How to build a solid stock investment strategy if buy & hold will not work in 2023
How to build a solid stock investment strategy if buy & hold will not work in 2023
If you made big profits with stocks over the last decade, well, first things first: congratulations! You managed to achieve many more than you could not. But, now is not the time to rest easy on your laurels believing you’ve got the market figured out, because with the 2022 bear market, that landscape has changed.
As 2022 saw buy-and-hold strategies start to falter, flounder and all-out fail, other strategies took to the fore as the new techniques for successfully gaming a new market. Many of these were quantitative strategies based strongly on volatility and backed by powerful tools like stock screeners and backtesting. Those strategies are still what fill in the gaps today when buy-and-hold strategies may not be the wisest approach to reaching your investment goals.
When Buy and Hold doesn’t work
As any investment analyst knows, sometimes the market doesn’t move up or down but sideways. When that occurs, how do you make profits with a buy-and-hold approach? Answer: you don’t.
Rather, you need a proper approach to that market climate: A strategy that gives you the correct long and short signals and the ability to act upon them instantaneously. An approach that incorporates the powerful tools of a stock screener combined with backtesting may be just the one. But, before we get into all of that, let’s delve deeper into what’s so wrong with buy and hold?
It holds up your capital
The greatest downside of buy and hold is its outsized opportunity cost. In other words, in order to hold a security you buy for a long period of time, it means the money you spent on that security is now tied up in that security until you sell it. The market may swing up and down many times in the interim while your hard-earned investment capital is just sitting there along for the ride.
Yet, if you don’t do so, and you try to chase alternative investment options as the opportunity arises, you throw the benefit of buy and hold out the window, which is that it can protect you from the inconsistencies of market timing. If your asset is lagging, the type of self-discipline buy and hold requires can be extremely hard to practice. So, you’re left with capital that could be earning you higher, faster returns languishing for some illusion of certainty. (Remember, market timing is also involved when you eventually need that money, such as in retirement or a sudden emergency.)
It takes time for returns to show
It can be hard to persist with a strategy when it seems to be failing. Because the one certainty about the markets is uncertainty, that markets swing (seemingly) unpredictably all the time, the gains from a buy-and-hold strategy only show after those swings have smoothed out over a duration of time.
The buy-and-hold approach is based on the statistics revealing a general trend upward in the market over most 10- and 20-year periods. (https://financebuzz.com/average-stock-market-returns)
But, by failing to sell or short equities when they are expensive and go long on them when the return to their ascent, you are effectively reducing your potential income, increasing risk and lowering diversification.
And, what if you don’t have as long as it takes for a laggard dragging down your portfolio's potential returns to recover? What if your timing lines up with one of those rare periods when the results don’t conform to the trend? Consider the example of a fast-growing biotech equity and a lagging utility company. Sure, you can mitigate the opportunity costs related to a poorly chosen investment via diversifying or using the buy-and-hold strategy with an index fund.
But, with buying and holding a diversified portfolio, you’re living on the hope that a few stellar performers will outweigh all the poor performers; or, you could risk selecting only losers and miss out on the gains from the high-flyers.
And, when you buy and hold an index fund, you’re still not immune to events that can affect the entire index at once, such as a crash, an industry disaster or a global crisis. When the market crashes, it doesn’t matter that you’ve held that index fund for years; what’s taken place in that moment can still wipe out all the gains you’ve earned over those years–in an instant! An extended bear market can wipe out an entire index fund’s prior performance. Yet, the natural inclination for many investors at times like these is to cling to those losing assets in hope of a turnaround and, perhaps, even average down on the drop. Certainly, certain well-chosen assets backed by solid companies will bounce back, but many others can sink far enough to destroy an entire portfolio.
Consider the notorious Enron fiasco. Once upon a time, the company was considered a Wall Street darling, and in mid-2001, analysts valued the equity at about $90 a share. Following the discovery of its illegal accounting, however, the equity started dropping like a hot potato until reaching 60 cents per share by the time the business disbanded.
