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Armando Alizo
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Armando Alizo is a senior technology manager with over 20 years experience in the development of financial and trading systems. Mr. Alizo has a BA in Physics from Cornell University and an MBA from Nova-Southeastern University. Areas of expertise include: Development, testing, and... More
  • How to Beat 99% of Investment Managers 20 comments
    Apr 10, 2011 1:09 PM
    In last week's post I discussed the misadventures of the Legg Mason Value Trust Fund (LMVTX) and its manager Bill Miller.  But in fairness, there is no reason to pick on Mr. Miler.   The vast majority of mutual funds underperform the risk adjusted returns of their benchmarks. 

    In the book Common Sense on Mutual Funds, John C. Bogle notes that only about 16% of mutual funds managed to beat the Wilshire 5000 Equity Index from 1982 in to the late 1990's.  And to make matters worse, even those funds that managed to outperform the Wilshire 5000 did so by such small amounts that it could well have been due to chance.

    So what is an investor to do under these circumstances?  Well certainly going the index fund route as suggested by Bogle would be one approach, although I'm more inclined towards implementing sound "Rule Based" investment strategies that have been validated empirically (i.e. soundly back tested).  This exactly what I have done with my own Market Indicator

    Let's test out a very simple Rule Based trading system that has been around for a long, long, time - BUY when the price of the index or stock goes above its Simple 200-day Moving Average (200MA), and SELL when it goes below that level.   In order to minimize false trades, I always like to use "buffers" around a Moving Average.  In this case I will use a 5% buffer.  This means a BUY signal will be generated only once the stock or index has gone 5% above the 200MA, and a SELL only once the price has declined 5% below the 200MA.  Trades will take place at the next day's closing price after a signal occurs (which is exactly the price you would get if you were buying/selling a mutual fund).

    Very simple, right?  Let's see how this has performed using the Vanguard S&P 500 Index Fund:

    BUY & HOLD
    S&P 500 Index Fund (VFINX)
    From 12/31/1989 to 12/31/2010
    Total Gain:                                   +435.96%
    Maximum Drawdown:                   -55.25% on 03/09/09
    Compound Annual Ret (CAR):     +8.32%
    Ulcer Index (UI):                            17.44
    CAR/UI:                                            0.477%

    S&P 500 Index Fund (VFINX)

    From 12/31/1989 to 12/31/2010
    Total Gain:                                   +760.05%
    Maximum Drawdown:                  -19.20% on 08/31/98
    CAR:                                              +10.79%
    Ulcer Index (UI):                             5.52
    CAR/UI:                                          1.955%

    So there you have it, simply buying and selling the VFINX fund using the signals provided by the Buffered (5%) 200-day Moving Average of the S&P 500 would have resulted in over 4 times the risk-adjusted return (CAR/UI) of just buying and holding the index fund itself.  In the process you would also have soundly beaten almost all Large Cap mutual fund managers. 

    That's the power of Rule Based investing. 
    Of course, it is possible to do even better, and my own Market Indicator would have produced higher returns over the same period with even less risk (as measured by Max Daily Drawdown and UI).

    Now, I will be the first to admit that the 200MA system detailed above isn't perfect.  During the roaring 1990's it would have underperformed the "Buy and Hold" option by about 2% a year with a very similar risk profile.  But over the whole Bull-Bear cycle the 200MA approach soundly trounced "Buy and Hold".   Since it is impossible to know when a secular Bull market will begin or end, I prefer to forgo a few of the gains in the up phase to avoid being "killed" when the inevitable Bear comes along!

    Happy Trading.

    P.S. If you would like to see the latest independently verified performance of my Market Indicator please click on the link below:

    Timertrac Logo

      We take care to assure accuracy of contents but accuracy is not guaranteed. My posts express my opinions, and are provided solely as a supplement to your own further research. It is each reader's responsibility to decide which, if any, opinions or recommendations are suitable for their own situation, and in what manner to use the information. Past performance is not a guarantee of future results.

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Comments (20)
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  • I'm not surprised there are no comments since instablog articles are not promoted. Your article is excellent and the results can be proven time and again with different scenarios. Personally, I like the 50 day and 200 day crossover but the 200 day +/- 5% works fine. These can be backtested at ETF This strategy can be written on one sheet of paper and would outperform 90% of fund managers over bull/bear cycles. I have convinced some friends to use this technique and they are very satisfied because they got clobbered in 2008 with managed accounts that sat there and did nothing.


    Once again, nice article and I hope some newbies will pay attention.
    11 Apr 2011, 04:33 PM Reply Like
  • Author’s reply » Thanks Extreme! I think we are on the same page here, and I agree that there are many different Moving Average approaches that work.


