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Compounding – if you live long enough to enjoy it.

I have just finished reading Edward O Thorps autobiography A Man For All Markets which is an excellent little read and a good addition to any traders library. In the book Thorp talks about he value of compounding returns. There is no doubt that success is trading or investing is based upon compounding your gains over the long term. Compounding is a wonderful tool in that what seem to be small quanta of difference can over time lead to an enormous difference in returns. For example an investment with a return of 10% compounded annually for 10 years yields $259,374 whereas the same investment compound at 11% yields $283,942. Extend the holding time to 20 years and the figures becomes $672,750 and $806,231 respectively. Time is the key to compounding and this is a point Thorp makes, he also makes the important point that most lack the patience to do this.

However, there is a sting in the tale of compounding that I have noticed that those on the sell side of the business either abuse or simply do not understand and that is one of scale. You will often see very long term charts of an index or an instrument and it shows a wonderful upward trajectory (well you wouldn’t show things that didn’t work) and the message is that you simply have to hold for whatever the requisite time is and you will eventually have a small pot of gold. The key word here is eventually because what is often overlooked is the time to achieve these mythical gains. There is no doubt at all that compounding is a very powerful tool and when combined with consistency and patience achieves remarkable things.

However there is always a but we need to be aware of. To demonstrate this I found a centuries worth of data on the All Ords and using $1 as the starting investment plotted what the return would be over the next 116 years.

$1

If you had started with $1 in 1900 and simply let the compounding returns of the index take its course you would have $487,801.23. At first glance this is quite impressive – the markets very long term rate of return sits at about 9% and if you let it do its thing for a long period of time then you get an impressive number at the end. However, there are two things to be aware of in viewing this data. Firstly, the time taken to achieve your goals, not only is the time itself a problem but the erosion of the value of your investment over time is a problem. I had a cursory look for long term inflation data but couldn’t find much dating back beyond the 1940’s but if you assumed an average inflation rate of 4% then this puts a large hole in the real end value of your investment. The second issue that is not addressed is the trajectory of the journey – the chart above is not of a capital guaranteed term deposit but of an index. The somewhat linear trajectory of the graph is deceiving since it does not take into account the extended and deep bear markets that were experienced. There were years when the market went nowhere and these events are testing for even the most hardened buy and hold advocate.

Time is both the ally and enemy of those who understand how to use compounding and it is this dualism that we need to be aware of. The practical implication of this is to leave your money in your trading account for as long as possible before taking it out and spending it. The impact of large withdrawals is quite remarkable in the damage it does to accounts but some people cannot resist spending in the short term to ensure they live in poverty in the long term

Timing Is Everything

It is no secret that I am not a fan of fund managers of any kind, be they the more exotic style of hedge fund that exists as an idiot tax for those who invest in them, the standard vanilla equity investment fund or the legally mandated rip off that are superannuation funds. My objection is simple, if you are going to take billions in fees  from people then you had better deliver something other than perpetually under performing the market. In a puff piece that looked somewhat like a marketing exercise Morningstar the ratings agency has named the top investment funds in Australia and the list was picked up by Fairfax and covered here. I have copied the list of top funds below.

1491953010731

Source – Fairfax

The article talks about the value of investing in the number one ranked fund since it has outperformed the index over the last 10 years – this point got me thinking about using 10 years as a point of comparison and the notion of starting points in general. As a general point I find selecting 10 years interesting since it makes certain that the funds are compared against the index during and post the GFC and it doesn’t take a genius to work out that the average return from the index since that time has been poor.

I decided to have a deeper look at the impact of starting times upon portfolios by digging up some data on the All Ordinaries Accumulation Index which is now referred to as Total Return Index since it includes the return from both gains in the index and dividends. Starting in 1960 I looked at what your average return would be to the present day if you had started investing at a given point. For example if you had invested in an index linked fund in 1960 your average return up until the present date would have been 13.53% whereas if you had begun your investment journey in 1994 your average return would be 9.99%. This might not seem to be a substantive difference but over time it adds up to a small fortune.

