Advantages and Disadvantages of Buying the Best Vs. Worst Performing Stocks
This article is not about a recommendation of a specific strategy. The goal is to provide insight into a well-known puzzle: growth investing versus value investing. Thousands of articles have been written on this subject, but the debate is as lively as ever: is buying growth stocks or value stocks more profitable? The short answer is: it depends on the market regime.
To illustrate the main point of this article, let’s look at two simple strategies:
- Buy the 20 best performing stocks in the S&P 500
- Buy the 20 worst performing stocks in the S&P 500
Best and worst performers are defined in terms of the 252 day rate of change metric. S&P 500 stocks are ranked according to the metric and the first strategy invests in the top 20 stocks and the second in the bottom 20 stocks.
Rebalancing takes place at the end of each year or after exiting positions due to the S&P 500 falling below the 200-day moving average. It’s a filter to avoid bear markets, at least in part, because it makes no sense to stay invested in such markets. Positions are restored when the S&P 500 crosses above the 200-day moving average. This filter to avoid strong corrections and bear markets has at least one serious drawback: there can be a saw-off effect due to the price of the S&P 500 fluctuating around the 200-day moving average, but this is rare.
The duration of the backtests is from 01/02/1990 to 02/10/2022. Commissions and slippage are not included as the objective is to examine general trends. A more serious problem when backtesting equity strategies is survival bias. To address this bias, we used price series of Norgate Data which include current and past constituents of the S&P 500. Note that if a stock is delisted, it is removed from the portfolio and there is no immediate rebalancing.
Below are the backtest results. The Y axis is a logarithmic scale for stock performance.
The top chart shows the stock performance of the buy strategy of the top 20 stocks. The next chart below is the strategy’s equity decline profile for the best stocks. The following graph shows the performance of the shares of the buy strategy of the last 20 stocks. The next chart below is the strategy’s equity decline profile for the lowest stocks.
A brief note on backtests: Realistic backtests always have volatile equity curves. Backtests with smooth straight lines on the logarithmic scale or exponential growth on the linear scale may be due to several sources of bias, including but not limited to data mining, spying on data, anticipation and survival.
The results are summarized below and compared to the S&P 500 Total Return.
|20 Stockings||20 High||buy and keep|
Here are some of the findings from the table above:
- Buying blue chip stocks or buying and holding have same equity volatility.
- The purchase of the last 20 shares has decline in equity volatility as expected.
- buy and keep outperforms both strategies even before commissions and slippages.
Buy and hold outperform on both an absolute and risk-adjusted basis. So this whole growth versus value conundrum has been to use additional filters to identify stocks beyond the metric we used in our backtest, including fundamentals. Essentially, a stock selection layer has been added. This may introduce bias in backtests due to multiple trials after changing the ranking metric for stock picking. This problem in itself presents another new conundrum.
The importance of diet changes
If the decision is made to follow a strategy, then the issue of growth versus value can only be resolved within the context of the current market regime.
Specifically, the best performing stock picking strategy generated the maximum decline during the dot com bear market, while the worst performing stock picking strategy generated the maximum decline in 2016 and when value stocks started. to underperform.
After the March 2020 crash, the stock started to outperform again, as shown in the strategy performance chart above. Is this a regime change or a “transient” behavior?
An answer to the above question could mean the difference between a 30% and 50% drawdown if a bear market occurs next, depending on whether you invest in growth or value stocks. Growth stocks generally have a higher beta and fall more than value stocks, which tend to have lower volatility.
Knowing when there is a change in the market regime is in many cases much more important than the strategy used. This is the main point of this article and obvious to many. Most seasoned investors know this well.