December 29th, 2016
My previous article (The WOW Factor) might appear at first glance as an exaggeration of some kind. For one thing, it is not a hoax or a data manipulation of some kind. It is just an aggressive trading program. It only needed deep pockets. The simulation was part of the development cycle where one tests for up and down limits. A lot of it is doable under more restrained methods. These added methods would have for sole purpose to reduce the strategy's volatility and drawdowns. They would still generate high returns, lower than what was shown, but still relatively quite high compared to market averages.
But, here is a question. How much drawdown and volatility are you ready to bare for higher long-term performance levels? If there is no volatility, there is no price variation, there is no return, or is there?
Since volatility is usually expressed using the standard deviation σ when σ is approaching zero, are we not approaching a straight line? And if a straight line, where is the price variation Δp to make a profit since σ would tend to zero?
The same goes for a stock price having a low beta. Does it automatically say that there is no price variation, or that price variations are very subdued, both up and down, compared to a benchmark? So many questions. And yet, they all deserve answers.
Take, for instance, STZ over the past 5 years. You see a low beta stock with a low σ having its price almost going straight up over the period. Yet, the price increased with an average 50% CAGR for those 5 years. A lot of trading methods might not even have selected it as a trade candidate, (not enough variability) or predicted that it would behave the way it did (no highly discernible patterns). Nonetheless, you had in STZ one of the smoothest rides you could get.
The best bet scenario was to go all in from the start, or was it?
Doing this would have given you a 50% portfolio CAGR over the past 5 years, putting you in the top 0.1% of portfolio managers on the planet. Lower risk and lower beta than the market with a much higher return. Some 40 alpha points above market averages. Year after year the price went up. It wasn't what one might call a trading vehicle, but more like an investment. You bought and you held for the duration, riding this almost straight line up. Trying to time it would probably have produced less.
Where was the portfolio efficient frontier or the efficient market hypothesis on this one? How about the proverbial reversal to the mean thingy, it was as if nowhere to be seen. Should stocks behave like STZ or not? First, the question: is it possible, is not a question. One just looks at the facts, at what was there. The future still remains unknown, but for the past 5 years, that stock did great by all counts.
My question is: could you have done more? The answer is: Yes. Among other things, you could have reinvested paper profits. Say that, as STZ went up, at every 15-point rise you took the added paper profit to buy additional shares. That you did this or not, the stock price would still have gone up. That was not your decision.
Your decision was what do you do about it? Do you ante up or not? You will always be with that question: do you, or don't you make the bet? What are the odds that you win your bet? I do not know. You do your research to get the conviction you need to place your bet, or you pass.
Still, that scenario would have taken your CAGR higher for the period. Starting with $ 1 million, buying additional shares at every 15-point rise, starting at $ 20 some 5 years ago, by the time STZ reached $155, instead of making $ 6.75 million in profits, it would be $ 13.67 million. Instead of getting a 50.6% CAGR, it was raised to 71.1% for the period. Adding some 21 alpha points to your already high portfolio return. All due to a simple trading procedure. Not even guesswork, just a procedure with no predictive ability. It only said what you would do if the price went up 15 points.
So, yes, you can do more. But, like in everything else, you will have to do more to get there. Even if you put up half of the paper profits to work, it will still push up your CAGR. Also, putting less on the table, cutting the initial stake by a factor of 10 ($ 100k), would give you one-tenth the above profits, and still maintain the same CAGR as above. You have a scalable trading strategy by design.
And we can't say that it is a complicated trading method, requiring a Ph.D. to understand, or even a computer to execute. It does not even require much of your time. You could put it on a machine to diversify your bets, to do a lot more stocks at a time, all that would be required is more capital which would produce a lot more. If you can scale it down, you can also scale it up and maintain its CAGR.
Would this have added risk? Yes. But note that it is not the market risk that increased. The beta did not change, the σ was the same, and yet, your risk increased. It increased due to the method of play. Not because of some structural change in the market, but by what you were doing as the portfolio manager. At the start, you were taking the same risk as anybody else taking a position in STZ. It is only at $ 35, that you added some shares, with already a 15 point profit in hand. I don't see risking paper profits the same as risking capital. One is, I risk their money, while the other is that I risk mine.
You could have quit at any time, at any step, on the way up. If you felt ill at ease, as presently, for example, you could exit the entire position with all the accumulated profits. Twice as much profit than not having executed that simple procedure. This also puts an opportunity cost on a single decision of yours, on not doing a simple task.
That says that maybe your real job might have been to find STZ. That was not very hard.
It was making new highs almost every other week over the past 5 years. That is 1,825 days where, every day, you were reminded that STZ was going up (1,300 trading days). That you started at $ 20, $ 25, or $ 30 would not make that much of a difference. But what would, would have been not participating at all.
Finding STZ in a market that has been going up for the past 7 years, how hard could that be? It was floating on top a sea of variance. Still, it clawed its way up penny by penny. Don't think for a minute that STZ was alone making new highs over those past 7 years. It had a lot of company. It was not the only scenario available. You could have had hundreds to choose from. That is where your computer comes in handy.
I hope some see the points I am making. The stock selection process might not be that difficult, but the method of play should be such that you can enhance on what is out there.
The profit reinvestment procedure was done, without trading, only to show a first step in getting there.
A stock with higher volatility (σ) and higher beta, can give one the ability to trade over the process, meaning that you can up the ante again. The higher beta, higher sigma stock is providing more trade opportunities, more: Δp>0 with greater amplitude.
A higher σ or a beta exceeding 1.00 say that the stock price swings more than the average. And this represents larger profit opportunities too. Again, do you take them or not? It is not the market that is going to decide for you unless you let it. Nonetheless, that you delegate this decision to the market, to a program, keep it discretionary or not, it remains your decision.
Oh yes, you would not have the ability to know when STZ would hit its 15-point markers as it was going up, but then again, did you know that before? I don't see what you would be missing since I do not think your trading methods ever gave you a clue on that one either. Otherwise, you would have been all in at $20 and stayed in. However, your programs too could have observed that, hey, STZ is going up...
The price of a stock is the representation of a company's value as a business. In one number you have a valuation, an estimate of its past, present, and its discounted uncertain future. That is what is tradable: the uncertain future. But you already know this. If a company is prosperous, it is making more money. It is increasing its valuation, and that is reflected in a future higher price. Before you want to participate, provide some risk support that someone else might not want anymore, you want to see some evidence that the company is indeed prospering. And that can only be shown by a higher stock price. If they don't succeed in showing you some Δp>0 over a recent period, why would you buy? Let any stock first show you that it has a Δp>0 over your period of interest, then you may get interested in it. And if at some point, it disappoints: dump it. You are in the business of making your portfolio prosper, and not in absorbing losses.
In all, if you want more, you will have to do more.