One Time When Buying Low and Selling High Makes Sense
When you find quality stocks or fund’s with strong management teams, you likely view dips as buying opportunities; eagerly waiting for them to experience a rough patch before buying in or adding to your investment.
Of course, you want to avoid being the sucker at the table – the investor who think s/he’s buying into a quality operation only to see it trend lower and lower because the team abandoned their principles, changed their strategy, etc. To prevent this, you may consider implementing a stop-out point. This does not prevent you from losing money, but it can help you avoid a disaster.
But let’s assume you found a quality team. You can add to your investment any number of ways. The most popular (and perhaps the most practical) way is to re-invest a part of your paycheck every month – to dollar-cost average; to keep buying a little bit at a time no matter what.
Another way is more tactical – to save and invest your dry powder during a dip. You buy in at lower prices with the belief that the stock or fund will trend up again in the future.
Let’s run a simple experiment on the SPY (the popular S&P 500 ETF). Everyone tries to beat the index, but many fail. One way that can help is to overlay a trend-following rule, so we can avoid major bear markets – as shown here. Perhaps, in this experiment, we can find a way to invest more intelligently and improve our returns.
Buy in When Recent Performance is Poor
The SPY’s average 24-month return since January 1952 is 17.53%; the worst 24-month loss comes in at a nasty -52.56% (2007-2009).
Remember, we’re looking for spots when we can deploy more capital to this “quality” investment, the S&P 500 – aiming to “buy low” when recent performance has been poor in expectation that future performance will be better.
One way we can do this is measure recent performance relative to recent volatility; basically, asking “what have you done for me lately?”
The graph below shows the rolling ratio of the SPY‘s 24-month return relative to it’s 24-month standard deviation (volatility). In the red zone, recent performance has been great while the green zone includes periods of poor performance.
When the ratio’s in the red zone, we don’t chase performance by investing more. We invest more when it enters the green zone when recent performance is poor.
Since 1952, the ratio has dipped into the green zone 78 times. When it has, the average next 24-month return improves to 18.88% with the best return being 61.74%; the worst 24-month return is -13.20%.
When investing in the green zone, the average and best-case returns increase while the worst-case return decreases.
On the flip side, if you invest when the ratio sits above the 90th percentile (the red zone), returns deteriorate. When investing in the red zone, the next 24-month average and best-case returns decrease to 15.81% and 60.74% (still solid), but the worst 24-month return increases substantially to -43.67%.
What is the point? That investors have better odds of earning higher returns and suffering lower drawdowns when they invest below the 10th percentile than above the 90th. The lesson is to not chase recent stellar performance and to take advantage of dips, not get scared by them.
The Same Strategy Works When Applying it to Melissinos Trading
Because I have been around a lot less time than the S&P 500 Index, I’m electing to use 12-month rolling periods instead.
In my firm’s case, there have been six instances of this ratio being both below the 10th percentile and above the 90th percentile. On average, when the ratio is below the 10th percentile, the average return over the next 12 months is a solid 14.47% (max 26.98%; min 10%); but when the ratio is above the 90th percentile, the average return over the next 12 months decreases to a putrid -2.08% (max 38.12%; min -15.43%).
These stats reinforce the point that investing when recent performance is poor gives you a better buying opportunity than when recent performance is great.
This gauge can help you avoid chasing returns and deploy your capital more intelligently without your emotions of making and losing money screw it up.
Below are the six occasions when Melissinos Trading’s performance has been above the 90th and below the 10th percentiles.
Past Performance is Not Necessarily Indicative of Future Results
There is always a risk of loss in futures trading.
This communication is for information purposes only and should not be regarded as an offer to sell or as a solicitation of an offer to buy any financial product, an official confirmation of any transaction, or as an official statement of Melissinos Trading LLC. All information is subject to change without notice.
Copyright © Michael Mellisinos
This post was originally published at Michael Mellisinos