MARCH 2013

March 2013

IF YOU ARE TERRIFIED OF BUYING STOCKS, READ THIS

PART II

Now, let’s get into the details.

The following is a nice overall chart of the period analyzed, from 1970, until the end of 2012. Data is taken from Measuringworth.com. We analyzed the daily market closes for the DJIA, everyday, for more than fifteen thousand days (spanning four decades). The chart shows a nice overall evidence of a large upward bias. The overall increase is from 811 points to 13,104 points, about 1,500% increase. In our example here, we do not take into account of any dividends declared, which will push an investor’s returns even higher.

Image 01

The chart above can be deceptive because of its highly compressed timeframe; it only shows that generally, stocks goes up a lot, most of the time.  If one’s take a closer look at a small section of the graph, the blown-up portion will reveal far more details not seen in the overview chart.  According to many “stock gurus”, this is where the money is made.

Illustration 2

Every day, the stock market will either go up, or down. Sometimes, it stays almost the same, but this is rare. From all of the trading days spanning 40+ years, on average we found that 52% of the time, the stock market (DJIA) will end up going up, while 48% of the time, going down. It is almost evenly split between the up days and the down days, however the manner in how this occurs, will guarantee that anyone who buys into the stock market, will end up making money no matter what.

For instance, from the 15,000+ sessions, there were 2,684 peaks and assuming you are a bad timing maestro who always unluckily buys at the peak, how would you fare? Will you consistently lose money, or will you consistently, make money? [This is totally contrary to the market’s gurus who always say buy low and sell high]

The table and graph below shows an example of how we do the analysis for the entire period from 1970 to 2012.

Illustration 3

Illustration 4

On top of that, we also set the bar high, that not just you are buying at the peak every time you make one, you will only sell the stock after it has gained 6.5% from the peak that you purchased it, if it ever goes up that high after falling down right after the purchase.  You will then of course wait until the market goes up, and buy again using the initial money and the profit, exactly at the peak.  What poor timing!

THE BAD TIMING MAESTRO

Despite being a bad timing maestro, the data showed that even if you have bought the share at the first peak and then the stock went down the very next day, provided that you hang on and wait, it will go back up and will then move past that peak (the price where you bought it), on average within 606 days, or a little less than two years.  You are almost guaranteed, to recover your money despite the “poor timing”, plus some profit, within two years (on average).  In the graph above, you would actually have made 6.5% within 30 days, not bad at all for a bad timing maestro!

Illustration 5

The numbers showed that the longest period you could be stuck and need to wait, is seven years, recorded back in the 1977-83 period.  Despite this worst and longest waiting period, it is only seven years, not 10.

Illustration 7

Illustration 7

The shortest waiting period for making 6.5% profit after timing your purchase poorly at a peak?
Seventeen days or just a little over two weeks. It could be shorter if you collect and count the dividends.

Illustration 7

The median or the most probable waiting time after buying from a peak?

308 days or a little less than a year.

That means, typically you can expect to get back your money plus a healthy dose of profit, within a year.

We have counted that there are as much as 41 occurrences where you can make this 6.5% profit, despite buying from a peak, each time! So, even being a bad timing maestro who consistently buys at peaks, you would turn your $25,000 in 1970, to $330,500 at the end of 2012.

If you are an investor that is in the market for trying to help others to make the world a better place (and also you are in for a long haul), you are guaranteed to make a profit based on the 40+ years of data.

The data showed that even if you consistently buy high, you are guaranteed to make a profit by selling it higher, because on average, within two years, the price will be higher by 6.5%. You can surely do better than a bad timing maestro who always buy high, therefore your returns could easily be many multiples more (than $330,500).
Now let us look at several trading regimes and see how they would fare.

BUY WHEN DOWN 2% and SELL WHEN GAIN 2%

Many people are looking for a simple formula, or a simple trading regime that can constantly make them money. For instance, if you program your trading regime to buy whenever the stock market declines by 2% in any single day, and sell when the market goes up by a total of 2%, how much money could you be making? This is an interesting trading regime, but are you guaranteed to make money, more than buying high? Let’s simulate!

