Bob Brinker had a great tweet the other day: “The Problem with buy and hold is not the math, which proves it works. The problem is with the evidence which proves investors can’t do it. ” Our post from last September echos that sentiment: Buy and Hold – The Best Strategy You Can’t Follow.
We know what you’re thinking, and don’t worry… We will not touch on potential reasons (and there are plenty) that make buying and holding stocks so difficult to stick to. Rather, we will touch on trendfollowing as a method to enhance your ability to buy and hold. While the bulk of portfolios should adhere to an efficient method of buy & hold investing, most real world investors need a release valve that can dynamically adjust when probability of large losses increases. Trendfollowing is a way to accomplish that.
Let’s look at the world’s simplest trendfollowing system to help explain what exactly trendfollowing is and why it could make sense within the context of a total stock portfolio. We are using Portfolio123 for the data behind this example. Here are the rules of the system –
- Own the SPDR S&P 500 ETF (“SPY”) as long as it’s most recent price is within 10% of it’s highest value over the last year
- Own Cash if the first rule is not true.
You can see from the rules – this simple trendfollowing system is looking at only the drawdown levels of the S&P 500, as measured by the SPY ETF. Trendfollowing is exactly what it sounds like. When prices are trending in a positive direction, let’s own stocks. When prices are trending in a negative direction, let’s hold cash.
We test this system from January 1999 to July 10, 2017. We rebalanced (or checked our rules) on a rolling 4 week basis. Below is a chart and table of the results: You can see, this simple trendfollowing system slightly trails a buy and hold approach, but it does so with only 66% of the volatility and cuts the max drawdown by more than half. (Drawdown is peak to trough pull back of your account…100k turning into 50k is a 50% drawdown.) Trendfollowing as a tool to help mitigate risk looks compelling. Similar return, less risk; an attractive combination.
While compelling, don’t ignore the negative. The downside of this type of system is the potential to miss out on rebounds that follow large drawdowns in the market. You can see how quickly buy & hold closed the gap following the financial crisis. This system’s “trend on – get back into stocks” signal takes a while to turn back on after a severe fall.
Could you tweak this system to improve it? Probably. But you know how the last 17 years has unfolded, you have the benefit of hindsight. Before you build in the complicated, let us stress the belief that simple beats complex.
Here’s the point – trendfollowing is not perfect, but it stands the chance of being an effective addition to a portfolio. It has the ability to dynamical adjust exposure and brings a form of risk management that’s value shines when diversification alone fails. The potential value add of exposure to trendfollowing could be a tool to allow the rest of your portfolio to stay the course when the course gets ugly. It could help improve your outcome, and after-all, that’s what any investment decision should be about.