Avoiding Black Swans

This Article written by Chuck LeBeau was originally published in Trading Markets and has been since re-posted in many websites

It is a great article and it demonstrate the absolute need of having a valid exit strategy.


A very comprehensive study of the Dow Jones Industrials caught my eye recently and I want to share some thoughts and conclusions based on the data in the study. The data I will be referring to is from a study encompassing more than 100 years of daily data on the Dow Jones Industrial Average. (Black Swans and Market Timing: How Not To Generate Alpha, by Javier Estrada, International Graduate School of Management, Barcelona, Spain) The data presented in this study begins on December 31, 1899 and ends on December 31, 2006. In total the study encompasses 29,190 trading days. I have highlighted the data about the worst days because it is usually ignored.

1) A $100 investment at the beginning of 1900 turned into $25,746 by the end 2006, and delivered a mean annual compound return of 5.3%.

2) Missing the best 10 days reduced the terminal wealth by 65% to $9,008, and the mean annual compound return one percentage point to 4.3%. But avoiding the worst 10 days increased the terminal wealth by 206% to $78,781, and the mean annual compound return by more than one percentage point to 6.4%.

3) Missing the best 20 days reduced the terminal wealth by 83.2% to $4,313, and the mean annual compound return to 3.6%. But avoiding the worst 20 days increased the terminal wealth by 531.5% to $162,588, and the mean annual compound return to 7.2%.

4) Missing the best 100 days reduced the terminal wealth by 99.7% to just $83 ($17 less than the initial capital invested), and reduced the mean annual compound return to −0.2%. But avoiding the worst 100 days increased the terminal wealth by a staggering 43,396.8% to $11,198,734, and more than doubled the mean annual compound return to 11.5%.

The author of this study concludes that these outlier days in either direction (the Black Swans) are so rare that it would be impossible for market timers to capture or avoid them.
I strongly disagree.

First let’s look at what it is we want to do with market timing. Do we want to capture the positive Black Swans or simply avoid the negative Black Swans? It would seem obvious that we would want to do both but if we had to choose only one course of action it is clear that we can derive the most benefit from avoiding the negative Black Swans so let’s start with that. Let’s see if we can avoid big declines using market timing.

As director of quantitative analytics at SmartStops.net I recently directed a ten-year study of the stocks in the S&P 500 Index. The study was intended to measure the various peak-to-valley drawdowns of each of the 500 stocks. Any drawdown of 15% or more was identified and measured. Since this article is focused on big drawdowns (the Black Swans) we will only look at peak-to-valley declines of 60% or more. Here is the data:
1) Of the 500 stocks 267 of them had experienced a drawdown of 60% or more.
2) 175 of them had experienced a drawdown of 70% or more.
3) 105 of them had experienced a drawdown of 80% or more
4) And 51 of them had experienced a drawdown of 90% or more.
5) The average of the largest drawdown of the 500 stocks was 61.67%

Those numbers might seem high at first glance but they are actually understated by quite a bit. The drawdown study ended in May of 2008 and we all know that the market has gone down a great deal since the study so the magnitude of the drawdowns would be even greater if the same study were conducted today. Also, as in any long-term study of a group of stocks, the results are skewed by “survivorship bias”. There were a lot of stocks that might have been in the S&P 500 ten years ago but for one reason or another they are no longer in the current index. Some of those stocks have declined to zero and are not included in the study.

Having looked at the nature of the problem let’s get back to the task at hand. Can market timing help us to avoid these drawdowns? Yes, it definitely can. A logical application of trailing stops would have avoided most of the big declines. Here are the results using the SmartStops trailing exits that are available for free on our web site.

1) Of the 500 stocks only 4 of them had declines of 60% or more.
2) There were no stocks that had declines of 70%, 80% or 90%.
3) The average of the largest drawdown of the 500 stocks was 22.58%

Now I must admit that I think that our SmartStops trailing exits are more sophisticated and effective than most trailing exits because the SmartStops are adjusted daily for trend direction and changes in volatility. However any serious effort at limiting the drawdowns with conventional trailing stops would certainly have had a very positive effect in reducing the magnitude of these declines. As the quoted Black Swan study clearly shows the avoidance of big declines improves performance very significantly. Here is a reminder of how that works:

1) It takes a gain of 150% to recover from a 60% decline.
2) It takes a gain of 333% to recover from a 70% decline.
3) It takes a gain of 500% to recover from an 80% decline.
4) It takes a gain of 900% to recover from a 90% decline.
5) It takes a government bailout to recover from any decline greater than 90%

Skeptics of market timing usually argue that efforts to avoid big down moves will result in missing the biggest up moves. However[The Discount code is SG2FREE30]I have never seen a study that shows any evidence to support that preposterous assumption. If you limit your losses and are willing to enter on strength you will not miss any major up trends. With a little planning and effort you can capture the Black Swans on the up side and avoid the Black Swans on the down side.

Chuck LeBeau is director of quantitative analytics at SmartStops.net and co-author of Computer Analysis of the Futures Markets (McGraw-Hill). For more of Chuck's commentary, visit www.smartstops.net

Trading Market http://preview.tinyurl.com/beadqz