Thursday, October 10, 2013

The I Hate Stocks Trading Plan

Update 5/6/2014: The trading plan outlined in this post has been revised. See "Revised Long-Term Trading Plan" for details.

In a recent conversation, a friend worried about the consequences of closing investments to evade the downside risk of a default on the U.S. government debt. (See my Sept. 27 post "Rolling away from risk" for a description of how I dealt with that risk.)

My friend had a point. Every trip out of a stock in taxable accounts has costs: A capital gains tax of 15% or 20% on positions held for more than a year, and up to 39.6% on positions held for less than a year.

"The tax is the same as a market decline that must be recovered," my friend said.

He makes a good point. That's one reason why traders with a long-term horizon tend to buy and hold on to their positions through all sorts of market declines.

Also, in all accounts, even those that are tax deferred, when most people sell their stock, they have no way of knowing when to buy it back. They don't have a trading plan. So often, they end up missing the market recovery that would allow them to eliminate their losses. (Full disclosure: That was me in the Crash of 1987.)

Besides, most people really hate this stuff. They don't want to spend the time it takes to get educated about the intricacies of trading. They have lives and better ways of spending them than hunched over a screen staring at charts.

Stocks, despite their reputation as a must have in any portfolio, have been far from a great investment so far in the 21st century, as the chart below illustrates.

In the chart, the black bars mark the open, high, low and close prices of the stock in each month. The close price is the tick mark on the right side of each bar. The red line is the average of the closing price in each of the last 12 months. It's called a moving average, because each time a month ends, the oldest month is removed and the newest is added, and the average is recalculated.

The green vertical line marks Dec. 31, 1999 -- the date where the hypothetical investor in my example below bought shares.

SPY 20 years 1 month bars with 12-month moving average in red

Let's imagine a long-term investor, with a job and a commute who, with the spouse, is raising twin children, each as cute as a button and, despite their physical resemblance, as different from each other as chalk and cheese.

Our investor is excited about the rollover into the next millennium, the dawning of a new and better age, and so decides to buy shares of a fund that tracks the blue chip stocks, the big household names that everyone knows:  The exchange-traded fund SPY, which closely shadows the S&P 500 index.

So the investor buys shares of SPY for $146.88 each at the market close on Dec. 31, 1999, the last day of the 1900s, and hangs on to the shares to the last day of last month, September 2013, when they're sold to help pay for the kids' college education. How did that investment go?

As it turns out, SPY hit a peak eight months after our investor bought the shares, and then dived 47% over the next two years. Our investor, throughly disgusted, quits looking at the brokerage statements, tossing them into a dresser drawer unread.

As the chart above shows, the investor bought at the high end of the stock's rise rather than following the maxim, "Buy low sell high". But that happens a lot. All of us love stocks when they've risen a good distance, and hate them when they're in the cellar.

In this example, stocks slowly roe over the next five years and eventually the investment is profitable again, not by much but it's better than a huge loss. The investor starts reading the brokerage statements again, and sometimes cracks a grin.

But then comes another crash, over nearly two years, that brings SPY down 53%, and brokerage statements again are tossed in the drawer.

Again, stocks painfully work their way up and by last month were again profitable. Time has passed. The investor's head is marked by a few gray hairs, the kids are growing up, and the investment is sold for cash at $168.01 per share on the last day of September, 2013, to pay for tuition, textbooks and housing at the state university down the Interstate a piece.

The investor gets out his calculator and figures out the profit: 14%. Not bad. But then a light bulb pops over the investor's head: That was over nearly 14 years. The annual result: 1% per year. For much of that period, the investor could have parked the funds in a money market account and earned about that much. So much for stocks and big gains from taking a risk.

The buy-and-hold investor's results looked like this:

BuySellNetNet Pct
December 31, 1999$146.88September 30, 2013$168.01$21.1314.39%

There is another way: The I Hate Stocks Trading Plan. It's simple. It only requires that the investor look at the stock's closing price on the last day of each month, and compare it to the average of the price at the end of each of the last 12 months.

There are only two rules:
  1. Buy the shares when the current month's closing price crosses above the 12-month average.
  2. Sell the shares when the current month's closing price crosses below the 12-month average. 
That's it.

The I Hate Stocks Trading Plan avoids most of the stock declines and provides a clear rule about when to buy back in. The results from following the plan look like this:

BuySellNetNet Pct
December 31, 1999$146.88October 31, 2000$142.95-$3.93-2.68%
April 30, 2003$91.91December 31, 2007$146.21$54.3059.08%
July 31, 2009$98.81June 30, 2010$103.22$4.414.46%
July 31, 2010$110.27August 31, 2011$122.22$11.9510.84%
January 31, 2012$131.32September 30, 2013$168.01$36.6927.94%

The buy-and-hold plan produced a 14% profit. The I Hate Stocks Trading Plan produced a 100% profit, doubling the investor's money.

That works out precisely to 1.04% a year for the buy-and-hold plan, and 7.2% a year for the I Hate Stocks plan.

The I Hate Stocks plan required five round trips into and out of SPY, which is less than one round trip every two years. The buy-and-hold plan required only one round trip. 

One of the five round trips resulted in a loss, which can be charged as an offset against future profits. Three were held long enough to qualify for the cheaper long-term capital gains tax; one was taxed at the higher short-term rate.

The buy-and-hold strategy was only taxed at the end, at the cheaper long-term rate. But a 100% gain in the I Hate Taxes strategy surely outweighs the increased tax bite, producing a substantially higher profit.

So that's the choice. For the long-term trader who has better things to do, is it worth looking at the statement once a month and making a simple calculation, and doing 10 trades, and in return getting nearly seven times the pre-tax profit of just leaving the money invested the full time.

Of course, as regular readers of Private Trader know, my way of trading differs from both of the examples given above. I trade for the shorter term. It gives me more of a chance of higher yields and less damage when trades go wrong through leverage and hedging, respectively.

My trading rules, much more complex than the I Hate Stocks Trading Plan, can be read here. And the classic Turtle Trading rules on which my rules are based can be read here.

Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.
No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decision decisions for his or her own account, and take responsibility for the consequences.

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