Investment Strategies Inspired By The Seven Rules Of Wall Street

You need to be decisive, patient and unemotional about your investment decisions. But you also need to be opportunistic. The strategies detailed in this blog post are strategies which have beaten the S&P 500 by a significant amount and done so consistently. But remember that the returns do not include for taxes, slippage and transaction costs and one has see whether it makes sense to invest in this way after accounting for these factors. Simple buy and hold with dollar cost averaging may not give the greatest returns but will be good enough if you can persist with it long enough.

RULE 1: LET YOUR WINNERS RIDE, BUT CUT YOUR LOSERS SHORT

The investment strategy based on this rule is as follows:

  1. The S&P 500 consists of a number of industries and a number of sectors.
  2. At the point you want to invest, calculate the trailing 12 month return for each of the industries and each of the sectors.
  3. Invest in the top 3 sectors which have had the highest 12 month trailing return. Hold for a year. Repeat step 2. You can easily do this by investing in ETFs or sector funds. The annual compounded return from 1990-2007 for this strategy has been 10.8% compared to 9.2% annual compounded return for the S&P 500.
  4. Invest in the top 10 industries which have had the highest 12 month trailing return. Hold for a year. Repeat step 2. If you have a big enough pot, you can buy all the stocks but that will difficult for most. Hence you can buy the stock with the largest market cap in each of the top 10 industries( objective choice) or buy the stock which you think has the best prospects( subjective choice). The annual compounded return from 1970-2007 has been 13.7% for this strategy compared to 7.6% for the S&P 500.

RULE 2: AS GOES JANUARY, SO GOES THE YEAR

The investment strategy based on this rule is as follows:

  1. Calculate the return for the month of January for each of the industries and the sectors.
  2. Invest in the top 3 sectors from February 1st of this year to January 31st of the next year. Repeat step 1. The annual compounded return for this strategy from 1990-2007 has been 12.4% compared to 8.3% for the S&P 500.
  3. Invest in the top 10 industries from February 1st of this year to January 31st of the next year. Repeat step 1. The annual compounded return for this strategy has been 15.9% compared to 7.6% for the S&P 500.

RULE 3: SELL IN MAY AND THEN GO AWAY

The investment strategy based on this rule is as follows:

  1. The S&P 500 performs better during the November-April period than the May-September period. The reasons may be because of vacations, a lack of capital inflows and earnings reality overtaking optimism. The November-April period is dominated by cyclical sectors while consumer staples and health care do the best in the May-October period.
  2. Invest in the S&P 500 from November to April of each year. Then invest in the consumer staples or health care sector or in both these sectors from May to October of each year. The annual compounded return for this strategy has been 10% compared to 5.8% for the S&P 500.

RULE 4: THERE’S NO FREE LUNCH ON WALL STREET( OH YEAH, WHO SAYS?)

The investment strategy based on this rule is as follows:

  1. Diversification is only true free lunch on Wall Street. Diversification works best when you use assets that have low correlation with each other.
  2. Information technology and consumer staples have the lowest correlation with each other among the sectors in the S&P 500.
  3. Invest 50% in the IT sector and 50% in the consumer staples sector and rebalance annually. This strategy gives an annual compounded return of 11.2% versus 8.2% for the S&P 500 from 1990-2007

RULE 5: THERE’S ALWAYS A BULL MARKET SOMEPLACE

The investment strategy based on this rule is as follows:

  1. Momentum works. Calculate the trailing 12 month return for the sectors and industries of the S & P 500.
  2. Invest in the top 3 sectors or top 10 industries.
  3. Repeat step 1 and step 2 every month. The sector strategy has an annual compounded return of  13.4%, the industry strategy 20.1% compared to 9.2% for the S&P 500 from 1991-2007.
  4. These strategies have high turnover. One way to decrease the turnover is to invest in the top 10% of the industries but only sell them if they go below the top 30% of all the industries.

RULE 6: DON’T GET MAD, GET EVEN

The investment strategy based on this rule is as follows:

  1. Equally weighted indices will give better returns than market cap weighted indices because they have higher percentage of small companies.
  2. Using equal weighted indices for the above strategies may give better returns over the long run.

RULE 7: DON’T FIGHT THE FED

  1. The S&P 500 gives a better return 6 months and 12 months after a rate cut than a rate hike.
  2. The sectors that perform the best 12 months after a rate hike are information technology, health care, telecommunications services and energy.
  3. The sectors that perform the best 12 months after a rate cut are information technology, consumer discretionary, industrials, consumer staples and health care.

The rules and the strategies detailed above can be modified to any other stock market also and may be helpful to outperform the market. But as I said before, a simple buy and hold strategy with dollar cost averaging may be the best for most as these strategies require you to monitor things for a long period and also stick with them when they are underperforming.

-personal notes from the book: The Seven Rules of Wall Street by Sam Stovall

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