    BTW - I submitted this to SA for publishing but they rejected it for being "too technical". I guess they like articles of the "Seven Hot Stocks That Will Double by Year End" variety! LOL!
    11 Apr 2011, 05:14 PM Reply Like
  • Thank you for the interesting article Mr Alizo.
    If this is so effective why do you think that it has not been widely implemented to the point of no longer being effective? I ask this with genuine sincerity... I understand that some folks egos wouldnt allow them to do so, etc... But why isnt there giant money somewhere doing this?
    Also, again will all due respect, I see that looking backward over the s&p 500 it worked well, but what happens on a broader sample? For instance, curious what this would look like if you plugged a broader sample into such as broader array of small, mid, & large cap stocks...
    Anyway, thanks for the info. I am always looking to expand my thinking, and will pursue this further.
    warm regards
    14 Apr 2011, 11:04 AM Reply Like
  • JC
    Prove it for yourself. Go to Yahoo finance and pull up an interactive chart of (spy). It is a tracking stock for S&P 500. Go to technical indicators and check simple moving average. Plug in 50 for the first moving average and 200 for the second moving average. When the fifty crosses the 200 a signal is generated. If the 50 is going above the 200 you buy. If the 50 is going below the 200 you sell. Click on max time frame at bottom of chart and you can see how it improves performance.


    Also, you can go to ETF replay and you can run a backtest on SPY with a 200 day average to show how it outperforms versus just buy and hold.


    Hope this is helpful!
    14 Apr 2011, 04:33 PM Reply Like
  • Thank you sir, I will in fact check it out for myself as per your suggestion. BTW, I have been reading backwards through your comments, and I put you on follow. I think you have a ton of experience that I am interested in reviewing. I will look forward to reading more in the future.
    best regards
    14 Apr 2011, 05:24 PM Reply Like
  • Thank you for your pleasant comments. I just enjoy talking about investing on all levels. Your question about why a 200 day average is so widely used that it would no longer be effective is a good one. I do not believe in passive investing (no market timing or stock picking). Market timing has helped me tremendously over the last 25 years or so. I believe Armando has touched on a very important reason by pointing out that most mutual funds and other institutions have to buy and hold. For me, I started in 88 using a 10% rule. I bought no load mutual funds and as long as they were within 90% of their 52 week hi I held on. If they dropped to 89% of their 52 week hi I sold them. We did not have computers or such good research in those days. I wanted something I could check once a week and be comfortable with. The reason I like this is very simple. Assuming no market crashes or anything of that nature how much of my investment was at risk? Ten percent! How much of the investment of a buy and hold investor is at risk? 100%. The idea is that the market will trend but you have to allow some variance for noise and normal volatility. As long as the market is trending up you ride. When it reverses you go to cash. My 10% rule has now changed to tracking moving averages but the premise is the same. You want to get most of the bull markets but little of the bad bear markets. These techniques will give you some false signals but if used over a complete market cycle they will enhance performance and reduce risk.


    14 Apr 2011, 06:33 PM Reply Like
  • Author’s reply » JC
    The question of why simple Trend Following strategies continue working in spite being well known is a good one. One would think that their effectiveness would disappear quickly. I suspect that as long as the vast majority of Mutual Funds continue focusing on Buy and Hold then simple Trend Following will keep working.


    As ExtremeBanker notes, there are multiple different strategies of this type, and they all have good track records.
    14 Apr 2011, 05:00 PM Reply Like
  • Thank you Armando, I am looking forward to exploring this further.
    best regards
    14 Apr 2011, 05:24 PM Reply Like
  • The thing with this simple strategy I think may be in exactly what johncworth asked, e.g. why not everyone using it?


    It is likely that what the article show to be effective (200MA system beating most fund managers) from 1989-2010 is not effective for 2000-2020 and totally beaten from 2010-2030 because market has one way or another moved to nullify the sweet region of parameters. I am not saying this would definitely happen, but Armando's argument is basically using past performance to predict future performance. To understand exactly how Armando's system could lose its advantage, just think what extremebanker said, with computers and the internet these days everyone could do his own datamining and find out sweet regions in paramter spaces or good families of simple strategies, for example to answer questions like, what is the best performing moving average days and buffer percentage to use for Armando's and Extremebanker's system? If every put the result into practice the systems will be loved to death.


