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Simple investing rule which outperforms NASDAC by 8%?

Discussion in 'Investing Strategies' started by try anything once, 29th Oct, 2008.

  1. try anything once

    try anything once Well-Known Member

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    Beat the Index by 8% PA?

    this is a repost from a few days ago. I got no takers so I thought I would try a more provacative title! I'm a firm believer in "you can't beat the index" but for the life of me I can't find fault in the results - please help!
    ================================================

    With all the boom and now bust headlines everywhere now it got me wondering whether the best time to be in the market may be when it is not too hot and not too cold - but "just right" somewhere in the middle (like Goldilock's breakfast!!)

    To test this theory I downloaded from Yahoo finance the price history for various world indexes and analysed whether there was an correlation between the historical 1 month, 4 month and 6 month index movement, and the forward 12 month performance. What I expected to see was for example that if the index has grown by more than 25% over the previous 4 months then the market is overbought and the next 12 months will be painful. Severely negative movements over 4 months (eg more than 30%) signal oversold/capitulation and the next 12 months will be better than average.

    I analysed AORD, S&P 500, NASDAC, Straits, Hang Seng, with as much historical data as I could find.

    Conclusions? some but not all indexes behaved in this way. AORD in particular showed little correlation. But a handful of indexes showed remarkable results.

    For Nasdac, by applying a "Goldilocks" style rule, the performance of the overall index could be bettered by at least 8% pa over the period between 1972-2008. Not only that, but there were only 8 years in this 36 year period where the index performance was not bettered. A similar result, (but with a different rule) could be achieved for the Singapore Index.

    Of course, since the underlying asset is the same (ie the index), the difference in performance is entirely to do with the level and timing of exposure to the market generated by the rule at any given time.

    This last point caused me to pause and question the result given the old addage of "timing the market" versus "time in the market". Also, the thought that if beating the index was this easy every pr**k would be doing it. So I would dearly like the results confirmed/validated by someone else.

    Any takers? If you are handy with spreadsheets and are interested in helping then let me know and I'll describe the rule in more detail
     
    Last edited by a moderator: 29th Oct, 2008
  2. AsxBroker

    AsxBroker Well-Known Member

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    Hi TAO,

    "A Random Walk Down Wall Street" agrees with you.
    Whether it's on NYSE, NASDAQ, ASX or any other exchange.

    Cheers,

    Dan
     
  3. try anything once

    try anything once Well-Known Member

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    ASX Broker

    Ok but as I said - whilst my head says it can't be done my spreadsheet is telling me otherwise. Hence the request to have someone independently verify my anaylsis/conclusions. :)

    Are you handy with excel modelling?
     
  4. ilori

    ilori Well-Known Member

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    Just on the idea of "can't beat an idex"... it seems very easy to beat an index from mathematical perspective... a couple of examples.

    1. If an index is declining, you simply exit the market. Even if you achieve 0% you will beat a declining index. (Zero is greater than any negative number.)

    2. An index is an average, by definition it includes a range of performances. If you have a simple system to select the better performers will beat an index. Eg. an index might contain 5 stocks with annual growth rates of +40%, +30%, +2%, -5%, -20%. The index would be +9.4%. A very simple system that says 'I will not select declining stocks/sell declining ones already held' will give average of say +24% ((40+30+2)/3). This is simplistic of course - but robust investment strategies can be built on this baic idea.

    Inability to beat an index may be an issue for massive funds who have a limited universe of investment. But it's debatable if their primary goal is the performance of the fund anyway. Cashflow comes management fees which are related to the the size of funds.

    Regards, Ilori
     
  5. AsxBroker

    AsxBroker Well-Known Member

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    Hi Ilori,

    1. If you did this you would then be benchmarked against a cash index not a share index (for the short term). If this was the case, would investors be better off investing in cash in their own name rather than paying MER?

    2. As an index is an average, half of funds "should" better it and the other half not. Fees obviously lowers returns compared to an index and also survivorship bias means that funds over time will disappear. Over 20 years there wouldn't be very many investors (apart from Buffett) who can continually out-perform the "average". They certainly don't seem to work at many fund managers, as there never seems to be one that consistently outperform it's peers through differing economic environments. Some fund managers actually say they prefer to continually be second quartile because they know it's alot harder to be continually first quartile.

    Performance and size of the fund is closely linked and both are their main goal. Fundies get paid a flat % MER/ICR (and some a small performance bonus). If my fum is $10m and I get a 1% PA MER, I get paid $100,000. Now, if my fund grows 20% and fum is now $12m and I get my 1% PA MER, I get paid $120,000. It's very much in the best interest of the fundie to maximise performance to ensure continual flow of new funds while keeping existing funds. I think some fundies are going to have less to spend on their xmas parties this year...

    Cheers,

    Dan
     
  6. try anything once

    try anything once Well-Known Member

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    thanks Dan - well explained

    Oh and for those who believe buying early in bull market and selling early in a bear market is an easy thing to do, I would suggest having a good look at market histories.

    If you look at the AORD in the period from 1969 to 1973 I suspect anyone attempting to do the above (timing the market) would have lost a lot of money - far more than someone who simply sat in the market throughout the period.
     
