The Stock Market and Its Ups And Downs
Investing in the stock could yield rich dividends if you make your investments properly but the stock market as such is a risky proposition. There would a number of people who would readily provide you a number of ideas on how to succeed in the stock market (this would include several individuals, brokerage firms and also the media-print and others included) and become a millionaire overnight.
But on the whole we may conclude that the advice provided by such so-called experts is not good enough or else we would have had a richer population. There are many people who would suggest buying stocks and holding it for a long term period irrespective of whether the markets come down or not. The big question is whether this is a good idea or not.
The behaviour of the stock market during the period from 2000-2002 when it saw a huge decline has made many people loose faith in the traditional “Buy and Hold Strategy” of holding onto stocks inspite of a decline in the market. Here we would go on with the assumption that if one is to hold on to the shares longer then the risk factor is also higher. Here we aim at explaining the benefits of not staying for long in the market. In such a case not only is the risk minimised but also the returns in such a case is more.
The studies go to show that from the period from 1970 to 2005 there have been many ups and downs in the market often referred to as seasonal investing by experts. In his book titled “Riding the Bear: How to prosper in the coming Bear Market” explains as to how one can make good profits by buying shares on the 1st of November and selling it on the 30th of April (known as the Favourable Period Strategy), on the other hand the opposite or the unfavourable period strategy refers to the unfavourable period which is considered to be from the 1st of May to the 31st of October.
In this article the standard that would be used for all studies would be the Dow Jones Industrial Average (DJIA). Other indexes such as S&P 500 Index, the Russell 2000 are all found to be more volatile and risky. This is shown with the calculation of the “Ulcer Index” or UI that is the measure of the amount of price declines from the highs or peaks of the stock market over a particular period of time.
The lower the Ulcer Index, the lower the risk. In a situation where there are major declines in the market, the indices with a higher Ulcer Index or UI would fall more rapidly and the fall would be deeper. Since our aim here is reducing the risk involved the DJIA seems best suited for the study.
The buy and hold strategy as we saw earlier would be a good idea in case of a rising market but a falling market which is very uncertain may provide an irresistible offer which can lead to an impulsive sale.
The Buy and Hold strategy may not be a good idea for investors as there can be times when for several years the market continues to show a tendency to move downward or sideways. In case of a decline that continues for a long time in the market the stock market would definitely be adversely affected.
Impact of Losses
Losses can have a major impact on the portfolio of an individual. For example, considering a hypothetical situation of a portfolio wherein the individual started with an investment of $10,000 and has been earning a 17% return on it over a period of 10 years. Taxes and inflation have not been taken into account here so as to simplify the calculations. Thus, at the end of the period consisting of 10 years the value of the portfolio would be $48070.
Now considering that the portfolio loses 10% every alternate year but is also earning 27% every other year. Under such a situation, the value of the portfolio at the end of the 10-year period would be $19500. Thus, as a result of this study the conclusion drawn is that if the portfolio has to gain the same amount and have the same value at the end of the 10 year period then since it loses 10% every alternate year it must gain 52% every other year to negate the loss.
Thus, the example shows as to how you need very high profits to compensate for the losses that have been incurred every alternate year. It goes to prove that when the losses are less, the risk involved is also less thus, resulting in higher profits.
Considering the period from 1970-2005 and the DJIA, this example assumes that the existing market is a bear market and that there is a fall in the stock market of 15-20%. Thus, the table below goes to show that the fall in the market has resulted in an average loss of –23% for the investor.
Table 1: Returns for the DJIA |
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Bear Mkt. Start |
Bear Mkt. End |
Length in Yrs. |
DJIA Losses |
1/1973 |
10/1974 |
1.8 |
-36.0% |
9/1976 |
3/1978 |
1.5 |
-23.0% |
8/1987 |
10/1987 |
0.3 |
-22.0% |
7/1990 |
10/1990 |
0.3 |
-16.0% |
3/2000 |
10/2002 |
2.6 |
-17.0% |
Investors who have been following the market cycle have been keeping out of the market during the unfavorable periods. The below mentioned Table, Table 2 also considers that the initial investment involved is $10000 and the period under consideration is from 1970-2005.