We found a total 294 trading sessions where the stock market declined by more than 2% in a single day. Armed with $25,000 as investment money, if you buy the market when the market drops by 2%, and then wait until it goes up by 2%, you will amazingly make, get this- far less than the bad timing maestro total haul; your money would still grow, but only to $94,000 (for a compounded annual return of 3.3% only). This is a lower return compared to the mistakenly buying high all the time regime!

How is that possible? Apparently, once you bought the market, you would miss a lot of ‘other’ wonderful opportunities. It seems that buying the market when it is going down isn’t a surefire bet to make lots of money. On the contrary, buying the market when it is going up can bring you plenty of money, if you are not greedy (and then sell it at the right time).
Despite having 294 sessions available to profit from, you could only participate in 67 of them because your capital would have already been sunk (due to buying) when the market drop by 2% initially.

Under this trading regime, your waiting time for making a profit is 555 days on average, slightly better than the ‘buy high’ always regime. The median is also slightly better, at 244 days. The longest time you could possibly need to wait is lower at 6.9 years only. But remember, your overall profit would be less, but still a profit nevertheless!

Now let’s create a new trading regime, one that can utilize a falling market better, and one that can utilize an upward going market better as well. Let’s set to only invest the $25,000 when the market has declined by at least 5% in several consecutive trading sessions. The argument goes that the lower we buy, the better our chance for making a better than average profit. Let’s also pump up the greed level a bit more, that we program the trade to only start selling after the market has gone up by at least 9%, thus guaranteeing us a profit of 9% on each and every trade that we executes.

BUY WHEN DOWN 5% and SELL WHEN UP 9%

We found 16 events where this trading regime can be executed, but take note that if there are two consecutive declines of 5% or more occurring, and we haven’t sell the previous purchase (since the market went down instead of going up 9%), then we are stuck and will need to wait. From the 16 events, if we did manage to execute and purchase the stock when the market has decline by 5% or more, and we did manage to sell after it goes up by 9%, then our accumulated profit is surprisingly, eerily similar to “down 2% and up 2%” regime. How can our more strategically planned regime of “down 5% and up 9%” turns the invested money to a similar number (of $99,000)? Again, the returns obtained are about 3.4% per annum. And again, both trading regimes are far lower than the “buy high wrongly every time” regime (which turns the $25,000 to a tidy $330,000).

Maybe we are still unable to catch the market at the very bottom, meaning we still buy at a rather high level. Or maybe the incidence is not frequent enough, that we are missing many other opportunities. Hence, let’s modify the trading regime further. Now let’s institute a “down 20% and up 40%” trading regime.

BUY WHEN DOWN 20% and SELL WHEN UP 40%

These numbers are indeed extreme, and the stock market has been down by 20% (in a month) only rarely, only four times in the entire four decades. The final number? It’s $96,000! This is very close to the other regimes; despite executing only four buy trades and four sell trades in the entire 15,000+ sessions!

How is this possible?

Is buying low even a good thing?

Indeed, this is sort of a conundrum to all investors out there, who knew clearly that they are supposed to buy low and sell high in order to make a profit. This study showed that it does not matter at all; in fact buying at any time, including at the peaks, will still result in the investor earning good profits. The data showed that buying as the market going down, typically yield lower returns. Perhaps investors could be missing additional opportunities as the market is trending down. In order to capture more opportunities, we decided to modify and create a new trading regime.

TIER TRADING

Let’s create a tier trading regime, where we split our trades and buy more as the market drops further. This way, we probably can hit the very bottom and make money from it as the market recovers. The new trading regime is “down 5% buy half, down another 5% buy the remainder”. In this tier trading regime, there is significantly more opportunities that can be captured than the previous regime, while ensuring the buys are near the bottom.

Illustration 7

Indeed, with this tiered method, we found that the opportunities available for making profit, has doubled from 16 occurrences to 32. Yet despite this doubling in frequency and doubling of the total trades executed, the total money that is made in the end? Each tier generated the same amount of $49,000 and the big surprise, the total amount made is still similar to the single tier trade of “down 5% and up 9%”.

Apparently buying more of a stock as it goes down, does not really generate more profits.