  7. Simon Hampel

    Simon Hampel Co-founder Staff Member

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    ... as the financial sage Kenny Rogers once said:

    "You got to know when to hold em, know when to fold em,
    Know when to walk away and know when to run.
    You never count your money when youre sittin at the table.
    Therell be time enough for countin when the dealins done."
     
  8. ilori

    ilori Well-Known Member

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    Thanks for the reply Dan,

    With respect, I think my points still stand (unless I'm just very confused, which I may very well be :) ).

    Going to cash in a crashing market is a prudent action to preserve capital, it's part of money management while still maintaining an equity investment strategy. When the market falls, you 'click' out and go to cash... the portfolio will outperform the index. I agree if you're forced to sit in cash for a long time because the market is totally unworkable then an issue might develop (if managing other people's money) - but will still be in a better position than portfolios holding shares all the way down, locked into paper losses and forced to spend 'time in the market' waiting/hoping for recovery.

    Generally, I believe an equity investment strategy doesn't have to be fully invested all the time. Being out of the market is a valid position - or a least it should be.

    As a general rider for my comments - when I talk about beating indexes I would't be referring to the large household funds. I haven't studied them in detail but it seems to me they have inherent issues with the size of the funds they manage - they will be 'market movers' and will have a limited range of companies they can invest in. Also, as I understand it, they must adhere to investment policies, weightings etc. which can work against them (even being forced to sell successful parts of a portfolio to 'rebalance' in line with less successful parts). Then there are overhead costs which must be deducted. I sometimes wonder if their focus in on marketing, building large funds, and then tracking a benchmark (which may be formed by similar funds anyway).

    Beating indexes can certainly be done by smaller operators (and have proven to myself that an individual can do it). An index is forced to include all component companies - those performing well and those performing badly. As an investor however, one has the freedom to include the good ones and exclude the bad ones. This effectively gives a better group of companies than the index and a higher average performance.

    Seriously, if there is a flaw in this idea would like to hear, as it seems robust to me. I've heard the idea that can't beat an index, but just can't buy it (it even seems illogical idea to me given the way I look at it).

    Anyway, just my thoughts on it :)

    Thanks again...

    Regards, Ilori
     
  9. ilori

    ilori Well-Known Member

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    Thanks Sim :) I think you and Kenny are spot on - knowing when to fold em and when to walk away...

    not wanting to be tooooo analytical... but "You never count your money when you're sittin at the table" probably touches on the psychological element of it all too...

    Lot of sense in dem der lines :)
     
  10. try anything once

    try anything once Well-Known Member

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    Ilori

    I think the flaw in your logic is "exit a declining market". The fact that the market has been declining in the past few weeks, has little correlation with the negative performance of the market for the next 12 months.

    By the same token, a rising market for past weeks/months does not give you a higher chance of double digit returns for the following 12 months. (on the contrary - the analysis I have done suggests it is worse than average)

    If there is any correlation, it seems to be that the 12 month forward returns are most spectacular in the period immediately following a drop in the market of more than 25% over a four month period. These periods are extremely rare (<1% of time), but when they happen, 80% of the time the market returns for the next 12 months are very high.

    As for picking stocks within an index, perhaps it could be done but I think it would be a full time job. Lets face it, even people who work for ASX listed companies have a hard time knowing something the market doesn't about where the share price will be in the future.

    Given that I can't do this full time, (and even if I did I don't think it would make s difference), I'll stick with indexing.
     
  11. Neil_Salkow

    Neil_Salkow Member

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    When making an investment decision, there are a few issues one needs to consider:

    “Do you use direct or indirect investments?”

    Unless you feel that you or someone that you trust can pick winning stocks or consistently, it would be reasonable to rather invest indirectly through professional fund managers.

    “Do you use an active manager or a passive manager?”

    There is extensive academic evidence to show that active managers cannot consistently beat the market. Since they have higher operating costs, as they need to hire more analysts and professionals to run their funds, they are normally more expensive. They also have high turnover as they are actively trading, resulting in higher transaction costs. They would need to use their ‘skill’ or time the market consistently over the long term to ‘beat’ the market after fees and therefore their passive management counterparts.

    Passive management is less expensive and there is not the additional ‘key man’ or ‘manager’ risk involved in these funds as opposed to active management. In light of the overwhelming evidence, and the benefits of passive management my preference is to use fund managers that do not base their investment decisions of the basis of market timing, forecasting or apparent skill.

    “Do you care about tax efficiency?”

    If the answer to that question is yes, then when selecting from the universe of available passive managers that are of investment grade, you are left with a handful (or less) of available funds.

    “Do you want to value tilt the funds?”

    Academic evidence has shown that expected return of equities is determined by three factors – equity markets, company size and company price. (Rather than stock selection, market timing or random factors in returns).

    3 Factors

    Equity Markets – Stocks have a higher expected return than fixed income and carry a larger risk.

    Company Size – Small company stocks have higher expected returns and risk than large company stocks. (Size is measured by market capitalisation)

    Company Price – Lower-priced “value” stocks have higher expected returns and risk than higher-priced “growth” stocks. (Price is measured by ratio of company book to market equity)


    Create your asset allocation that you are happy with (ie the risk you are willing to accept) and stick with it. Trying to time markets consistantly is not only impossible, it is a costly exercise (especially if you get it wrong).