Wednesday, March 21, 2007

A Mechanical Strategy That Has Produced Consistent Stock Market Profits

In this post, I'd like to introduce a mechanical strategy that has yielded profits in 81 of the 82 historical periods studied. I'd then like to divulge the specific mechanical rules and explore what it takes, psychologically, to be able to pursue this strategy.

First, a few notes about the strategy's performance:

1) The 82 historical periods studied cover decades, not just a selected grouping of years. That period has included many bull, bear, and sideways markets and many economic conditions. While past performance is no guarantee of the future, the lengthy period over which this strategy has been successful suggests that it is highly robust;

2) The strategy has not been optimized or curve-fit in any manner. The system rules are very simple. Indeed, as we'll see below, the average annual returns as noted on the chart above very much understate the achievable returns of market participants;

3) The strategy does not require access to unusual market data or resources. The strategy utilizes data from the public domain. Indeed, anyone can benefit from this strategy without being tied to the screen during the day. The amount of time and effort needed to make decisions and trades does not interfere with holding a full-time job or any other life responsibility or activity.

OK, now for the performance run down:

The average annual return for the strategy is 14.17%. This is without any leverage whatsoever. Out of the 82 historical periods studied, 39 produced returns greater than 10% per year and 20 yielded returns greater than 20%. Six periods provided returns greater than 40%. The one losing period out of the 82 lost an average of -.25% per year. As a result, the risk-reward profile of the strategy is very favorable.

I'm quite convinced that these results are more impressive than those achieved by most mechanical systems marketed to the trading public. It's difficult to think of a strategy that has been so consistently profitable over a period of decades.

Here are the specific system rules:

1) Buy the Dow Jones Industrial Average at the end of the last trading day of the year;

2) Hold the position for 25 years;

3) Sell the position on the last day of the 25th year.

That's it.

Buy it. Hold it. Sell it.

The reason the above results greatly understate actual returns is that I haven't factored dividends (and their reinvestment) into the mix. My data on S&P 500 Index dividends finds that, going back to 1928, these have averaged 3.92% annually. Even if you assume no reinvestment whatsoever, you can see that adding this return to the mix means that every single period studied has been profitable. Buy and hold over the course of a 25 year investment career has never lost money going back to the start of my historical data in 1901.

The returns from the chart above were obtained by taking every sequential 25 year investment period from 1901 to 2006 to simulate what any investor might have obtained based on each beginning year. For a more in-depth treatment of these long-term return, their amazing consistency, and how they handily outpace inflation, I recommend the book Triumph of the Optimists: 101 Years of Global Investment Returns by Dimson, Marsh, and Staunton.

How many in-and-out traders, over the course of a 25-year career, can achieve such consistency and returns? How many actively managed funds can boast of such a record?

But think of the psychological fortitude it takes to participate in this strategy. An investor needs to ride out bear market drawdowns, periods of economic recession, oil shocks, inflation, and myriad geopolitical crises.

Just as important, an investor needs to tune out the many, many "sky is falling" jeremiads that were issued over those years, as market commentators became convinced that market meltdowns were in the offing. Consider the fact that, for the career investor, those cries of doom have never been vindicated. Never.

Indeed, to hang in there for a quarter century, an investor has needed the optimism described by Dimson, Marsh, and Staunton. The pessimist sees emerging nations that will eclipse the U.S.; the optimist sees free markets on the rise worldwide, providing expanding markets and improving standards of living globally. The pessimist sees peak oil. The optimist envisions the spirit of human innovation, which will provide cheaper and more abundant forms of energy, reducing the tensions now present over limited oil supplies. The pessimist sees bear markets. The optimist perceives fresh opportunities to pick up bargains.

So that's what it takes to benefit from the mechanical strategy of buy and hold for a lifetime: optimism and the courage to tune out intervening events and voices.

Don't get me wrong; I love trading. It is challenging, stimulating, and potentially quite rewarding.

But let's not kid ourselves. If we were to trade in and out of careers every time we became fearful of our current career progress or every time another career looked better, we'd wind up with a lifetime of unfulfilled promise. If we similarly traded in and out of relationships, we wouldn't achieve a fraction of the emotional depth and fulfillment of a fine lifetime marriage. The great rewards go to those who invest themselves in life--and who have the tenacity and optimism to stick with those investments and build upon them.