Aim shares have roared back: the FTSE Aim index has risen 50 per cent since its low point in March. History suggests we should jump on this bandwagon.
My chart shows why. It shows how investors would have fared if they had applied the 10-month average rule proposed by Meb Faber at Cambria Investment Management to the Aim index. This rule advocates buying when prices are above their 10-month average, and selling when they are below it.
Had you followed this rule since 1996 – being in cash when not in Aim shares – you would have quintupled your money before dealing costs. That’s an average annualised return of 7.3 per cent. By contrast, staying in Aim shares would have made you less than 1 per cent per year even including dividends.
The 10-month rule has worked because it would have got us into Aim share just before big rallies, such as the tripling of prices in the late 1990s and doubling in 2009-10. But it would have got us out before big falls. The rule told us to sell in May 2000 thus saving us a 66 per cent loss, and to sell in August 2007 thereby saving us from a 50 per cent loss.
There’s a reason why the rule works so well. Aim shares tend to be small, young and hard to value. Which means that they are driven by sentiment even more than other stocks. And sentiment is infectious: it spreads from person to person. As Cornell University’s Robert Frank showed in Under the Influence and Yale University’s Robert Shiller showed in Narrative Economics, our beliefs are formed by our peers. When some investors buy, others follow.
Prices rises thus feed on themselves, as do falls. The 10-month rule allows us to surf the waves of sentiment while also telling us when to jump off. And right now, it is telling us to buy.
But, but, but. There’s an obvious problem here. We cannot trade the Aim index itself. We can only buy individual Aim stocks many of whose returns differ a lot from the index’s. And it’s expensive to buy and sell these as often as the 10-month rule requires.
All true. But the rule is still useful. Think of it as being like advice to anglers on when and where to fish. Such advice doesn’t guarantee a big catch but it does tweak the odds in his favour. The rule now tells us that the Aim lake is better-stocked than usual.
What’s more, this exercise tells us that two common pieces of financial advice are wrong.
One is the idea that you cannot time the market. The rule tells us that in fact we can. Of course, it doesn’t get us into the market right at the bottom and out right at the top. But it does protect us from the sort of long bear markets that can destroy our wealth. That’s a great thing.
The other wrong advice is that equities should be a long-term investment. Aim stocks are not. The index has under performed cash over the last 25 years. But it has given us some great short-term profits, rising more than 50 per cent not just in the past few weeks but also in 1999, 2004 and 2009.
And herein lies the point. It’s easy to get carried away by short-term profits into thinking they can continue. But they don’t. In fact, Todd Feldman at San Francisco State University has shown that believing that the current environment will persist is one of the most expensive mistakes investors make.
Aim shares can sometimes make a nice short-term relationship, but they are a lousy marriage. The 10-month rule gives us the discipline to exploit this fact.
