February 18, 2013

I occasionally participate in a LinkedIn forum on automated trading systems. One poster raised the question: < if your returns are so good, why aren't you a hedge fund? >  It is a very legitimate question to which I answered: the answer is in the game itself, time and CAGR. A definition can be found here.

Personally, I use a mix of my own trading strategies and also have my friends benefit from them. So, technically, I am kind of small hedge fund. But still, because of limited account size, I'm certainly not using my strategies to their fullest potential. Here is why.

The basic formula is Cap x (1+CAGR)t. To be good, a CAGR of 20%+ should be enough, the higher the better. Mr. Buffett achieved over 20% CAGR over the past 50 years (so, long term it can be done): 10M x (1 + 0.22 )50 = 208 B.

I have not seen him implode, his trading strategy stood the test of time, and above all, it is relatively simple: Buy under-valued stocks, reinvest dividends and reinvest generated profits; oh, and be ready to hold forever. I also think that his trading methods will hold in the future. This is not the kind of strategy that will break down with time.

With equal CAGR who would you choose, an unknown or Mr. Buffett? The answer would suggest that you need even better performance levels just to be considered; and based on my experience, even that does not appear to be enough. Someone designing a long-term trading system to generate 7% should save himself some time and buy some indexed funds; at least his time would be freed while achieving almost the same long-term results.

The problem has only 3 parts: initial capital, CAGR and time. If you have less than 10 years to allocate to this problem, abandon; even a 25% CAGR would generate only 7.3 times initial capital. To reach this level, you would have to wait the whole 10 years to get there. Putting 10 more years could raise your initial stake by 53.36 times. You should see my point: fire up your spreadsheet and just fill in your own numbers. A little anomaly should also be put into context: the future is still there to unfold and therefore, there is no guarantee of a future positive CAGR. One reason why a strategy should have a long-term vision.

A Long-Term Vision

I can backtest stock trading strategies in a few minutes, I can let the computer do it thousands of time. But if I want to trade live going forward, I can only have one run. Of the thousands of strategies I might have tested, only one can be chosen to go forward. I better select my best, a selected few, or the one I prefer most, to do its job over the next 20 years, preferably longer.

This means I'm looking at 2033 before being able to convince someone that it has been done, and by then I am sure they will still say it is not enough. The next 20 years are also uncertain, and again, past results do not guarantee future results. Say someone agrees nonetheless, then another 20 years to 2053 would be needed to say: you see, we did it. But in my case, the "we" would probably be from my grave.

The Problem's Reality

Now, the real problem I see is the initial capital. Even if you had a 100k portfolio and a Buffett 22% CAGR, it would take 20 years to reach 5.3M. I'm not saying this is bad, but personally, I find it a real waste of a perfectly good trading strategy. Look at it more closely: 10M using the same strategy over the same time interval would result in 533M. Making the first scenario appear so minuscule in comparison. The only conclusion should be: find as much trading capital as you can and as fast as you can. The opportunity cost is also exponential, waiting and/or insufficient funding can be very very expensive.

But first, develop a worthwhile long-term trading strategy. Test it and test it again until you have removed its biases, its inherent flaws or over-optimized routines. I see all the time strategies that are so poorly designed that they were doomed to fail no matter what the future would have been. So first point: do your homework, and do it properly.

I think that most posters on the LinkedIn forum are trying to find more funds, or at least that is exactly what they should do. Each having their own unique trading strategy. Each promoting the benefits of their particular view of what a trading strategy should be. It is fascinating to see all those points of views. It must be partly why I participate in this forum since I like to see how others are looking at the problem and what solutions they have found.

The higher your CAGR, the higher your efforts to attract additional funds should be. It is very simple math. But you should also be ready to manage your accounts for years to come because time is also a major part of the equation, if not the most important. Look up the concept of doubling time, it should put the thing in perspective. I would say like Mr. Buffett: compounding is a very powerful tool.

IMHO, some of the promoters looking for more funds should also look to mix their own strategy with what should be considered opposing views. Long-term investors adding short-term trading methods; or short to mid-term swing traders adding long-term investment strategies. But that is only my point of view which is most certainly not shared by many.

My wish would be that those having done their homework reach their goals and find the financing they need to make a real difference. Not raising additional funds is a major mistake that can become with time, a monumental one.

Created...February 18, 2013,   © Guy R. Fleury. All rights reserved.