Table 2: Returns for Seasonal and Buy and Hold Strategies |
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Year |
DJIA Returns |
DJIA Returns |
Short Term |
Buy&Hold |
||||
UPS |
FPS |
Rate Return |
Returns |
|||||
May 1 - Oct. 31 |
Nov. 1 - Apr. 30 |
During UPS |
(Annual) |
|||||
Percent |
Dollars |
Percent |
Dollars |
Percent |
Dollars |
Percent |
Dollars |
|
1970 |
2.7 |
10,270 |
24.6 |
12,460 |
4.1 |
10,410 |
4.8 |
10,480 |
1971 |
-10.9 |
9,151 |
13.7 |
14,167 |
2.8 |
10,701 |
6.1 |
11,119 |
1972 |
0.1 |
9,160 |
-3.6 |
13,657 |
2.5 |
10,969 |
14.6 |
12,742 |
1973 |
3.8 |
9,508 |
-12.5 |
11,950 |
4.7 |
11,485 |
-16.6 |
10,627 |
1974 |
-20.5 |
7,559 |
23.4 |
14,746 |
5.8 |
12,151 |
-27.6 |
7,694 |
1975 |
1.8 |
7,695 |
19.2 |
17,577 |
3.2 |
12,540 |
38.3 |
10,641 |
1976 |
-3.2 |
7,449 |
-3.9 |
16,891 |
2.8 |
12,891 |
17.9 |
12,546 |
1977 |
-11.7 |
6,577 |
2.3 |
17,279 |
2.9 |
13,265 |
-17.3 |
10,375 |
1978 |
-5.4 |
6,222 |
7.9 |
18,644 |
4.1 |
13,809 |
-3.1 |
10,054 |
1979 |
-4.6 |
5,936 |
0.2 |
18,681 |
5.6 |
14,582 |
4.2 |
10,476 |
1980 |
13.1 |
6,714 |
7.9 |
20,157 |
5.2 |
15,340 |
14.9 |
12,037 |
1981 |
-14.6 |
5,734 |
-0.5 |
20,056 |
8.7 |
16.675 |
-9.2 |
10,929 |
1982 |
16.9 |
6,703 |
23.6 |
24,789 |
6.1 |
17,692 |
19.6 |
13,071 |
1983 |
-0.1 |
6,696 |
-4.4 |
23,698 |
4.7 |
18,524 |
20.3 |
15,725 |
1984 |
3.1 |
6,903 |
4.2 |
24,693 |
5.7 |
19,580 |
-3.7 |
15,143 |
1985 |
9.2 |
7,538 |
29.8 |
32,051 |
4.0 |
20,363 |
27.7 |
19,338 |
1986 |
5.3 |
7,938 |
21.8 |
39,038 |
3.2 |
21,015 |
26.6 |
24,481 |
1987 |
-12.8 |
6,922 |
1.9 |
39,780 |
3.7 |
21,792 |
2.3 |
25,045 |
1988 |
5.7 |
7,317 |
12.6 |
44,792 |
4.0 |
22,664 |
11.8 |
28,000 |
1989 |
9.4 |
8,005 |
0.4 |
44,971 |
4.6 |
23,707 |
27.0 |
35,560 |
1990 |
-8.1 |
7,357 |
18.2 |
53,155 |
4.2 |
24,703 |
-4.3 |
34,031 |
1991 |
6.3 |
7,820 |
9.4 |
58,152 |
3.0 |
25,444 |
20.3 |
40,940 |
1992 |
-4.0 |
7,507 |
6.2 |
61,757 |
1.8 |
25,902 |
4.2 |
42,659 |
1993 |
7.4 |
8,063 |
0.03 |
61,775 |
1.6 |
26,316 |
13.7 |
48,503 |
1994 |
6.2 |
8,563 |
10.6 |
68,323 |
2.5 |
26,974 |
2.1 |
49,522 |
1995 |
10.0 |
9,419 |
17.1 |
80,006 |
3.0 |
27,783 |
33.5 |
66,112 |
1996 |
8.3 |
10,201 |
16.2 |
92,967 |
2.8 |
28,561 |
26.0 |
83,301 |
1997 |
6.2 |
10,833 |
21.8 |
113,234 |
2.9 |
29,390 |
22.6 |
102,127 |
1998 |
-5.5 |
10,237 |
25.6 |
142,221 |
2.8 |
30,213 |
16.1 |
118,569 |
1999 |
-0.5 |
10,186 |
0.04 |
142,278 |
2.7 |
31,029 |
25.2 |
148,449 |
2000 |
2.2 |
10,410 |
-2.2 |
139,149 |
3.4 |
32,084 |
-6.2 |
139,245 |
2001 |
-15.5 |
8,796 |
9.6 |
152,507 |
1.7 |
32,629 |
-7.1 |
129,359 |
2002 |
-15.6 |
7,424 |
1.0 |
154,032 |
.90 |
32,923 |
-16.8 |
107,626 |
2003 |
15.6 |
8,582 |
4.3 |
160,655 |
.55 |
33,104 |
23.3 |
132,703 |
2004 |
-2.7 |
8,350 |
1.4 |
162,905 |
.80 |
33,369 |
3.6 |
137,481 |
2005 |
1.8 |
9,051 |
9.3 |
178,055 |
1.8 |
33,970 |
-0.66 |
136,574 |
Total Returns |
-15.0% |
1,681% |
240% |
1,266% |
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The above Table2 shows that the element of seasonality is present in the market. By using the BHS, it shows that the DJIA returns were 1266%. There were 11 years were losses were there. The UPS showed losses during 16 years ranging from -0.1% in 1983 to –20.5% in the year 1974.