And, as indicated earlier, not only did this affect Enron stock in particular but the entire energy and utility industry. This can happen just as easily, too, when certain advances in technology make a whole industry or sector irrelevant. Had you invested in such an asset or sector and not used any signals to get you out of it at the right time, your entire investment could have been wiped out.
Quantitative Analysis and Volatility
One way to help avoid such a scenario is by using techniques like quantitative analysis and indicators like volatile conditions to know when, exactly, to get into an investment and when to get out of it.
The definition of volatility is as the standard deviation of an investment’s returns. In doing so, it serves as a measurement of risk. By tracking volatile conditions in any asset, sector and the market overall, you can better time your investments for maximum gains and optimum use of capital. By plugging volatile conditions into a quant investing algorithm, you can better identify signals to go long or short on a particular asset and invest in ways that exploit those rapid changes just as rapidly as they occur. In this way, you can scrape profits off of the same asset as it goes up and as it goes down.
The key to quantitative investing, known for short as quant investing, is the use of algorithms to analyse enormous quantities of data, then systematically executing trades according to the determinations of this analysis. Examples of data you might plug into such an algorithm include:
Pace of prices change
Instead of simply relying on future prognostications, a quantitative strategy grounds all trades in historical data.
Benefits of quant investing include:
Breadth – By allowing you to analyze a massive set of possible investments compared with only the handful that human analysts can capably focus on.
Cost – By relying on more affordable software solutions rather than employing excessive, expensive human managers and analysts.
Discipline – By basing your trades on the consistent application of programmed rules, removing the human element of psychology and emotions from trading decisions.
Speed – By allowing you to take advantage of opportunities over much shorter periods of time than buy-and-hold strategies, thereby permitting you to exploit new and evolving factors via executing thousands of trades per second.
While one common criticism of quant investing is that such strategies and techniques never (or rarely) catch the very top or bottom of the market, they also prevent over- or undershooting; they accept a smaller yet guaranteed profit in exchange for a larger potential profit. And, by doing this thousands of times per second, quant investors can easily compensate for this trade-off through the sheer quantity of such trades being executed.
Quant Investing in 2023
Now, let’s apply this knowledge to the coming year. The general market consensus is that 2023 will see a continued progression of increased volatility in the market: so much so that sufficient, adequate historical precedents may be hard to come by.
According to analysts from Morgan Stanley, the strong outperformance of quantitative strategies in 2022 was the result of several catalysts, including:
A tightening global central bank monetary policy, leading to significant macro trends that conformed seamlessly to the “trend-following” strategies many quant investors utilized
A disparity in worldwide interest rates, allowing quant investors to use “carry” strategies to collect the spreads between high and low rates
The re-emergence of equity value investing as investors were forced by higher rates to concentrate on fundamentals and, thus, the relative outperformance of value stocks
Valuation disruptions resulting from technological advances, thereby reversing much of that outsized performance.
The challenges that equity investors faced in 2022 included an S&P 500 about 19-percent down YTD, while government bonds and credit markets didn’t fare much better. Quant investors in the same challenging market environment, meanwhile, benefited from capital appreciation and diversification to post a total return of 3.9 percent.
Macro themes will continue to drive markets over the year ahead, according to Morgan Stanley. Analysts there expect the market environment to shift in 2023 from one marked by rising global interest rates to one marked by a receding of inflationary pressure, a slowing of global growth and, subsequently, an end to rate increases. The firm projects a 0.2-percent bottom of annualized growth in developed markets in the year’s third quarter. As a result, interest rate curves may steepen, causing a selloff in US equity markets in the first quarter as investors shift to fixed income investments like bonds. The firm expects the S&P 500 to bounce between 3,000 and 3,300 until closing out the year flat at around 3,900.
