Four percent model - developed by Ned Davis
Overview
The four percent model is a trend following model which was developed by Ned Davis. The four percent model uses the Value Line Composite Index (KCBT) however, other traders have applied this model to other indexes. The Value Line Composite Index is calculated by Arnold and Bernhard & Co. and is an un-weighted price index of approximately 1700 stocks.
Application of model
To construct this model, the investor is required to record the weekly close of the value line composite (which can be found in your newspaper or in Barron's.)
Buy signals are generated when the index moves up 4% or more from any weekly close.
Sell signals are generated when the index moves down 4% or more from any weekly close.
In both cases, this is 4% not 4 points. Buy signals continue until a sell signal occurs, and vice versa. For example: If a buy signal is triggered, a sell would not occur unless the weekly close is greater or equal to a 4 % drop or more between weekly closes, (even if the value line may have had a greater than 4% move during the week).
Historical
Historically, when testing the 4 % rule, it has shown to be profitable. Since it is a trend following system it ensures the trader is on the right side of the trend. Since the value line composite could not be traded until 1982 (Stock index futures), the following results are theoretical based on the value of the composite. In 10/12/1979 the value line composite was at 115.16 until 12/1/1995 the value line composite was at 329.31. During this period the 4 % rule generated 61 buy signals, the average buy signal was active for 80 calendar days. Of the 61 signals, only 30 were profitable. The average gained in the 30 profitable trades were 14.1 % per trade, while the 31 unprofitable trades lost an average of 3.5 %.per trade. The average gain was 4.7% per trade. when the annualized profit per year is calculated, it generated a 16.2% gain from 1966 to march 20, 1996.
Advantages/Disadvantages
The advantage of using trend following systems is that you are never really on the wrong side of the trend for too long, historically they generate profit, as seen in the example above. It is also important to note that the average gain was 4.7% per trade, but when the annualized profit per year is calculated, it generated a 16.2% gain. Buy and Hold over this period would have generated .2.7% per year. Trend following systems require the trading to adhere to the rules and emotional decisions are extremely discouraged. The 4% rule is also less demanding than other trading systems.
The major disadvantage is that trend following systems generate signals after the trend has formed or is broken. Critics of trend following systems argue that entry signals miss a large part of the up trend, and loses could be lessened since exit signals are generated after the trend is broken.
Recommended Reading: Martin Zweig's, Winning on Wall Street.
