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A subscriber sent me the below article, and I thought you might find it interesting.

Buy strength, or buy weakness? In the most concise way possible, that simple question marks a dividing line between most fundamental investors (at least of the value ilk) and most technicians (from the "breakout" camp). Given that, I ran a simple -- very simple -- test to see which strategy proved more profitable.

Using the S&P 500 as my sample set, my "buy strength" test had me buying any stock that had just made a 50-day high. Each trade took 10% of my equity, and I simply held for 30 days before selling. The "buy weakness" test was just the opposite. I bought any stock making a 50-day low, with all other parameters being identical. Both tests started in mid-1985.

The results were surprising. The strength test consisted of 1,583 trades, yielding a 10.35% yearly return, with a whopping 40.45% maximum drawdown. On the other hand, the weakness test had 1,592 trades, resulting in a healthy 25.28% yearly return, with a manageable 29.17% maximum drawdown.

So, go figure: Buying weakness trumped buying strength. For me, that's right up there with admitting golf is not a sport!

Q: What was the average win for each trade? Average loss?

A: The average win for each trade in the "buy weakness" was 11.14%. Average loss was 8.56%. Win percentage was 59.48%.

Q: What is maximum drawdown?

A: Maximum drawdown is the largest percentage drop from peak to trough (in terms of equity) before a new peak equity is achieved. For example, if you started with $100 and moved your equity to $200, then went down to $100 before getting to $201, you'd have a 50% maximum drawdown.

Q: Fascinating piece! But it begs the question ... if this [buying on weakness] strategy can return an average 25% per annum, then why bother with any other? In fact, why bother trading at all? Just set up automatic trades and sit back. Surely a trading strategy can't get any simpler than this, and yet the return is outstanding.

A: This really gets to the core, doesn't it? So let's stipulate that the point is well-taken. In fact, with a little tweaking, one could use this strategy and beat nearly 99.9% of all funds, mutual, hedge and otherwise. Still, people resist. Why?

Most traders/investors think they're better at trading than they really are. A purely mechanical strategy for them? It'd be a slap in the face, because they know they can easily do better than 25% per year! 

Remember, most traders/investors/fund managers are fundies. For them, the "story" is everything. No way a hedgie is going to tell their clients they bought XYZ simply because it was at a 50-day low. Shoot, if it were that easy, the client could do it on his own!

Even a 29% drawdown is a bit hard to take. Of course, if you're in the market long enough, that's pretty standard. But again, no one ever thinks that will happen to them. (See No. 1)

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