Why Buy & Hold Is Dead

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2 Why Buy & Hold Is Dead In this report, I will show you why I believe short-term trading can help you retire early, where the time honored buy and hold approach to investing in stocks has failed the general investing public and for all realistic intents and purposes is DEAD. I will show you why I believe short-term trading can be a winning strategy where the time honored buy and hold approach to investing in stocks and mutual funds has failed the general investing public. Most people with IRAs, 401Ks, or non-qualified portfolios were heavily invested in stocks and mutual funds with no clue regarding what was about to happen to their portfolio prior to the huge market crash in October And what happened was they lost as much as 50% or more. Do you know why? Because they did not have a trading method with specific rules on when to enter the market, exit the market, and control risk along the way. And it will happen again, as a careful analysis of history discussed in this report will demonstrate. In contrast to the buy and hold and hope approach encouraged by well meaning but ill informed analysts and brokers, a good short-term trading method does not rely upon forecasts or hope that everything will be all right. Instead, a good short-term trading method recognizes that while markets are unforecastable, identifying clearly established short, intermediate, and long term trends is very possible, over and over again. It is the identification of these trends and the ability to trade in and out of them with the expectation of capturing a portion of the trend while using strict risk controls that gives short-term trading, what I believe, is a huge edge over buy and hold. So let s take a closer look at short-term trading, why people invest in the markets, risk versus reward, and some hard data that exposes the truth about the buy and hold approach. Short-Term Trading Defined Short-term trading is a commonly used term to describe any method of trading whose trade duration lasts from a few days to a few weeks using daily charts. Position trading, on the other hand, is any method of trading whose trade duration lasts from weeks to months. The next category would be investing, which is typically viewed as being in a position for months to years. Another name for short-term trading is swing trading, which gets its name from putting on trades that attempt to capture swing moves typical of a bull market from a swing low (when the market corrects down after a sustained rally and then begins to go up once again) to a new swing high which would mark the end of the new rally. Or in a bear market, where the market makes a swing high (when the market rallies up after a Copyright Profits Run, Inc. Page 2 of 20

3 sustained move down and then begins to go down once again) to a new swing low which would mark the end of the new leg down. I believe that short-term trading with the right method is the best way to trade in the stock market for a few reasons. Figure 1 Swing Trade Examples There are many methods available that can be classified as short-term trading methods. Some are good and some are not. It is important to note, that short-term trading is not without risk and as such requires strict adherence to a good method including sound money management principles. I believe that short-term trading with the right method is the best way to trade in the stock market for a few reasons. 1. I believe that the trader has the opportunity to achieve the greatest gain for the time invested, meaning that only end of day data is considered in making trading decisions and consequently it is not necessary to sit in front of a computer all day long during market hours. 2. With short-term trading you have the opportunity to use your account dollars more efficiently. For example, if it were possible to gain 10% in one trade lasting for 3 weeks, and then redeploying those same funds in the next trade opportunity, wouldn t that be better than tying up those same funds for a 1 year trade that yielded 10%? 3. I believe you can use much tighter stops than is possible for methods aimed at longer trade durations. Copyright Profits Run, Inc. Page 3 of 20

4 Definition An investor that is able to follow an investment methodology that has the potential to produces net profits or positive returns over time can be said to have a Winning Edge. For example, a stock investor that has a Winning Edge can expect to achieve more winners than losers or where the average winning trade is higher than the average losing trade or both. In other words, the odds are in your favor, so the more trades that are made, the probability of being a net winner increases dramatically. I believe a good short-term trading method is one of the best ways to achieve a winning edge capability. Because, once you have mastered the method, you own it for life and are no longer dependent on others for your trading success. Casinos use the concept of a Winning Edge to great effect they know that while they will suffer losses on occasion, they will be net winners because they have a Winning Edge. As thousands of bets are placed, the probability of a casino being a net winner becomes a near certainty. That, of course, is why they are so happy to see you come to their establishment. Impact on Portfolio Value Let s look at the impact of a Winning Edge on portfolio value. Figure 1a shows an ideal graph of portfolio value increasing steadily over time through the consistent application of a Winning Edge. Figure 1b shows the same thing, except it reflects the reality that even with a Winning Edge, portfolio value does not go straight up there are occasional drawdowns. Figure 1c is a variant of 1b. Instead of several small drawdowns, Figure 1c depicts one significant long-lasting drawdown followed by the portfolio value recovering to new highs. While the portfolio values fluctuated differently, all three charts show net positive gains that you would expect through the consistent application of a Winning Edge. Copyright Profits Run, Inc. Page 4 of 20

