you should tempt fate.

Now, you may have heard that you can place "stop-loss" orders at a specified price. Unfortunately, when your intended price level is penetrated, your stop-loss order automatically converts into a market order, exposing you to the same problem.

A different order type, a "stop-limit," might help, but that requires monitoring, with no guarantee that you'll achieve your initially desired price.

Just stay out of amateur hour and use highly liquid ETFs with low expenses, and you'll be fine.
The complete rules to pick Mama Bear ETFs

Based on the beta testing of Goldilocks Investing, the book will contain two minor edits that differ from my seminar:

1. The iShares 20+ Year Treasury ETF (TLT) has been replaced by the Vanguard Long-Term Government Bond ETF (VGLT). The latter fund only became available as recently as 2009. Using the Vanguard ETF reduces the annual fee from 0.15% to 0.12%. Hey, every little point adds up.

2. When we use StockCharts.com to compute the 5-month total returns, as shown below, we will always graph 106 trading days. This displays what we want — the return for 105 trading days (the equivalent of 5 months) — because of the way StockCharts counts days.

The image below shows a StockCharts.com PerfChart for the nine ETFs in the Mama Bear menu as of Aug. 28. To pick the correct ETFs — no matter what day of the month you choose to reallocate your holdings — first paste the following address into your browser and press Enter.

stockcharts.com/freecharts/perf.php?VONE,VTWO,VEA,VWO,VNQ,PDBC,IAU,VGLT,SHV

StockCharts

Step 1. Click the Show Histogram Chart button to display columns, not lines.

Step 2. Double-click the number of days, enter 106, and then press Enter to scale the chart.

Step 3. Momentum Rule: Find the 3 ETFs with the highest total return during the 5-month period. If, because of a previous month's rankings, you already own all 3 ETFs, do nothing. Otherwise, switch your portfolio to roughly equal weights of the Top 3 ETFs.

Step 4. Negative Momentum Rule: If any of the top 3 ETFs had a lower return than SHV (cash), hold SHV in that position instead. (Notice that the 0.00% return of SHV as of Aug. 28 is too small to see in this graph.)

It's not necessary to rebalance your holdings unless any ETF is more than 20% off its target dollar amount. Exact percentages are not crucial.

The Mama Bear Portfolio, plus the Papa Bear and Baby Bear, will be explained fully in the forthcoming book. Soon, our Web site will also show the correct allocation each day for each portfolio, eliminating the need to check StockCharts. Best wishes for your success!
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