October 30, 2012

How can I win the stock market game? One asks this simple question and is bound to receive a million answers. Almost everyone has a piece of advice on this subject, with lots of investment folklore, hot tips, and unsubstantiated claims.

There is no real secret to playing the game. Look at those that are successful at it and do the same. Then try to improve on what they did. If you study someone's trading methods and find that their past performance results were mostly due to chance, then that was their secret recipe: luck. Luck is not predictable, and as my first piece of advice, one should not bet the farm on it, at least not most of the time.

When studying the investment methods used by someone like Mr. Buffett, for instance, you soon realize that his performance did not come by chance but from an uncanny understanding of the investment game itself. A major tool in his trading (investment) arsenal is compounding, which permeates his longevity in the market.

Over the past 50 years, Mr. Buffett has managed to maintain over a 20% CAGR (compounded annual growth rate); in fact, about 22%, which translates to (1 + r)50 = (1 + 0.22)50 = 20,797 times his original \$10M investment. A most remarkable achievement. It's equivalent to an average doubling time of less than 3 years.

In a world where the Buy & Hold investment strategy is almost considered a sin, you have someone like Mr. Buffett applying his investment philosophy and outperforming the average Buy & Holder and over 95% of all other market participants. The question becomes: how? And to this, the answer is very simple: he did it by reinvesting accumulating profits in more stocks. Mathematically, Mr. Buffett transformed conventional portfolio management procedures into a trading methodology where compounding would also apply to his increasing profits.

Any stock market wealth accumulation process can be described in the following manner:

W(t) = PoQo + Σ(H.*ΔP)

where PoQo represents the initial price times the initial number of shares acquired. And where Σ(H.*ΔP) stands for the payoff matrix of the total profit generated by whatever trading strategy (H) is applied. This is the main concern of any trading system. Another way of expressing the above equation is that the wealth accumulation process W(t) is the initial investment W(0), to which is added all the generated profits over the lifetime of the portfolio. There are many other representations that could be used. It is just that I like the above for its simplicity.

The above wealth-building equation is the discrete form of its continuous representation:

W(t) = PoQo + t  H dP

which again says the same thing as the above. In both cases, the trading strategy H is what will make the difference. It's the inventory holding function matrix H that matters most. Therefore, to win the game, one has to build a better holding function matrix H+ than the Buy & Hold. It is how this holding function will evolve over time that is the key to building better portfolio performances.

Most concentrate on predicting prices when it comes to enhancing performance which, by the way, should also be considered a worthwhile endeavor. However, predicting prices has an increasingly limited value the farther out in time you want to predict. The probability number associated with a prediction is at best a rough estimation of what could be, not of what will be. It is as if making a short-term prediction is about the same as making a short-term bet on the outcome of roughly a random process.

We play for the price differences (ΔP), and profits can only be made if the selling price minus the buying price is greater than zero: Psold – Pbought > 0. This does not mention the time interval required to make a profit, nor does it mention its trade size.

Looking at the above equations, there are not that many variables in play. It would appear that the first order of business is a stock selection process; on which stocks and over which time interval should one apply his/her trading strategies. But even doing this, one would be confronted with the statistical heritage of modern, post-modern, and stochastic portfolio theories. It is not because you want or plan to trade that you will not be confronted with what was.

Deciphering the secret nature of the market is a trivial pursuit. There is no secret nature. All you have is a big marketplace where you can buy or sell shares. In this sense, the market is a zero-sum game where your profit comes from other player's losses.

(to be continued)...

What will follow is a common sense approach looking at the trading strategy development process in view of overall long-term performance.