Tharp's Thoughts Weekly Newsletter (View On-Line)

• Article Strike Another Blow Against Buy and Hold by D.R. Barton, Jr.
• Trading Education 2011 Fall Workshop Schedule
• Trading Tip Trading Results and Large Numbers by Ken Long
• Mailbag The Golden Cross

Spend 8 Days with Systems Expert Ken Long

"Ken Long evolved from one of my best students in the 1990s to an outstanding long-term trading system instructor to one of the best intra-day and swing traders that I know today.

Now, he consistently makes single and double digit R-Multiple trades on a daily basis. Systems he teaches continue to have some of the highest SQN® scores that I have seen."
—Dr. Van K. Tharp

To learn more about Ken's back-to-back workshops in October,
as well as the rest of our fall schedule, visit our workshop page.

by D.R. Barton Jr.

“Never wrestle with a pig. You both get dirty and the pig likes it.”
—Multiple (ambiguous) Attributions

As a sophomore in high school many decades ago, I was sure my career aspirations were largely set: I wanted to study and work with animals. As a high school student, I didn’t really want to research a lot of possible fields, but I distinctly remember writing down “marine biology” and “zoology” as my two preferred fields of study on a standardized test that year.

So I had been looking forward to the first day of junior biology: I loved the subject and many of my friends were in the class. The teacher, Ms. Jennings, was an icon at my high school. She was an extremely bright woman who lived out in the country. She drove a monstrous Cadillac De Ville whose color could best be described as puke green. She was legendary for tough grading and dressing students down in class discussions.

I ignored all of these well-known facts and jumped right in on the first day’s discussion about the life spans for vertebrates and invertebrates. Ms. Jennings asserted that elephants were the longest-lived land dwelling animals due to their size. That was my chance—I had just seen a National Geographic TV special that stated unequivocally that the Galapagos tortoise was the longest-lived land vertebrate.

Boldly, I leapt in stating references and ages, but Ms. Jennings would have none of my insolence. She berated me in front of the class and required that I return after school so she could personally set me straight.

Upon my return that afternoon, she stood ready: a huge smile on her face and a textbook in her hand already open to the page on vertebrate longevity. It showed a table that went from mouse to human to elephant to whale showing increased longevity from 5 years for the mouse to 100 years for the human to 250 for the elephant and 1,000 for whales. Incredibly, the text estimated these life spans based on heart size! I immediately went to the copyright date and found 1933! My teacher was basing her information on a book that was older than her (and she was ancient, for Pete’s sake!).

I learned a couple of valuable lessons that day. One concerns our quote above about wrestling with a pig. The second lesson relates directly to a trading and investing truism: “Conventional wisdom dies hard.”

Conventional Wisdom Dies Hard

For decades, the financial industry has preached buy and hold as the best strategy for investors and as described in Safe Strategies for Financial Freedom, mutual fund companies have led this charge.

Financial institutions prescribe buy and hold for many reasons and they all point to maintaining their own profits and balance sheets:

• Mutual funds get paid based on assets under management, not on performance; therefore, keeping your money under their management is their top priority.
  
• Redemptions are expensive for funds. For every “sale,” funds have to manage paperwork and eventually incur transaction costs when they sell shares to raise cash for the redemption.
  
• Buy and hold is the easiest strategy for a client to follow—and for a fund to manage. After selecting a fund, there are no other decisions to be made or actions to be taken. Meaning that, once again, it’s a lot easier to keep your money under their management.
  

Buy and Hold Is Obsolete

Van and I have written extensively about the shortcomings of buy and hold as a strategy (as has Ken Long). Today, I’d like to share some more data that drives another nail in the coffin of this dying practice.

One of the most compelling arguments for buy and hold is the very long and sustained uptrend in the equities market when we look back nearly a century. The chart below shows the Dow Jones Industrial average dating back to 1921. There can be no denying that we’ve been in a long-term uptrend, even if there are some clear pullbacks (and yes, there are some problems with index pricing bias over the long run).

One of the often-promoted fallacies of buy and hold has been that you’ll make good returns given a long enough holding period. This argument, however, has been laid to rest by some excellent research done by Ed Easterling of Oregon-based Crestmont Research, an investment management and research firm. His data was featured earlier this year in the New York Times, and I’ve waiting for a good time to comment on his excellent work.

