Wednesday, March 21, 2007

A Mechanical Strategy That Has Produced Consistent Stock Market Profits


In this post, I'd like to introduce a mechanical strategy that has yielded profits in 81 of the 82 historical periods studied. I'd then like to divulge the specific mechanical rules and explore what it takes, psychologically, to be able to pursue this strategy.

First, a few notes about the strategy's performance:

1) The 82 historical periods studied cover decades, not just a selected grouping of years. That period has included many bull, bear, and sideways markets and many economic conditions. While past performance is no guarantee of the future, the lengthy period over which this strategy has been successful suggests that it is highly robust;

2) The strategy has not been optimized or curve-fit in any manner. The system rules are very simple. Indeed, as we'll see below, the average annual returns as noted on the chart above very much understate the achievable returns of market participants;

3) The strategy does not require access to unusual market data or resources. The strategy utilizes data from the public domain. Indeed, anyone can benefit from this strategy without being tied to the screen during the day. The amount of time and effort needed to make decisions and trades does not interfere with holding a full-time job or any other life responsibility or activity.

OK, now for the performance run down:

The average annual return for the strategy is 14.17%. This is without any leverage whatsoever. Out of the 82 historical periods studied, 39 produced returns greater than 10% per year and 20 yielded returns greater than 20%. Six periods provided returns greater than 40%. The one losing period out of the 82 lost an average of -.25% per year. As a result, the risk-reward profile of the strategy is very favorable.

I'm quite convinced that these results are more impressive than those achieved by most mechanical systems marketed to the trading public. It's difficult to think of a strategy that has been so consistently profitable over a period of decades.

Here are the specific system rules:

1) Buy the Dow Jones Industrial Average at the end of the last trading day of the year;

2) Hold the position for 25 years;

3) Sell the position on the last day of the 25th year.

That's it.

Buy it. Hold it. Sell it.

The reason the above results greatly understate actual returns is that I haven't factored dividends (and their reinvestment) into the mix. My data on S&P 500 Index dividends finds that, going back to 1928, these have averaged 3.92% annually. Even if you assume no reinvestment whatsoever, you can see that adding this return to the mix means that every single period studied has been profitable. Buy and hold over the course of a 25 year investment career has never lost money going back to the start of my historical data in 1901.

The returns from the chart above were obtained by taking every sequential 25 year investment period from 1901 to 2006 to simulate what any investor might have obtained based on each beginning year. For a more in-depth treatment of these long-term return, their amazing consistency, and how they handily outpace inflation, I recommend the book Triumph of the Optimists: 101 Years of Global Investment Returns by Dimson, Marsh, and Staunton.

How many in-and-out traders, over the course of a 25-year career, can achieve such consistency and returns? How many actively managed funds can boast of such a record?

But think of the psychological fortitude it takes to participate in this strategy. An investor needs to ride out bear market drawdowns, periods of economic recession, oil shocks, inflation, and myriad geopolitical crises.

Just as important, an investor needs to tune out the many, many "sky is falling" jeremiads that were issued over those years, as market commentators became convinced that market meltdowns were in the offing. Consider the fact that, for the career investor, those cries of doom have never been vindicated. Never.

Indeed, to hang in there for a quarter century, an investor has needed the optimism described by Dimson, Marsh, and Staunton. The pessimist sees emerging nations that will eclipse the U.S.; the optimist sees free markets on the rise worldwide, providing expanding markets and improving standards of living globally. The pessimist sees peak oil. The optimist envisions the spirit of human innovation, which will provide cheaper and more abundant forms of energy, reducing the tensions now present over limited oil supplies. The pessimist sees bear markets. The optimist perceives fresh opportunities to pick up bargains.

So that's what it takes to benefit from the mechanical strategy of buy and hold for a lifetime: optimism and the courage to tune out intervening events and voices.

Don't get me wrong; I love trading. It is challenging, stimulating, and potentially quite rewarding.

But let's not kid ourselves. If we were to trade in and out of careers every time we became fearful of our current career progress or every time another career looked better, we'd wind up with a lifetime of unfulfilled promise. If we similarly traded in and out of relationships, we wouldn't achieve a fraction of the emotional depth and fulfillment of a fine lifetime marriage. The great rewards go to those who invest themselves in life--and who have the tenacity and optimism to stick with those investments and build upon them.

20 comments:

hcarstens said...

What a great exercise!

--h

Missy said...

Wow, love the marriage analogy you used and it is so true. I don't treat my relationships like my trading at times. So I will trade until Dec 31st this year, then start my new mechanical system. I may go thru periods of being broke and 25 years from now I will be past retirement age, but what the heck I am all in. How about the SP I would think with the upward bias on the SP with rejiggering this would work there also?

David said...

Your last paragraph is an important point to internalize in an age of immediate gratification.

One step further on your points today might be to read and perhaps re-read the first 60 pages of the Elliott wave principle to build a working understanding of "degree of trend". This simple yet powerful working paradigm allows us to better understand the example you offered today but more importantly why it may or may not work in the future.
Elliot waves are not a complete trading tool by any stetch but, they offer powerful insight especially in the time period discussed today. Dave

mOOm said...

Yes, but quite a few of the 25 year periods didn't even beat inflation. And that I think is very important. Buying and holding though can be part of the overall mix. Diversification over time periods of holding is a good idea I think. Most great investors both trade and invest.

AnaTrader said...

HI Brett

A quarter century........beats Buffett?

More importantly, one has to be preferably in the thirties or forties to benefit fully from this mechanical strategy of holding for 25 years.

It sure will not benefit me!

Brett Steenbarger, Ph.D. said...

