Comparing 5 Investing Strategies

"Don't try to time the markets".
"SIP is the best way an average investor can participate in the stock markets."
"Asset Allocation is critical. Allocate your assets across stocks and bonds according to your risk profile".
"Hold stocks for the long run".

The professional investment community loves to push such advise to the average investor. Investors, in turn, fall in line and play along thinking that the advisors are experts and hence know best. Such statements become gospels and people follow them blindly.

Do such statements really hold weight? An examination is worth the time spent.

But first, let us figure out what constitutes a good investment.

The most obvious thing is return on investment. Everyone wants this to be as high as possible. Thats a no-brainer.

However returns are not risk free. An investment that offers higher return than another one with the same amount of risk is a better investment (all other things being equal). We like to make a lot of money with the least risk possible (unless one seeks thrill out of risk taking). Hence risk is another parameter of an investment.

Returns can be stable or returns can be volatile. When returns are volatile, we experience large swings in our equity. While we love it when we get large upswings, large downswings cause large depletions in our equity, they cause anguish and anxiety. Normal people would, given all other things being equal, rather not have such large downswings. Hence a downswing (peak to trough move called a drawdown) is another parameter we should measure.

Some people might seek high returns and be willing to tolerate high drawdowns. Others may be happy with lower returns but a lower drawdown. It depends upon the investor. To equalise drawdowns, we compare it with the return and arrive at a ratio (lets call is the Stress Ratio) as drawdown per unit return. i.e Drawdown/Return.

The lower the Stress Ratio, the lesser is the drawdown compared to the return, hence the lesser the stress caused to the investor.

(I have not considered standard measures such as te Sharpe Ratio, Treynor Ratio etc since they are period dependant for calculating the standard deviations)

With this little background, let us compare 5 different investing strategies.

All of them have been back tested on the S&P CNX Nifty from July 1990 (max data available) till July 2008, i.e. 18 years. Each assumes a transaction cost of 0.6% mainly as brokerage. The strategies are as follows:

1.) Buy and Hold:
You bought the Nifty in July 1991 and held on without any activity over the entire duration. Stay invested for the long run.

2.) Asset Allocation based on Price:
You split your money in the ratio 70:30 between the Nifty and 1 month Fixed Deposit and rebalanced your portfolio every month to maintain this 70:30 ratio. So if stocks went up and the ratio of stocks in your portfolio exceeded 70%, you sold some stocks and put the proceeds into a 1 month fixed deposit so as the restore the ratio to 70:30. When stocks fell, you did the reverse. Automatically, you bought stocks low and sold them high...seems nice, doesnt it?

3.) Asset Allocation based on valuation:
You use the Price to Earnings ratio (PE) of the index to decide your equity and debt allocation. You set a percentage for equity (100% in equity if PE <=15 linearly decreasing to 50% for PE = 25 and then linearly decreasing faster till equity = 0% for PE>=30) depending upon whether the index is cheap or expensive. Automatically, you bought stocks when they were cheap and sold them when they got expensive...again, seems very sensible.

4.) Cost Averaging or SIP
You invested a fixed sum of money into the markets through the Nifty first trading day of every month, month after month. You bought more units when markets were down and bought lesser units when markets were up. Some kind of cost averaging here. This is what advisors propound. Of course, mutual fund houses love this (they get a regular and assured stream of money coming into their schemes).

5.) Market Timing using Trend Following:
While no one knows market tops and bottoms, here you buy the Nifty after market bottoms have been established and markets start moving up and sell after market tops have been established and markets start moving down. One such strategy is used. This strategy means you wait for a bottom to form and once you identify a bottom, you buy. Similarly for selling, you sell once prices start to fall. We follow certain rules for buying and selling. Essentially you (imperfectly) time the markets.

So how do these strategies compare? Given below is a table depicting their performance:

(Theoritically, price can go down to zero. Hence in the first 4 strategies, risk is equal to the equity exposure)

Clearly, Trend Following (a kind of market timing) gives you the best return with the least risk and the least maximum drawdown. Also, the Stress ratio is lowest at less than 1.
The difference between market timing and other popular strategies is striking. Market timing gives a higher return at lower risk with lesser stress. Note the difference in the ending amounts for Rs. 1 lakh invested (last column).

PE based Asset Allocation also gives a better performance compared to the other three. Buy and Hold strategy gives a higher return than an SIP or price based asset allocation, but has the largest drawdown.

Note how an SIP is the worst in terms of returns and also in terms of the Stress ratio. So much for the merits of an SIP!!

Another observation not reflected in the table is that trend following gives much lower drawdowns compared to the other 4 methods. Also, drawdowns are recovered faster with trend following.

Ok, you may say. The 1990s had long periods of bad market performance. How about the performance in the bull market that started in April 2003? Here is the same till date:

A raging bull market makes buy and hold the best approach but with a large drawdown. So is the case with PE based asset allocation which has shown a better drawdown and hence a better Stress Ratio. Trend following has a lower return but a better drawdown performance and a superior stress ratio. Again, SIP is poorest in terms of return performance as in terms of stress ratio.

Note however that if you remove the period from April 2003 till date, the performance of the first 4 strategies turns out pretty bad. The returns for July 1990 till March 2003 for the first 4 strategies come in at 9-11%, while that for Trend Following comes in at 20.1%. Trend following is more consistant in good and bad times.

Perhaps we can draw some conclusions from the above analysis:
-We compared 5 rule based investing non-discretionary methods.
-Market timing can work. In fact, over long periods, the performance of one such method (trend following) seems markedly superior to the other popular methods.
-Popular methods like buy-and-hold, Asset Allocation and SIP do not have risk control mechanisms. Prices can go down and keep going down and cause a great deal of anxiety.
-SIP and Asset Allocation stategies are defensive in nature. They prevent greater losses than what would have occured otherwise. They do not make you more money.
-Market timing creates more wealth with less risk and lower stress. We should attempt market timing of some kind instead of avoiding it.