A Profit Chart You Won’t Believe

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Sep 21st, 2012 | By | Category: Featured, Trend Playbook, Trends
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“The four most expensive words in the English language are, ‘This time it’s different.’”

– Sir John Templeton

“This time it’s different”. “The new normal”. There are plenty of clichés floating around the investment world right now as money managers try to explain what’s going on in the market.

That’s not really surprising. After all, professional investors need some sort of excuse when they lose money – and in absolute terms, investment managers lost more of their clients’ money in 2008 than ever before. But is this post-crash market really different? Not a chance.

And in fact, one long-term strategy actually gave investors the chance to make millions of dollars in 2008 as everyone else was getting shellacked. Today, I’d like to share more details with you…

Last week, I showed you why the tried and true “buy and hold” approach isn’t really what most investors think it is. And I told you about trend following, an approach to investing that focuses on riding the market’s biggest trends to substantial gains. If you missed it, you can catch up here.

When it comes to a new investment strategy, I realize that the proof is in the pudding. That’s why I want to show you how a simple trend following system would have fared through 2008′s catastrophic market. I’ll even show you how you can put that strategy to work for your portfolio today…

 

A Simple Trend Following Approach

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. Today, we’ll construct a quick one.

If you’re familiar with technical analysis at all, 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 stellar indicator of trend – if it’s moving steadily higher, then we know that a stock is generally moving higher over the time 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’ll 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, Mr. Market is entering an uptrend, and if it moves below, it’s entering a downtrend.

So, how would that simple strategy have fared over the last fifteen years? The chart below shows all of the times that the system would have traded and what your profits would have looked like:

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 look at the white chart below of your profits. It tells an even more exciting story.

See the handful of flat lines over that period? Those are the times you’re out of the market because the system said “sell”. So you didn’t touch stocks for almost 2 years while the tech bubble was bursting, and you were out of the market for all of 2008! I think you can see just how dramatically this system reduced the risks of being an investor.

But despite that “hands off” approach to investing, you still beat the market by a wide margin.

Remember, the rules we just made up are crude. By adding some extra simple short selling rules to the approach, our trend following system could have upped its total profits to 80.8%, and actually made substantial profits when the floor was falling out for everyone else in 2008.

Our crude trend following system produced a chart that’s hard to believe, especially when you consider the fact that it includes two of the biggest market crashes in most investors’ memories. There’s a lot an investor can do to improve performance beyond what I’ve showed you – 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 that following trends (and not trying to predict them) holds the keys to some incredible returns while smashing risks much lower than you’d see from a “buy and hold” approach.

Happy trading,

Jonas Elmerraji, CMT


Author Image for Jonas Elmerraji

Jonas Elmerraji

Jonas Elmerraji, CMT, is the co-editor of STORM Signals and Penny Stock Fortunes, and a contributor to Agora Financial’s Trend Playbook. Jonas got his start on the fundamental side of the market, poring over financial statements and valuations to find sound investments – today, he specializes in blending fundamental and technical analysis. Jonas is a senior contributor to TheStreet.com, and has been featured as an investment expert in Forbes, Investors Business Daily, and CNBC.com among others. 

Jonas holds a degree in financial economics from UMBC and the Chartered Market Technician designation.

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  1. [...] First off, if you haven’t had a chance to read last week’s article, I’d strongly recommend taking a look to get up to speed on trend following. You can find it here. [...]

  2. Why did you pick 300 day moving average? I remember reading a book many years ago that said the same thing for 200 moving averages. I’m curious if you back tested several values and choose 300 from your tests.

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