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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.

Expanded

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.

Random

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.

Looking For The Next Amazon

I came across this piece the other day. It is a good bit of work because it highlights neatly the interplay between returns, risk and drawdown. This triumvirate holds sway over the trajectory of our investing but it is continually ignored by most, as all traders in some way shape or form seek the biggest bang for their buck. The article looks purchasing AMZN from the perspective of a buy and hold investor and it would have been truly stomach churning experience – I can only think of one person who would have done that and it is Jeff Bezos the founder. I thought I would redo one of the charts from the article so the scale was a little clearer.

The chart below looks at the value of $1 invested in AMZN.

amzn

What I want to highlight is the decade long wilderness between 1999 and 2009 before the stock makes a new high – this is a very long time between drinks. It is a given that simple risk mitigation procedures such as having a stop ameliorate some of the problems generating by buying and holding and for simple curiosity I thought I would look at how having a simple 52/26 week entry and exit signal would perform. The rules are simple you enter on a 52 week high and sell on a 26 week low. To put this idea under a bit of stress I made the conditions for entry and exit disadvantageous by requiring the buy to be at the high following and the exit to be the low of the following week.  The system not surprisingly only generated a few trades and they are as follows –

Trades

You will note that I have only looked at absolute dollar and percentage gains based upon purchasing a single share. So it not a truly exhaustive systems test by any stretch of the imagination. What did surprise me was that it only generated a single loss and that the stock has had a near triple digit gain whilst  quite mature. The old adage price is irrelevant holds true.

There are probably two points to be gleaned from this. Tales of survivor bias that you hear from buy and hold investors do not reflect the true story because for every AMZN there are probably another ten that at best go nowhere  or at worst simply disappear. This is particularly true for stocks that made their first appearance during the Dot Com bubble. And simple ideas work surprisingly well.

 

 

Going Nowhere

I wrote a little while ago about the need to be aware of the history of markets and their propensity to go nowhere for significant periods of time. This sort of saga is unfolding in the US with their markets making no real gain for some 18 months. The US seems to be range bound at present with no desire to move outside of this range The reality of this is that $1.00 invested in the S&P500 18 months ago would now be worth the princely sum of about $1.06.

500

ETF’, ETF’s, ETF’s…..Everywhere

Flash a-ah
Savior of the Universe
Flash a-ah
He’ll save every one of us

(Seemingly there is no reason for these extraordinary intergalactical upsets)
(Ha Ha Ha Ha Ha Ha Ha)
(What’s happening Flash?)
(Only Doctor Hans Zarkhov, formerly at NASA, has provided any explanation)

Flash a-ah
He’s a miracle

(This morning’s unprecedented solar eclipse is no cause for alarm)

Flash a-ah
King of the impossible

He’s for every one of us
Stand for every one of us
He save with a mighty hand
Every man, every woman
Every child, with a mighty
Flash

Apologies to Queen fans and those of you old enough to remake the appalling 1980’s remake of Flash Gordon. My inbox of late has been awash with various people extolling the virtues of ETF’s and how they are going to save us all. These emails have offered various strategies for setting up a stress free retirement by gearing into ETF’s over various indices. I have nothing against ETF’s – they are simply another tool, although I am always amazed at the breathless enthusiasm of people who have just discovered them. In many ways they are reminiscent of those idiots who do Crossfit without realising that it is simply circuit training without the spinal injuries.

Part of my interest in the material I have received is the exhortation to invest in the S&P/ASX200 ETF (STW) and I have no problem with that as a basic premise. It has always been my contention that part of Australia’s growing retirement crisis could be alleviated by removing fund managers from the equation and simply dropping everyone into a low cost index ETF. The retirement pool available to investors would double because the majority of fund manager generate less than half the return of the index over the long term. However, there are some subtleties that everyone needs to be aware of. The first of these may be that the S&P/ASX 200 is not the best vehicle for taking advantage of the movement in the local market. Since the GFC Australia has had a two tiered market. The first tier is represented by the stocks in the S&P/ASX20, the second and lesser tier is the S&P/ASX200. I accept that the difference in performance of the these two is often minimal, but in trading small differences can produce very different outcomes.

Screen Shot 2015-07-06 at 8.31.50 am

In the table above I have looked at a few performance metrics for the S&P/ASX 20 ETF (ILC) and the S&P/ASX200 ETF (STW) ILC is a relatively recent listing so data only goes back few years so i have compared both from the same date. As you can see in terms of these basic metrics ILC is a better vehicle, it has a higher return and a lower drawdown. If these were two trading systems you would opt for ILC. To compensate for the short comparison period I also looked at the relative performance of the price only indices and this showed a more nuanced picture.

Screen Shot 2015-07-06 at 6.52.49 am

The S&P/ASX20 index has had historical periods of outperforming the S&P/ASX200 index. However, there have been periods when this has been reversed. So we are left with a conundrum as to which one we would pick. However, this question is no different to deciding which equity market to invest in at any given time. It is simply a matter of looking at relative performance over time and since the GFC the S&P/ASX20 has been the strongest performer.

To muddy the water a little bit I also looked at the performance of ASX – that is the listed entity that runs our equity markets and compared it to both indices.

