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May, 2011

TO LOWER RISK, INVEST JUST 12 DAYS A YEAR!
by LARRY

Many thanks to my mother-in-law, Evelyn, for sending a newspaper article about this approach, which involves being invested in stocks or stock mutual funds on only the first day of trading each month, greatly reducing exposure to equity market drops by being on the sidelines roughly 95% of the time (the calculation assuming trading days average 20 a month).

The strategy is based on a 1/2/11 Associated Press article, by David K. Randall, "How to Beat the Market? Only Stay a Day at a Time." It turns out that, for various seasonality reasons, such as when mutual fund managers tend to add stocks to their portfolios, the first day of trading each month typically results in a bit more gain for equities than with the other trading days combined.



So, the idea is to place one's buy orders at the close of trading at the end of one month, after 12/31, for instance, and then place one's sell orders at the close of trading on the first trading day of the next month, 1/2, for example (since January 1 is a holiday). The rest of the time, one can park the proceeds in safe cash reserve instruments such as money market accounts. While the latter are hardly giving any yield at all recently, on average money market accounts have historically paid a return of at least 3.00%. Translating that into the method's non-equity holding period, one might over the long haul with this trading system obtain an extra 2.85% or better a year just from the cash reserves assets used in lieu of being in the market most of the time.


Added to that will be the average gains from equity investments on each first trading day of the month. Using an initial investment of $10,000 in the S & P 500 Index as an illustration, over the previous 11-years through the close of trading on 12/1/10, the gains, not counting dividends, from first trading day of the month investing (in an exchange traded fund tied to that index) would have been $3816. That is, one would end up with $13,816 at the end of the period, not counting money market gains, a 38.16% overall return.

If one were to add in a reasonable estimate of the average annual gains from the days when investments were in money market funds, the total comes to $17,441 (assuming average compound annual returns for the money market holdings of 2.85% times 11 years, beginning with $10,000 = $3625, and that amount added to the $3816 in total gains from the equities phase of the system). Dividends were not calculated, as it is too complex with so many very short-term holding periods and different dividend payment dates. However, there would probably be at least some stock dividends, which would add to the overall benefit of this approach. Even without them, the record of this system for the 11-year period ending at the close of trading on 12/1/10 would have been 74.41% overall, or an annualized gain of 5.19%.



In contrast, over the 11-year period through the close of trading on 12/1/10, for an investor who had simply invested $10,000 in the S & P 500 11 years earlier and held onto his or her shares, not counting dividends, the redemption amount would been only $8209. Per Standard and Poors, with all possible dividends added in, this rises to $10,365, still well below the gains from the one day a month strategy. This is only a 3.65% overall gain, or an annualized return of a mere 0.33%. On average, then, the one day a month trading system, everything else being equal, would have beaten a buy-and-hold approach by a minimum of 2.65% a year, but that becomes at least 4.86% annually if the average historical yields on money market accounts are added in.


All of this may be well and good, you say, but if it were great, why are money managers and financial consultants not generally using or advising this approach? Here are some reasons why not:

  • Probably the biggest hurdle of the one day a month trading system is that it results in higher taxes. Assets that are held for a year plus one day get long-term tax treatment. Profitable short-term trading gives income that is simply added to one's earnings to come up with the appropriate tax rate each year, then taxed at that often higher rate.

  • In addition, there would be commissions on each monthly trade vs. potentially just two trades, a buy and a sell, for the long-term buy and hold approach.

  • Also, the 2.85% average money market yield in the example above is far from assured. At current money market rates, one will be lucky if the income from the money market holdings simply offsets the commissions on the stock trades.

  • Such frequent trading also requires a lot more record keeping.

  • What is more, it is just extra hassle to keep track of precisely what day to buy and sell each month and to then exercise the discipline needed to make the indicated switches regardless of what else is going on in one's life at the time. Get it wrong once or twice, and one may acquire losses that undermine the rest of the system's gains.

  • One needs to remember as well that the 11 years through 12/1/10, taken as a whole, were extraordinarily dismal for stocks. There were two major bear markets. The two bull markets in the period were not sufficiently profitable to offset all the losses. A more normal 11-year period would have seen average annual gains for the S & P 500 Index of about 10%. Would the one day a month approach have been competitive during more lucrative times? The reported research so far does not answer that question.


With all of that being admitted, I think there may be a place for the one day a month trading system, albeit requiring that the trader have a compulsively methodical attitude toward his or her money management tasks. Given that required level of oversight and control, this method might be profitably used in that portion of one's holdings which are in tax-deferred accounts, eliminating the largest handicap, higher taxes.

Further, it might be a worthwhile system to use just some of the time, when coupled with other seasonality factors. For instance, the time of the year we are in now, from May 1 through October 31, falls under the "Sell in May and Go Away" guidance, so named because most of equity profits occur from November 1 through April 30, but the remaining months (May-October) generally have more volatility, and hence more and deeper periods of losses, as well as showing lower overall gains. There are typically profits, but they are so modest as to be almost insignificant.

Thus, one might reduce risk in the least profitable, most risky 6 months of each year by employing the one day a month strategy only in that period, then being normally invested at one's desired level in equities (for instance 60% of one's liquid assets) from November through April. This way one will at least still have a shot at close to or above average equity returns in the riskiest part of the trading year but with far less exposure to risk than with the buy and hold approach.

And if one is a trader anyway, used to dealing with higher taxes due to short-term transactions, one might use the one day a month technique along with margin debt during the riskiest 6 months of the year, increasing one's potential profits then, yet without seriously increasing risk and costs. As a rule, I do not like margin debt. However, this strategy is so low risk otherwise that if one is careful and disciplined it might be one way margin could be profitably employed.



In sum, a short-term trading strategy, such as one day a month in stocks, is definitely not for most of us, but it could be profitably employed by some, particularly during the May through October months, when ordinary long-term holdings are otherwise at greater risk of significant loss.


DISCLAIMER

Larry is not a professional. Don't take him seriously!

Actually, the investment article provided here is for general information only and should not be considered as professional advice, a solicitation to buy or sell any security, or the Word of God. Investors are encouraged to do their own research while considering their personal goals and circumstances, or consult their own professional financial advisors, before making investment decisions. Neither Larry nor LARVALBUG will be liable for any losses sustained by any visitor to this site.

(Disclosure statement: Larry and Val have holdings in some of the suggested assets but do not "make a market" in any of them and do not derive any direct benefit from recommending them, except perhaps for a bit of smug self-satisfaction.)



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