Thanks, Henry. It is a sobering mirror to one's trading: figuring out whether our active decisions truly add alpha--

Brett

Brett Steenbarger, Ph.D. said...

Hi Missy,

I do think that a few decision rules re: how to add money to an investment account each year (along the lines of dollar cost averaging and diversification, for example) would greatly aid returns. My gut tells me that some simple rules re: adding more capital after down market years and less during periods of high inflation/interest rates would be especially effective--

Brett

Brett Steenbarger, Ph.D. said...

Hi David,

I've seen Elliott waves used to justify everything from super bear markets to raging bull highs. I've also seen how easily they are manipulated with "alternate counts". Maybe there's some value there somewhere. I like to keep an open mind. The Elliott field, however, is so full of intellectually dishonest people, however, that it makes it hard to take any of it seriously.

Brett

Brett Steenbarger, Ph.D. said...

Hi Moom,

I think if you look at returns including dividends, including the rigorous study of Dimson et al, you'll find that buy and hold has handily beaten inflation in most market periods.

If a trader can objectively demonstrate that, after costs, he or she can provide incremental returns (alpha) above and beyond buy and hold, then of course it makes sense to actively manage capital. From what I hear from industry insiders who should know best (those who run brokerage firms, FCMs, etc.), the vast, vast, vast majority of traders don't even cover their costs. It's a small fraction that can beat inflation and simple buy and hold.

I agree with you: having separate capital for investment and for trading makes a lot of sense. Thanks--

Brett

Brett Steenbarger, Ph.D. said...

Hi Anatrader,

Where the 25 year horizon becomes important for the older investor is vis a vis estate planning--

Brett

Marc said...

Hi Brett,

Great post. I think you highlight the big difference between trading and investing. Investing is like building a business...in fact, you are essentially being a small partner in a large business. Trading is a whole different animal with a lot of psychological elements and different motivations (although I think everyone wants to make money).

I was reading an article this morning about the widespread availability of computers and backtesting...which you do so well. At what point does this become a self fulfilling prophecy or become subject to a Heisenberg effect? I guess this would be the efficient market theory in practice. Anyway, what do you think?

Marc

tradingup said...

Hi Brett,

Great post; interesting historical data.

Given this mechanical strategy, could one buy and hold a position with the Dow Jones ETF, DIA? If so, wouldn't it make sense to buy a few shares in their IRA? Could be a great estate planning technique?

AA

quints said...

Dr. Brett, I think your work is the best. But, I have to disagree with you here. First of all, you don't have 82 periods. There is obviously a rediculous amount of overlap. (82 25 year periods would take us all the way back to Roman times.) So when it comes to non-overlapping periods, you have a statistically insignificant sample! Also, you are looking at one market, for the USA which happens to have become the world super power over the period of your sample. It is like saying, pick the country that is going to emerge as the world leader over the next 100 years, then invest in it's stock market. The hard part is picking the country IN ADVANCE. In retrospect, America is an easy bet. What would your results have been if you had selected Prussia?

Notwithstanding, I love this blog and I hope you enjoy my response!

Brett Steenbarger, Ph.D. said...

Hi Marc,

Thanks for the note. I agree that patterns lose their impact once they become common currency. My speculation is that they are replaced by more complex patterns. At one time, the simple technical patterns probably possessed an edge. Now they're on all the software and analyses such as David Aronson's show that they are random--

Brett

Brett Steenbarger, Ph.D. said...

Hi Quints,

You make a valid point: it's not possible to conduct statistical tests of significance when the data are overlapping (not independent). The thrust of my post, rather, was descriptive: to illustrate that--regardless of the starting year--25 year holding periods in the Dow have yielded positive returns once we factor dividends into the mix.

Dimson et al have looked at similar holding periods in the stock indices of other countries and, as you note, many do not show equivalent results. (World War II, for example, greatly impacted returns in Europe). When you compare long-term U.S. returns to the average performance of mutual funds and active traders, however, the contrast is stark. It's tough to beat the buy-and-hold benchmark in U.S. equities! Thanks for the note--

Brett

heywally said...

Nice post. Day trading is indeed very very hard. A variation on buy and hold for a very long time is to use sentiment indicators and back tested high % swing trades, based on research available at sentimentrader.com and markettells.com (both mentioned favorably by Brett). This seems to be the direction that I am evolving to.

Brett Steenbarger, Ph.D. said...

Hi HeyWally,

I think your swing trade idea is excellent, allowing you to take advantage of overnight movement. Proper position sizing to adjust for increased volatility of longer holding period would be important--

Brett

天下无双选股大师 said...

At first glance, it seems to be ture. However, The returns didn't count any other factors such as inflation, interest rate. The strategy is just a lookback statistical result suffering from survival bias, not a practical strategy. If investment is so easy, why not those portfolio managers all invest DJI?

Brett Steenbarger, Ph.D. said...

Hi,

As I noted earlier, the chart doesn't include dividends (which makes results much more impressive) and inflation (which moderates results). Dimson et al have examined long term returns after dividends and inflation and have found very positive risk premia associated with long holding periods. But no one said it's easy. There are plenty of drawdowns that customers won't sit through. So portfolio managers seek active management and shorter term outperformance, only to frequently underperform buy and hold.

Brett

WEIRD-ENGLISH-WRITER said...

THINK THIS ONE BETTER.
# DOW OVER MA200=BUY/LONG. SELL/SHORT WHEN DOW BELOW MA200. PROTECT PROFIT AT MA100 OR MA200, WHICHEVER FIRST. [AND REENTER AT MA100].Repeat forever...