Is simplicity the best way of investing? (based on historical data)


With the huge volatility in the market in recent months due to the many unprecedented events (is it me or do you all think that the word unprecedented has been heavily used nowadays), there have been many questions from many different groups of people on the topic of investing. Some of these questions are "Is this the best time to get into the market?" or "Is this a dead cat bounce?" etc. Most of these questions point to the same topic of trying to understand what's exactly the best way to invest.


Could we actually use historical data and perhaps some statistics to understand this? That's what we are about to find out in this article.


First, what's the most common way of investing for most of us here? I believe the usual way is to create our very own portfolio of stocks based on what we believed to be the best set of criteria that no one else ever thought of. We are very confident of what we have chosen and swore to protect this carefully selected portfolio from any possible criticism till the end of time. We took every challenge to our portfolio like a personal challenge to our intelligence and would be ever ready to take on any challenger with a full suit.


Essentially, what we are trying to do is to be our own fund manager.


And how well do fund managers did in recent history?


In an article published last year by CNBC, it shows that most large-cap funds have lagged S&P 500 for the nine consecutive years. Not only did these funds lagged the index for nine consecutive years, it was also found in a study done by S&P that almost 92% of large-cap funds lagged S&P 500 after 15 years. While some of these funds have initial success in beating the index in the one year (roughly around 35.5% of the funds), the percentage dropped quickly as the time horizon lengthens. Now, even most professional fund managers have failed to beat the index. What make us think that we could?


And that's actually the most interesting part. Everyone likes to think that he or she can beat the statistics. Everyone likes to be the hero in his/her story. I'm not bursting your bubble here and tell you that you cannot be one of the chosen ones by the universe to beat the index. What I'm trying to paint to you here is that statically speaking, you are much better off buying the index.

Ok great! Should I run off to buy the index and hold it till the kingdom come?


Let's take a look at the history of S&P 500.

As you can see, the market has been in an uptrend though you might have the dumps during the bear markets like the one in 2009 or even the Great Depression in 1929. No matter how bad the market depression once was, the market always recovers and resumes its uptrend throughout history. At this point of time, we might be starting to cheer and think that we have find the cure to world hunger, I mean the best way of investing, and start to put all our funds into the index and never look back.


That's what quite a lot of people believe in and also why many people think that passive investing is the best way forward. While we have established index investing gives you much higher chances of success in your returns, I think the jury is still out on whether passive index investing is the way to go. Could we have even better returns if we were to do active index investing?


I came across this interesting and heavily discussed reddit post which was posted 2 years ago. In this reddit post, the author did a fantastic job in backtesting a few simple market timing strategies against the buy-and-hold strategy for 100% stocks (in this case S&P 500) and the buy-and-hold strategy for 100% bonds (in this case 10-year Treasury Bond) based on data since 1871! Before we proceed on with the results, let's take a look at what are the few simple market timing strategies which are being used here.


Strategy 1- Sell the stocks (S&P 500) when the S&P 500 closes below its 200-day SMA and buy the bonds (10-year Treasury Bond). Hold the bonds until the S&P 500 closes above its 200-day SMA and buy the stocks when that happens.


Strategy 2- Sell the stocks (S&P 500) when the 50-day SMA of S&P500 closes below the 200-day SMA and buy the bonds (10-year Treasury Bond). Hold the bonds until the 50-day SMA of S&P 500 closes above its 200-day SMA and buy the stocks when that happens.


Both market timing strategies are not difficult strategies. In fact, they are relatively simple. You just need to look out for very few technical indicators like the 50-day SMA, 200-day SMA and also the stock price.


Now, back to the results. How do these market timing strategies fare based on historical data from 1871 to 2017? You may view a fuller version of the results breakdown from the author here.

(Sharpe ratio is only calculated since 1943 as the author is using the yield on 3-month Treasury Bill as the risk free rate)


Surprise, surprise! Both market timing strategies turn out to have better results (in terms of CAGR, Sharpe Ratio, Max Drawdown) than the usual conventional methods of buy-and-hold. I wont go into details on what does each of these metrics means as you can refer to the links. What I will like to point out here is that simple market timing strategies like the common one highlighted here not only protect your investments (with a much lesser max drawdown). They also provide you with better returns in terms of CAGR and relative to the risk taken (sharpe ratio). While strategy 1 seems to work better than strategy 2 across the entire historical period, the author has also clarified that strategy 2 works better than strategy 1 if you focus only on historical data from 1999 to 2017. I strongly encouraged you all to read his post in full.


However, do note that these strategies usually work well until they don't (if you know what I mean). This is also why strategy 2 works better in recent years as compared to strategy 1. While historical trend and data could allow us to make better decisions, they are not 100% effective in predicting the future. In fact, nothing does. It's just that when you base your decisions on statistics and data, you are making a more informed decision than someone who invests based on gut feelings.


So where do all these bring us? Is simplicity the best way of investing?


Well, yes and no. While statistics has show that simplicity in the form of index investing give you better chances of success than stock picking, the data shown here has also highlighted that simplicity in the form of buy-and-hold forever is not always the best way. Hence, a little complexity in terms of market timing strategies is still needed to maximise your returns and protect your investments. Even with these little complexity, I will say it's still fairly simple.

Isn't it? #datascienceinvestor


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