Trading and Relation between Dreams and Reality (or Importance of Benchmarking)

Wednesday, 26 August 2015

It happens quite often that novice (systematic) traders are lured by markets with a dream of making a fortune. They have heard stories about traders getting rich quickly by following a simple and replicable strategy.

If there is a huge disconnection between dreams and reality of trading, just few newly come investors perservere and are able to earn money. Maybe it is easier to perservere if you are aware from the beginning what in reality can be achieved, by comparing yourself against professionals and simple buy-and-hold strategy on various instruments.

To put things into context I have added a table below (which is updated in 5-minute intervals on the homepage) of main asset classes.

As it can be seen - out of passive instruments, equities have offered highest annualized return (from 3.3% to 11.12% - depending on the index in question). However, in order to achieve such a return you would have to be able to withstand the drawdown of 50%+. Imagine a moment, where your account is losing more than 50% from its highs.

Let us have a look at what results professionals achieve. The bottom table shows results of hedge fund managers in different categories. When we look at annualized returns, they are all in the teritorry of +10% and lower. What stands out is sharpe ratios - ranging from 0.45 - 1.23. Those are generally higher than sharpe ratios for buy-and-hold of instruments in the table above. Sharpe ratio is just a simple measure that allows us to compare how stable various instruments are (calculated as annualized return/volatility). Thus, money manager with higher sharpe ratio is generally considered better. Sharpe ratio of more than 1 is considered as very good.

Now, let's have a look at stock-picking strategies and tactical asset allocation strategies. We can see multiple combinations of parameters that provide sharpe ratios of 1 and higher.

I guess the conclusion is quite clear. I would be more than wary of strategies/traders claiming to make e.g. 30% return per year. Maybe they mean last year, but forget to mention their drawdown of 80% from 3 years ago (and thus much lower annualized return than mentioned 30%). The same applies to strategies that show perfect result in backtest, but it is highly improbable that such strategies be sold to retail traders.