DISCUSSION ON DOW THEORY VS BUY AND HOLD - 23.05.23

From the desk of Capt.D.Ganesh Raja

DISCLAIMER

Please be informed that the author of this blog by Capt Ganesh Raja Dhanuskodi (Hereinafter called Capt Ganesh) is not a SEBI registered Research Analyst or Financial Advisor. Capt Ganesh writes this blog to express his views based of more than two decades of experience in capital markets and based on the Quant system which he has invented and he does not do this for “consideration” as per SEBI regulations, which means he does not receive economic benefit through it. Readers of this blog must seek advice from registered Investment Advisors / Research Analysts before taking any trading or investment decisions.

Capt Ganesh has been investing and trading actively since 2001, building trading models since 2013 and has invented an AI based intraday trading system, which has a pending patent approval.

Dear Friends,

I came across this excellent article and thought of sharing with you all. It compares Dow theory returns with that of “Buy and hold” strategy. Dow theory is considered one the building blocks of Technical analysis. Though my system is not based on Dow theory but to be honest there are quite a few technical parameters also, in addition to so many other filters. In popular media in India there is a general bias against such systems even to the extent of disdain by many, without understanding the underlying principles. “Don’t time the market”, is a common advice you will come across but people who have devoted their time and energy have proven their alternative methods quite successfully abroad and even in our country . Not for once I am deriding the value of “Buy and hold” strategy but it has its drawbacks too, Please read the article and know for yourself:

http://www.dowtheoryinvestment.com/p/normal-0-21-false-false-false-es-x-none_2.html#:~:text=The%20Dow%20Theory%20outperforms%20buy,dismal%20%2D16.72%25%20on%20average.

Excerpt from this excellent article:

Investors get blinded by performance. However, in real life, the investor is killed by draw downs. A 15% average performance is worth nothing if, somewhere along the road, there is going to be a draw down of -50%. Buy and hold is nice in theory, and it may work provided the investor has deep pockets (staying power) and psychological fortitude. However, in real life, very few investors possess both attributes at the same time. Thus, the publicized return figures of many investing strategies are not attainable in real life because the investor cannot endure the draw downs. If the average retiree needs to draw 4% off his capital annually (and this is a very realistic and even modest assumption), a draw down of 50% in any given year, will force him to draw 8% if he wants to keep his expenditures intact. Of course, he can cut with expenses, but as we well know, this is not an easy feat. Even if the retiree manages to reduce expenditures by 25%, this implies a withdrawal of 6% while being in the midst of the draw down. As a result total equity would be reduced by 50%+6%, thereby remaining only 44% of his original capital. A draw down of such magnitude is akin to a black hole. It is very difficult to escape from it. In most instances, the retiree will finish by eating up all of his capital. Game over for him!

The standard deviation of annual returns clearly favored the Dow Theory. Buy and hold experienced a standard deviation of 17.43% whereas the Dow Theory had a more modest 10.99%. Once again, the Dow Theory excelled by reducing significantly risk.

True to its underperformance in good years, the Dow Theory managed to make only 9.28% in winning years, whereas buy and hold made 13.65%.%. Hence, in good years, the Dow Theory underperformed buy and hold by -4.08%. However, we shouldn’t get greedy. When the market is behaving nicely, there is no need to squeeze 13.65%. I’d rather prefer to make 9.28% in good years and containing my losses to only -7.85% (instead of -15.42% for buy and hold) in bad years. The investor’s long-term survival demands fewer stellar years and fewer horrible years. We don’t want a roller coaster; we just like a gentle smooth ride. Furthermore, it should be born in mind that the Dow Theory managed to outperform buy and hold by more than 2% when the whole period is considered (1966-1981).

But averages are misleading. Let’s take a look at the deepest drawdown suffered by the buy and hold investor during that secular bear market. Measured on a year-end basis between 1973 and 1974 buy and hold lost -44.16%.

Do you want to know how much did the Dow Theory lose in 1973-1974? Make your guess….

The Dow Theory only lost -5.89% because it managed to keep the investor in cash (out of the market) during the great bulk of the devastating 1973-1974 bear market.

In real life, very few investors could survive such -44.16% devastation. Especially those nearing retirement. In my humble opinion, such draw down is an indictment of buy and hold.