Comparing Investment Approaches
“OK,OK”, you say, “You call this site
Great Investment Strategies
and I haven’t run across a single #$%#@! strategy yet, good or bad! What gives?”.
This article will make amends.
On this page, I’ll demonstrate the pros and cons of three distinct approaches. You can even call them strategies, if that will appease you.
The stock we will pick is Prudhoe Bay (BPT) , one of my favorite unit investment trusts. (Yes I own this stock.) It is specifically chosen because it has performed so well for the buy-and-hold investor over the last decade. $10000 invested in 2000 would have grown to $371,315 in 2010 if dividends were reinvested. ( See article here.)
If ever a buy-and-hold approach will beat a more active strategy, you would think, it would be with BPT. Well, read on. You might be surprised to find the active approach produces better results with less risk.
Investors are told that if they choose equities, they should be in it for a longer period of time. At least three years, and the longer the better. I agree with that. But I also acknowledge the fact that probably over 50% of all investors have holding times of less than 4 years in the same stock.
So in my example I’m choosing a shorter period: 3 years. The same point would be valid for a 10 year period, as I’ve demonstrated elsewhere. (See the article Investment Heresy: Why Timing The Market Is Crucial
The first graph below, shows the result of holding BPT from June 2008 to June 2011. As you see, the stock performs first performs dismally, dropping from $70 to $40, before recovering and growing to $116. During this period, it paid $26.88 in dividends. The total return, assuming round trip brokerage commissions of 2.5%, totals 96.5%.
Not bad at all, over three years which included the worst drop in recent stock market history!
But there is a big problem with this approach. Most investors panic as the value of their holdings plummet. My experience is that most hit the panic button between a 20% to a 30% drop. And they wait far too long to get back in. So they lock in their losses.
Most stock brokers will try to dissuade their customers from such counterproductive actions. But many customers yank their assets anyways.
A second approach involves some form of a hedge strategy. If this investment goes sour, it is offset by positive results in an other investment which tends to go up when the main investment goes down.
Many investors hold their money in an IRA account or a trust account. At times these accounts are not permitted to short stocks, others may not use options to hedge a position. Let us assume that is the case.
(For those who can do so, we have delineated another strategy in an article at Seeking Alpha).
In the case of BPT, an IRA investor could place 2/3′s of his investment in BPT, then hedge the remaining funds with an investment in Direxion’s Daily Energy Bear 3x ( ERY) . This fund is an Exchange Traded Fund (ETF) which has been conceived to go up 3-fold for every tick down in the price of oil. If oil goes down 10%, ERY will go up about 30%.
Let’s say the investor has $50000 to invest. $33,000 would be invested in BPT, the balance, $17,000 would be allocated as a hedge.
The idea here is to be strategic in your purchase of ERY. Leave your hedged funds in your money market until you need them. Use this money to buy the ETF whenever a bullish signal occurs. Sell it again when a bearish signal occurs. A simple, very effective strategy for doing so is to use the Relative Strength Index or the Commodity Channel Index(CCI). I prefer the latter.
In the chart below, you see the results of this strategy deployed over the same period as the example above.
As you see, every time the signal crosses above the zero line on the 10 period CCI for ERY, I use my cash reserves, representing 1/3 of my investment , to buy it. When it recrosses I sell.
There are times a loss will be incurred in this trading of ERY. But if followed meticulously, the law of averages will have it actually making money. This assumes you are paying moderate brokerage fees, or are doing your own trading through a discount broker.
Over this period, using the hedging strategy, the investor is left with a 99% return, after all brokerage fees. This is just slightly inferior to the buy-and-hold approach in this example. But in many other markets it will actually outperform the buy-and-hold.
The real point though, is that the investor has far less downside risk. Any loss in the oil investment tends to be offset by a corresponding gain in the reverse oil ETF.
When oil is increasing in value, you don’t need or want the hedge. So you use your trading signals to get you out. This is important in this strategy. If you don’t do that, you will be eliminating all the upside potential of BPT, and you’d only be left with its dividend returns.
There is no need to do that.
If you are comfortable holding margin in your account, you could actually use 100% of your money to buy BPT, then use margin to buy the ERY whenever appropriate. (As long as you trade in and out of ERY, you should never be running into margin calls.) This would give you even better overall results: approximately 201% over the period. This consists of about 99% on your BPT long position, along with another 102% on your hedged traded position.
The virtue of this hedged position should be obvious: you still have a great return, but you’ve eliminated the heart-wrenching downside risk. Look at the chart, whenever BPT is down a lot, ERY is up by three times that amount. The balance shown in your portfolio over the period should never dramatically decline.
Clever readers will probably have noticed the phenomenal results we got just trading ERY with the Commodity Channel Index. Why not just deploy that on BPT directly and leave ERY out of the picture. What better hedge can you find than the actual stock itself!
This brings us to the third strategy. Just go long and short the main stock itself, committing the full value to the purchase. (If you will kindly direct your attention to the chart below…)
As you see, the results of this trading strategy alone, produce a 178% return over the period. This, of course, assumes you are not using one of those onerous brokers charging you 2% every time you buy and sell. We will not name names…
The advantages? Simplicity. You’ll also feel comfortable that you are never very far on the wrong side of the market’s momentum. And you’ll see your portfolio gradually increase nicely over time. In the first days and weeks of trading, you may see your balance drop below its initial balance. Not every trade makes money. But on average, the trades should work for you or you’re misreading the signals.
Unfortunately, this ability to go short the stock is not available to IRA investors. So the 2nd strategy will serve those investors better.
Alright, now the caveats. Every good strategy needs a few caveats, or so my lawyers say.
What are the hitches then?
- The stock you trade must be shortable
- Even if it is shortable, shares may not be available at your brokerage to short it.
- If you’re deploying the 2nd hedging strategy, you’ve got to find the right instrument to be a good hedge for your main investment.
- You could not be paying attention and miss a trading signal.
- You could be paying attention and still miss a crossover. Know what a stock gap is?
- Your main stock – BPT in this case – could go hog wild and plummet for a reason completely unrelated to the price of oil. Think earthquakes, terrorist attacks… you get the picture. Defensive stop losses well below the stock ALWAYS make sense.
- You could do everything perfectly, and still lose money. What can I say? Life sucks!
There. My legal team seems happier.
Can I still go on calling this blog “Great Investment Strategies”?