If you had bought shares in the IPO of Apple at the IPO price of $22 in 1980 and held them through to the present day, you would have achieved a compound annual growth rate close to 17%. $100 invested in 1980 would be worth around $17,000 today, not including the sparse dividend payouts.
But take a look at the first chart below: this is the stock price since 1985. The chart immediately below that represents the peak to valley drawdowns Apple has suffered during its tumultuous history.
What would it have felt like holding Apple stock when it was suffering an 82% draw down from its equity high? The average of the five largest peak-to-valley percentage drawdowns has been a whopping 65%. I wonder how many investors had the guts (or more probably the luck) to hold Apple over the years through good times and bad.
We all know the Apple story but let’s revisit it in conjunction with the share price chart. On 12 December 1980, Apple launched the Initial Public Offering of its stock to the investing public. When Apple went public, it generated more capital than any IPO since Ford Motor Company in 1956. But it was five years before the stock rose and remained above its initial offer price.
After a dramatic rise in price through to the end of 1987, the stock did little overall for the next decade and by 1997 was 82% below its all-time high. If you sold out at this stage (at an unadjusted $29) your return would have been a miserable 1.6% per annum over 17 years.
What ailed Apple during these years? Founder Steve Jobs was ousted by Jon Sculley following a power struggle in 1985. Competition from Microsoft, who launched their Windows GUI and gained market share. Competition from other operating systems. A series of failed consumer products.
How would the average investor have felt during this period? Would he have held the stock during these times of severe decline and lacklustre performance? Research has shown that the vast majority of stocks ever listed have ceased to exist – why should Apple have proved the exception? There seemed to be good reason to sell out and many did so.
Would any of us have had the luck or skill to predict the return of Steve Jobs as CEO and the subsequent soaring of the stock price through to the present day? Who can know the future? Not I, that’s for sure. Where will Apple go from here? I don’t know and nor does anybody else for certain. What do the analysts say and do they know more than the man on the street?
I have been an analyst with an investment bank myself. Their job is to generate commission for the sales desk. Analysts may know a lot about the companies they follow, but they are no better at predicting the future than you are.
So what do I recommend? I recommend ignoring the news and taking a sceptical approach by following the share price using a simple, rule-based mechanical system. Why? On the whole, doing so is likely to produce better long-term, risk-adjusted returns than either Buy and Hold or discretionary fundamental analysis. Let us apply one simple trend-following system (amongst scores of possibilities) to Apple stock since 1985 and compare the risk/return statistics to Buy and Hold.
Here is a bog standard, no frills, easy-to-understand, trend-following system. A Bollinger Band breakout.
I like it; I have traded it and will in all probability do so again. Long established masters of the universe can switch channels here; those newer to the game should stay tuned and read on.
I am told this system was described by Chuck LeBeau and David Lucas in their 1992 book Technical Traders Guide to Computer Analysis of the Futures Markets. It’s dead easy to trade and you only require end of day data. It’s a relatively slow system, so good for the hobby trader with a day job, or anyone else who does not wish to sit glued to a screen all day.
- Calculate the simple moving average of the close for the period of your choice. I shall use 80 days for this example.
- Calculate the standard deviation of the close over the same 80-day period.
- Surround the 80-day moving average with an upper and lower band.
- The upper band equals the moving average plus two standard deviations.
- The lower band equals the moving average minus two standard deviations.
- Use whatever multiple or fraction of standard deviation you choose: I shall use two for this example.
- Long entry: If you have no position, when the price closes above the upper band, buy at the market on the open of trading on the following day.
- Long exit: If you are long and the price closes below the moving average, exit at the market on the open of trading on the following day.
- Short entry: If you have no position, when the price closes below the lower band, sell (go short) at the market on the open of trading on the following day.
- Short exit: If you are short, when the price closes above the moving average, buy at the market on the open of trading on the following day.
- Stops: If you like to use stops, you can use the current moving average level to place your stops in the market. And update them daily or periodically.
Risk a small fixed percentage of your account value on initiation of each trade. Your risk is the difference between your entry price and the moving average, excluding overnight movement, gaps, slippage and fast markets. Let’s use 5% of capital on an account of say $300,000 trading just Apple.
position size = (desired percentage risk x trading equity)/(entry risk )
Let’s apply this to a long position in Apple on 9 January 2012. Use the previous close of $422.40. The moving average was $394.62. Risk is therefore $422.40 – $394.62 = $27.78.
Position size is therefore: (0.05 x 300,000)/(27.78) = 539 shares. 539 shares assuming an entry price of 422.40 will cost $227,674. Although you have paid $227,674 for your shares your risk is only $14,957, since your predefined exit will be at $394.62.
Here are the assumptions made in my test run:
- Long only trades taken
- Risk per trade: 5%
- Slippage: 7%
- Commission: $0.01 per share
- No interest earned on unused balances
- Starting capital: $300,000
- Start date: 1 July 1985
- End date: September 2013
In the two charts below you will see the results of trading Apple shares on this basis.
Here is a table from which you can see the relative merits of Buy and Hold and the operation of this simple system for the period concerned:
The system (at the given position size) results in a lower absolute CAGR. A number of important factors must be noted:
- Absolute return could be greatly increased by using a higher position size if desired.
- The risk-adjusted return for the system is far higher than that of Buy and Hold, the number of winning months is far greater and the maximum peak to valley drawdown is much, much more bearable.
To find the risk-adjusted return, divide the higher annualised standard deviation of monthly returns of the Buy and Hold by the much smaller standard deviation of the BBBO system results: 46.57 / 13.56 = 3.43.
Now divide the higher CAGR of Buy and Hold by this figure to give you the risk-adjusted return of Buy and Hold (i.e. what return you could expect from Buy and Hold for an equal standard deviation to that of the BBBO system): 20.89% / 3.43 = 6.09%.
Now let us take a cooler, more rational and more cautious approach to investing. Single stock risk is not worth taking. When the next Enron or Lehman hits the headlines you will be grateful you were investing and trading a large, diversified portfolio.
Would I want to risk 5% per trade? No, I would not. I would want to trade a big and diversified portfolio and risk a much smaller amount per trade. By doing so I would expect the CAGR to increase (certainly in risk-adjusted terms) and the maximum drawdown to remain at similar levels or decrease.
My belief is that successful investing is not complex and that the adoption of simple, rule-based trading methods is likely to provide far better returns than conventional stock picking approaches based on discretionary decisions and fundamental analysis.
Don’t forget the above results are purely hypothetical. The potential investor considering mechanical systems must take a great deal of time and effort to devise and test strategies on a great variety of historical data. Investors must satisfy themselves that the concept has reality and there is a prospect of success in live trading going forward.