Is the Best Offense Really a Good Defense?

When we first meet people, my wife seems to like to tell everyone that I like investing, and follow stocks very close.  While it can make for a great icebreaker at parties, it also opens me up to having to listen to some of the dumbest theories on how to buy stocks.  I’ve heard everything…from buying stock based upon which team wins particular College Football games (companies closer to the winning team will be more productive) to buying stocks based upon the company’s choice of plants (lower cost plants means that they are frugal) to buying stocks that are close in symbols to a more common stock (so they will be bought more by accident).  Most things you hear at parties don’t make a lot of sense.  Until now…I spoke to someone who had an interesting theory.

(Author’s note: Before you write any comments, please read the following:

• This is NOT my theory, I only found it interesting.  I have no idea if it will earn you a ton of money.  You may be better off doing what you are doing now.
• It would have taken me years to get every number exact in the numbers below.  The purpose of this article was to show the theory, not my mathematic skills.
• I’m not endorsing or recommending this theory.  Before you change what you are doing, please consult a financial professional.)
  

Here is the basis to his thinking:

1. People would gain more by playing defense (protecting themselves on the downslides), rather than playing offence (trying to time the market highs).
2. In the vast majority of the Bull/Bear cycles, the market tends to bottom out at about 50% above where the bottom was in the previous down cycle.  So, any gains that achieve about 50% in a Bull Run are likely to be wiped out in the next Bear market.
3. Someone would gain more by getting out early, going into bonds, then waiting for the next bear market to end before getting back in.
4. When a market corrected, it tended to correct about 33% from the peak.  It may go down more (as it has now in 2008), but he would rather get in early, to catch the quick upswing, rather than trying to time the market bottom.
   

Here is how his theory works:

1. By the time a market peaked during the height of a bull market, he would already in bonds and other guaranteed investments.  He would have received a good price on these, as he bought them during the middle of a bull run, when no one else wanted to buy safe, boring investments.
2. He would be happy to sit in these safe investments until the market corrected by 33%.
3. When the market hit 33%, he would go ALL IN, and buy 100% stocks.  His thinking was that all of the risks were taken out of the market, and dividends were at their peak.
4. He would exit the market once his stocks were up 50%, regardless of the market conditions.  He would buy safe, guaranteed investments.
5. He would then only get back into the market when it fell 33% from its peak.
   

Although he wouldn’t share his totals (only to say that he has “easily beaten” the market), I was able to get enough information to do some calculations:

• He inherited $10,000 in 1962 and made his first purchases in July 1962 with his theory.  He was ready to exit the market when the next bull run hit 50%, this time for good.
• He would only invest in “large, blue chip companies” with high dividends.
• He always went 100% in when he switched from stocks to bonds and back.
  

Calculating an exact total that his investments grew would be difficult for the following reasons:

• He did withdraw some money for life events such as buying a house.
• He didn’t remember exactly what he received in terms of Interest rates, stock prices or even which exact stocks he bought.

So, for the purposes of calculating the formula itself (and not his exact return), I used the following variables:

• During his “Safe Investment” periods, I allotted a gain of 6% annual return (for interest and any capital gains).  The rates would have been higher or lower during much of this time, but it is reasonable to assume that on average, he was able to achieve this number.
• Since he didn’t know which stocks he owned, but knew they were always large, I used the DJIA as the guide.
• Although it is virtually impossible that he was able to buy and sell EXACTLY at the various percentage entry and exit points, for the purposes of the calculations, this is what I used.
• Since I didn’t know what his tax situation was (i.e. did he use a 401K account?), I didn’t factor in any capital gains or dividend taxes.

So, how did he do?

Based on a entry point of January 1st, 1962

	Start	Finish	Change	CAGR
His Theory	$10,000.00	$223,015.72	2130.16%	6.82%
DJIA	$10,000.00	$113,158.67	1031.59%	5.29%

So, is he going to give Warren Buffett a run for his money? Well, a similar investment in BRK.A (assuming that you held the DJIA from 1962 until 1967, bought BRK in 1967 and held to today), you’d have over $80,000,000….

However, for the average person, this might not be the worst way to beat the market, and sleep well at night

Comments

[cyborg1939:]

I have followed on the radio two well-known and respected finance/investing pundits. The first believed himself to be particularly good in the area of real estate. When the housing market turned down he told his national audience that this was a minor blip and nothing at all to worry about (LOL).

The second gentleman touts being one of the all time best market timers---he had NO CLUE about what happened beginning in September 2008, none. ( and with his high powered proprietary system) (LOL).

What is the point?: the point is that even the pundits are burned all the time.....and the Wizard of Oz is who he really is. Humility is the name of the game.

Cheers, Cyborg

2008 Oct 23 07:56 PM

[Larry Belle...:]

Cyborg,

I echo your sentiment, although I might not have worded it in the same manner.

Even Buffett himself is down this year, so no one is above the market. While there is no way to avoid getting hit during a massive downslide in the market, this way might at least offer a "blanket of safety" during troubled times.

thanks for reading
Larry

2008 Oct 26 07:10 PM