Many of you know that I’m a real fan of superior graphics—pictures that present data in compelling and useful ways. And Mr. Easterling presents his data in a very compelling way in the graph below. His picture shows the average inflation adjusted annual returns for money invested in the S&P 500 at the beginning of one year and then taken out at the end of another year.

Click here to see a larger copy of the graphic.

Here are the useful and sometimes startling primary conclusions that we can draw from this wealth of data:

• The time frame of your buy-and-hold investment is paramount. Anyone who says, “You can’t time the market” is just kidding themselves. You are timing the markets...unless your holding period is 60 – 70 years!
  
• That 60 – 70-year time horizon is what is needed for “stable returns.” Shorter time periods (i.e., anything useful to you or me) have inherent volatility and uncertainty of returns.

Using reasonable 20-year holding periods, we can see that buy and hold has not only been a bad idea in the last decade, but has really been a weak performer since the 1970s. Here is some data specific to this recent period:

• There have been 41 separate 20-year holding periods ending between 1970 and 2010 (1951 – 1970, 1952 – 1971, 1953-1972 ...1989-2008, 1990-2009, 1991-2010.).
  
• Of those, only five have had average, annual, inflation-adjusted returns higher than 7%.
  
• 14 or 34% of the 20-year holding periods have given moderate returns of 3 – 7% annually.
  
• More than half (22) of them have given average, annual, inflation-adjusted returns below 3%.
  
• And seven of those periods gave negative inflation adjusted returns.
  
• Some of the worst returns for any hold period have been posted over the last 12 years.
• So overall, you had about a 70% chance of earning less than a 3% return, and you had better than a one-in-six chance that your money would actually shrink in buying power over 20 years!  It all depended on which year you started/ended the 20-year holding period. 

Buy and hold has truly turned into “buy and hope.” The investment model that worked for my grandparents just doesn’t perform in today’s faster-paced market environment.

Like my old high school biology teacher needing to scrap her 1933 textbook, it’s time for those in the financial industry promoting buy and hold to scrap their outdated beliefs and adopt new strategies for managing client money. Truthfully, though, I don’t expect much progress in this area because conventional wisdom dies hard.

I’d love to hear your thoughts and feedback—just send an email to drbarton “at” vanktharp.com. Until next week…

Great Trading,
D. R.

About the Author: A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena. He is a regularly featured guest on both Report on Business TV, and WTOP News Radio in Washington, D.C., and has been a guest on Bloomberg Radio. His articles have appeared on SmartMoney.com and Financial Advisor magazine. You may contact D.R. at "drbarton" at "vanktharp.com".

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Trading Education

2011 Fall Workshop Schedule

Click here to see our full workshop schedule with details

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Trading Tip

by Ken Long

My research has shown me that traders gain two very important edges from systems that present large numbers of trading opportunities. One of them is primarily psychological and the other allows a trader to change the way.

System versus Self

Sometimes I think we try to give ourselves too much credit and, at the same time, too much blame for our trading results. If the market really is a complex adaptive system and if our judgment is only a small part of the contributing factors that actually generate results, then we are likely to overestimate how much our decision-making contributes to performance.

There is no doubt that we are responsible for our results in the macro sense. It is a healthy philosophical and psychological mind-state to be responsible for results.  It has become clear to me, however, that the positive edge for many robust trading systems is small but persistent and relies on having a large number of opportunities to gain realistic confidence in realizing the expected, average return. The fewer opportunities your systems generate, the more the variance of individual trade results influences the final results. 

This is only true concerning systems that have been designed and tested, prototyped and rehearsed, and in which the appropriate role for human discretion has been designed. In this kind of system, which is quite different than seat-of-the-pants trading, you might find a win rate of 55%.  Five losing trades in a row might prompt you to question your own performance and decide you are in a losing streak but, in fact, all you have seen is a string of losing trades that can be expected as a normal part of any large number of opportunities.

The right reaction would be to check your rule set and the details of your execution.  If you are within parameters, simply continue to take the entry signals as they occur rather than trying to reinvent yourself after a normal string of losses.