We are yet to discover any regime that can guarantee you significantly higher profits, each simulation takes considerable amount of time to be completed. If your trading regime is more complex (with conditional ‘ifs’ for instance), the programming will indeed be quite complex. No wonder some people resort to super computer for making trades!

Although we could not uncover a surefire way of making tons of money, we sure do found a way where you are guaranteed to make money, no matter what by buying good stocks. Another highly probable explanation for the similar performance of all the regimes tested is the fact that the Dow Jones Industrial Average Index is an overall performance of the companies in the index. ‘Overall’ and ‘average’ would typically yield well, the ‘average’ and in this case, that’s exactly what happened.

BUY AND SIMPLY HOLD REGIME

It seems that the more complicated the regime, the less money is made (perhaps due to the average of the DJI). So then why not simply buy and hold? Simple and no headache. If you simply invest the $25,000 back in 1970 and never sell them, in 2012 the money would have grown to $379,000. Interestingly, the amount is the highest from all the regimes! Buy and hold does work in the case of owning DJIA index shares.

DISCUSSION & CONCLUSIONS

Some of you may notice that the $25,000 turned into only $300k plus is actually a low number. This is true for all of the regimes, because dividends are not included. If dividends are included, the number could easily triple or quadruple. For example, based on calculations for S&P 500 index data, with dividends fully reinvested under a buy and hold regime, the $25,000 would turn to $1,400,000! That’s a return of 5,670%! (1,475% without dividend reinvestment). Other regimes would yield a number lower than this because some dividends could not be obtained when you are out of the market (calculations obtained from dqydj.net)

Illustration 9

Of course your overall return will beat everything else out there (other than owning high-flying individual stocks).  It is so easy to make money in the stock market, even a consistently wrong timing maestro could do it.  If you think 1.4 million dollars is already exceptional returns, check out the following chart, you will definitely be blown away!

Illustration 10

And to those who want capital guarantee on their money, they can put it in CDs and their $25,000 would turn to about $316,000.

Now let’s summarize the findings in a table:

Illustration 11

Clearly the buy and hold strategy would yield the best result for an index stock such as the DJIA, but for maximum return, nothing can beat owning the stock of a winning company. Your chance of losing money is actually pretty slim, if you invest your money in good quality companies. Watch them closely and rebalance your portfolio as necessary. Your total return will surely be higher than any of those ‘maestro’ out there who constantly buy and sell.

Finding a good company that creates value and is managed well (company whose products and services you buy and like), then you need not worry in buying the company’s stocks. If however, you are trading and trading is your source of income, then it would be hard to make money constantly, as you have to forgo a good number of opportunities.

So, if you are scared of buying stocks, then don’t be. Data has shown that, if you buy and then wait, then by the 8th year, you would have made a profit, no matter what happen to the market in between that. The main thing is, do find a good company or if you are still scared of putting all into one company, then spread your money into several good companies. By the time you need your money, you would have already got a tidy sum of money invested. To know more, read the Personal Finance chapter in the last book of the series – Wealth of the United States; available from Amazon.com.

Now before we end this out of the ordinary monthly publication of ours, let’s assume for once, that you are a wizard capable of predicting the stock market lows and highs. Let’s assume you buy each time the market hits bottom, and sells every time it hits the peak. What will happen to your initial $25,000? We found that there were 2,600 times of such events occurring, and assuming that each time you use your wizardry magic to buy low and sell high, you will turn the $25,000 to, well get this:

6,840,416,137,122 dollars!

Nobody out there did make such a grandiose profit (so no wizard at all out there in reality and nobody can predict the future), and the most an individual can make from the stock market is a couple of billions, and that is nowhere close to six trillion. The yearly return for this unreal wizard is 60% per annum on the money. So should you get a return that high in a year, you know you could have been a wizard, but be warned, greed is not good and don’t push your luck too much!

Special thanks to Measuringworth.com for the excellent data on the DJIA used for the analysis and also the excellent calculators available from their website. Also thanks to dqydji.net for the S&P calculators used to obtain the dividend reinvestment accumulated amount used for comparison with our analysis.

COPYRIGHT 2013- SHARIF RAHMAN & AMY NORWOOD

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