Wednesday, December 3, 2014

Dow Theory Update for December 3: Why the Dow Theory works. Its non-parametric nature

A greak book on momentum I recommend.

I have just read a very interesting investment book entitled “Dual Momentum Investing: An Innovative Strategy for Higher Returns with Lower Risk” by Gary Antonacci.

It is a very well researched book written, though, by a practitioner. The main thesis of the book is that relative strength (i.e. buying the top 10% performing stocks, or buying the best-performing  asset class) coupled with absolute momentum (that is assets or stocks that are in a positive trend) increases performance while drastically reducing drawdowns.

Furthermore, the book contains a vital insight: The strategies proposed by Gary are non-parametric (that is they do not depend on moving averages, oscillators, etc. with a predetermined look back period). He makes the conclusive case that non parametric systems are much more dependable when looking forward than parametric based systems (i.e. a moving average). In other words, they are more robust and likely to continue to perform in the future.

While the strategies suggested by Gary have nothing to do with the Dow Theory (even though they could benefit from it), I derive two conclusions:

A) Trend following (and the Dow Theory is a sophisticated, albeit not overfitted, way of trend following) works, it has worked for the last 200 years, and due to human biases as well even fundamental factors (good or bad economic conditions tend to persist), it is very likely to continue outperforming buy and hold in the future.

B) Non parametric trend following is much more dependable and is more likely to work when “out of sample." This insight speaks ill of moving averages, but highlights the beauty of the Dow Theory which does not depend on moving averages or lookback parameters but merely on the completion of patterns. Readers should re-read this paragraph until it soaks in. Non parametric systems have a built-in advantage when looking forward than parametric ones. This is why I have such strong faith in the Dow Theory: it has a huge track record, and there is no risk of overfitting.

No more words are necessary. You just need to cogitate (or even search on the web) over the advantage of non-parametric systems.

The Dow Theorist

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