Three written rules kept a four-fund portfolio's worst fall to 10.0%. Holding the same four funds without the rules meant a worst fall of 19.7%.
The rules cost return too. Before costs, $10,000 run by the rules grew to $19,078. Without the rules, it grew to $23,422. Here is what rules-based investing is, how to write the three rules and what they did on real prices from 2017 to 2026.
What is rules-based investing? Rules-based investing means running a portfolio by rules written down in advance, which say what to buy, how much to hold and when to sell. The rules are tested on past prices, then followed the same way every time.
A rules-based portfolio needs at least three written rules: an entry, a position size and an exit.
Tested on past prices of four funds from 2017 to 2026, three rules checked once a month kept the worst fall to 10.0%. Holding the same funds fell 19.7% at worst.
The rules also made less. $10,000 grew to $19,078, against $23,422 for holding, before costs.
What is rules-based investing?
Rules-based investing runs a portfolio from written rules. Each rule must be exact enough that two people reading it place the same trade on the same day. "Buy good companies" is an opinion. "Buy when the month-end price is above its 10-month average" is a rule.
Because the rules are exact, a computer can run them the same way every time. We cover the wider approach in What Is Systematic Investing?
The test of any rule set is a backtest: running the rules on past prices as if they had been traded. We explain the ways a backtest can mislead in What Is Backtesting?
How to build a rules-based portfolio: the three rules
Our three rules come from a published paper, A Quantitative Approach to Tactical Asset Allocation by Mebane Faber (2007). They are checked once a month, on the last trading day:
Rule 1, entry: buy any fund whose closing price, with dividends counted, is above its 10-month average. The 10-month average is the mean of the last ten month-end closes.
Rule 2, size: each fund gets 1/4 of the portfolio. The quarters are reset to equal size at every check. A quarter whose fund is not held sits in 3-month Treasury bills. These are loans to the US government, repaid after three months.
Rule 3, exit: sell any fund whose closing price, with dividends counted, is below its 10-month average. Its quarter moves into Treasury bills.
The idea is simple. A fund above its average has been rising, so the rules hold it. A fund below its average has been falling, so the rules step aside. Rules like these follow trends.
Each trade is placed at the close of the next trading day. The rules are checked only once a month. So a fund, once bought, is held for at least a month.
Gold stands in for the paper's commodity index, while its property index is left out: our price data has neither. The portfolio uses four exchange-traded funds (ETFs):
SPY (the S&P 500 ETF): US shares.
EFA (the developed-markets ETF outside the US and Canada): large and mid-sized companies.
IEF (the 7–10 year US Treasury bond ETF): bonds with seven to ten years left to run.
GLD (the gold ETF): gold bullion.
The fair comparison is the same four funds, held in equal quarters and reset each month, but never sold. All results are before costs unless stated.
Growth: the rules vs holding the same four funds
Source: YX Insights price data; FRED (DTB3); YX Insights
From 31 July 2017 to 24 September 2026, $10,000 run by the three rules grew to $19,078. That is 7.3% a year. The same four funds, always held, grew to $23,422, or 9.8% a year. The rules made less over the whole period.
31 July 2017 to 24 September 2026 | Three-rule portfolio | Same four funds, always held |
|---|---|---|
$10,000 became, before costs | $19,078 | $23,422 |
Return a year | 7.3% | 9.8% |
Worst fall from a peak | 10.0% | 19.7% |
Volatility a year | 7.5% | 10.5% |
Return in 2022 | −7.4% | −11.8% |
Share of the portfolio invested, on average | 71.8% | 100% |
Funds switched in or out | 72 | 0 |
$10,000 became, with 0.1% charged on every dollar traded | $18,698 | $23,340 |
Source: YX Insights price data; FRED (DTB3); YX Insights
The table sets out the trade-off. The rules gave up 2.4 points of return a year: 7.33% against 9.77% before rounding. In exchange, the worst fall was roughly halved, while volatility dropped. Volatility here is the yearly size of the portfolio's daily swings, measured by their standard deviation. It was 7.5% for the rules and 10.5% for holding.
How many funds the rules held each month
Source: YX Insights price data; YX Insights
Each bar shows how many of the four funds the rules held after one month-end check. On average, 71.8% of the portfolio was invested. The rest earned the Treasury bill rate.
At seven checks the rules held no funds at all. Six came in a row, from May to October 2022. That year, shares and bonds fell together: SPY lost 18.2% and IEF 15.2%. The four funds held in equal quarters lost 11.8% in 2022, while the rules lost 7.4%.
The rules also stepped aside in early 2020. At the end of February, SPY and EFA closed below their averages, so both were sold. The rules' worst fall that spring was 6.0%. Holding all four fell 17.3% from its peak.
The rules switched a fund in or out 72 times in nine years. That is about eight trades a year across the four funds, or two per fund.
Worst falls: the rules vs holding the same four funds
Source: YX Insights price data; FRED (DTB3); YX Insights
This chart shows each portfolio's drawdown, its fall from the previous peak. The rules' worst drawdown was 10.0%. It ran from a peak in September 2021 to a low in March 2023. Holding the four funds had a worst drawdown of 19.7%, from a peak in November 2021 to a low in September 2022.
What the rules gave up
Trend-following rules are late by design. A fund must climb back above its average before the rules buy it again. So the rules missed part of the sharp rebounds in 2019 and 2023:
2019: the rules made 9.9%. Holding the four funds made 20.0%.
2023: the rules made 4.6%. Holding the four funds made 15.2%. At the end of October 2023, three of the four funds were below their averages. In November, SPY rose 9.1% and EFA 8.2%. The rules gained 1.3% that month. Holding gained 6.1%.
Costs widen the gap a little. Charging 0.1% on every dollar traded cuts the rules' final value to $18,698. Holding falls to $23,340. Holding pays costs too, because its quarters are reset to equal size each month.
How to check a rules-based portfolio before you use it
Five checks help before you trust a rule set:
Write the rules before you test them. Rules changed after seeing the results only describe the past.
Compare like with like. A mix of shares, bonds and gold should be judged against holding the same mix.
Change one setting. We reran the rules with an 8-month and with a 12-month average. Each had a worst fall of 9.0%, against 19.7% for holding. Both returned less than holding.
Count the trades. Two trades per fund a year is easy to follow. A rule that trades every week costs more and is harder to follow.
Ask if you would sit through the worst fall. A rule only works if it is followed in the bad months.
Our guide How to Read a Backtest walks through a full report. Can Systematic Investing Beat the S&P 500? tests a single trend rule on the index fund.
Rules-based investing means writing the entry, size and exit down before any money moves, then following them. On these four funds, three rules checked once a month roughly halved the worst fall. The price was a lower return.
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