Applying this knowledge to quant investing, such swings point to strategies that follow short-term to medium-terms trends. You may also look at “carry” returns as disparities emerge in policies across global central bank policies. This may favor going long on bonds in places where high rates may cause investors’ holdings to appreciate as rates ultimately normalize. In addition, it may be beneficial to offset the higher capital cost with defensive investing in value-based assets, which look to deliver promising returns in '23.
For however long volatile conditions stay high, causing the market to continue to favor value investments, investments in high-quality, undervalued stocks seems wise. This means crossing quality and value filters in your quant algorithms.
Such an approach requires careful and well-timed trading, which quant investing allows you to achieve. It lets you construct a balanced portfolio that’s diversified not only across sectors or regions but across different quantitative strategies.
One factor intrinsic to successful quant investing, no matter your strategy in the moment, is transaction costs. Successful quant investing requires thousands of transactions over short bits of time, potentially cranking up transaction costs that eat into profits. Gains you achieve through strategies designed to offset physical market loss can be completely offset by these transaction costs, essentially debilitating hedging programs and causing missed opportunities to generate alpha. Each order, then, needs to be analyzed not just for its potential success but for how its transaction cost could offset any profit. Quant investing allows for such a necessarily granular view.
Vital to projecting what a particular investment approach may cost requires incorporating essential factors of any given trade, not least of which is volatility and also includes projected market impact, volume and the bid-ask spread. These are the very attributes you may plug into your calculations to model trading costs. This can also bolster strategies that assess any slippage between the live environment and the backtest model as well as shed light on what’s causing it.
Stock Screeners and Backtesting
Every investor knows the golden rule of investing is to “buy low, sell high. ” The key to achieving that prime directive is to select the right stocks at the right time using an effective strategy. Stock screeners can help you select the stocks that meet your model’s criteria. Then, backtesting can show you whether your investment approach for those stocks would have been successful for you over a historical period.
A stock screener allows you to set custom rules to come up with a list of stocks that potentially meet your investment criteria. Then, you can devise a whole investment approach around those stocks based on factors of volatile conditions and short-long, aka sell buy, signals, among others.
While you’re basing this calculus on data from today’s market, you can easily backtest your strategy against past data, and more particularly, against a specific period in the past marked by a combination of sideways movement of those stocks and high volatility. (This is just the scenario, in fact, that experts predict for 2023.) Then, you can glean whether your approach would have delivered you profits. While past performance is not a signal of future performance, it’s often a better gauge than mere fundamentals.
This evaluates how viable a trading strategy might be by assessing after the fact how well it would have worked out in retrospect according to historical data. If an approach proves successful using this method, a trader may feel emboldened enough to employ that approach moving forward, the theory behind this being that, if an approach worked well in the past, there’s a good chance it will also work successfully now and into the future; and, by the reverse token, if an approach worked poorly previously, there’s a good chance it will also work poorly now and into the future.
One tip for success with this technique is to select carefully the specific period of historical data you use as your sample. Once you find a potentially successful approach this way, you can then backtest it further using alternative periods of time or data that fall outside your sample, to verify how viable it may really be.
Given that both quant investing and backtesting rely heavily on historical data, they are a clear match for an alternative approach to investing than risky, expensive and inefficient buy-and-hold approaches.
The ten-year bull market ended in 2022. Buy & Hold did not work anymore. Volatility on the stock market is not likely to disappear anytime soon. However, if you have the knowledge and tools for making use of massive data sets to find those winning stocks, backtesting your strategies for hedging your bets and deploying those strategies at the optimal time, you give yourself a distinct advantage over the rest of the market.
Given the uncertain and not-confidence-boosting predictions for 2023, all signs suggest that yesterday’s investing wisdom won’t cut it today. That’s why we offer an alternative to weather these conditions and keep you on track to growing those profits.
Check out our other blog articles about stock screeners and backtesting tools, which allow you to build solid quantitative investment strategies.
Check out also the new stock screener and backtesting tool of SimFin that will be released in February 2023.
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