Capture

What interested me when I looked at this data was the remarkably consistent nature of the returns – they are all positive. Whilst, this is to be expected it is nonetheless interesting that the index doesn’t put together strings of negative years and this is shown in the raw data that I will look at later. What is also evident is that there seems to be a tailing off in average returns which is more obvious when this data is plotted as a chart.

r2

The reason for this drop off can be found in the raw data as shown below. This data is the true return for the index for each year in the sample.

r1

In this table I have highlighted each year where the return was over 25%. You can see a cluster of such returns in the 1970’s and 1980’s with a drop off in 1990 and 2000 and since 2010 there has not been such a year. In performance outliers count disproportionately and when they are lacking things look bleaker. I have no real explanation as to the rationale for the drop off in returns although I would surmise it may be simply due to a lack of funds flowing into the market due to the real estate boom. My recollection of the lift in 1991 and 1993 where due in part to the pent up recovery in the market post the 1987 crash but also that real estate struggle under the regime of high interest rates so we had an asset rotation underway.

Despite this drop off in returns over the past decade there is still no compelling reason to buy a managed fund. However, it is important to note that these are average returns over deep time – it in no way diminishes the importance of not being in the market when the market has nothing to give you. What also amazes me about fund managers is that they believe timing is so hard when in fact with simple mechanical rules it is remarkably easy as I have already demonstrated here using the ETF STW. Trading is only as hard as you make it or in the case of fund managers it is only as hard as you want to make it appear.

 

 

 

 

Winners and Losers

I have been thinking some more about the issue of short selling and the problem faced with the upward bias of equities. Armed with excel I decided to look at the average gain as a function of the average loss for the stocks in the S&P/ASX 200 – once I had the data it was a simple matter of dividing average gain by average loss for the past year and seeing what the data said.

Gain_Loss

I have colour coded the data in the following way – those coded blue are above average, those coded orange are below 1. The higher the number the better the performance of the stock in terms of its average gains versus its average losses over the past year – this doesn’t necessarily mean that the stock was a runaway winner in terms of trend trading but rather it had a strong propensity to make good its losses. It should also be noted that all this does is tell us a little bit about the past and nothing at all about the future. Ideally, if you were a stock picker you would want to look back and see a high number and a strong propensity to trend over the long term – the winner for this period of data is WHC.  In terms of losing stocks a ratio of 1 could be interpreted as the stock simply meandered during the year and congested and a ratio of below 1 is a bad sign.

What is interesting to me is the strength of the upward drift in stocks. However, it does need to be considered that the S&P/ASX 200 is a biased sample size since stocks are in effect selected for their upward drift. My guess is that if I were to repeat this list next year some 20% of these stocks would baring some miracle have been dropped from the index and replaced.

 

 

Nothing To See Here

With a free afternoon I decided to look at the individual performance of stocks that make up the ASX 200 since the beginning of the year. What I did was assume that you invested $1.00 into each on the first trading day of the year and then see what their current valuation was. The table below maps them from highest to lowest.

table

It doesnt take a genius to work out that you will get a spectrum of values ranging from the very good – BGA to the very bad – ISD. The count is mildly positive with 109 stocks being at breakeven or above for the period. You can get a better sense of the distribution by looking at the frequency distribution of values below.

table 2

As you would expect there is a fat hump in the middles and two reasonably even tails. Some did really well, some did really badly and most didnt really do much However, this once again raises the question of the value of this sort of analysis and I would say outside of curiosity there is none. But it passed the afternoon and satisfied my curiosity.

Jumping At Shadows

I was reviewing the latest Investment Trends data which can be viewed here. There are a few things that jumped out at me but I want to discuss the chart I have posted below.

crash

This chart looks at the current fears investors/traders have about the market. What is interesting about these fears is that as you would expect they are all events that investors cannot control and they are also largely irrelevant. Whilst I understand that fear is a default setting for many particularly within the echo chamber of both social media and mainstream news the fear of an impending crash is an irrelevant one. My view that it is irrelevant is because in part this is a perennial fear for investors that never comes true. In many ways it is akin to having a fear of sharks when you go to the beach.

Ords

These two charts look at what might be termed the equity curve for investing $1.00 in the All Ordinaries Index in 1984 and the underwater equity curve of this investment. A few things are apparent – markets do have periods of collapse although not as often as you would think. The market went almost two decades without a pullback of 20% or more. Indices always recover – note I said the index not that market. Your stocks might be completely stuffed but the index recovers due to its upward bias.Survivor bias can work in your favour of you hold and index ETF.

The number of times that the index has ended with a week on week 20% decline are surprisingly rare as can be seen below.

ords zz

However, this style of data does little to assuage the nervousness of the irrational, even pointing out that simple systems exit the market in the initial stages of the market collapse offer little comfort. The conventional wisdom of the standard market participant is that they go to bed on Wednesday and wake up on Thursday and the market instantly collapses 30% on the open with no warning. This certainly was not my experience of the 1987 crash or the prelude to the GFC. In 1987 the market had actually peaked in September and the market became extremely unstable in the weeks before and had actually given up 10% and then gapped down before the crash. There was ample time and warning, the same is true of the GFC.

