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Feature
 What
If � What If?
By
Chuck
LeBeau
As the Director
of Quantitative Analysis for SmartStops.net, I spend a great deal of
time browsing the web and other sources looking for hard to find
information about exit strategies.
On more than one occasion I have stumbled upon articles that
oppose any effort at market timing; to further their argument they
cite various studies that show how much long term performance might
suffer if market timers somehow missed �X� number of the biggest
up days in the market.
These highly
biased studies are assuming that any attempts at market timing will
be totally futile and ineffective.
These studies assume that market timers somehow missed all
the biggest up moves and yet suffered through all the biggest
declines. With that
assumption, it�s not surprising to see these studies conclude that
with bad timing the performance would have suffered a great deal.
I believe these studies are totally one-sided and extremely
unfair to market timers. To
set the record straight I�m going to take one of the most credible
and complete studies and present the results in a manner that is
fairer to market timers.
The
data I will be referring to is from a study encompassing more than
100 years of daily data on the Dow Jones Industrial Average.
(Black Swans and Market Timing:
How Not To Generate Alpha,
by Javier Estrada, International Graduate School of Management,
Barcelona, Spain).
The data presented in this study begins on December 31, 1899
and ends on December 31, 2006. In
total, the study encompasses 29,190 trading days.
1)
1.
A $100 investment at the
beginning of 1900 turned into $25,746 by the end 2006, and delivered
a mean annual compound return of 5.3%.
2)
2. Missing the best
10 days reduced the terminal wealth by 65% to $9,008, and the mean
annual compound return one percentage point to 4.3%.
But avoiding the worst 10 days increased the terminal wealth by 206% to
$78,781, and the mean annual compound return by more than one
percentage point to 6.4%.
3)
3. Missing the
best 20 days reduced the terminal wealth by 83.2% to $4,313, and the
mean annual compound return to 3.6%.
But
avoiding the worst 20 days increased the terminal wealth by 531.5%
to $162,588, and the mean annual compound return to 7.2%.
4)
4. Missing the
best 100 days reduced the terminal wealth by 99.7% to just $83 ($17
less than the initial capital invested), and reduced the mean annual
compound return to�0.2%. But avoiding the worst 100 days increased the terminal wealth by a
staggering 43,396.8% to $11,198,734, and more than doubled the mean
annual compound return to 11.5%.
This
data clearly shows that successful attempts to skip the worst down
days would not only reduce risk but gain much more than might be
lost by missing some or even all of the biggest up days.
But perhaps more importantly, there is no evidence in this or
any other study that shows that trying to avoid the biggest down
moves will result in missing the biggest up moves.
Why do the people who write these one-sided articles assume
that the market timers will be wrong all the time?
Most
of the big days up or down occur in the midst of major trends that
can easily be identified with simple timing tools that do not need
to be particularly precise to be effective.
Market timers do not have to exit exactly the day before the
major decline day or enter the market exactly the day before a major
advance. A precautionary
exit in a downtrend identified weeks before the major decline day
will suffice and perhaps produce even better results as some of the
less spectacular decline days might also be avoided in the process.
The same is true of entries.
Market timers need only identify that an uptrend is underway,
and in most cases the major up day will follow sooner or later.
About
the Author: Chuck LeBeau is the Director of Quantitative Analytics
at www.SmartStops.net
and he is also co-author of Computer Analysis of the Futures
Market (McGraw-Hill).
Chuck
is a featured speaker at IITM's upcoming How to Develop a
Winning Trading System Workshop, January 2009. Chuck has
more than forty years experience in the markets and is widely known
for his specialized knowledge of technical analysis, system trading and
exit strategies. For 60 days of free service (10 stocks) on
smartstops.net use the code VANTHARP60FREE.
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