Learn how to avoid the downside of the market with simple, time tested, quantitative trend following. You don’t need to be a genius.
Using the S&P 500 as an example I explain:
-The problems With buy & hold investing
-How trend following can protect your wealth (from drawdowns and volatility)
-How simple trend following works.
My Blog Post which covers the lost decade between 1965 and 1975
Portfolio Visualizer for Trend Following Backtest
Worlds Longest Trend Following Backtest by Alpha Architect
Avoiding The Big Drawdown by Alpha Architect
Hey everyone what I got open on my screen right here is the last decade of the 2000’s particularly the S&P 500 as represented by Vanguard’s S&P 500 mutual fund that tracks the index. Through the 2000’s, the decade where stocks went nowhere horrible decade for investors you started out with a $10,000 investment in 2000 January first it was ten years later at the end of 2009. You’d lost basically 10%t of your money as you can see right there. So not a fun time to be a you know an investor and you had some big drawdowns, you went you know from having 10,000 down to 6000 then back up and then you lost 50% of your money in the financial crisis and then you kind of started rebounding.
So I started my investing career as an investor in the early 2010’s right after this happened. So you know I was looking at asset allocations and no matter which asset allocation you ultimately see something like this you know. 10 year period things gone nowhere lots of drawdowns if it doesn’t look appealing, I wouldn’t want to be an investor and I still don’t so I refuse to be an investor that is you know investing right here and then losing 40% of my money. That’s got to get painful feeling, I haven’t gone through that yet and I hope I don’t and I plan on avoiding it quantitatively as I’m going to explain here nor would I want to be you know up here with 12,000 in my brokerage account and then get down there below 6000. Got to be a horrible feeling you know this volatility in the drawdown is just not something that most people can sit through and I think a lot of investors say yeah no problem you know I can ride out the drawdowns, I’m in it for the long term but when push comes to shove it just doesn’t work out for them. They can’t do it or they don’t, they might stay invested but they might not be investing more money in for buy and hold the work you have to be investing money you know at the drawdown periods. But for many of us you know our income goes down when we’re in this periods.
So what can we do to avoid the drawdown? Now I’m going to bring up you know a couple of the profits as I call them of the investing world, and I don’t believe any other you know any other garbage one of which is Peter Schiff. Peter Schiff is one of those guys that believes the market is going to collapse, the economy is going to go to shit and only he knows how to protect you from it Now that stuff is junk I don’t think Peter Schiff knows anything more than anyone else, in fact I say that he knows a lot less than anyone else you know but these guys try to pump you into buying gold or some special foreign stock. Usually through some high priced, overpriced investment and they kind of have this following that of people that believe they’re like a god of some sort. That’s just ridiculous, I don’t want to go down that road. I did follow Peter Schiff for a couple of years you know way back you know before I even started investing but the one thing about him is he’s consistently wrong he doesn’t rely on any data he is just a talking head making noise you know and publishing books and market news and all kinds of commentary.
Ultimately his end goal is just to get you into his funds and his investments to make money. So I knew that that wasn’t something I wanted to get into so I researched and kept looking for ways of quantitatively avoiding periods you know like the lost decade here and that led to Trend Following. So trend following basically means that you go with you know the market, so when the market’s going down you stay out of it when it’s going up you get back in and you can do this with a simple moving average. You see the 10 month simple moving averages is the red line here, so if the S&P 500 is above its 10 month simple moving average you’re in it you’re invested. When it goes below its simple moving average and it’s in a down trend you get out and you go to cash. It’s very simple to do, it only requires you know trading once a month you can just look once a month S&P 500 up the very first day of the month. S&P 500 above its moving average you stay in, S&P 500 below it you go to cash or an alternative asset as I will explain.
So you know here you see a period from 1990 to 2012 and this is you know by Med Faber. Med Faber had done a lot of research on Trend Following and has published quite a few papers but let’s see what it looks like in practice. So first we’re going to remove that. Time period I’ve got set from 2000 to 2017, so if the 10 month simple moving average. Or excuse me if the S&P 500 is above its 10 months simple moving average you’re invested as you would be here. One in the 10 month simple moving averages below it you’re out of it you’re invested in cash and you can see that from a time period of 2000 to present the try to follow it started use absolutely kick the ass of buy and hold. You know buy and hold out a cumulative or compound annual return of four point seven nine percent timing portfolio up at nearly eight percent. Not to mention the draw down much lower only a 16.7% drawdown versus nearly 51% drawdown for buy and hold and sharp ratio which measures basically risk adjusted return is much higher than buy and hold.
Now for some people sitting in cash is an optimal you know you can get some return in our asset classes that do get returns particularly those that have a low or negative correlation to stocks and that would be bonds. Particularly Treasury bonds but for the sake of this I’m just going to show it with a total bond market index by Vanguard. So you know when you’re looking at it let’s go back to the morning star right here. Through the last decade bonds pretty much went up, they had a little bit more momentum as things were going down that’s to be expected with a lower correlation. So rather than going into catch you could go into bonds and get a little bit of you know kind of extra returns, little bit of extra returns instead of sitting in cash. So a plug in the you know Vanguard Total Bond Market Index and we’ll redo this and you’ll notice that the annual growth rate goes up a little bit, not a lot just a little bit. Up just over one and a half percent gets you some more returns rather than sitting in cash you sit in a relatively stable asset so you know investing in the stocks when they’re above the simple moving average and then going to bonds when you’re below it has done pretty well. It’s gotten you nearly a 10% return, we’ll call it nine and a half that is what it is you know for the last 17 years or so and minimize your drawdown.