5 : Impact on Portfolio Value All three charts show net positive gains that you would expect through the consistent application of a Winning Edge. Time a. b. Time c. Time Figure 1 Now let s examine a chart of the S&P500 from 1950 to 2001 (Figure 2). As you can see, if your strategy was to buy and hold the basket of S&P500 stocks from 1950, your portfolio would show a net gain of about 9% per year. Therefore, this strategy exhibits characteristics of a Winning Edge. Copyright Profits Run, Inc. Page 5 of 20

6 S&P500 If your strategy was to buy and hold the Dow Jones stocks from 1900, your portfolio would theoretically show a net gain of about 6% per year Figure 2 Average Return = 9% / year Likewise, if you look at a chart of the Dow Jones Industrial Average from 1900 to 2001 (Figure 3), you see again that if your strategy was to buy and hold the Dow Jones stocks from 1900, your portfolio would theoretically show a net gain of about 6% per year. This, too, exhibits Winning Edge characteristics. Here is a look at the NASDAQ composite from 1978 to 2001 (Figure 4). Again, a buy and hold strategy exhibits Winning Edge characteristics. Copyright Profits Run, Inc. Page 6 of 20

7 Dow Jones Industrial Average While a buy and hold strategy could have theoretically produced approximately 6 to 13% per year return in the previous examples, this strategy requires that you never sell while somehow replicating the index performance in your portfolio. Average Return = 6% / year Figure 3 NASDAQ Average Return = 13% / year Figure 4 While a buy and hold strategy could have theoretically produced approximately 6 to 13% per year return in the previous examples, this strategy requires that you never sell while somehow replicating the index performance in your portfolio. Neither of those factors is very Copyright Profits Run, Inc. Page 7 of 20

8 likely to occur in the real world, which calls into question the robustness of a buy and hold strategy. It becomes apparent that some level of stock or mutual fund trading may be required in the real world if you are to attempt to increase the value of your stock portfolio over time. Let s look at a few scenarios. Some level of stock or mutual fund trading may be required in the real world if you are to attempt to increase the value of your stock portfolio over time. Figure 5a shows the portfolio value over time of a short-term stock trader who has occasional successes, but ends up giving back profits in subsequent trades with no net profit when all is said and done. This tends to be the experience of traders who trade without discipline and without rules in other words, without a Winning Edge. Of course, such a trader could do even worse by consistently losing money over time as shown in Figure 5b. Figure 1, on the other hand, shows the kind of results you would expect from a trader using a strategy with a Winning Edge. Short-Term Trading: No Discipline - No Rules 0% / yr a. Time -xx% / yr b. Time Figure 5 Copyright Profits Run, Inc. Page 8 of 20

9 Impact on Risk There are many ways to define risk from highly technical statistics to very simplistic statements. I prefer to define risk in terms of what happens to a trading position that I don t like. For example, I don t like it when my portfolio suffers a drawdown (loses money), and I don t like waiting to recover my losses so I can break even. Both of those occurrences represent risk to my portfolio and me. So it should not be surprising that my definition of risk includes both of those elements (Figure 6). It took 7 years for the S&P500 to break even, with a drawdown as high as 48%. Risk % drawdown time to breakeven Time Figure 6 Percent drawdown: The amount lost from the previous peak portfolio value. Time to break even: The opportunity cost of lost trading opportunities. With this straightforward definition, it becomes easy to evaluate the level of risk inherent in various strategies. Take a look at Figure 7, which shows the S&P500 from 1950 to What would be the level of risk for the buy and hold strategy discussed earlier? By simply examining the graph, you can see that the time to break even took 7 years from 1973 to 1980, and during that period, the percent drawdown was 48%. Since 1956, there were five other drawdown periods ranging from one and half to four years. While not as severe as 1973 to 1980, the percent drawdown was still very significant, from a low of 16% to a high of 39%. Copyright Profits Run, Inc. Page 9 of 20

