A Momentum Strategy To Beat 'Stay-Invested'

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Includes: FXB, GLD, LQD, SPY
by: Efficient Alpha

This is part of our series written exploring the myths in popular investing as exposed in Michael Dever’s new book, “Jackass Investing.” In the book, Dever uses experience from three decades of hedge fund management to explore how the conventional wisdom in investing and portfolio management preaches little more than gambling. For an introduction to the series and the book, see our previous article looking at the return drivers for stocks.

By Mario Mainelli

In this article, I will be focusing on the myth “Stay Invested So You Don’t Miss the Best Days”. The gist of it is that investors foolishly hold stocks longer than they should as their stock is on a downward spiral. This is because they fear they may miss the “best days” if they exit. Dever demonstrates an interesting point using the returns to the S&P 500, invested over the 20 year period between 1990 and 2010. One dollar invested in the S&P 500 on January 1, 1990 would have been worth $3.56 at the end of 2010 (assuming all dividends were reinvested). The chart below shows the returns under the same situation, but given the stipulations that the investor missed the 10, 20, and 30 best and worst trading days:

The chart demonstrates that as you miss a greater combination of best and worst trading days, your expected return increases. Since there is no way of knowing on which days will fall the best or worst returns, we can assume an equal chance of missing either. Translation: don’t be afraid to withdraw from a stock that has been falling out of fear of missing some future profit. The profit you will gain if (and it is a big if) the stock begins to rise will not always compensate you for all your losses incurred as the stock fell.

Investors have a tendency to let the amount of money they have lost on a stock blur their judgement on what they should do next. It is textbook behavioural finance: we act irrationally to satisfy a subconscious need that we may have. The need in this case is to feel that the entire investment wasn’t a total waste of time/resources/dignity. Thus, we hold, and hold, and hold, praying the stock will rally. However, as shown in the scenario above, these “best days” will usually either not occur at all or not be sufficient to cover the losses sustained in order to achieve these profits.

The concept of irrationality displayed by investors can be best demonstrated with a simple example of a poker hand. Imagine that you’re in a game of Texas Holdem’ with a rival whom you’d love to wipe out. You’ve already poured close to $100 dollars into the pot chasing a straight. The last card is flipped and, to your dismay, you’ve completely missed your straight and now have just a Jack high. Somehow, sensing your disappointment, your opponent raises $15. Every shred of common sense in your body tells you to fold, but why not throw in another $15 for a chance to win over $100? Despite how tempting it may be to call the $15, it is not in your best interest. Odds are that your opponent can beat a Jack high and you would be throwing away that extra $15. If the fundamental reasons for the investment have changed, you need to change the investment.

The gambling analogy above nicely compliments one of the author’s quotes from the chapter: “Only taking the best trades and avoiding the disasters? That’s investing. Being afraid to cut losses for fear of missing out on profits? That’s gambling.” They certainly don’t build elaborate/expensive hotels and casinos in Las Vegas because they are losing; investing is clearly the better option over gambling. Most people will easily see the stupidity of calling the $15 in the above scenario, but be blinded by the same concept when it comes to investing. If a stock that was purchased at $60 is now trading at $40, forget the $20 dollars you’ve lost! This is a sunk cost. It is spilled milk, and we all know better than to cry over spilled milk. Go back through your analysis and make a new, rational investment decision.

Most investors will not think objectively and rationally, though, because they let their emotions interfere. This brings us back to behavioural finance, a recurring theme in Jackass Investing. The action section for this chapter uses a strategy based on behavioural finance. It is a momentum-based strategy that uses investors’ sentiment to create a diversified portfolio. The moving average concept, which takes the average price of a stock over a given period, is essential to this strategy. The idea is to choose securities that, at month end, are priced higher than their respective moving average, as this is an indicator that it may shoot up in price. Dever discusses using a 250 day moving average to capture investor’s sentiment. I’ve modified this slightly to use the 200 day moving average, based on an article by renowned market technician Wayne Whaley. The article shows that using the 200 day moving average provides a better return over other moving average periods. Also essential to this strategy is diversification. The example given in the action section has a total of 30 securities, which is great for diversification, but mainly geared towards investors with a large portfolio. The portfolio I’ve created has hit most of the same categories as the author’s, but has only 6 components: SPDR Gold Trust ETF (NYSEARCA:GLD), IShares Iboxx Investment Grade Corp Bond (NYSEARCA:LQD), CurrencyShares British Pound (NYSE:FXB), Dow Jones –UBS Orange Juice ((DJUBSOJ)), NuStar Energy L.P (NYSE:NS), and SPDR S&P 500 ETF (NYSEARCA:SPY).

Note: The strategy was created based on prices from Oct 25, 2011. The surplus section shows, in dollar amount, the difference between the current price and the 200 day moving average.

As you can see, each of these securities is currently trading above its 200 day moving average, a momentum indication for a price increase in the near future. I’ve diversified the portfolio by including several asset classes, most of which have a low Beta. The ETF’s in gold, Corporate Bonds, and British Pounds should perform well in the current volatile market conditions. I’ve also included exposure to both energy and commodities, which provide great diversification benefits. The allocation given to the S&P is higher than the rest because I wanted to overweight the equity component, as I believe this has the most upside potential as the economy recovers. The moving average indicator is great supportive evidence that a stock will increase, but it should not be relied upon alone. Investors should combine this strategy in a portfolio of diversified strategies to lower volatility from any one return driver. We've shown other strategies throughout the series that investors can use to diversify their portfolio. Visit our website for links to each of the articles within the series.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: This series has been written on a contracted basis with the book's author. The opinions expressed in the article are those of Efficient Alpha and not necessarily those of the book's author. Efficient Alpha has been contracted to describe strategies and concepts used within the book but not to promote or recommend any strategies, the author, or the author's services.