good link

No post this weekend. Had to work a full day at my day job.

I did however follow a great link provided by Falkenblog. Has to do with low volatility stocks providing returns in line with overall equities (contradicting Modern Portfolio Theory), so that your return per unit of heartburn is maximized. Not only heartburn, but 'risk' insofar as (i) big drawdowns to your account have the potential to cause panic and lead you to sell at the worst possible time or (ii) you may have an unexpected use for that money you previously thought was 'long-term' and end up needing to sell at relatively low prices.

Quote for the Week: "He that cleaves to wealth had better cast it away than allow his heart to be poisoned by it: but he who does not cleave to wealth, and possessing riches, uses them rightly, will be a blessing unto his fellows." - Siddhartha Gautama Buddha (c. 563 BC - 483 BC).

saving philosophy major; market timing minor

I won't be doing a full post this week with analysis since I was traveling for work all this past week and need to catch up on emails today and the chores corresponding thereto. What free time there was this weekend was spent indulging my new interest in backpacking, which entailed spending hours and untoward amounts of money at R.E.I. accumulating the gear I intend to use on at least a couple trips to the Shenandoah National Park this spring/summer. Funny how it's so easy to justify spending when it can be classified as an 'investment' that will produce years of enjoyment. Any remaining hesitancy can be easily obliterated by imagining future trips with my sons (the youngest of which is only 6 months of age). All I can hope is that by spending the money, I'll feel obligated to actually go out and put the gear to use (sort of like a gym membership initiation fee).

Separately, in regards to the 'market timing' posts of late, I should mention that these quantitative rule-based strategies aren't really market timing in the purest sense of the word, at least not to my way of thinking. I think pure market timing entails moving in and out of the market based on esoteric gut-level decision making. In other words, it's based on an intuitive synthesis of whatever quantitative and/or qualitative information happens to be available at the time and is therefore not conducive to testing against historical data. Alternatively, I see the rule-based strategies as data-driven decision making, which because they're systematic, are conducive to testing. Now, perhaps it's possible that someone has an ability to practice pure market timing, but even if so, there's no point in writing about it because the reader can never know whether or not the ability truly exists because it can't be verified by a test. Rather, any prudent reader would have to fall back to Occam's razor and assume the writer is full of BS and is simply trying to either enhance their own bank account balance or their social status.

Now, having provided the above disclaimer, I may from time to time write about a personal decision to enter or exit the market based on whether or not I think it's headed up or down. I'm not sure why I might do this, other than this blog might one day be read by my kids when I'm gone and it might be nice and/or helpful from them to read in relation to their own future investing endeavors. Or perhaps, having a written record of my trials and errors might help me refine a strategy quicker than I otherwise would. In any event, I'll try to practice my own market timing rarely and only then with thoughtful reasoning based on the three fundamental drivers of market prices, which are (i) long-term valuation metrics, (ii) intermediate-term economic growth, and (iii) short-term market sentiment. Still, there is no way of knowing ex-ante whether my decisions will do me more harm than good over the long run.

To a large extent, do to the huge uncertainty, market timing is an insignificant factor in long-term investing success. Much more important in accumulating a nest egg sizable enough to maintain one's standard of living throughout retirement is the discipline to save money, which in turn is a lot like diet and exercise. My friend across the street who is a financial advisor conveyed this analogy to me as follows: "What diet and exercise regimen is best? The one you can stick to." It doesn't matter if you follow Adkins, South beach, Weight Watchers, or Jenny Craig because it ultimately comes down to the simple fact of calories in and calories out. In terms of saving money, it ultimately comes down to finding some way of mastering your desires. You will never succeed in denying yourself something you want. Your only hope is to change what you want. Obviously, this is an ideal state of mind and, based on my expenditures this weekend, one I've yet to reach.

Quote for the Week: "Life's necessities are cheap and easily obtainable. Those who crave luxury typically have to spend considerable time and energy to attain it; those who eschew luxury can devote this same time and energy to other, more worthwhile undertakings." - Lucius Annaeus Seneca (c. 4 BC-AD 65), Roman Stoic philosopher.

market timing (part 5.5)

I thought it worth elaborating on last week's post regarding rule-based trading according to moving-average momentum. In particular, if that strategy provides greatly reduced volatility with somewhat less reduced returns, then that begs the question of whether or not there is a way to generate only slightly reduced volatility with non-reduced returns? In other words, buy&hold levels of returns with less volatility than the buy&hold portfolio. [By the way, if I ever find a formula like this, or better yet, one with greater returns than the buy&hold portfolio and less volatility - I may try making a living off it before I disclose it in this space.]

As a straightforward non-creative attempt at providing an answer, I've tweaked last week's analysis as follows: rather than going to cash when the moving-averages are trending down, see what happens if you short the market at those times. The results of this test are shown in the chart above.