But I don’t want you to think that this trend following strategy is some holy grail, it doesn’t. It’s not here to help you beat the market you know the reason why I’m showing this period from 2000 to 2017 is because there’s a lot of kind of up and down with the market sideways going. When you go into a bull market the trend following the lags behind it so if we go from the period of 2010 to present you’ll notice that the buy and hold portfolio is four and a half, five percent above an annual return above the trend following portfolio. So it’s doing well, it’s a bull market buy and hold is working. So the trend following strategies really work when the market isn’t a bear market and that’s when they shine. Over the long term they equal out, you’re going to get about the same return you know over a long period of time just without the drawdown and volatility. So to illustrate that we’ll set this back as far as this thing can go which is 90’s or, late 8’s excuse me based on the data available for the S&P 500 mutual fund. And you’ll see you know during the bare run of the 80’s and 90’s into the dot com bubble the buy and hold you know index of the S&P 500 just absolutely kicked the trend of followings ass. There are times here when people are probably saying trying to follow him doesn’t work but when the skies go grey and the bears came to town the trend following strategy started to shine and as a buy and hold you know dropped the trend following took off and you know through the end of the 2000 with the financial crisis it still you know went on.
Now we don’t know where our current bear, excuse me bull market is going but it could catch up to the trend following strategy. Trend following isn’t a 100% of the time a winning strategy but it gives you some protection so that you have money when things go south you know. Some of the big things with buy and hold investing is that you’re supposed to be continually investing money but the reality is when we’re in these bear markets your income is lower. Psychologically you don’t want to invest, you want to hold on to cash. So it doesn’t work, you’re not investing when the market is down as you should be you know through buy and hold strategy. The trend following works because it keeps your sanity together, you don’t have to live through the drawdowns I tend to think of it like insurance. When there’s a bull market you’re spending a little bit of money in the terms of percentage annual return to avoid losing money later. That’s how I see it, it’s like an insurance policy to me. When the market goes down I know I’ll have money there to use for whatever I need to use it for or just for my own sanity. And that’s something I’m willing to trade and I think many investors are, I think that the current trend of flocking towards buying old investments is going to go south once we run into a bear market here because many investors are just. Overestimating their risk tolerance they say yeah I’ll be able to live through these I’m in it for the long haul. But when things go down you know 10% down 20% they’re probably going to want out or they’re going to wish they were trying to follow.
The other thing too is not all markets go up forever. There’s the case of Japan, Japan and the Nicki index. It kind of peaked in the in the late 80’s and it never recovered since then and pauses camera for a second while I pull it up. Alright so here’s the Nicki 225 Japan’s index. It peaked right here just before 90, it was up here and it never recovered since then so you know I bet there’s a lot of people in Japan saying Buy and Hold just doesn’t work look at our economy. And there’s nothing to say that the United States can’t go Japan, there’s nothing to say that the S&P 500’s trend is going to keep going up. So a lot of the investors that were you know back in the Japanese markets probably wish they were trying followers now I believe the S&P 500 in the U.S. equities will continue this up trend for the foreseeable future but they might not. You know they always say past is not prologue when it comes to investing returns and while the S&P 500 has had a great return what if it doesn’t? And that’s where trend following comes in and trend following offers some protection, it’s 100% quantitative. You know you can look at the strategy the first day of the month if it’s above the simple moving average you go into your stocks, if it’s below it you go into bonds.
There’s nothing hearsay, there’s no punditry, there’s no talking heads like Peter Schiff telling you oh it’s going to crash. You don’t care you don’t even need to watch the news in fact I suggest you just do not watch the news. I don’t, I don’t care what the news says about the S&P 500 but let’s just see what we’ve got here. Let’s just see what it says today, S&P 500 just did something that is meant gains 100% blah, blah, blah. This stuff doesn’t matter, with trend following all you need are two simple numbers, the current price or total return and the simple moving average and you’re either into your investment or you’re not. So yes you could try to follow S&P 500 but there are ways also to make it more diverse and trend follow other markets, you know we can look and see that this not only appears robust outside of time as we’ve seen here but through other markets as well. So we can take a merging markets for example and you’ll notice. Merging market data only available from 96. And it gets whipsawed a lot more but you avoided a lot of the drawdowns associated with a more emerging markets here and you’ve actually had a higher total return again we don’t know if that is going to happen going forward. We can’t guarantee you’re going to have a higher total return but you can you know avoid some draw downs.
We could do the Eva index, other foreign stocks. I did this wrong. Out of Market asset of bonds. From 2003 again foreign stocks you’d have avoided the big drawdown of the financial crisis and avoided a lot of the, you know up and down volatility since then to have a higher total return. Trend Following works across nearly every asset class and you know if they take my word for it there’s Alfa Architect has done a ton of back tests on it, they’ve even got some back test going back as far as the 20’s with data on it showing how robust it is. So all linked to those in the show notes and let me know if you have any questions you know I think there’s a lot of investors out there that if they knew about trend following and knew how easy it was they would do it and that’s what I’m trying to tell more people about it. Thank you guys.