By the same token, you might think you were on a hot streak after five wins in a row and be tempted to change your rules or accept more risk. This would not be justified either because five wins in a row would be quite usual for a 55% accurate system.

With a large number of opportunities, you understand that streaks within your parameters occur as a normal part of executing your system and they happen on a recurring basis—nothing more than that. 

Be the House

Let’s say you find a trading system with a slight statistical edge in the market based on a large number of opportunities.  You would want to measure the reliability of its edge and if that proves robust enough, you could depend on it in multiple market conditions and perhaps in all types of markets. When you have such an edge, the best strategy to adopt is that of a Las Vegas casino—be the house. You want to play a positive expectancy game with as many iterations as possible to achieve the expected average return of your system. 

The statistical edges for Las Vegas casino games are very small. However, these small edges are mathematically certain because of tightly-controlled conditions and the environmental attractions the casinos offer. 

Because the conditions are so carefully controlled, the house can expect its mathematical edge to work in its favor precisely because of the large number of chances.  If you are the house, you want 1 million people playing blackjack for one dollar per hand, rather than one person playing a single hand of blackjack for $1 million. 

In the same way, if people in your neighborhood like to gamble, the best strategy for the whole neighborhood is to pool their money into a single pot and send that money to Las Vegas to play a single hand of blackjack, winner takes all. A single hand of blackjack is the best possible return for your money in Vegas, although it has a slightly negative expectancy under most circumstances. 

A short-term trader who has plenty of opportunities is better off taking five positions at 1% risk per position than a single position at 5% risk no matter how he decides to rank order the signals by quality. This assumes, of course, that the signals that pass the screening criteria are equally reliable in the long run. 

The greater the number of trials in the sample size, the greater your chance of achieving the average expected return of a positive expectancy system. There is a natural tendency among traders to try to concentrate their capital on what they consider to be the best trade available. However, if your system is generating multiple signals, you are better off taking all of the signals at reduced risk, provided that you have done your back-testing work and admin costs of trading are low.

What This Means for You

By trading a system with an edge of large numbers, you can benefit in a similar way that casinos benefit from their customers.  You can also trade with more confidence in the system’s performance over time and have less concern over any individual trade's results or even streaks in the results. 

About the Author: Ken Long is a retired Lieutenant Colonel in the U.S. Army with a Master's Degree in Systems Management. He is a doctoral candidate researching the management of uncertainty and an active trader. He is a proud father of 3, a husband, teacher, student and martial artist. Ken is also a dynamic workshop instructor for the Van Tharp Institute. The above article was reprinted from Ken's blog. Read more of Ken's essays at http://kansasreflections.wordpress.com.

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Mailbag

The Golden Cross

A reader's question in response to D.R. Barton's August 2011 article on the Death Cross.

Q: Just looking at the short side (the Death Cross) is like looking at only one side of the coin. I'm nearly sure that if you combine the reverse, let's call it the "Heaven Cross" (i.e., going long when the 50 crosses the 200 MA upward) with the Death Cross rule, you probably will have a very sustainable and decently performing trading strategy.

I think this 50/200 MA rule is very rudimentary. But probably it is good enough a system
for people having not much clue about the markets but still want to put their cash at work.

Moreover, I would probably recommend just following the "Heaven Cross" and going into
cash when the "Death Cross" appears, during secular bull markets.

And during secular bear markets to follow the combination of the two.

Anyway, you know that many more things have to be considered as well, but I think you get my point; I would analyze both sides of the coin.

A: In short, the Death Cross doesn’t work, but the Golden Cross (what you dubbed the Heaven Cross) does work over longer periods of time.  I wrote an article about that back in July of 2009. 

For my recent article though, I was trying to get people to look at the part that doesn’t work!  The market has had a distinct upward bias if we look back 80 or 90 years, so it makes sense that long-term uptrend signals work and long-term downtrend signals struggle to add an edge.

Bottom line: Golden Crosses have proved useful, Death Crosses have not.  If I were designing a system, I would find some other signal than the Death Cross to tell me when to exit and/or go short.

—D.R. Barton, Jr.

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