Last week, I wrote about how Treasury spreads predict upcoming market declines, and I had planned on following that up with a look at how labor market conditions influence the stock market. However, that article has to wait, as I was asked a rather simple question that I did not have an answer for. The other day, a friend of mine who invests solely through his 401(k) and only in index funds or ETFs asked me the following: Is it better to simply buy stocks and hold them, or is there another strategy that gets better results?
My initial thought was, of course, there are better strategies, but then I realized that what was really being asked was: For someone who invests only in the broad market and has little investing experience, is there a simple strategy that will yield better results than "buy and hold"? I answered that I thought so, but I could not say for sure. That was a disappointing answer, so I thought I would investigate the issue some more.
The Model and Data
First, I had to find a simple strategy that even the most casual investors could follow. I settled for a strategy that is well known amongst many traders: the 50-200 crossover. This strategy consists of selling a stock when the 50-day simple moving average moves below the 200-day simple moving average, and buying the stock when the 50-day average goes above the 200-day one. Finding these averages is easy, since many websites, such as Google or Yahoo, offer charts that will plot the averages versus the current stock price. Second, I decided to use the SPDR S&P 500 Trust ETF (NYSEARCA:SPY), which tracks the S&P 500, to test the strategy on. I pulled historical price and dividend data for SPY from Yahoo Finance, going back to 1993, and created a spreadsheet with all the work and results discussed in this article. You can find the spreadsheet here.
Now, let's get to the results. I will assume that an investor started with $10,000 and paid $10 per trade for commission. Between November 1993 and January 2016, an investor with a "buy and hold" strategy would have ended the 23 years with a little over $60,000. The investor using the crossover strategy would have had around $75,000. These figures include dividend payments, which I assumed were re-invested for the "buy and hold" investor and for the crossover investor when they held shares of SPY. A 25% better return is impressive, but it ignores one major factor: taxes. The "buy and hold" investor will only have to pay long-term capital gains, while the crossover investor might end up paying short-term capital gains.
First, when discussing taxes, I assumed both investors to be in the 25% income bracket and the 15% capital gains bracket. Between 1993 and 2016, the crossover strategy would have resulted in an investor selling shares 11 times. Of those 11 times, 5 would have resulted in paying short-term capital gains, but of those 5 short-term trades, only 3 resulted in gains - the other two resulted in losses, and hence, no taxes. Incredibly, despite half the trades being eligible for short-term taxes, the results of those trades only account for a total gain of less than $100. The other 6 trades, which would have long-term capital taxes, account for the other $64,000 in gain. The buying and selling using the crossover strategy was infrequent enough to keep the investor from paying any short-term capital gains taxes.
After taxes, the "buy and hold" investor has about $51,000, and the crossover investor has $65,000. So the crossover strategy is clearly superior, right? Well, there is one more assumption we should question.
Up to now, I had assumed that taxes, whether for short- or long-term capital gains, were deferred as if the investors were holding SPY in a 401(k). But what if an investor has to pay taxes when they sell the securities? Under this condition, the portfolios are much closer. The investor using the crossover strategy in this scenario is unable to get the benefits of compounding the deferred taxes and ends with $56,000, while the "buy and hold" investor will still have a portfolio of $51,000 after taxes.
The market volatility of recent decades, especially the market collapses in 2001 and 2008, made the crossover strategy much more profitable than just buying and holding. I believe that volatility will continue into the future, making this strategy profitable going forward. When investing in an ETF or index fund that follows the broad market, if you are able to defer paying capital gains taxes, then using the crossover strategy should work well for you. If you cannot defer taxes, then I would stay with "buy and hold" because the strategies were simply too close in their results, and "buy and hold" is the more conservative approach.
This was just one example, and you could try different strategies. For instance, while there is nothing wrong with moving into cash when selling one's shares, another strategy might be to move your money into an ETF that tracks U.S. Treasuries - they do well in times of crisis. That is just one idea, and I'm sure there are better ones. For now, however, I will stop with the simple example shown above. Hopefully, this article was somewhat helpful, and if you have any other strategies that work for you, feel free to leave them in the comments.
Disclosure: I am/we are short SPY.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am very much hedged against SPY and VTI. While I have some long positions in these funds, I have even more long term put options on both.