The Dow Theory compared to Buy and Hold

What happens in the long run to the Buy and Hold strategy compared to The Dow Theory?

There is a blog that made a comparison between the performance of the Dow Theory and the Buy and Hold strategies over a period of 115 years, from 1896 and 2011.

As we know, a simple strategy of buy and hold stocks in the Dow Jones has been quite a good investment even though the Dow has had periods with falls of 90, 50 and 40%. Despite that, we know that stocks will go up in the long run (till the end of the world of course).

However, this strategy has its limitations, and it is not advisable for anyone and anytime.

The other strategy is based on the fundamental ideas of The Dow Theory.

This one is more technical, and its objective is to get us out of stocks when a big bear market comes. Therefore, this strategy was quite good in years like 1929, 1973-4, 1987, 2008, for example.

Dow Theory entry

To enter the market again, you will have to wait for the bottom to be reached and a consolidation area.

You will enter the market again when it has already risen around 10%, depending the year it could be more or less.

Notice that this system does not say anything about going short, which in my point of view could make it more profitable, but that is another story.

Taking into account both strategies, it seems clear that both will perform quite well in secular bull markets. In markets with false bear signals (congestions) the buy and hold will perform better.

In bear markets, The Dow Theory will outperform buy and hold.

Dow Theory vs Buy and Hold

So let´s see the results of study:

  • 4% of the years The Dow Theory had the same return that Buy and Hold.
  • 4% of the years The Dow Theory had a better performance losing only 0.95% compared to a whopping 16.72% of the Buy and Hold (bear markets).
  • 2% of the years Buy and Hold had a return of 14.89% and Dow Theory 6.35%.

Both methods will have profits for the 115 years:

  • Buy and Hold: 496.56 – 491.56 + 613.46. Divided by 100 equals 6.18% as an average profit.
  • The Dow Theory: 496.56 – 27.93 + 261.62. Divided by 100 equals 7.30% of average.

In view of this, we can see that the years the “Buy and Hold” was better than Dow, it returned 402.66 % (0.412*115*(14.89-6.35)). And the years the Dow was better than Buy and Hold it returned 533.18 %.

So it seems that Dow Theory outperforms Buy and Hold by a significant amount.

However, there is a little problem with The Dow Theory. If we take into account that with The Dow Theory we will be out of the market, and therefore in cash some years, then it is logical that we lose some of the dividends of those years.

For example, if we got out of stocks in March 2008 and bought back in April 2009, we would have missed the dividends. If that happens almost every bear market like the ones in 1929, 1930, 1931, 1973, 1974, 1987, 2001, 2002, etcetera, then we would lose a significant amount of profits that in the long run will lower the bigger returns of The Dow Theory.

Also, we should not forget the transaction costs involved in buying and selling equities, because if we buy and sell 100 times then the commission costs will be felt.

Therefore, we could say that from the point of view of return and profits, both strategies are quite similar, with a slight advantage for The Dow Theory.

Dow Theory advantage, however, comes in the form of a psychological factor.

With that strategy, we will avoid panic moments and the psychological pressure that everybody faces when the markets have fallen a 90% (like 1929) and the End of The World seems close.

In moments like that, even some men with nerves of steel will succumb.