    We can only hope that most investors are *always* not intelligent and diligent enough to follow a rule-based systems.
    So be happy that few people are replying this article. ;-)
    17 Apr 2011, 08:55 AM Reply Like
  • Author’s reply » mh001, As you state "We can only hope that most investors are *always* not intelligent and diligent enough to follow a rule-based systems. So be happy that few people are replying this article. ;-)"


    If you check out some of the back-and-forth discussions and comments I've posted on articles in SA, you would definitely see that the majority of those on this site can't grasp the importance of rule-based investing. They prefer to use completely subjective approaches that have not been validated empirically (i.e. back tested). I guess that being illogical is just typical human behavior. Go figure!
    21 Apr 2011, 05:00 PM Reply Like
  • Thank you for the interesting article. One question that I had when you calculated the returns from a buy and hold vs. rules-based strategy: did you factor into account taxes at all? I've heard that the alpha for many trading strategies actually looks much worse once tax implications are taken into account.
    25 Apr 2011, 10:18 PM Reply Like
  • Thx for the article. Have you looked at previous time periods? I believe that there are periods where this strategy outperforms (last decade, 1970s) but also extended periods where it underperforms buy-and-hold (1980s, 1950s).
    26 Apr 2011, 09:39 AM Reply Like
  • Author’s reply » @Thoth, I did not consider taxes, but the difference in performance vs. Buy and Hold is large enough that the strategy still beats the market. In any case, if you're like me and do all your trading with nontaxable retirement accounts then it isn't an issue.


    @kittycb, You're right - during strongly upward trending secular Bull markets this strategy will underperform slightly. However, this is compensated by its great performance in Bear markets. See my comments in the post about the 1990s.
    26 Apr 2011, 02:03 PM Reply Like
  • I have had Bill Lussenheide at Capital Management time my annuities for years and I am convinced this method is the best for long term investing - 7 years and more. See Investment He gives you the timing signals free on his website.
    2 May 2011, 09:57 AM Reply Like
  • Author’s reply » Hi Mr. Responsible - I'm familiar with Bill Lussenheide's approach which also uses Moving Averages to time various markets.
    While I think my Market Indicator (AMI) does a better job of timing the S&P500, I think Bill's approach is a very solid one.
    Because of his timing system, Bill was able to avoid a good part of the market meltdown that took place in 2008. He uses Timertrac to independently verify his performance (as do I).
    2 May 2011, 04:54 PM Reply Like
  • Absent any extenuating circumstances, do you consider a stock trading below its 200 day average a good buy? What I was looking at in your model is that if I strictly followed the sell rule and then once I sold, bought back in at some point before the price/200day avg cross, I could make much bigger gains. Or, since I'm relatively broke, as long as a stock is below its 200 day avg I could continue making incremental investments in it until the price rose over the 200 day avg, and then I could simply hold the stock and build my cash reserve until the price fell below the 200 day avg again when I could sell, then move back in once I thought the bottom had been reached.


    You did a really nice job showing the strengths of your strategy, what are some of the risks/weaknesses?
    8 Aug 2012, 02:55 PM Reply Like
  • "I could make much bigger gains."


    You have a geater chance to lose according to this system since not crossing 200MA from below is a sign of lack of strength.
    It's a general rule that do not try to out-smart your system. You are defeating the purpose of that system.
    8 Aug 2012, 10:10 PM Reply Like
  • Author’s reply » I agree with mh001's advice to not try to out-smart your system. A system is simply a trading strategy that has been demonstrated to work in a given market over a period of time. It isn't perfect, and most definitely it is not a crystal ball that will let you predict the future. That is why in general terms I recommend using several different markets and systems in order to diversify and minimize the risk of having any one approach "bomb out" at the same time.
    With regard to using the 200 Day Moving Average to "time" the market - this approach has demonstrated its value when used with most stock market indices (e.g. SPX, RUT, etc.), but it is no silver bullet. For example, the 200 Day MA is NOT useful approach for timing Gold stocks (XAU), as I discovered myself during extensive backtesting. So don't assume that any trading system or approach works until you have fully back tested it - and even then, it is no guarantee!
    8 Sep 2012, 04:42 PM Reply Like
  • One should also be aware that market timing is not always about perfromance. Sometimes it is about managing risk and volatility. That is why I started timing in the first place. The crash of 87 gave me a couple of very sleepless nights and that is when I knew I could not set through a serious bear market. Several commenters have asked why this system continues to work even though many are aware of it? My answer is buy and hold investors alway overestimate how much risk they can tolerate. Bottoms are eventually made by investors who pull the trigger at the wrong time. That is why they are bottoms. Capitualization will occur when investors realize they have overestimated there risk tolerance and finally sell. Rules based investing helps eliminate these emotions from your investing. OK, maybe I don't outperform the market (although I am very confident I have outperformed on a risk adjusted basis) but I do sleep much better at night than if I was a buy and hold investor.
    12 Sep 2012, 09:00 AM Reply Like
  • Author’s reply » @Extremebanker: I agree with you completely - It is not just about returns but also risk! Your observations on market psychology are spot on as well. During major bull markets, a trend following approach like the one I detail above may underperform, but over the whole market cycle I am confident that it will provide better risk adjusted returns.
    16 Sep 2012, 12:55 PM Reply Like
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