market timing (part 4)

As contemplated last week, I've tested our optimized trailing stop-loss and trailing go-purchase parameters against some out-of-sample data to evaluate if this strategy has any relevance or if the positive results using S&P data from the 2000s is simply a quirk of randomness. The chart above conveys the results using Dow Jones Index data from 1930-2000.

Again, as with most strategies that entail being out of the market some portion of time, the volatility of the trading portfolio is less than that of the buy&hold portfolio. As is typical, this lower volatility is accompanied by lower returns. To determine if the returns are sufficient given the reduced volatility, we scale down the buy&hold returns according to the lower Beta of the trading portfolio. Then we compare these 'adjusted' buy&hold returns to the trading portfolio returns, to see if the trading strategy added any excess return or 'Alpha'.

In short, I think the results are minimal / inconclusive. You can see the average Alpha of the trading strategy over the decades is roughly 2% per year, which although nothing to sneeze at, is a small amount when compared to the approximately 4% standard deviation of that same Alpha . In other words, the Alpha doesn't appear highly statistically significant and one could reasonably conclude the Alpha is actually 0% and the obtained result of 2% is simply a fluke.

However, I still found this to be a worthwhile / interesting exercise. For one, I think investors should always position themselves to withstand the worst (i.e. don't bet more than you can afford to lose). In this case, although worse fates can always occur, the 1930s were a tough time by any standard. Imagine nearing or having just entered retirement and then realizing a negative 5% annualized return over the next decade. Talk about something that will force a re-prioritization of your life. In this context, I think it noteworthy how well the more conservative trading strategy of trailing stop-losses and trailing go-purchases outperformed the riskier buy&hold strategy. I mean, if a strategy is going to come through for you with flying colors when you need it the most, then it warrants some consideration regardless of its average performance. This brings to mind some words of wisdom often quoted by a friend and financial advisor who when mentioning the inadequacies of averages, says something to the effect of, "The average depth of Lake Michigan is only four feet, but I wouldn't want to walk across it".

Quote for the Week: "The more pleasures a man captures, the more masters he will have to serve." - Lucius Annaeus Seneca (c. 4 BC-AD 65), Roman Stoic philosopher.