- Black swans exist among daily equity returns at a much greater than normal frequency. For example, a $100 passive investment in the Dow Jones Industrial Average at the beginning of 1900 grows to $25,746 by the end 2006 (5.3% mean annual compound return), but:
- Missing the 10 best days (0.03% of trading days) reduces terminal wealth by 65% to $9,008 (4.3% mean annual compound return). Missing the 20 best days reduces the terminal wealth by 83% to $4,313 (3.6% mean annual compound return). Missing the 100 best days reduces terminal wealth by 99.7% to just $83 (-0.2% mean annual compound return).
- Avoiding the 10 worst days boosts terminal wealth by 206% to $78,781 (6.4% mean annual compound return). Avoiding the 20 worst days boosts terminal wealth by 532% to $162,588 (7.2% mean annual compound return). Avoiding the 100 worst days boosts terminal wealth by 43,397% to $11,198,734 (11.5% mean annual compound return).
- On average across all 15 markets over many decades, missing the 10, 20 and 100 best days reduces buy-and-hold terminal wealth by 51%, 71%, and 98%, respectively. Avoiding the 10, 20 and 100 worst days boosts terminal wealth by 150%, 373%, and 26,532%, respectively. (See the chart below for more recent country by country data.)
The authors derive several points from this data but the point I would take is that one must control risk. The asymmetry of percentage returns makes big losses much more damaging than big gains are helpful. A 100 % gain is erased by a 50% fall. A 50% loss requires a 100% gain to recover. Loss control is key. Great market timing traders tend to be very good at controlling big adverse moves. The great buy and hold investor types are usually described as value investors because they focus on a "margin of safety" ( low risk ) before they ever get in. No matter your time frame of investing or trader focus first on not losing your money.
Update: Saw the following news item today:
The Shanghai Composite Index closed down 1.19% Wednesday at 4,803. At current levels the index is up 79.5% Y-T-D but off 21.6% from the life -time high of 6,124.04 posted October 16.That sounds pretty good for the year and it is. But the 21.6% fall back is 1,300 points while the gain now is about 2,100 points. So the drop from the highs is almost 65% of the remaining gain. A perfect example of the asymmetry of percentage gains and losses.
Update 2: For those interested in a counter argument to the main topic discussed in the CXO post or in the paper they site I suggest Mark Boucher's excellent book "The Hdege Fund Edge" or Nelson Freeburg's Formula Research paper on Boucher's method.
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