The Stock Market: Beautiful One Day, Perfect The Next (Part 2)

Several weeks ago I used simple conditional probability to formulate an optimal investment strategy:

…put your money into the market only if the last month was up.  If the prior month was down then keep/take your money out.  Lather.  Rinse.  Repeat.  In theory this strategy should work about 65% of the time.  If, on the other hand, you put your money into the market when the previous month was down (or sideways) you’ll have just 49% chance of making a profit.
The Stock Market: Beautiful One Day, Perfect The Next

The purpose of the analysis was not, and is not, for anyone to use as financial advice (which I am not qualified to give).  It was for academic interest only.  And this remains the case.  However, I wanted to measure how the theory would “work” in the “real world”.

I decided to test my theory over a timeframe covering the last five years.  This has been an interesting period on the Australian Stock Exchange (ASX) to say the least.  Several years of a huge bull run completely wiped out in 12 months by the Global Financial Crisis.  I wondered how my investment strategy would hold out against that kind of shenanigans.  Using monthly average ASX All Ordinaries adjusted close indexes (AORD) I invested a theoretical $10,000 in the market at the beginning of January 2004.  Strategy 1 is my optimal strategy: put money into the market only if the previous month was up.  If the previous month was sideways or down then pull your capital out.  Strategy 2 is the control: capital remains in the market.  For example, the first six months of capital growth using Strategy 1 and Strategy 2 would look like this:

(adj close)
Monthly Δ Strategy 1
Strategy 2
Start $10,000 $10,000
Jan 2004 3283.6 -0.7% $9,932 $9,932
Feb 2004 3372.5 2.7% $9,932 $10,201
Mar 2004 3416.4 1.3% $10,062 $10,334
Apr 2004 3407.7 -0.3% $10,036 $10,308
May 2004 3456.9 1.4% $10,036 $10,456
June 2004 3530.3 2.1% $10,249 $10,678

Between January 2004 and October 2008 there were 58 months in total.  For 39 of those months the ASX All Ords went up, and the average percentage movement of these “up” months was +2.6%.  In the remaining 19 months the index went sideways or down, and the average percentage movement of these “flat/down” months was -4.1%.  This has obviously been skewed by the market meltdown over the last year or so and the last two months in particular.  We’ve seen some horror months on our Stock Market lately.  For example the AORD fell fell a massive 11.3% in January 2008 (looking back this was the death of the coal mine canary), 11.2% in September 2008 and then fell 14.0% in October 2008.

But what if you had used my investment strategy over the last five years?

Well the bad news is that Strategy 1 quite significantly underperformed Strategy 2 during the bull run.  A few relatively minor flat/down months here and there meant that capital was pulled out and very healthy returns would be missed during the subsequent month.  But the good news is that Strategy 1 protected the investor against the financial meltdown.  By October 2008 the initial $10,000 invested using Strategy 1 in January 2004 was worth $14,508 (average growth of 8.0% p.a. compounded) vs. $12,047 (3.9%) for Strategy 2.  So the really good news is that Strategy 1 outperformed the market by more than double.

Woo hoo!

Enough hubris.  Of course things are a lot more complicated in the real “real world”.  For a start, history is no guarantee of future performance.  Strategy 1 might look good on the spreadsheet but carries more risk.  Also, the success of Strategy 1 over Strategy 2 assumed no brokerage fees.  And it took no account at all of dividend payments or relative tax consequences.  Under the weight of these considerations Strategy 1 doesn’t look quite so “optimal” after all.

But an interesting result nonetheless.




2 Responses

  1. What would happen if you varied the time frame on your strategy? Possibly to week or even day?

  2. That is a very good question. I’ll have to revisit the data. I’d also like to test the theory on other stock market indices such as the Dow Jones.

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