How to Keep "Worst Days" From Denting Your Portfolio

How to Keep "Worst Days" From Denting Your Portfolio

The Trader's U E-Letter

Wednesday, August 24, 2005

How to Keep "Worst Days" From Denting Your Portfolio: Issue #149

by D.R. Barton, Jr., Chairman, Trader's U

"He uses statistics as a drunken man uses lampposts - for support rather than illumination." - Andrew Lang, author

Like our quote from Mr. Lang, last week we found that mutual fund marketers make dubious use of statistics to support their case (as do other folks with a vested interest in promoting a buy-and-hold strategy).

Let's jump right into a more balanced and logical view of the buy-and-hold argument, and then take a look at what the mutual fund advocates aren't showing us.

A Quick Review - Two Sides to a Favorite Buy-and-Hold Defense

Last week, I beat up on mutual funds. While that's always fun and educational, I find myself in need of a little balance. To be fair, much of what's wrong with mutual funds stems from regulatory issues. Mutual funds are required to satisfy regulatory restrictions before they can go about making returns for their clients - from how they charge fees to how much of their assets have to be invested at any given time.

Here are the two sets of data that we looked at in our last issue. The first is the one touted by the "buy-and-holders," and the second is the one they never show us.

The average S&P 500 return from January 1984 through December 1998 was 17.80%. Here's what it would look like if you missed the best days during that period:

If you missed the BEST: Annual Returns
0 days (buy-and-hold) 17.80%
10 days 14.24%
20 days 11.99%
30 days 10.01%
40 days 8.23%

And now, here's what happened if you missed the worst days for the same period (the numbers buy-and-holders never let us see):

If you missed the WORST: Annual Returns
0 days (buy-and-hold) 17.80%
10 days 24.17%
20 days 27.04%
30 days 29.45%
40 days 31.66%

Cue the Suspense Music: Here's the Shocker

What happens if we combine the data? What would happen if you sat out the best AND worst days? Here are the results:

If you missed the BEST and WORST: Annual Returns
0 days (buy-and-hold) 17.80%
10 days 20.31%
20 days 20.68%
30 days 20.80%
40 days 20.87%

This gives us a rather startling conclusion: If you miss an equal amount of the best and worst days, you outperform buy and hold regardless of how many days you miss! This has wide-ranging ramifications for us.

But here's what it boils down to: If we stay out of the market during the worst periods, we can outperform the market, even if we miss the best periods. And the consistency is striking.

So what do we do with this information?

First, challenge any recommendation to blindly buy and hold any investment. Always ask, "Where will I get out if I'm wrong?" And second, don't buy into the hype that buy and hold is the only way to make money in the markets.

But let's not dismiss the buy-and-hold strategy completely; it's useful in some instances.

Buy and Hope, Buy and Forget, Buy and Manage

The problem I have with a buy and hold strategy is that there is no implicit exit point. Buy and hold means that you stick with the investment through thick and thin, or until you need the money. The problems come when you need the money sooner rather than later and, you're stuck in a down cycle.

But many folks need or want an investing strategy that requires little maintenance, so… let's look at how to better manage long-term investments.

When buy and hold is okay: If you are going to hang onto an investment through a couple of intermediate market cycles (say eight - 10 years), then history tells us that you have a very good chance of making money. The equities markets have an upward bias over time, as long as the world economy continues to expand. Diversifying your portfolio with other asset classes (precious metals, commodities, bonds, etc.) is almost always a good idea for long-term investing.

A better way for most folks: For most people, a "buy and manage" strategy may be a better choice. It rarely makes sense to hold an investment through drops greater than 25%. The Oxford Club (the parent organization of Trader's U) has long advocated a 25% trailing stop for long-term positions. Trailing stops have two functions: They allow you to protect your equity in case of drops against your position, and they give you a way to take profits after a move in your favor.

The Chart of the Week

Last week with EBAY, we were looking at a test of a key support level. That was broken and it seems we can reasonably expect a pullback to fill the mid-July gap.

Great trading,

D.R.

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