Do NOT Ditch ‘Dogs of the Dow’

Posted on Feb 25 2016 - 2:45pm by Dan

A few days ago I wrote an article, in which I gave away … for free, a profitable investment strategy.

It works.  It works well, and it has a ton of data behind it.  It is not the best long-term investing strategy I have.  I feel the best investing strategy that I have, is contained within our valuation course.  But I am passionate about helping folks at home, who wish to direct their own investments.  And truly, there are many, many, many different ways to invest and trade.  So we freely shared “Dogs of the DOW” as a longer-term strategy, that ones could use if they wished.

However, some have leveled criticisms towards “Dogs of the DOW”, and I would like to address those criticisms here …

The Dog Portfolio’s Construction is a Mismatch to the DJIA’s Structure:  This perhaps, is one of the worst and most egregious arguments of all.  It belies a basic and critical misunderstanding of the quantitative mathematics of any profitable investment strategy.

Basically what this argument is saying, is that the Dow Jones Industrial Average price weights the stocks within the index.  Whereas the ‘Dogs of the DOW’ gives equal weight to the ten stocks that it holds.  What does this mean?  Well, you may have IBM trading at $130 and VZ at $51 per share, right?  How much importance do you give each one of those stocks in a portfolio, when the price is quite different, as well as the general size of the company and it’s balance sheet?  When you price weight a stock within an index, the stock influences the index in proportion to it’s price per share.  In other words, you take all of the stocks within the index and divide them by the total number of stocks.  Whereas, when you equal weight, you give small companies the same amount of weight as you would large companies.

So is the “Dog Portfolio” a mismatch to the Dow Jones structure?

Yes!  Absolutely!  Who cares ?!?

Show me a trade desk, anywhere on planet Earth, in which the Risk Manager seeks traders with strategies that uses components of an index, and then asks if their strategy uses the same weighting construct as the index.  Please.  I’m begging you.

Because you would have just identified the most idiotic firm on planet Earth.

If you use the exact same method as an index and try to mirror that index as closely as possible, at a certain point you might as well buy that Index via an ETF.  If you can earn a return with less volatility, but near the same amount as the index?  And do so repeatedly, year after year after year in a multitude of environments?  Who cares how you do it!  This isn’t NASCAR.  We’re not measuring body panels, to make sure they are the same ‘weight’.

Let me put it this way.  A trader comes to me, and tells me that he has a strategy that can beat the market.  It produces great results, it’s historical results can be tracked back for 80 years.  People are using it, to this day.  I can guarantee you I am not going to ask him if he uses the same weighting formula as the index that some of these individual names may just so happen to be a part of. 

There are no ‘rules’ as to how you beat a stock index, other than amount of risk you are willing to accept as seen in risk-adjusted performance metrics.  It’s a marketplace.  It’s a competition. DOW Jones has their method of weighting the index.  Great.  Wonderful. You get to use whatever method you wish to use, to earn a good risk-adjusted return.  As a matter of fact, the less correlated your particular approach is to the index, mathematically the better your performance may be.  End of story.

The Basis of the Dogs of the DOW approach Leaves Many Unanswered Questions:  Again, in all honesty, I am shaking my head that this is even proffered as a concept worth consideration.  The exact phraseology used as a counterpoint was: “this simplistic methodology leaves so many un-analyzed questions“.

Welcome to investing and trading the markets.  

Any professional trader on planet Earth is going to tell you the same thing.  In order to trade profitable, you must learn to embrace uncertainty.  There is no investment strategy on this planet that can answer every question, and guarantee anything.

The best investors, and the best traders I have met with my nearly 20 years in this business?

Keep it simple.  And they embrace uncertainty.

And I want you to notice something with these arguments.

They are not saying that “Dogs of the DOW” does not work.  What the author is saying, is that he doesn’t like it, because it can’t answer all the questions for him.  Nor does he ever specify what his exact investment approach is, using these metrics.  

Quite frankly, I don’t care what his investment approach is.  There are many methods to invest and trade.

And the fallacious arguments only got worse, as the article went on …

Dependence on the Calendar Year:  Just so that I am not quoting something out of context … allow me to quote what the author stated … exactly …

“The portfolio is built only once a year, using year-end dividend yield data. (Plus, all positions no longer in the top ten yielders are automatically sold.) But there is no magic in the annual calendar, other than seasonal and tax effects”

Are … you  … kidding me?

Again, this belies a basic misunderstanding of the quantitative mathematics behind any investment or trading strategy.

The periodicity is one year, which is not dependent on the calendar year.   The periodicity of a strategy and the calendar year are two different things. And quite frankly … who cares if it is only built on the calendar year!  

The proof, is in the pudding.  The results of the strategy speak for themselves.  I mean, this objection is so … inane on the face of it, I almost don’t know where to begin.

Freezing the portfolio names for the year:  The objection seems to be, that you should not freeze assets for one year.  Well … the periodicity / time-frame of one year, is actually part of the strategy itself, and since the strategy actually works I’m not really sure what the point is here?

In fact, the aforementioned article that objects to the “Dogs of the DOW” strategy, only highlighted the point that I made in our original article on the strategy itself, namely …

It is typical to see many new retail traders obtain such a method, that has been proven to work over time and they then try to “improve it” … and “tweek it”, because they are ‘bored’ with it.  Or in a completely egotistical manner they think they can mathematically improve the edge; without understanding the mathematics that creates the edge, and despite the fact that they’ve only been trading for one year.  And their lack of discipline manifests itself in a variety of actions.  For example, they take their profits too soon and do not hold the stocks for a year.  Then they will add a technical tool, and then someone else with some winning profits distracts them, and they tweek it again.  And soon, they have destroyed the very process they were attempting to use.  By ‘tweeking it’, they have removed those independent variables that worked to give a consistent edge in the first place.

No Rebalancing:  And once again, I am stumped.  Because this objection is factually incorrect, just on the face of it.

Absolutely “Dogs of the DOW” is re-balanced.

Once per year.

Which is outlined in the mandate of the strategy itself.  At the end of the year, you sell everything, and look for the new 10 stocks to purchase. 

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