10 S&P500 f. e. How long will it take the next bear market to break even after the next major market crash? Don t kid yourself. Another huge crash will happen.. S&P 500 Risk Assessment a. b. Average Return = 9% / year Percent Period Time to Break Even Drawdown a years 16% b years 35% c years 48% d years 29% e years 36% f years 39% c. Figure 7 d. A key question you should ask is how long will it take the next bear market to break even after the next crash? Don t kid yourself. Another huge crash will happen. History repeats itself. Why should today be any different than yesterday? Reviewing Figure 8 for the Dow Jones Industrial Average, from 1900 to 2001 the following risk assessment for a buy and hold strategy can be made: Copyright Profits Run, Inc. Page 10 of 20

11 Dow Jones Industrial Average e. This analysis shows that adhering to a buy and hold strategy would have required uncommon resolve and patience. d. b. Average Return = 6% / year a. c Figure 8 As of 2001 DJIA Risk Assessment Percent Period Time to Break Even Drawdown a years 48% b years 36% c years 89% d years 37% e years 39% As you can see from this data, time to break even was extensive in the first half of the Twentieth Century. Likewise, a review of Figure 9 for the NASDAQ index from 1978 to 2001 indicates the following risk levels for a buy and hold strategy: Copyright Profits Run, Inc. Page 11 of 20

12 NASDAQ d. The stock trader who trades without a Winning Edge fairs even worse, where the time to break even and percent drawdown are in a repetitive pattern that lead nowhere. NASDAQ Risk Assessment a. b. c Figure 9 As of 2002 Average Return = 13% / year Percent Period Time to Break Even Drawdown a years 29% b years 32% c years 37% d years 83% While the buy and hold strategy technically has a Winning Edge, the preceding analysis shows that adhering to this strategy would have required uncommon resolve and patience to endure years, sometimes decades, of time to break even and near-catastrophic percent drawdowns. The stock trader who trades without a Winning Edge fairs even worse, as you can see from Figure 5a where the time to break even and percent drawdown are in a repetitive pattern that lead nowhere. Worse still is Figure 5b, where the time to break even is infinite with percent drawdowns approaching 100%. Contrast that level of risk with a stock trader who trades with a good short-term trading method that is capable of providing a Winning Copyright Profits Run, Inc. Page 12 of 20

13 Edge. As Figure 1 shows, ideally such a trader experiences relatively short time to break even periods with modest drawdowns. This trader is obviously the one to emulate! Conclusions In order to be successful, your strategy must indeed have a Winning Edge. The conclusion from reviewing this information suggests that in order to be successful, your strategy must indeed have a Winning Edge that you can realistically employ. Furthermore, your strategy must exhibit risk levels within your risk tolerance and be consistent with your goals, and why you are investing money. I believe a good short-term trading method can provide such a strategy. Key Components You should now have a good understanding of how a Winning Edge impacts returns and risk. It s now time to dive deeper into how to potentially achieve a Winning Edge. Remember, I defined a Winning Edge as an investment methodology that has the potential to produce net profits or positive returns over time. At least four key components are required: 1. Money Management Guidelines 2. Selection Criteria 3. Specific Entry and Exit Rules 4. High Velocity Turnover High Velocity Entry & Exit Rules Selection Criteria Money Management Guidelines The absence of any one of these components will dramatically reduce, or even eliminate, your chances of achieving a Winning Edge. Let s now have a look at each of one these components in detail. Copyright Profits Run, Inc. Page 13 of 20