As expected, this strategy produces the same volatility as the buy&hold portfolio. The reason is because, every day, long or short the market, your portfolio will bounce around one way or another in proportion to how the market moves. Also expected, the Beta of this strategy is in the ballpark of zero. To understand the reason, simply imagine being long the market 50% of the time and short the market 50% of the time. When you're long, your Beta is 1.0; when you're short, your Beta is -1.0. Mathematically, 50%*1.0 + 50%*(-1.0) = 0.

However, the returns from this strategy don't beat the buy&hold portfolio. They don't even do well enough to provide a superior Alpha in comparison to last week's strategy of going to cash, rather than shorting the market. I can't really provide a full explanation for why this is, except to say two things: 1) transaction costs are doubled because not only do you have to buy and sell, you also have to sell and buy (to short), and 2) the market is very (although maybe not perfectly) efficient, which causes a high degree of randomness.

Overall, I have to conclude this buy&short strategy is inferior to last week's buy&sell strategy because you have higher volatility and (slightly) lower returns.

Side note: check out 'Black Monday' (and the days following in Oct-'87) in the chart above. Wow.

Technical Notes:

1. One reader commented last week that the 6% returns for the buy&hold portfolio looked low. In other words, everyone tends to think stocks provide 10% returns in the long run. A few reasons for the discrepancy: first, the returns shown in each decade are geometric, rather than a straight average of the ten years; second, the returns in each decade exclude the results of the first 200 days in order to first calculate a 200-day moving-average prior to beginning the analysis; third, these returns are for the Dow Jones Industrial Average (historical dividend adjusted pricing provided by yahoo finance), which may vary from what an outfit like Ibbotsson may deem to be the 'stock market'.

2. It's interesting how the Beta can be near zero and yet the trading portfolio appears to somewhat follow the buy&hold portfolio when viewed on a 10-year chart. This is something to keep in mind when considering any statistic that's calculated based short term data (e.g. daily). Many paradoxes in finance (life?) can be resolved by rigorous attention to the time frame under discussion. In many cases, the small deviations from the short-term statistic (be it Beta, an average, or whatever) accumulate in one direction over the long-term. For instance, people like to point out that when the U.S. market declines, foreign stocks tend to decline as well, thereby nullifying the diversification benefit. However, when they say this, they are mainly thinking in terms of the short-run (i.e. days), when the diversification benefit is a actually a long-term phenomenon. Foreign stocks are less correlated with U.S. stocks in the long run mainly due to long run factors like demographics, political regimes, etc.

Quote of the Week: "Not needing wealth is more valuable than wealth itself." - Epictetus (AD 55–AD 135) Greek Stoic Philosopher.

market timing (part 5)

This week I decided to test a slightly different momentum strategy as follows:

1. If the price exceeds both the 50-day moving average ("MA") price and the 200-day MA price, then buy.

2. If the price is less than both the 50-day MA price and the 200-day MA price, then sell.

3. Otherwise, hold (e.g. price exceeds 50-day MA, but is less than the 200-day MA).

Same as last week, I tested this strategy against Dow Jones Index prices going back to 1930. For each decade, I waited 200 days (in order to calculate a 200-day MA) and then bought into the market. From there, all buy/sell decisions were driven by the aforementioned rules.

The chart above illustrates the results. Again the trading portfolio was less volatile than the buy&hold portfolio. Again, the average Alpha was approximately 2% (annualized). Again, the strategy performed well during the 1930s, when you would have needed it the most.

However, this strategy produced a more consistent Alpha, the standard deviation of which was only 3%, so the average Alpha of 2.3% divided by the standard deviation of roughly 3.0% was about 0.76. Although I still can't say this is statistically significant, it's better than the 0.53 result from last week's trading strategy.

The only decade in which this strategy didn't work well was the 1990s, when pretty much everything simply marched upward. And in my opinion, not doing as well as the overall market in the good times, isn't as awful as doing worse than the overall market in the bad times.

If you study the chart in detail, take note of the 2000s. What's interesting here is although the Alpha was technically 0%, that's basically just a quirk of both the Trading Portfolio and the Buy&Hold Portfolio having produced 0% returns. You'll notice the standard deviation of the Trading Portfolio's annual returns during this decade was only 11%, which is much less stomach churning than the Buy&Hold Portfolio's 25%. In my book, having the same returns (even 0%) with much less volatility is a win. Think about if you lost a job with corresponding health insurance and faced some unexpected medical bills - all of a sudden, that savings you thought wouldn't be needed for at least 10 years is the subject of urgent demand. Would you rather face the prospect of pulling your money out of a Buy&Hold Portfolio or the more stable Trading Portfolio?

Quote for the Week: As in nature, emotions abhor a vacuum. If we progress in vanquishing negative emotions such as wishing for certain things to be different and instead spend more time enjoying certain other things as they are, then we will find we are experiencing a degree of tranquility that our life previously lacked. We will then naturally become more susceptible to joy. - Paraphrasing of "A Guide to the Good Life: The Ancient Art of Stoic Joy", page 123.