Sunday, December 7, 2003
Issue Contents:
| 13:27 | Strategies for Success Potential returns. |
| 16:39 | Strategies for Success Cornerstones of success. |
by Teresa Lo
In the October issue of Strategies for Success, we examined anumber of factors that dictate how much money traders and investors can expect to make based on market conditions. In this month's newsletter, we examine the issue of potential returns on trading activities.
Of all the email that we receive, the top question is always concerned with how much money a trader can expect to make. While it might seem straightforward, the fact is that, regulatory concerns aside, we simply believe that we cannot set expectations for gains, mainly because we can only make as much money as market conditions allow, regardless of what we want.
Another issue is that the goals of investors tend to be quite different than that of traders. The investor is looking for capital gain, while the trader is looking for income. In order to achieve their goals, investors assume significant risk, while traders sacrifice ego-boosting home runs for consistent base hits. Once we recognize the differing objectives, we can start to look at what we can reasonably expect from the market, and more importantly, from our accounts.
Let's take a look at the numbers. A friend of mine recently asked me to trade her account. I said that before we do anything, it would be good to go over the numbers. How much money can we expect to make with her $25,000? She believed that I "should be able to" make a couple thousand dollars each month. That's $24,000 per year. Over a period of 200 trading days, that's roughly $120 per day, after commission. When we break it down to a percentage figure, she is expecting me to "slam dunk" a 96 percent annual return, presumably year after year.
No doubt you've seen performance claims on other websites. My favorite one boasts a 90 percent accuracy rate, and tells visitors that subscribers can expect to earn between 2 and 5 percent DAILY. Whip out the calculator, and we multiply 200 days by 90 percent to produce 180 as the number of expected winning days. Multiply 180 days at 2 percent each gives us an expected 380 percent annual return. At 3 percent, the return is annualized at 540. At 4 percent, the return is annualized at 720 percent. At 5 percent, the return is annualized at 900 percent. If we compound $25,000 over four years at their lowest expected rate of 380 percent annualized, the account would stand at a whopping $1.58 MILLION, after four years, assuming that the trader paid 35 percent income tax on each year's again along the way. WOW! Even Warren Buffet didn't need statistics like these to become a billionaire. His secret? T-I-M-E. He was consistent in avoiding big losses while his wins compounded over decades.
Let's do some research. From a number of sources, we can almost make a rule of thumb that states in any given year, 75 percent of professional investment managers are unable to beat a broad index such as the S&P 500. And when they do, it's big news.
Once we examine the historical returns of professional mutual and hedge fund managers, it becomes exceedingly hard to reconcile expectations and reality. As we've said many times in the past, the bottom line is that successful investing or trading is not a get-rich-quick scheme. From the investing perspective, allocating savings to the stock market is simply an attempt to gain greater returns for increased risk. From the trading perspective, it is a business, and as such, it takes both skill and money to make money. This means that for my friend, in order to obtain the return that she expects, I would have to either take insane risk and hope to get lucky, or she needs ten times the capital to reduce her risk of ruin to an acceptable amount. In fact, professional risk and money management procedures are designed to limit risk, while allowing time to compound the inevitable wins.
It goes back to those old sayings, "If it sounds too good to be true, it probably is." and "It takes money to make money."Research Links:
Dalbar Study: Fund Returns Often Depend on You
Jimmy Liew: Hedge Fund Investing Examined
Banking 2000: Hedge Fund Mania, Some Words of Caution
Dennis R. Hammond: Indexed Investment Management
The Washington Post: Getting Whipped in the Best of Times
2004.01.14 Subsequent to publication, a reader sent in the following:
The real return in this case is even bigger and the way to compute it is this: (this is the so called compound percent formula) if you take 2% increase a day for 180 days and reinvest everything, the total is going be (1.02)^180 [ it's 1.02 to the power of 180] which would give us a nice round number of 35.32. So your intitial capital will multiply 35-fold! It's a very nice number -- by the end of the year one would have $883,000 instead of $25,000. Cool. So these guys don't know what they are talking about.
by Teresa Lo
Dear Santa:
I am writing to let you know that you can skip my house again this year and forward any presents to a needy family. While there were one or two years early in my twenty-year career where I certainly appreciated the good cheer you brought, it has been a long time since you had to make a stop at our house, and I hope to continue the tradition again in 2004 by following the tried and true strategies for success:
- Know that “living rich” does not require a lot of money. It’s really true that all the good moments in life are free. The company of a good friend, the laughter of a child, and enjoying one’s vitality come to mind as examples.
- Know that “getting rich” can’t be done in an instant, or with no money. The first step, as economists say, is to delay consumption. The rest of us simply know this as “savings”. Taking risk-adjusted forays into the stock market is but one way to grow the nest egg over time. Just ask Warren Buffet about the effect of compounding small successes over a lifetime. I am always realistic.
- Know that there is a market sentiment cycle, the one that Justin Mamis wrote about so eloquently in his book . I will remember at all times that there is a tradeoff between price and information risk. When price is low, we don’t know much. When I know everything, I can expect to pay dearly for it in the form of high prices, when things “look good from far, but are far from good”. I will not fall in love with a trade or an investment.
- Know that I cannot squeeze blood out of a stone. I can only make what the market allows me to, given a measureable trading range. Doing any more than that means that I have to take on much more risk than can be justified by the potential reward.
- Know that I will make thousands of decisions over the course of an investment or trading lifetime. No individual trade matters in the long-run because each transaction is the means to an end, and the goal is to simply make money on a risk-adjusted basis. I will not allow a single trade to destroy my account, just because I refuse to admit defeat or my ego insists on being right, no matter what the cost. I will not vaporize my precious savings, because it has taken a lifetime to accumulate it.
- Know that I am no more psychic than the next market participant, and therefore, I will never be able to buy the exact low or sell the exact high. I am Forrest Gump.
- Know that “strategy before tactics” is my motto, and that I will always have a scenario mapped out based on deductive analysis before I enter into any transaction. This allows me to have a number of tactics organized so that if events do not unfold as anticipated, I will have a Plan B, Plan C, Plan D and Plan E, all ready for execution to deal with whatever happens. I will expect the worst, hope for the best, and not be a (dead) deer caught in the headlights.
- Know that if I adhere to all the rules, I will be the odd man out, and look funny to my peers, my friends and neighbours when it comes to investing and trading. I will resist being a lemming. I can run along side the pack as they charge, but when the lead animal disappears from the horizon, I will assume that it has fallen off a cliff.
Thanks for taking time out to read my letter, Santa. As you prepare to get on that big old sleigh of yours, rest easy, because there are a number of us out there who are doing our best to lighten your load.
Have a good holiday season, and have a Happy New Year!
Sincerely,
Teresa