Screen Shot 2015-07-06 at 8.47.39 am

If I drop in a dodgy long term performance comparison between the three, then the picture becomes much more interesting.

Screen Shot 2015-07-06 at 9.01.55 am

This raises the question of whether you should invest in the market or the people who run the market? Its strange how things are never as obvious as they first seem….

Returns Comparison

With the majority of world markets running hot I thought it would be interesting to compare last years returns for a handful of markets with their returns YTD. In the chart below I have looked at the value of $1 invested in each market for the 2014 calendar year and for the calendar YTD.

Screen Shot 2015-03-20 at 2.06.10 pmThis chart confirms what most people already know – for the majority of market the first quarter of 2015 has been very positive with some markets already eclipsing their 2014 full year returns. The US has been somewhat subdued whereas Asia and Europe have been very strong. However, presenting returns this way does tend to give only part of the story because the trajectory of those returns is unknown. For example the Swiss Market Index has been robust this year but the return was punctuated by a drawdown of almost 15%. Contrast this with the performance of the S&P500 which in the YTD  performance has only drawdown about 3.6%.

Despite this limitation it interesting to watch what appears to be a rotation in performance from the US which has lead the world for the past five years or so to Asia (particularly China) and to select European markets.

 

Oh Dear…..Part One

I actually saw this article the other day whilst having breakfast after training. The opening point so caught my eye that I had to find the original source article and see if it was correct – my looking over someones shoulder guess was that is was not. The article begins with a somewhat staggering claim and as they say extraordinary claims require extraordinary proof.

Investing in shares can be a wonderful way to build a nest egg for your retirement. You’re taking a part-ownership in real businesses, whose directors and managers spend their time trying to make you more money – and who often give you a six-monthly dividend payment for the privilege.

How good can it be? Consider a hypothetical investment in the companies that make up the All Ordinaries index. $10,000 invested in 1984 was worth a cool $278,000 in 2014, even if you never added another dollar. That’s a very nice return for in effect doing nothing but waiting. Adding just a small amount each month would have seen you with a very nice seven-figure sum. How many other “do nothing” strategies offer you a million-dollar pay day?

If I’ve got your attention – and I hope I have – here’s how to get started:

Scott Phillips – Motley Fool

It got my attention because I think the claim is wrong and I have not been able to reproduce it. I fired up excel and I dropped $10,000 into the All Ordinaries index .Remember the claim is that you have bought the shares that make up the All Ords therefore your portfolio will completely match the performance of the index (there is a problem with this idea but more on that in a moment.) My $10,000 investment by yesterdays date had grown to $70,258.79 – you will agree this is a l0ng way shy of the reported $278,000. You can see the trajectory of the equity curve below. Note, an equity curve is the only honest way to talk about and to illustrate returns. Take note of this point because I will return to it.

Screen Shot 2014-12-11 at 4.55.44 pm

[Read more…]

History Counts

One of the more frustrating things about trading is that in some ways your returns are bounded by the environment within which you are investing. This is particularly true if you are dim enough to be  a buy and hold investor. The underlying sentiments of markets ebbs and flows and this sentiment infects all aspects of the market. as the old saying goes all ships float on a rising tide, implying that bull markets are good for all stocks and I believe this to be largely true. For aggressive disciplined traders bull markets present a cornucopia of opportunity that is too good to resist. However, flat markets are painful and dull and once again they are especially painful for those who are inactive investors who are merely carried along by what is happening.

I wanted to look at the broad distribution of returns of various periods – this is one of those dodgy back of the envelope things that I like to do. What I did was look at the three metrics as applied to the All Ordinaries, the value of $1 invested for the time period, the maximum drawdown for that period and the annualised return. These are shown below.

Screen Shot 2014-11-25 at 10.42.44 am

I broke the returns up into decades since this is about the average lifespan of an investor/trader. So for the period 1991 to 2001 if you had invested $1 into the All Ordinaries at the beginning of this period by the end it would have been worth $1.98. During that period you would have had to endure a maximum drawdown in your investment of 22% and your annualised return would average out at 7.1%.

There are a few interesting points to this table –

1. The index only produced double digit average annualised growth once in this survey. For the decade sized samples from 1998 onwards the returns were very modest.

2. A single event such as the GFC can have a devastating impact upon long term investment strategies. If you do not take any prudent measures to avoid or manage them. it should be remembered that we are encountering such events about once every ten year.

3. The best decade was 1997 to 2007. However, if I look at these returns in more detail this decade had four good years that produced most of the returns. If I isolate this period of 05/03 to 09/07 I found that $1 invested at the beginning of this period had grown to $2.09 by 09/07 with an annualised rate of return of 18.9%.

4. When you invest matters.

For the sake of completeness I did look at the returns for simply holding throughout this period and the results were as follows –

Screen Shot 2014-11-25 at 11.04.11 am

The above table puts into perspective much of the hype you hear from find managers about being in the market for the long haul, good shares always get better, dont miss the good day blah…blah…blah. Very little that is said by the sell side of the industry stands up to scrutiny – what you see here is very modest returns. I feel that the central point is that the majority of returns are made during very select periods of time and outside of those periods traders either need to be very active or simply search further afield for opportunities.

 

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.