Thursday, October 30, 2008

Buy & Hold vs Timing the Market

Yesterday we looked at the Buy & Hold (B&H) strategy from a historical perspective and saw that portfolio returns are a function of when one decides to enter into positions as well how long one holds onto them. Today, we'll look at how adopting even a simple market timing strategy can significantly increase your portfolio returns.

A market timing strategy
I came up with a simple market timing strategy and tested it out on the S&P 500 index tracking stock, the SPY, over the past ten years. The results were so far beyond my expectations that I couldn't wait to share the results with a few friends. Not only were they impressed, but they all said, “Hey D.K., you're not going to give this one away, are you?”

Yes and no. I'll show you the results but I'm going to keep my timing scheme proprietary because I do think it's a marketable commodity. I'm sorry, but I confess to being a capitalist, and although I do love writing my blog, my ultimate goal has always been to turn it into a money-generating enterprise.

The strategy that I devised was very simple. It identified two bull markets and two bear markets (including the one we're in now) in the past ten years. (My charting and simulation software only has data going back to 1998.) The beauty of this strategy is that it required only four trades in 10 years; on average, that's one trade every couple of years. Or if you just wanted to play up markets, that would be only two trades in ten years. Making even this minor portfolio adjustment results in a big pay-off as we'll see in the table below.

B&H versus market timing
I ran four simulations from 2/6/98 – 10/29/08 trading the SPY only. The first simulation was a pure buy and hold strategy; that is, I bought my full SPY position on 2/6/98 and exited it yesterday. In the other three simulations, I used my market timing scheme. The long-only portfolio involved being fully invested during bull markets and going into cash when the market turned down; vice versa for the short-only portfolio. The last simulation was a combination of the previous two—that is, I bought the SPY during bull markets and shorted it during down markets.

Simulation parameters:
$10,000 initial investment
100% margin requirement (essentially no portfolio leverage)
Full cash position used per trade
2% account interest; 3.5% margin interest (default values)
$9.95/trade commissions (no reg. fees included)

[Note: ARR = annual rate of return]
[Click on table to for a larger view.]

The results
Wow! You can see that the pure buy and hold strategy is vastly inferior to the market timing strategy. Even if you only played the long side, you'd be in cash during the down cycles where your money would be earning interest (especially if you put it into higher paying vehicles such as short-term CDs). By far the most profitable approach is to play both sides of the market. Here, you have the advantage of compounding your return even further than if you only play one side. Note also that the market timing scenarios resulted in much smaller drawdowns, an obvious observation as larger drawdowns are expected when the market is moving against your position.

We've shown here that even a simple market timing strategy provides superior returns to the traditional buy and hold mantra. There may be other timing schemes that offer better results, but I haven't been able to come up with one that's as simple to use nor as effective.

No comments: