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I Think We Have A Different Definitions Of Success

Investing is hard there is no doubt about that and being an amateur investor is even harder because you have to rely upon the supposed expertise of others. This lack of familiarity with the industry and its nuances combined with a dependence upon others makes life very difficult for those on the outside.  However, this difficulty is further compounded by the total and utter bullshit that is spewed out by the industry as to how successful they are and how indispensable they are, as a case in point consider the following paragraph –

Many superannuation industry participants were surprised at the Financial System Inquiry (Murray) arguing that the superannuation system was inefficient and uncompetitive. This confused many within the industry as there are many great achievements – collectively, the industry has delivered:

  • A 5% annual real rate of return on investments over 25 years.
  • Part closure on the population’s under-insurance gap through group policies.
  • A large capital market which has reduced our reliance on foreign investment into Australia – and we have a large pool of assets invested abroad.
  • Widespread international recognition of the Australian system as one of the most effective in the world

Source – RiceWarner

The cited Murray Inquiry is correct, the Superannuation industry is inefficient and noncompetitive but in my view it is also incompetent and somewhat delusional. If we were to take a step back and look at the primary difficulties that all investors face it would be fair to say that they are primarily psychological in nature. Investing or trading is primarily a psychological endevour. You are constantly engaged in a battle with both your basic programming and your own inner demons. Once these are brought under some form of control then the game does become a little easier. Within the rich cornucopia of psychological maladies that afflict us all you would find delusion to be a cornerstone in many. A large population of traders consider themselves to be much more effective than they really are. In fact the entire hedge industry is afflicted by this curse as it would seem by the above paragraph is the superannuation industry and its cheerleaders.

In the above piece I have highlighted the points which in my mind set the tone for the industry. The industry believes it is a great success because over 25 years it has delivered a real return of 5% – the problem with this is over the same period of time the real return on the market is  8.8%. This differential doesn’t sound like much but in terms of the long term returns of an investment that is continually compounded it is enormous. Consider the data presented below where I have compared the return on a simple balance of $25,000 compounded at both the market rates of return and that of the industry.


The job of a fund manager is to deliver what is known as alpha, this simply another word for skill. If a fund manager delivers a long term rate of return of 10% and the markets rate of return is 8% then you can consider this differential to be the application of skill. The superannuation industry in Australia does the opposite – it is a drag on performance. Yet intriguingly it considers itself to be successful. This delusion has profound effects on investors since they are being charged for the privilege of being underfunded in their retirement. There is an extraordinaire difference between having $84,658.87 in retirement and having $205,902.87  This year the superannuation industry will probably take around $2B in fees yet it will undoubtedly deliver yet another sub par year. This adds to the tens of billions already taken from investors. Outside of politics and the public service it would be hard to find an industry that delivers so little value for such cost to the average consumer.

Whilst I cannot give investment advice I can only reiterate what I have said before. If I had to have superannuation I would opt for an index linked fund with the option to move into cash when required and I would shift in an out of these two options based on the application of a long term moving average over the All Ordinaries as per the free chart below –


Nothing fancy or complex, when the index is above the moving average you move into the index when it is below you move into cash.

The Order Of Things Matters

Every now and again I get sent a magic trading system complete with equity curve, generally these are some sort of magic system someone is flogging that promises massive returns and never has a drawdown. They are the sort of quit your job with $10,000 and intra-day trade FX and make $10,000 per week. If you have been around markets long enough you will have seen this sort of thing – I have to give them some credit because at least they include and equity curve as opposed to simply quoting some mythical average return like fund managers do. Equity curves do convey a lot of information – they tell you about the trajectory of funds that have been invested. You can get a sense of how bumpy the journey might be and whether you could stomach the trip. However, the thing they do not tell you is the role of luck in achieving those particular returns. The returns a trading system generates and in turn its equity curve are uniquely sensitive to luck – not so much in the sense that the trader may have gotten lucky and run into the largest bull market in history which is entirely possible. But rather they are completely dependent upon the order in which the returns where generated.

To give you a simple example of this consider the chart below. In this chart I map the value of $1 invested in the All Ordinaries and $1 invested in the All Ordinaries but with the returns reversed so the return for 2015 becomes the return for 1900 and so on.

True Vs Reversed

I have plotted these on a log scale so you can get a sense of the journey – you can instantly see how simply reversing the returns changes the track of the curve. The reversed values lag behind the true values for 2/3 of the time, it lags for the first 30 odd years, catches up and then begins to lag again from the mid 1970s’. The true returns have a terminal value of $437,097.87 whereas the reversed values top out at $420,087.87. Simply changing the order costs the system $16,941.77

The same is true small changes in return – in the true return the years 1985 and 1986 were power years. They were the high point of the 1980’s bull run in terms of absolute returns with a return of 44% and 52% respectively but in looking at returns the question needs to be asked as to what the curve would look like if these were just average years of 9% return. Traders tend to spend too much time thinking about all the ways it is going to go right but very little time is spent on what could go wrong.


The true values have the same terminal value of $437,097.87 wheres the changing of 1985/86 to average years drops the return to  $264,251.37 – a difference of $172,846.50. Whilst this does make for an interesting through experiment it also has practical implications. Trend following systems are built upon the outlier years – this is what generates their returns. If you miss these outliers then your returns over time will be ordinary. Traders do have a habit of missing these years simply because they are either caught in someone else’s narrative and miss market moves, they dont believe the move when it happens because they have a preconceived view of how much an instrument/position is worth or they are caught by the limiting belief that you can never go broke taking a profit. I lost count of people in the mid 1990’s who thought that COH was overvalued at $3.00. Granted its path to $157 has not been linear but its move to $45 was as close as you can get. This move is gone forever for such traders and will never return.

The same situation applies to the random reordering of returns. The chart below is the true returns compare to a randomly reordered sample of the same returns.


The randomly reordered returns show almost a century of relative under performance including a substantial initial drawdown. So when you look at an equity dont take it as gospel, think  of the ways in which the journey could have changed with a few simple alterations or slip ups along the way. The overall aim of any form of system design is to produce a system that is incredibly robust and which shows profitability over a wide range of conditions and events.  In trading you need a little luck but you do not want to be dependent upon it.

More ETF Magic

About the only joyous thing about Christmas is that there is a marked slowdown in the amount of junk  mail that hits my inbox. And to be honest I do miss the emails telling me that people have the ideal job for or that Svetlana from Kokshetau in Kazakhstan is desperate to send me pictures of her recently shorn yak. Paradoxically I have not seen a slowdown in the number of emails extolling the virtues; nay magic of index ETF’s. This got me thinking about the nature of indices and their construction. In simplest terms an index is simply an aggregation of stocks design to represent a sector of the market. However, stocks are not simply lumped into a group and passed off as an index, an index can be either price weighted such as the Dow or market value weighted index such as the S&P500.  With the Dow the weighting of each component is a function of its price whereas with the S&P500 components are weighted according to total value of their outstanding shares. Each method of construction results in a different end product.

Because we have two mechanisms of solving the same problem we can compare and contrast what each solution looks like when plotted against one another. This might seem to be a somewhat academic problem and in many ways it is is except when you consider that when being told to buy an international ETF investors are directed towards SPY which is a representation of the S&P500 –  a market weighted index. You might think so what but remember this is not the only way to measure an index and that the folks who create ETFs are nothing if not inventive. As such there is a price weighted version of the S&P500  known as the Guggenheim S&P 500® Equal Weight ETF or RSP

It is therefore easy to compare the performance of these two instruments –


For the period being considered it appears as if the equal weighted version has given the market weighted ETF a bit of a belting. This raises the question as to why do dislocations occur between the performance of two indices constructed using different methodologies and the blindingly obvious answer is that it is the different methodologies account for the different performance. Granted they hold the same stocks but they hold them in different ratios. For example SPY’s largest holding is Apple which makes up 3.12% of its portfolio whereas its holding in RSP is capped at 0.21%. This means that when Apple does well SPY will do well but when it does poorly it will drag the performance down. Equal weighted indices are to some extent insulated against the travails of a single stock.

The existence of instruments such as RSP introduce a layer of complexity for ETF traders since they offer a variation on the theme of index investing that may or may not suit them. Unfortunately, for those who pump magic index ETF systems the world is a little more nuanced than they think it is.


It Was Going So Well

As followers of the blog will know I have been using my copious free time to experiment with building a new system from the ground up and then testing it live. There is no point testing new theories and ideas within the electronic purity of a computer program unless you are going to put actual money into them and see how you and the system perform under live conditions.  This system contains a mix of long and short time frames and I have been experimenting with the mix of instruments that I bring into the portfolio and I recently added Natural Gas. Interestingly the first trade was a winner, catching the move up from early November. This was interesting because my experience of such things is that the first trade is usually pretty much a dud.  The energy part of this portfolio of which Natural Gas is a part is a true long/short system so it takes every signal that the system generates – in some ways it is a generalised stop and reverse system. So when the system generated a signal in the opposite direction I naturally took it and it looked to be doing well until it was hit by a large intra-day reversal.  This generated another signal in the opposite direction which I took – and here is the rub. The power for this part of the system comes not from its entry signals but rather from its aggressive money management, as such this reversal signal was also stopped out.


Since this is a new system I review the decision making behind each trade to make certain that the rules were followed and whether there is anything that can be learnt from the trade. I am a firm believer that this form of post trade analysis should be part of everyone’s routine but only up to a point. This is in reality a limited amount of information that can be gained from the majority of trades. If you have followed the rules then it is a process of simply accepting the result and moving on. Endless cogitation about what you should have done is largely unhelpful.

When I first started experimenting with stop and reverse systems way back in the day I used to get enormously frustrated at this sport of scenario – I liked the notion of stop and reverse in markets that had a tendency to swing in sentiment such as energy markets but lacked the emotional maturity to deal with inevitable consequences of such an approach. Nowadays I couldn’t give a flying f$5k about the trades. It is mildly annoying when you wake up and see that you have been stopped out for the second time in 24 hours and I dont think that ever goes away. You do need some emotional investment in your own success or failure – to think otherwise is pointless.

General Advice Warning

The Trading Game Pty Ltd (ACN: 099 576 253) is an AFSL holder (Licence no: 468163). This information is correct at the time of publishing and may not be reproduced without formal permission. It is of a general nature and does not take into account your objectives, financial situation or needs. Before acting on any of the information you should consider its appropriateness, having regard to your own objectives, financial situation and needs.