Monday, January 31, 2011

Make Stocks Earn Their Way Into Your Portfolio

The investment industry has us pre-programmed to be fully invested all the time, for reasons we have discussed ad nauseum in many prior articles. Let's try, just for a moment, to reverse that thinking. Let's assume instead that we want to hold cold, hard cash (well, in the bank), until stocks prove their merit. Only once they have demonstrated their potential to provide better risk adjusted returns than cash over the intermediate term do we part with our cash in order to buy stocks. The following simple case study illustrates 2 simple ways for stocks to earn their way into your portfolio. If they don't, then we will hold cash.

The first method applies a momentum filter, such that stocks must have provided a higher total return than cash over a prior multi-month period in order to qualify for portfolio inclusion. If the the returns to stocks over the past year or so have been less than the returns to cash, we will stick with cash. Otherwise, if stocks have delivered a better return than cash over the same period, we will purchase the S&P 500 stock index for our portfolio.

(Any investor can gain exposure to the S&P500 stock index by purchasing any number of exchange traded funds, the most popular of which is SPY, traded on the New York Stock Exchange.)

The second method applies a simple moving average filter, such that stocks can earn their way into the portfolio only if they close out any month above their 9 month moving average. If they close out any month below this moving average, they are sold and we hold cash instead.

Note that we use the prevailing cash interest rate available in each historical period when calculating the results below, which are for the period from December 1971 to the present:

  1. Total returns improve for both strategies over Buy and Hold
  2. Volatility, the traditional measure of portfolio 'risk' is lower in both strategies, and by almost 50% with the Momentum approach
  3. Max Drawdown, or the worst drop in value from peak-to-trough, is over 100% worse for Buy and Hold than for either of the strategies
  4. Longest Drawdown, or the longest period of being 'underwater' in your investments, is between 80% and 120% Longer for Buy and Hold


There is absolutely no justification for a Buy and Hold approach. Even simple systematic approaches deliver at least the same returns, and with much less risk.

Appendix: Test results

Test 1. S&P 500 Buy and Hold Total Return, 1971 - 2010

Test 2. S&P 500 vs. Cash Ranked By Multi-Month Relative Strength

Test 3. Hold S&P500 above Moving Average, hold cash otherwise