14 Money Management Guidelines Given the risk inherent in any investment methodology, you need to have sufficient funds and personal resolve to cover that risk so you can continue to enjoy the rewards without being knocked out of the game. Money management is about balancing risk with reward. Given the risk inherent in any investment methodology, you need to have sufficient funds and personal resolve to cover that risk so you can continue to enjoy the rewards without being knocked out of the game. The number one rule of money management and the most effective thing you can do is to reduce your methodology s risk in the first place. For stock traders, you do this by exploiting the predominant trend. That is, you take mostly long positions in bull markets and mostly short positions in bear markets. The reason being is that three out of four stocks will follow the predominant trend. The second rule is to ensure that the risk (drawdown percentage and time to break even ) does not exceed: Your emotional tolerance for losses High Velocity Entry & Exit Rules Selection Criteria Your financial capability to live through those losses Your ability to stick to your trading methodology Money Management Guidelines Emotional Tolerance for Losses For example, if your methodology is to buy and hold an index basket of stocks, then you must be comfortable with the multi-year time to break even and drawdowns of 20% to 50% or higher that are inherent with this methodology. Otherwise, you may fall victim to selling at precisely the wrong time. On the other hand, if your methodology produces minimal drawdowns and time to break even as is potentially the case for the trader with a good short-term trading method, it is much easier emotionally to stay committed to your plan. Copyright Profits Run, Inc. Page 14 of 20

15 Financial Capability Financial capability is simply about assuring that given the funds you have available for trading purposes that you do not over-commit to any one transaction or position where an adverse outcome would impair or eliminate your ability to continue trading the methodology. Estimate the expected maximum drawdown and time to break even (based on historical data), and be prepared to cover such a drawdown in the future without abandoning your investment plan. Suppose you employ a good short-term trading method that suffers three losses in a row (yes, even a good trading method can experience three losses in a row. There is no holy grail of trading, losses come with the territory and must be managed). If you risked 10% of your account (the amount you plan to lose on a trade if it goes against you) on each of those trades, your account would suffer a drawdown of 27.1%. If on the other hand, you had only risked 1% on each trade, your account would have had a 2.7% drawdown. That s quite a difference. Now ask yourself if you could maintain your discipline and take the next trade when your account just lost over 27% of its value in just three trades. The answer for most traders is no. So never put yourself in that position. It s not necessary and it is certainly not prudent. Sticking To Your Trading Methodology Given a good trading method with a Winning Edge, you can only succeed by sticking to the methodology. That means having the discipline to follow the rules and to keep trading even when losses occur, which they inevitably will with even the best methodology (remember, there is no Holy Grail in stock trading). It is much easier to adhere to this discipline if you have only committed funds to your trading program within your comfort zone (your Financial Capability) and you limit the planned risk per trade to a small percentage of your account size. Copyright Profits Run, Inc. Page 15 of 20

16 Selection Criteria By using a very demanding set of selection criteria, you could potentially increase the odds of having a winning trade. The second component to a Winning Edge method is to develop a set of criteria that must be met in order to consider taking a position in any given investment vehicle. For stock trading, this would be your criteria for selecting which stocks to consider for long or short positions. If the High Velocity Entry & Exit Rules Selection Criteria Money Management Guidelines criteria are not met in any way, you should simply pass on that stock and go on to the next. Stock selection criteria can typically be based on fundamental analysis (earnings performance, industry group strength, etc.), technical analysis (price patterns, support and resistance levels, etc.), or both. Whatever the basis, the criteria should be very demanding so that only the best trading opportunities emerge. For example, from the U. S. stocks only a handful would be selected for consideration on any given day. Then, by applying the entry rules of a good short-term trading method, entry orders for, say, two stocks might actually be placed, expecting only one of those to follow through with market action that triggers the order. The ratios look like this: Stocks Stocks Orders Orders Scanned Selected Placed Filled By using a very demanding set of criteria, you could potentially increase the odds of having a winning trade. Remember, just because a stock meets demanding fundamental criteria doesn t mean it s a good stock to trade. Rather, you must be patient and wait for market conditions to align consistent with your trading system rules before pulling the trigger. Copyright Profits Run, Inc. Page 16 of 20

17 Specific Entry and Exit Rules Most of the time the market forecasters will issue buy recommendations, but seldom do they issue sell recommendations. A good short-term trading method will utilize specific entry and exit rules that have proven to work effectively in the past under varying market conditions. These rules are essential to ensuring that the odds of winning are high, and are also essential to having a Winning Edge. High Velocity Entry & Exit Rules Selection Criteria Money Management Guidelines Good entry rules will typically demand a low-risk entry point and also require short term confirming market action to trigger the order. Good exit rules will typically include both a profit target point and a stop loss point, with adjustments along the way. In the absence of these rules, you re more than likely to find trouble and be unable to achieve a Winning Edge (see Figure 5). The most common example of a stock trader that trades without specific entry and exit rules is one who trades on the basis of the news networks, the commentary of the day, analyst reports, and other hot tips. This type of trader trades stocks based on free advice available to the unwary public. The assumption here is that somehow you can profit from this hodgepodge of recommendations. Most of the time they will issue buy recommendations, but seldom do they issue sell recommendations. This approach offers no Winning Edge at all and illustrates the importance of having specific entry and exit rules. Copyright Profits Run, Inc. Page 17 of 20