At the end of the period considered the investment of $10000 was reduced to $8501. Even here it was observed that the favorable period from the 1st of November to the 30th of April recorded a total return of 1681%. Considering the taxes during the period and also after deducting the transaction costs, it was seen that the FPS or the favorable period strategy still did better than the BHS. Taxes were of course to be eliminated from the BHS returns too.
Risk Management
The seasonality strategy goes to show and is proved from the hypothetical studies that with adopting a favorable period strategy you can reduce your exposure to the market and thus reduce risks. This strategy in comparison to the Buy and Hold Strategy (BHS) would get better returns as well in spite of being out of the market for half the time. Whether any further reduction in risk can be done is our focus here.
The following study is also based on a seasonal strategy and assumes that the politics in the country increase the favorable period before the Presidential elections. This favorable period is also seen to have an effect on the entire economy. The effect is on the macro economy, thus it has a far reaching impact in the economy like increase in the profits of the company, a positive effect on the stock market of the country and the like. For this example the prime year for investing in the stock market is taken as a year before the presidential election.
With the 4-YCS or the 4 Year Cycle Strategy it is assumed that any investor would make an investment in the stock market once in four years. The other years the investor invests his money in the money market away from all the risk. The period taken under consideration for this study is taken as 1970-2005. Thus, taking the prime year as a year before the Presidential election, as per the example the year would be 1971. Thus, the four-year ending would be 1975, 1979, 1983, 1987, 1991, 1995, 1999 and 2003. For the other three years since the money is invested in the money market the risk factor is eliminated.
Table 3 goes to show that the 4 Year Cycle Strategy offered better returns as compared to the favorable period strategy or FPS. The 4 Year Cycle strategies earned a return of 2406%. This higher rate of profit could be attributed to the fact that in the 4YCS there was no loss-making year under this study for the entire period.
Combining the Strategies
The seasonal strategies namely the favorable period strategy and the 4Year Cycle Strategy have outperformed the BHS or the Buy and Hold Strategy. A thought goes out to a study where probably combining the two strategies can have a better effect on returns and also decrease the amount of risk. For studying the effect of such a combination let us consider the same time period as in the above two cases.
The best of both the approaches and strategies is taken together. The period under consideration here is the period from 1970-2005. All the years have the same set of rules applicable to them excluding the nine years (that is each year preceding the Presidential election that was studied as per the 4 Year Cycle Strategy).
It is assumed that for the investor remains invested for the entire year as per the DJIA. Table 3 depicts the results of the calculations as per the 4Year Cycle strategy and also as per the Combined Strategy.
