Most Popular ArticlesJune 16, 2009
Figure 4 provides even more compelling support for the MAC system. I calculated risk-adjusted returns using the ratio of CAGR to its standard deviation, measured monthly from January 1871 to April 2009. Standard deviation of returns is a generally accepted measure of risk. By this definition, the MAC system beats buy-and-hold hands down across all MA lengths. The stability in risk adjusted return performance and their insensitivity to the MA length show that MAC is a robust system.
Standard deviation treats both up and down volatility as risk. Judging from the “missing out the best days” argument buy-and-holders embrace, I presume that they don’t consider upside volatility as risk - only downside volatility. A more relevant measure of downside risk is equity drawdown. Drawdown is the percentage decline from the most recent equity peak. There are two ways to evaluate drawdown: average drawdown and maximum drawdown. Figures 5 and 6 respectively show the results of the two methods.
If you don’t view price surges as hazardous and consider only price plunges as risky, then you surely won’t care for the buy-and-hold approach. Buy-and-hold delivers a whopping negative 85 percent maximum drawdown, courtesy of the Super Crash from the 1929 peak to the 1932 trough. Even the average drawdown is a painful negative 26 percent. In comparison, the maximum drawdown for MAC is only negative 15 percent and the average drawdown is no worse than negative 4 percent.
I ignored both transaction costs and taxes, so now let’s check on these assumptions. Figure 7 shows the number of round-trip trades (from buy to sell) for the different MA lengths. The average is 0.38 trades per year, or one round-trip every 2.6 years. Even with the 2-month MA, MAC generates only 0.9 round-trip per year, or a holding period of 1.1 years. The low trading frequency of MAC not only keeps transaction costs low, but lowers the tax rates from ordinary income rates to long-term capital gain rates.
Have we found the Holy Grail?
Based on aggregate performance over the entire 138-year period, the MAC system beats buy-and-hold in both abosulte performance and risk-adjusted return. Have we indeed found the Holy Grail that works for all seasons? To find out, stay tuned for Part 2, in which I examine MAC and buy-and-hold on a monthly basis and by decade to see how they compare in all bull and bear markets since 1871.
Theodore Wong graduated from MIT with a BSEE and MSEE degree. He was General Manager of several Fortune-500 companies designing sensors for satellite and military applications. He started a hi-tech company via a LBO in partnership with a private equity firm. He now consults on management and investment best practices. While studying for his MBA, he discovered his true passion was in investment research. He combines engineering analytics with econometrics modeling to enhance quantitative investment analysis. He seeks absolute returns by active risk management in both up and down markets. He can be reached at .
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