Conceptual Paper Of The Trading Strategy: Dogs Of The Dow Theory (Dod)
University of Technology MARA (UiTM) – Faculty of Business and Management
University of Technology MARA (UiTM)
June 4, 2014
Investment objective of yielding higher return at lower risk is one of the challenges faced by participants (mainly investors) in share market. With an aim of overcoming this common challenge, past scholars have tested various trading strategies and even proposed new strategies but the outcomes are still puzzling. These high evolutions pertaining to trading strategies that occurred in investment world are covering several aspects such as fundamental features (ratios of the companies) and the economic variables yet the results were discourage due to mix results reported. Ample of causes could attribute to these situations where one of the most identifiable reason was unpredictability in global economic condition. Thus, this paper attempts to focus on the high yielding strategy of Dogs of the Dow Theory as one of the trading strategy in constructing portfolio in which this strategy are distinctive from the common high yielding approaches. This paper consists of several parts, namely the evolution of the trading strategies and the empirical evidences supporting Dogs of the Dow Theory as a trading strategy.
Conceptual Paper Of The Trading Strategy: Dogs Of The Dow Theory (Dod) – Introduction
Effective trading strategies defined as decisions made by investors to manage their investment in order to meet the goals and objectives in investing activities (Brown and Reilly, 2009). Trading strategies will benefits the investors from several aspects especially in gaining higher returns at lower risks. Further describes as the actions taken by companies and investors in generating desirable returns through designated portfolios, powerful and reliable trading strategies are also crucial and are required because of the competitions among companies in attracting potential investors (Ekaputra and Sukarno, 2012).
In investment world, returns are known as rewards for investors in bearing risks, whereas risks are the chances that the actual returns vary from the expected returns targeted by the investors (Basu and Chawla, 2010). Usually, risks fall under two categories, namely systematic risks (uncontrollable and non-diversifiable risks) and unsystematic risks (controllable and diversifiable risks). However, in relation to investment activities, only systematic risks (known as market risks) are considered due to the ability of portfolio to eradicate the unsystematic risks (known as unique risks) through diversification strategy (Kazi, 2008). William Sharpe (1964) and John Lintner (1965) first declared these ideas through the theory of Capital Asset Pricing Model (CAPM) and it had been widely accepted and practiced among scholars.
Diversification strategy in fact is one of the most effective techniques in reducing risks of investment since it prohibits investors from putting all eggs in one basket. The rationale behind this technique is the content of the portfolio whereby shares from various industries will be grouped together in constructing a portfolio. As a result, individual risk possess by each industry could be controlled due to varieties of shares from different industries that could provide higher returns at lower risks (Hoh et al., 2011).
Evolution of Trading Strategy
Numerous well-known and highly practiced trading strategies or theories have evolved where one of the fundamental theory in constructing a portfolio was known as Modern Portfolio Theory (MPT). Proposed by Harry Markowitz in 1952, the theory has since been expanded by William Sharpe (1964) and John Lintner (1965), which led to the development of Capital Asset Pricing Model (CAPM) before it was further enhanced solely by Stephen Ross in 1976 as the Arbitrage Pricing Theory (APT). The ideas behind these three theories vary yet it is still related to the construction of portfolios’ strategy as a whole. The popularity of these theories also is conclusive since it still being practiced especially in academic field (Shamsabadi et al., 2012 and Zhang and Li, 2012) although their effectiveness are still being debated among past scholars due to mixed results reported.
Consequently, several new trading strategies had been developed in order to overcome the imperfections of these three theories and one of them is high-yielding strategy, which will be the focal point of this paper. One and the foremost well-known of high-yielding strategy is Dogs of the Dow Theory (DoD), which had been popularized by Michael O’Higgins and John Downes in 1991.
Modern Portfolio Theory (MPT)
Known as the father of modern portfolio theory, MPT was introduced by Harry Markowitz through the article of “Portfolio Selection” published in 1952. He suggested that investors are always expecting to be compensated whenever they are taking additional risk (Swisher and Kasten, 2005) whereby the issue of how to allocate funds among various assets was the ideology behind his book (Elton and Gruber, 1997). MPT also is associated with return and risk (variance) identification in determining the most efficient portfolios available.
Markowitz (1991) further stated that MPT is contrast from the theory of both firm and consumers in three major ways. Firstly, it focused on investors rather than the manufacturing firms or consumers and secondly, it is about economic agent who works under uncertainty. Lastly, MPT can be used to direct practice where investors who have a sufficient computer and database resources could benefits more from this theory (mainly, institutional investors).
Generally, MPT works under several assumptions where investors aim to increase the expected return throughout their investment and they make investment decision solely on the expected return and risk measurement. Besides that, they also are risk averse where they will accept greater risk only if they are compensated with higher return. Next, investors agreed to a single period investment horizon where there is no taxes and transaction cost in investment market. Finally, investors are able to access the information simultaneously (Ravipati, 2012 and Roychoudhury, 2007). Abundant of arguments occurred among past researchers on the reliability of MPT’s assumptions especially those related to individual investors whom have unique investment behavior and risk tolerance (Wang and Zhang, 2012).
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