Investment Heresy : Why Timing The Market Is Crucial
This posting will address that age old question: which is a better approach to investing, a “buy and hold” philosophy or one that attempts to “time the market”.
It is our contention that a good investor can, and should, time the markets. Since this contention flies in the face of conventional investment wisdom, we will set out to prove that here.
First, let’s begin with the observation of “buy and holders” that stocks go up more than they go down.
A simple glance at this historic chart of the S&P shows that stocks, over time, clearly go up.
Why is that? Stocks represent the value society places on the total capital stock accumulated up to that point of time, including the technology and knowledge embedded in that capital stock. Since mankind accumulates more and more capital in the form of embedded
technology, and that technology allows mankind to produce new technology and capital goods at a faster pace, society as a whole ends up richer over time. Stocks, being a measure of that wealth, will go up over time.
Of course cataclysmic events, such a wars, famine, or natural disasters a country’s capital stock and cause a generation-spanning drop in the value of all goods and services. In that case stocks of that country will normally decline to reflect the depleted capital stock.
But you can’t predict cataclysmic events, buy-and-hold advocates argue. So you can’t avoid those in the first place. And in normal times, stocks mostly go up, “Buy-and-hold” investors conclude that if you are investing for the long run, say 10 or 15 years, you can safely invest in stocks and be confident of doing well.
Just as clearly as the first observation is true, the second is false.
Ten or fifteen years is not a long enough time frame to guarantee a positive outcome. Somebody entering the market in 1928 did not get back to even until the mid-1950′s, almost 25 years later.
Some buy and holders believe “that was then”. Today, they argue, economists and political leaders are much more knowledgeable about how economies really work and have a variety of tools at their disposal to prevent such a recurrence.
Well, clearly, the case of Japan belies that statement. Look at the graph below, representing an index of the top 225 stocks in Japan. Somebody investing in the Nikkei index in 1990, and holding on for dear life over the next 20 years, through thick and thin, is rewarded how? With a loss of about 75% of the person’s investment. And that is before inflation!
Source : yahoo finance
Clearly then, buy and hold does not always work.
Those advocating a “buy-and-hold” approach some times grudgingly admit that yes, even over a long term period, you can lose your shirt in stocks. But they go on to say: it beats the alternative. How many times have you heard that statement: “You can’t time the market”.
That too, is false. We’re sorry if we’re bursting your intellectual bubble here. But we’d rather do that than see you lose serious money in the markets.
With the examples below, we’ll show you concrete proof that you can time the market. You won’t be right on every trade, but you only need to be right on average.
Financial heresy, you say? Blithering madness? Total lunacy?
Humor us. Read on.
To demonstrate this, we’ll take a simple strategy, composed of two moving averages. There are much better strategies, but these are more complex, and beyond the focus of this article. This strategy is composed of two simple moving averages, one based on a 14-day period, one on a 45-day period. There is no magic to these periods, ,other values could have been applied, but these periods work.
The strategy can be applied to any stock, or to any index of stocks. We’ve chosen the Dow Industrial Index and the Nikkei for our example. But we could just as well have applied it to IBM, to currency trading or to corn futures. We’ve used a longer time period in the example, but the same priniciple holds true of shorter periods, in which the averages are measured in weeks or days as opposed to months.
This strategy is :
- Buy when the stock is trading above it’s 14 day moving average
- Sell when it crosses below that 14-day line
- Repeat until the 14-day average crosses the 45-day average, signifying the start of a new downward trend
- Make sure that
- the 14-day moving average is sloping up
- the 14-day moving average has not crossed below the 45 day moving average
- Whenever the 14-day average crosses below the 45-day average, this signifies a downward trend. You reverse strategies, and short the stock.
- Buy to cover your short position whenever
Repeat that process of shorting until the 14-day recrosses 45 day moving average, signifying a new larger uptrend
- the 14-day average recrosses the 45 day average
- and the 14-day average slope is headed down
To see how this simple strategy compares to a buy-and-hold strategy, let’s look at a 10 year history, in three very different market cycles:
1) an up-cycle 2) a down-cycle and 3) a sideways cycle, when stocks are neither gaining nor losing.
The Up Cycle – Dow 1995 – 2005
As you can see, this was a time of rising stock prices. An investor buying in early 1995, and holding for 10 years, would have come out with a 66% gain, net of assumed 1% transaction brokerage fees to buy or sell.
For the same period, our moving average strategy resulted in 9 trades, for a gross gain of about 87% but a net gain of only 79% after brokerage fees.
Not bad, you say, but is it worth all that trouble?
The Down Cycle – Nikkei 2001 – 2011
For a recent decade-long example of a major downcycle we turn to the Nikkei from 2001 to 2011. A buy-and-hold strategy over this period would have gotten in at 13800 and ended up at 10228, for a misery-inducing 31.3% loss after fees. as a period characterized by large swings in the market that resulted in no ultimate gains. Small dividends over this period would hardly have acted as a balm to your wounds.
In sharp contrast, our moving-average strategy on this same index yields a much more satisfying 58.1% after trading fees of 15% are factored in. The difference between trading and a buy-and-hold approach is a whopping 91.4%! Now we’re talking!
The Sideways Cycle – Dow 2000 – 2010
The last decade from 2000 to 2010, was a period characterized by large swings in the market that resulted in no ultimate gains. An investor during this period, in a buy-and-hold mode, would have ended with a loss of about 7.7% after trading fees of 1%. (Of course, some dividends would have accrued, slightly offsetting the loss.)
During the same period, our simple moving averages trading model would have taken us to the sidelines, holding in cash or a money market while the 14-day moving average was trading sideways to down. The first signal to enter the market occurred in 2002, and had us selling short. The short position is then covered at a profit in early 2003. After the 14-day average crossed the 45-day average, our signal to go long, the strategy at first produced a number of small churning-type trades in 2005 as the market direction was equivocal. Then we profited nicely on a breakout to the upside. Overall, despite this being a decade-long cycle of market stagnation, our trading strategy would have yielded a healthy a 26.1% gain after all trading costs. Not great over 10 years, but far better than the buy-and-hold.
Clearly then, timing the market works. In all three market types, the system makes money. Not every trade is profitable, but the odds are deeply in the investor’s favor that the average trade will be profitable.
In a straight up market with almost no downturns , a buy-and-hold approach can sometimes beat the moving average strategy. But such market conditions are rare.
Meanwhile, in sideways and down markets, the moving average approach outperforms the buy-and-hold approach by orders of magnitude.
Have we convinced you by now? Great. Now we can get you to the next step. Shaping the best strategies to mitigate your losses and multiply your gains. Keep reading this blog. And do your your friends and family a favor. Share the link.