This page will add a little “beef” to the title of this blog: “Great Investment Strategies”. It invokes the rationale and demonstrates the efficacy for not one, but several great investment strategies, and the pros and cons of each.

Why Stocks?

Let start with the basics, and move from there. Should I even be invested in stocks? They say pictures tell a thousand words, so here’s the answer in one picture:

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The answer, put succinctly “Only if you want to increase your wealth.” The only exception, is for people who need the money in less than 2 years. For a longer explanation of why stocks will outpace cd’s, bonds and general inflation , read the this previous post

Are Stocks Safe?

For many people, investing in stocks is an exercise in sadomasochism. If you can hang on through the bad years, you will do fabulously. But let’s face if, most people don’t have the stomach (or the right spouses) for the tumultuous ride.

Part of the problem is, nobody really knows their tolerance for risk until they’ve personally been through the maelstrom of a stock market crash. My experience with investors over the years is that they are fine for the first 10 or 15 percent drop – though worried of course. At 20% the real panic sets in, and at 30% or 40% true, unadulterated terror completely overrides all rationality.

In fact, this is why research has shown that the average mutual fund investor reaps about a 4-5% return, whereas the average mutual fund doubles on that performance. Investors start out with the best of intentions, but lets face it :
they wimp out when the going gets tough.

Can I Avoid The Drops?

That, of course, is the million dollar question. If you have some time on your hands, I recommend reading the 55 – page academic analysis of a variety of systems that claim to have perfect market-timing ability.

But since I realize that not all of you share my admittedly peculiar interests in financial arcana, I can spare you some time: the authors Ivo Welch and Amit Goyal conclude two things:

  1. Market timing strategies do work
  2. None of them work perfectly all of the time

I’m sad to admit that that’s been my own experience despite years of trying. This is also why nobody should be investing money in the very short term (less than 1-2 years) in which they cannot afford any loss of principal.

But wait. There is a silver lining!

Specifically, a wide body of academic research demonstrates that certain models that involve quantitative analysis and market timing vastly outperform a traditional buy-and-hold strategy:

“We document significant ‘‘time series momentum’’ in equity index, currency, commodity, and bond futures for each of the 58 liquid instruments we consider…

…A diversified portfolio of time series momentum strategies across all asset classes delivers substantial abnormal returns with little exposure to standard asset pricing factors and performs best during extreme markets.”

Source:

—Moskowitz, Ooi, and Pedersen (2012)



What Is The Bottom Line?

There is no holy grail of investing. No perfect system exists that never loses money. But by applying careful analysis, a rigorous discipline, and the power of mathematics, a number of different approaches offer significant advantages over a traditional buy-and-hold approach. Deploying them, you have a choice of

  1. the same great growth as a long-term buy-and-hold approach, but with much less volatility and lower drawdowns.
  2. the same gut-wrenching volatility as a buy and hold approach, but with far better overall growth!

What all of these strategies usually share in common are two simple rules:

  1. Avoid stocks with weak absolute performance
  2. Use an appropriate moving average to determine the shift of a trend.

Even the strongest fundamentally sound stocks suffer from drops in investor sentiment, when Mr Market enters his depressive stage. Take that opportunity to sell the stock. There’s an old saying among traders: “Don’t fight the market.” The stock may be a great value, but it could drop much lower before the sentiment shifts again.









The models shown below represent a few distinct approaches that all offer superb risk/reward relationships when compared to a traditional buy-and-hold approach.

Same destination, fewer bumps


  • Long Short Mean Reversion
  • Performance-based limited selection
  • Mean reversion methodology
  • Goes short and long simultaneously
  • Not compatible for IRA’s

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July 15, 2003 – August 18, 2015

  • MOM/Mean Reversion Strategy
  • Broad-based ETF selection
  • Combines mean-reversion with momentum
  • Deploys short term bond ETF as hedge
  • Long-only strategy (IRA-compatible)

(click to enlarge)


July 15, 2002 – August 18, 2015

Same Bumps, But A Lot More Ride

  • Long Short Mean Reversion
  • Performance-based limited selection
  • Less conservative hedging allocation
  • Mean reversion methodology
  • Goes short and long simultaneously
  • Not compatible for IRA’s

(click to enlarge)


Jan 4, 2003 – July 17, 2015


  • Nice and Steady Strategy
  • Performance-based ETF strategy
  • Momentum based selection criteria
  • Goes long only
  • Compatible for small accounts (< $100,000)
  • Compatible for retirement accounts

(click to enlarge)

Jan 1, 2005 – December 5, 2015

We should caution you that these are based on back-testing methodologies. Real-world results can and will vary somewhat. The back tests are also based on our own very low transaction costs. Your own results can differ if your transaction fees are much higher.

As always, we cannot guarantee that past results can be reproduced in the future

Of course, technical rules that these methodologies deploy to limit downside risk will only work if any market crash does not occur within seconds or minutes, as evidenced by the 1987 “flash” crash. In such situations, our trend-based technical indicators may be too slow to signal an opportune exit. (We have taken measures to ensure that any selling that is done is performed with limit orders, to prevent selling at ridiculously low values.) Technical rules will not protect an investor in a 1987 type “flash” crash. They would, however, be very valuable in a slower crash, similar to that of 1929 or 2008 , which took weeks to develop.

Some of the risk factors that could negatively impact future performance, but are impossible to completely mitigate are:

  • A breakdown of the stock trading system, preventing our defensive mechanisms from triggering.
  • A sudden departure from normal rules of trading initiated by an arbitrary change in government regulations, for example a suspension of short trading. (Seem crazy? This just occurred on the Chinese Shanghai exchange. We may not be China, but it also occurred in the 2008 stock market crash.
  • A flash-crash type of event, with precipitous, inexplicable drops and recovery within seconds or minutes
  • A technological failure of trading systems due to software or hardware systems attack or telecommunications and internet failures.

Conclusion

Generally speaking, we believe that stocks tend to follow certain patterns that largely reflect the psychological ebbs and flows of investor sentiment. Even as we enter a market that is driven more and more by computer algorithms (like the ones we use), and less and less by human active participants, we believe that these patterns will persist. They will persist because the models built into these computer systems. like ours, reflect the biases of the humans that develop them in the first place. This causes us to believe that the prevailing historical model, one which incurs steep and relatively sharp declines, followed by slow grinding uphill climbs, will persist over the foreseeable future. In such an environment, our simple technical rules will, by design, improve risk-adjusted performance.

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Disclosure: The material presented on this site is for illustrative and educational purposes only. The graphs shown above represent back tested results and do not reflect actual investing results. Investing in options involves risk of loss, and these losses can be substantial. Only risk capital should be used when trading options. We do not currently own any funds discussed in this article. We are a fee-only investment advisor, and are compensated only by our clients. We do not sell securities, and do not receive any form of revenue or incentive from any source other than directly from clients. We are not affiliated with any securities dealer, any fund, any fund sponsor or any company issuer of any security. This report is for informational purposes only, and is not personal investment advice to any specific person for any particular purpose. We utilize information sources that we believe to be reliable, but do not warrant the accuracy of those sources or our analysis. Past performance is no guarantee of future performance. Do not rely solely on this research report when making an investment decision. Other factors may be important too. Consider seeking professional advice before implementing your portfolio ideas.

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