Use This Simple Math Trick to Book 80% Gains…

It’s time to bust some myths about everyone’s favorite way to invest: buy and hold.

For starters, there’s no such thing as a “buy and hold forever” approach (no matter what certain octogenarian billionaires in Omaha may claim). That’s because anyone who has ever tried it is broke.

Even though everyone in the industry calls index investing passive, there’s nothing passive about it. The Dow, the S&P, and the Russell are all active investment strategies.

“Of all the stocks that were part of the original Dow Jones Industrial Average, only General Electric is still a part of the index,” our stat man Jonas Elmerraji says. “The index has changed 48 times since it was created — all of those changes being picked by the editors of The Wall Street Journal. That means that the Dow is, in fact, an active stock-picking index.”

The S&P 500 is no different. S&P components are picked by a committee at Standard & Poor’s, who try to make the index mirror the 500 biggest stocks on the market. Since the rules on who makes it into the S&P 500 are largely based on who’s the biggest, stocks that fall get tossed out, and stocks that increase in value get added. So, in other words, the S&P committee is selling the losers and buying the winners.

The bottom line is this: passive investing doesn’t spare investors from the risks of stock picking. It just takes the stock picking off portfolio managers’ plates and leaves it up to Dow and S&P. That doesn’t always work out very well. During the 2000 – 2012 secular bear market, the S&P 500 lost just over 2%. So much for “buy and hold” always delivering long-term gains.

But there’s a better way to invest…

The key is in that phrase I mentioned from the S&P: selling losers and buying winners. It’s ironic, but the most successful long-term strategy any fundamental investor can point out is an approach known as trend following.

“The main idea behind trend following is simple: the market moves in big, long-term trends, and if you can identify them, you can ride them. It’s an approach that some of the most successful investors in history have used — and one you can use too,” Jonas continues. “Trend following can also avoid the pitfalls that index investors have struggled with over the years. You see, the S&P’s approach to trend following is crude at best. Since correlations between stocks in the S&P are very high, it’s not as effective at reducing risk as it could be. That’s why a purpose-built trend following approach makes so much more sense than all the buy-and-hold brouhaha.”

For trend followers, there are basically two steps to figuring out what to buy: identifying when a trend begins and identifying when a trend ends. To do that, we don’t rely on emotion or opinion. Instead, it’s critical to base any investment decisions on a set-in-stone system.

Let’s build a quick system using a bit of simple math…

You’ve probably heard of a moving average. In short, it’s the average price of a stock over a set number of days.

A moving average is a great indicator of trend. If it’s moving steadily higher, then we know that a stock is generally moving higher over the period that we’ve set. More importantly, we can define moving averages mathematically, so, we’ll go ahead and use a moving average as our trend indicator.

For simplicity’s sake, we’re going to apply it to just one investment: the SPDR S&P 500 ETF (NYSE:SPY).

So let’s create a quick rule. If SPY moves above the 300-day moving average (a long-term average that approximates a year’s worth of price data), we’ll buy. If it falls below the 300-day, we’ll sell.

“In real terms, that rule says that if SPY moves above the 300-day moving average, the market is entering an uptrend, and if it moves below, it’s entering a downtrend,” Jonas concludes.

So, how would that simple strategy have fared during the previous bear market?

The chart below shows the hypothetical profit and loss of sitting back and letting that simple system trade for you:

All told, you’d end up with gains of 74.3% — nearly double the 40% and change that a buy and hold approach would have earned you.

But there’s an even more exciting story here.

See the handful of flat lines with red arrows pointing to them over that period? Those are the times you’re out of the market because the system said “sell”.

That means you wouldn’t have touched stocks for almost 2 years while the tech bubble was bursting. You also would have been out of the market for all of the 2008 crash.

You can see just how dramatically a simple system like this reduces the risks of being an investor. Despite the hands-off approach to investing, you still beat the market by a wide margin.

Remember, the rules we demonstrated today are crude. But by adding some extra simple short selling rules to the approach, this same trend following system could have upped its total profits to 80.8% by making substantial gains when the floor was falling out for everyone else in 2008.

Of course, we can improve performance beyond the system we created today. Adding individual stocks, more complex rules, or introducing statistical optimization are all things that can easily improve returns under a trend following system.

But the key here is the fact that following trends (and not trying to predict them) can fuel some incredible returns while smashing risks much lower than you’d see from a “buy and hold” approach.

Sincerely,

Greg Guenthner
for The Daily Reckoning