How often does the Dow Theory outperform buy and hold? Part III
In my post “How often does the Dow
Theory outperform buy and hold?”, which you can find here, I
started a series of articles dedicated to examining the classical/Rhea Dow
Theory “flavor” under all market environments and across time.
At the risk of repeating me, it is worth
remembering some interesting findings we made.
We found out that the Dow Theory outperformed buy
and hold. Both in raw terms (average returns) and risk-adjusted returns (much
lower standard deviation of returns).
However, it was also ascertained that 41.2% of
the time the Dow Theory severely underperformed buy and hold. Only 29.4% of the
time managed the Dow Theory to outperform buy and hold. Therefore, the overall
Dow Theory outperformance was made in relatively few, but critical,
years. I encourage you to read that post
and absorb all its details.
I made clear too that the Dow Theory
tended to underperform buy and hold during bull markets. However, I didn’t
provide the readers of this blog with specific figures relating to secular bull
markets. This is what we are going to do in this post. By the way, an in-depth
study of what happened during the secular 1966-1981 bear market can be found here.
We are going to focus our attention on the
1982-1999 bull market. How did the Dow Theory fare?
It fared well, but its performance was slightly
less stellar than that delivered by buy and hold. So, once again, it is
confirmed that the Dow Theory comes really in handy when the going gets tough. There
is no need for protection when the market is in a smooth ride. And as explained
here and here, timing devices rarely outperform bull markets.
During these 18 years, those that bought and hold
the Industrials made an average gain of 15.94% annual.
Those following the Dow Theory (in its
classica/Rhea “flavor”) made an average gain of 14% annual.
So the Dow Theory underperformed buy and hold by
1.94% on an annual basis during the secular 1982-1999 bull market.
This is fully in line with the findings we made in
the first post of this saga. The Dow Theory underperforms when markets go up.
However, true to its “protector” function, the Dow Theory managed to make
+24.21% in 1987 (the year of the crash) whereas buy and hold made a meager
+2.26% for the year.
Hence, in such fateful year, the Dow Theory
managed to outperform buy and hold by almost 22%. Not bad, I think!
But yearend figures are only part of the story. If you read mypost concerning the 1987 stocks market crash, you will learn that the loss
experienced by Dow Theorists from the top amounted to only -13.49% whereas buy
and hold endured a loss of -36.13% from top to bottom.
An image is worth more than thousand words, I
encourage you to read the 1987 crash post and, more importantly, look at
the chart. It says anything you need to know.
1990 was not a particular good year for the stock market. Buy and hold lost
-4.34%. The Dow Theory made a somewhat modest loss of -4.28%.
Now let’s break down the out and underperformance of the Dow Theory versus buy and hold.
In only 2 years, the Dow Theory managed to outperform buy and hold.
As you can guess such years were 1987 and 1990, namely when there is trouble in
the air.
In 8 years the Dow Theory equaled buy and hold. Those were typical secular
bull market years when the Dow Theory remained fully invested along the primary
trend during all the year. Thus, the Dow Theory remained fully invested from
1993 to 1997, that is five consecutive years. This gives you a measure of the
strength of the secular bull market.
In 8 years, the Dow Theory underperformed buy and hold.
Now let’s
take a look at the standard deviation of returns. If you go back to my post “DowTheory’s performance during the secular 1966-1981 bear market," you’ll see that the standard deviation of annual
returns for buy and hold during such a vicious bear market amounted to 17.43%
(the Dow Theory had a much modest standard deviation of only 10.99%).
During the
secular 1982-1999 bull market, things were different. It was such a bountiful
period that the standard deviation of returns for buy and hold declined to only
11.45%, which was slightly lower than the standard deviation for the Dow Theory
at 11.60%. I do think that such secular
bull market was the closest thing to nirvana for buy and hold investors, which
perversely, resulted in blinding them as to the realities and hidden dangers of
buy and hold when one doesn’t have the privilege of having permanent tailwind
(something similar doomed famed Dow Theorist Schaefer).
The slight
underperformance of the Dow Theory during the 1982-1999 secular bull market may
disappoint investors. However, what I wrote here remains fully applicable:
1.
The Dow Theory smoothes out performance. It tends to deliver less than
buy and hold in “good” years, but delivers much more in “bad” years. All this
is accomplished with a higher average annual return. Such smoothed performance
implies less risk for the investor and in technical jargon, we would say it has
a higher Sharpe Ratio.
2.
Such smoothed performance is the closest thing to a free lunch. I am
sure most seasoned investors would settle willingly with 2% less annual
performance (i.e. 8% instead 10%) in exchange for reducing volatility, and draw
downs. This is why bonds are successful in the first place. Or to put it
differently, if there was an insurance that covers draw downs most investors
would be willing to pay a premium of, say, 2% in order to protect themselves
against the unexpected. This is why “puts” and derivatives are successful too.
The Dow Theory provides us with ca. 2% annual average out performance
while reducing dramatically volatility. It is like the insurance company paying
us to buy its insurance. Not bad at all.
3.
Investors get blinded by performance. However, in real life, the investor is
killed by draw downs. A 15% average performance is worth nothing if,
somewhere along the road, there is going to be a draw down of -50%. Buy and
hold is nice in theory, and it may work provided the investor has deep pockets
(staying power) and psychological fortitude. However, in real life, very few
investors possess both attributes at the same time. Thus, the publicized
return figures of many investing strategies are not attainable in real life
because the investor cannot endure the draw downs. If the average retiree needs
to draw 4% off his capital annually (and this is a very realistic and even
modest assumption), a draw down of 50% in any given year, will force him to
draw 8% if he wants to keep his expenditures intact. Of course, he can cut with
expenses, but as we well know, this is not an easy feat. Even if the retiree
manages to reduce expenditures by 25%, this implies a withdrawal of 6% while
being in the midst of the draw down. As a result total equity would be reduced
by 50%+6%, thereby remaining only 44% of his original capital. A draw down of such
magnitude is akin to a black hole. It is very difficult to escape from it. In
most instances, the retiree will finish by eating up all of his capital. Game
over for him!
4.
Therefore, the Dow Theory by strictly limiting losses in the “bad” years
(remember in “bad” years the Dow Theory lost -0.95% versus -16.72 for buy and
hold) clearly helps the normal investor lacking unlimited funds and/or
mental fortitude. Furthermore, average returns don’t give the exact picture.
Buy and hold lost on a year-end basis
more than 30% six years, whereas this never happened with the Dow
Theory.
Have a wonderful weekend.
Sincerely,
The Dow Theorist
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