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.