I perhaps shouldn’t be too hard on such market participants because the survey also notes that the majority of investors take their advice from market analysts.

 

Where Is The Money?

One of the frustrating things about being a trend follower is that it takes time to overcome the inertia of a new system, particularly if that system is based upon slightly longer time periods such as weekly data. Part of the frustration that traders encounter is based upon the simple mechanics of how systems work. A system that is correctly designed takes its losses quickly and allows its profitable trades to simply roll along. This results in the system instantly going into drawdown and it is this drawdown that causes traders to develop friction with their system. This friction often leads to tinkering as they attempt to force the system to give them something it cannot give. This is exacerbated in times of a flat market – you cannot force returns from a market. The All Ords of late has not really been a stand out performer as can be seen from the chart below the market has been slowly grinding its way up in a broad channel.

Ords

With this in mind I thought I would look at the yearly returns for the various stocks within the All Ords – so I found some data on their percentage returns and stuck it into a frequency histogram to see what the performance of individual stocks looked like.

Frequency

I have a arranged the data into a serious of blocks and did a count of the number that fell into that category. I also calculated the average performance of the group which for this period stood at 17.09%. However, if I drop out the 200% and above outliers this average value falls to 13.04%. As you might have guessed the majority of values cluster around the mean with a long right handed tail. This sort of distribution is common with stocks since we have unlimited upside but limited downside – a stock cannot decline more than 100%. Our psychology dictates that we are instantly drawn to the right hand side of the chart and the extreme outliers that occurred over the past year. And as traders these are the sort of trades that we hope ours might evolve into. However, in doing so we ignore that left hand side of the chart. The majority of stocks (60%) have below average performance. You may assume as a trend follower that this is not an issue since you would avoid these large losses and poor performance by the use of stops but that ignores the reality of the actual trading process. As a mechanical trader you will not incur these losses but you will burn time wading through these non performing stocks before you hit the ones that do perform. You waste time, a little bit of money and a lot of patience dealing with this mediocre performance.

My anecdotal experience has been that trading returns are made up of a lot of modest returns and a tiny handful of trades that do very well but to get to the ones that do very well you have to crank through a reasonable number of trades and you have to keep going. This is where the notion of emotional resilience comes into its own in trading and the ability not to tinker with the system hoping that it will generate these sorts of trades. Systems dont actually generate these sorts of trades – the market does so you cannot actually build a system with the preconceived notion that it will find you trades that generate a 500% return. What the system does do is generate a population of trades, most of which will be duds and hopefully a few large winners. But in the beginning all trades look the same.

 

Once Upon A Time

Sometimes I feel sorry for traders/investors who need to construct a narrative as part of their investment process. Whilst you are cocooned inside your own delusional story you would never know whether your story is the right one and is the one the market has chosen. As an example consider the year to date moves of various indices from around the world.

Index Performance YTD

As might be expected there are a range of performances but what is interesting to me is that if you look at the US markets in isolation you see something interesting. The Russell 3000 and S&P500 are doing better than the benchmark index. This positive performance seems quite obvious when you drop in the performance of the VIX – the so called fear index.

Index Performance_VIX

The VIX has had a somewhat precipitous drop since the beginning of the year. As such the narrative could go volatility (uncertainty) has leaked out of the system therefore investors feel more comfortable with equities. Sounds reasonable, however, there is always someone who will spoil a good story. Consider the chart below  is of the ETF GLD and the Dow since the US election in November. GLD tracks the spot price of gold so it serves as a useful proxy.

Dow_GLD Since Election

Throughout November the gap in performance between the Dow and GLD widened – this would fit our existing narrative of the market being more settled therefore there is no need to set in place a hedge via gold. However , this story starts to change as Trumps profound lack of suitability as President  becomes obvious and the performance gap narrows. If we shrink the time frame down to YTD only then the Trump idiot premium widens.

Dow GLD YTD

All of a sudden we have a wrinkle in our narrative. The original narrative was uncertainty has left the system, investors are happy and buying equities but hang on the performance of gold which is traditionally seen as a hedge instrument is improving. WTF is going on?

This is the issue with narratives they are simply stories designed to make us feel better about our decisions as such they are equal parts post-dictive error, self justification  and comfort food. Hence, they are largely meaningless.

 

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