18 High Velocity Turnover The rate at which you profit depends on the percent return and the time it takes to achieve that return. Velocity is defined as the rate of travel in a particular direction. Another way to think of velocity is to ask how long it will take to get your money back with a reasonable rate of return once you place a trade. High Velocity Entry & Exit Rules Selection Criteria Money Management Guidelines With this general definition in mind, remember that the object of investing is to make money on your money consistent with your goals within strict risk control parameters. More specifically, the objective is to profit over time. The rate at which you profit depends on the percent return and the time it takes to achieve that return. For example, a 10% return that takes one year will yield a 10% annualized rate of return. On the other hand, a 10% return that takes one month will yield a 120% annualized rate of return. In the first case, it takes one year to get your money back, whereas in the second case it only takes a month. Both cases return your money with a 10% return, but the second case has a dramatically higher velocity (120% annualized rate of return). Copyright Profits Run, Inc. Page 18 of 20

19 Short-Term Gains vs. Long-Term Gains % It is important to note that forecasting market direction is not a key component of a Winning Edge Time 10% every 2 months 10% every 3 months 10% every 6 months 10% every 12 months 46% 10% 1 year Figure 10 This is why high velocity and short-term short-term trading can be such important components of a Winning Edge and why significantly higher rates of return can potentially be achieved compared to traditional buy and hold strategies. Figure 10 shows the power of high velocity trading. The Perils of Forecasting It is important to note that forecasting market direction is not a key component of a Winning Edge. There are two reasons for this. First, it is impossible to accurately forecast market moves on a consistent basis. Second, thankfully, it is not necessary to be able to do so. But what do most people do? They listen to the forecasters for a clue on what strategy they should follow and how their investments will perform in the coming year. I believe this is potentially a losing strategy and inconsistent with a Winning Edge method. This should be a great relief to all who have struggled with this issue. Instead, stick to the key components of the Winning Edge and a good short-term trading method, and leave forecasting to the forecasters. Copyright Profits Run, Inc. Page 19 of 20

20 Summary I believe the short-term stock trader armed with a good short-term trading method that provides a Winning Edge has the potential to outperform the buy and hold strategy. Let s do a brief review of what was discussed. I suggested that the data presented in this report would show that a good short-term trading method is potentially far superior to the traditional buy and hold and hope approach to the markets. I talked about the importance of understanding why you invest money and what your goals are in that regard. Then, a powerful methodology called the Winning Edge was introduced. The performance of a buy and hold approach was looked at by analyzing the historical stock index charts in terms of rate of return and risk as defined by time to break even and percent drawdown. And finally you saw why I believe the short-term stock trader armed with a good short-term trading method that provides a Winning Edge has the potential to outperform the buy and hold strategy in both rate of return and assumed risk. I hope this report has been informative and adds to your success in the future. Good Trading, Bill Poulos Disclaimer: Stocks and options trading have large potential rewards, but also large potential risk. You must be aware of the risks and be willing to accept them in order to invest in the stocks and options markets. Don t trade with money you can t afford to lose. This is neither a solicitation nor an offer to Buy/Sell stocks or options. No representation is being made that any account will or is likely to achieve profits or losses similar to those discussed in this report. The past performance of any trading system or methodology is not necessarily indicative of future results. All trades, patterns, charts, systems, etc., discussed in this report are for illustrative purposes only and not to be construed as specific advisory recommendations. Information contained in this correspondence is intended for informational purposes only and was obtained from sources believed to be reliable. Information is in no way guaranteed. No guarantee of any kind is implied or possible where projections of future conditions are attempted. Copyright Profits Run, Inc. Page 20 of 20