A much needed reality check
I have shown many times in this blog
that the Dow Theory works unambiguously not only with stock indexes but also with other markets (i.e., HERE and HERE). What do I mean by “work”? I mean four things:
1. That we achieve outperformance v. Buy & Hold (BAH).
2. That we achieve drawdown reduction v. BAH
3. We can apply it to many markets (not an “oddity” with stock indexes).
In this post, I explained why the Dow Theory not only “works” but beats
most, if not all, known trend-following systems.
So, everything seems rosy. Let’s use the Dow Theory, which will be the
stress-free and sure way to get rich. Well, it is true that if one is patient
and long-term oriented, one can get rich. However, I know firsthand that most
people become trend followers with distorted expectations. When confronted with a couple of losing or just sub-optimal trades, they become discouraged and throw in the towel in disgust. Typically, they become trend followers after a beautiful run-up seen from the sidelines (greed) and quit when the recovery is at hand (fear). Lack of consistency and discipline is their downfall.
This post aims to
give a reality check. Below I show the four issues every investor
should cope with when using the DT (or any trend-following system):
1. Most trades are small winners & small losers. Given that, by definition, you seldom buy at the bottom (except Capitulation for U.S. stock indexes, as explained HERE and HERE, and links contained therein) and never sell at the top, you will never catch the whole swing.
2. When you sell, your next re-Buy will, in most instances, be at a higher level, discouraging many investors.
3. Depending on the trending characteristics of each market, you’ll have between 60% and 30% of losing trades. The U.S. bond market, which performed beautifully with the DT, only had 50% of winning trades. Thus, half the time, we had to put up with losing trades.
4. While long-term, the DT outperforms, given the lack of trades, the spells of underperformance may last significantly. From 1953 to 2021 (68 years), there were 21 years where the Dow Theory for the 21st Century (DT21C, which is an improved version of the DT) underperformed BAH. Therefore, ca. 30% of the time, the DT underperformed annually. If we take rolling 5-year periods, things get better: 17.5% of the time, the DT underperformed, which means that 82.5% of the years, the DT outperformed BAH. Hence, patience is vital.
Of course, the four above-mentioned “drawbacks” affect other trend-following systems even more than the DT. The more accurate and profitable the system, the less pronounced the “disadvantages” will be.
So how does the DT achieve outperformance? Every now and then, a significant drop decimates Buy & Hold. By getting out early, the Dow Theory may lose, let’s say, 10% instead of 40% for BAH. To recover 10%, we need 11.11%. However, to make up for a 40% loss, we need 67%. Therefore, the significant drawdowns that sooner or later afflict BAH are the source of the Dow Theory outperformance. According to my experience, even a 15% drawdown may result in outperformance for the Dow Theory. However, it can be challenging for many investors to wait for years for the big drawdown. Years pass by, and the Dow Theory fails to outperform while performing (that is, being profitable). In this post, I proved that the worst years for BAH are usually the best years for the Dow Theory. Intelligent investors will see that the weak correlation of returns between the Dow Theory v. BAH makes it an excellent diversifier. Furthermore, since the Dow Theory works across many markets, the investor should aim to build a diversified portfolio across many asset classes (at least including bonds), and those more sophisticated should even have some allocation to the short side. By going long and short and diversifying across markets, one can significantly reduce the periods of underperformance v. BAH.
The trader must also learn to navigate through uncertainty. When opening or closing a given trade, we don't know whether it will be successful or whether the next re-Buy will be at a higher price (the abhorred "whipsaw"). We go with the flow and take what the market gives us. We know that some trades will result in underperformance (but not necessarily "lack of" performance), and we stay the course. However, many traders get incredibly annoyed when the next re-Buy is at a higher price level prompting them to think that they should become "Buy and Holders". In real-time, nobody knows what will happen after a Sell. We deal with uncertainty. Re-buying at a slightly higher price level is the price we pay for the "insurance" against the big drawdown that sometimes happens. The profile of trades taken under trend-following (and the DT) is that most trades are a "re-Buy" at a higher price level. However, in some trades, the drop following a Sell is breathtaking and more than compensates for the re-Buys at a slightly higher price. Patience and faith in trend following are required.
One trade is statistically irrelevant. However, when several trades pile up, a pattern of outperformance and drawdown reduction v. Buy and Hold emerges. Of course, to reap the coveted fruit of outperformance & drawdown reduction, one must stay the course and not throw in the towel in disgust because one specific trade did not result as expected. If all SELLs resulted in re-BUYs at a lower level, then the Dow Theory (and trend following ) would self-destruct as all traders would gravitate to the newly discovered money-making machine.
Trading is rewarding only for those that understand the game, and the odds, know the strategy thoroughly, and have the psychological fortitude to endure periods of underperformance. There are no shortcuts to success.
Tom Basso, featured in The New Market Wizards, a legendary trend follower, published one book called “Panic Proof Investing” to teach his clients what to expect of a trend-following fund and not panic at the first spell of underperformance. His book is a psychological “fortifier.”
OK. Let’s assume you have read this post so far and are mentally equipped to deal with losing trades, modest winning trades, and periods of underperformance. You may be asking yourself: How much can I make?
The Dow Theory for the 21st Century (DT21C) has outperformed BAH by 3.21% p.a. Drawdown was reduced by ca. 50%. So, in risk-adjusted terms, the DT21C trounces BAH. Many readers will think that a 3.21% annual outperformance is too little. Well, it wouldn’t be that much if we were doing leveraged short-term trading and/or trading specific stocks, not the Indexes. The only way to target higher returns is by doing more trades (but there will be more noise and less signal, so no free lunch), leveraging, sometimes shorting, and picking specific stocks. You will increase your bottom line if you are skilled, but the time commitment will rise exponentially.
However, to beat BAH by more than 3%, without leverage, with less
than a trade per year, and only long, is quite a feat. By definition,
if we measure performance based on years, making more than 3% annually with
trades that last approximately one year is remarkable. As I explained HERE,
there are ways to push the envelope without resorting to (1) overtrading,
(2) leverage, and (3) shorting. Going the extra mile for additional
outperformance not only increases the bottom line but also serves to shorten
the periods of underperformance. The higher the annual
average outperformance v. BAH, the more likely the spells of underperformance
will be short lived. Accordingly, one of my real-money portfolios which I show to my Subscribers is based
on the Dow Theory for the 21 Century (as a trend filter) coupled with high
relative strength ETFs. The system targets 5% overperformance v. BAH but, more
importantly, to shorten the periods of underperformance (which is not a lack of
performance, merely less performance).
So, I am convinced that the DT is a great way to outperform the market with less risk. However, we should know what to expect first and be willing to stay the course. Knowledge is power. But knowledge requires effort. Reading this blog is an excellent place to start.
Do you want to know more? Go to the free area of our website, where you'll find more resources:
Manuel BlayEditor of thedowtheory.com