Table 3: 4-Year Cycle and Melded Strategy |
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Year |
4-Year Cycle Strategy Returns |
Melded Strategy Returns |
||
Percent |
Dollars |
Percent |
Dollars |
|
1970 |
7.84 |
10,784 |
24.6 |
12,460 |
1971 |
6.11* |
11,443 |
6.11* |
13,221 |
1972 |
4.70 |
11,981 |
-3.6 |
12,745 |
1973 |
7.90 |
12,927 |
-12.5 |
11,152 |
1974 |
9.0 |
14,090 |
23.4 |
13,762 |
1975 |
38.3* |
19,486 |
38.3* |
19,033 |
1976 |
5.3 |
20,519 |
-3.9 |
18,291 |
1977 |
5.3 |
21,607 |
2.3 |
18,712 |
1978 |
7.2 |
23,163 |
7.9 |
20,190 |
1979 |
4.2* |
24,136 |
4.2* |
21,038 |
1980 |
12.7 |
27,201 |
7.9 |
22,700 |
1981 |
13.8 |
30,954 |
-0.5 |
22,587 |
1982 |
9.4 |
33,864 |
23.6 |
27,918 |
1983 |
20.3* |
40,738 |
20.3* |
33,585 |
1984 |
10.3 |
44,934 |
4.2 |
34,996 |
1985 |
7.3 |
48,214 |
29.8 |
45,425 |
1986 |
5.6 |
50,914 |
21.8 |
55,328 |
1987 |
2.3* |
52,085 |
2.3* |
56,601 |
1988 |
7.7 |
56,096 |
12.6 |
63,733 |
1989 |
8.4 |
60,808 |
0.4 |
63,988 |
1990 |
7.0 |
65,065 |
18.2 |
75,634 |
1991 |
20.3* |
78,273 |
20.3* |
90,988 |
1992 |
3.8 |
81,247 |
6.2 |
96,629 |
1993 |
3.1 |
83,766 |
0.03 |
96,919 |
1994 |
4.4 |
87,452 |
10.6 |
107,192 |
1995 |
33.5* |
116,748 |
33.5* |
143,101 |
1996 |
5.5 |
123,169 |
16.2 |
166,283 |
1997 |
5.3 |
129,697 |
21.8 |
202,533 |
1998 |
4.9 |
136,052 |
25.6 |
254,381 |
1999 |
25.2* |
170,337 |
25.2* |
318,485 |
2000 |
6.4 |
181,239 |
-2.2 |
311,478 |
2001 |
3.5 |
187,582 |
9.6 |
341,378 |
2002 |
1.6 |
190,583 |
1.0 |
344,792 |
2003 |
25.3* |
238,800 |
25.3* |
432,024 |
2004 |
1.5 |
242,382 |
1.4 |
438,072 |
2005 |
3.4 |
250,623 |
9.23 |
478,506 |
Total Returns |
2,406% |
4,685% |
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The results shown in the Table 3 provide a good insight into the two strategies of investment. It shows that the Melded Strategy (MS) or the combined strategy has produced a better return on investment as compared to the 4Year Cycle Strategy. However, the Melded strategy saw five years when there were losses ranging from –0.05% in the year 1981 to –12.5% in the year 1973.
It would not be right to take into account the year 1973, as this was a year of terrible losses due to the OPEC oil embargo. If the year 1973 is excluded then the range could be taken as –3.9% in 1976 to –0.05% in the year 1981.These results are extremely encouraging as compared to the results of Table 1.
Conclusion
The examples in the study is for a period covering 35 years and includes the ups and downs of the market especially the years of major declines like in the year 1987 and the 2000-2002 period. There have been two strategies studied here in comparison to the Buy and Hold Strategy (BHS), which are the Favorable Period Strategy (FPS) and the 4Year Cycle Strategy (4YCS). The two strategies have proved that it is possible to earn a higher rate on your investments by staying invested for a lesser time period.
This would in turn reduce the risk involved as well. The study depicts that the BHS or the Buy and Hold strategy has provided a return of only 1266% under the same conditions as compared to the FPS or the favorable period strategy which had a return of 1681% even though the investor remained invested for a period of 6 months every year.
In comparison to this the 4Year Cycle Strategy earned a return of 2406% by staying invested for only a period of one year for every four years. The BHS had more years of losses and also a higher risk involved. On the whole the the BHS had 69% successful years as compared to 82% successful years in case of FPS or the Favorable period strategy and 100% success in case of 4YCS.
Summary
The above study goes to show that one can earn a handsome return from the stock market even while staying invested for a lesser time as this would result in lowering the exposure to losses. The effects of the bear market were minimized to a great extent and at other points even eliminated in the study.
The adverse effects of the stock market crashes in the year 1987 and also the 2000-2002 have been eliminated (with only a marginal loss of –2.2% in the year 2000). The Melded Strategy discussed (a combination of FPS and 4YCS) has generated a result equal to 3.5 times the returns earned with the BHS or the Buy and Hold Strategy (with exposure to the market for a shorter period and also lesser risk).
Predictions
Predicting the stock market is a tough task, but observing the market has brought out clear trends or patterns over the years. This study aims at understanding such trends and also understanding future trends based on this. Based on an understanding of the past trends (based on available evidence) it can be forecasted that the stock market would be in a on a positive note for the period of one year from the fall of 2006 to the fall of 2007.
The year 2007 is a year preceding the Presidential elections in 2008. The results of the 4YCS goes to show that the average gain considering a time period of 35 years is 19.5% and thus, if the DJIA is at 11,689 on the 27th of September, 2006 then there is a possibility of an average increase of about 20%. This rise would take it to 14,027, which is great for the investor.
The article has only an academic motive in mind and does not suggest any particular approach for the purpose of making decisions regarding personal investment. The information provided and the analysis carried on is not for explaining any particular market trend.