January 7th, 2017

People don't see how easy it could be to do more. If only they gave it more time. The ultimate objective is to outperform long-term averages and to make sure you do. So, here is back to the basics.

You give yourself the job to go from point A to point B. Nobody is forcing you on this, that is, to play this game. You already know your point A, that is where you are right now; with all your resources, know-how, and expertise. You know where you want to go. The only thing left is to determine the path to get there. And here, Google Earth or a GPS won't help you.

Academic portfolio management literature since the '60s will point out that the long-term expected outcome of your endeavor will, in all probability, end up being about the same as secular averages. And, by this means no alpha generation is expected, which in turn means, doing almost nothing or everything, you should expect to get about the same as most other people (the average).

In the stock market game, the short-term trader is at a real disadvantage. It is as if his choice was to literally gamble his way out, under uncertainty, as if playing in a casino, thinking that he can beat the odds and outsmart everyone, even the market itself. Surprisingly, he might even be lucky at it too. But he will have to use his special kind of math that only works for him until it doesn't. We could call it dream math, for lack of a better word, which has the peculiar property of having a much higher guessed-at expectancy than the underlying probability. A way of saying that future claims are much higher than what reality might currently permit or admit (aka self-hype).

Or, he could make a plan of where he wants to go and gamble along the way, knowing he will eventually get to point B. As if implying that if you only gamble, you might not reach point B at all. A visit to the gambler's ruin theorem might bring more light to this. Playing a game where you are doomed and not knowing it, does it spare you from doom?

Nonetheless, the method of play is a matter of choice. Some like gambling for its entertainment value no matter what and view having a long-term plan as a boring restraint to their undertaking and enjoyment, if ever there was one.

The trader/investor making a plan gets the advantage and has a considerably higher probability of reaching his destination. He can see point B on the horizon and figure out how he will get there the most efficiently possible. It does not mean he won't take or enjoy some entertainment along the way.

In building a stock portfolio, an investor is faced with the same kind of problem. The most simple way I can express this quest, for any type of investor/trader, is with the equation: A(t) = A(0) + n∙u∙PT, which says: point B = A(t), is the destination. While, the starting point: A = A(0), is from where one needs to engage on his/her path to accumulating: n∙u∙PT in net profits.

Should you want to play the stock market casino, you better understand those 3 numbers: n∙u∙PT, since to reach point B from point A, you will have to walk the path: A(t) - A(0) = n∙u∙PT. One thing you will realize trading over the short term is that point B needs to be far far away. You want to make it not only worthwhile but also reachable, a compromise of sorts. It will require quite a lot of time.

Making a thousand-dollar profit on a trade is not reaching point B. It is only reaching n = 1. How many more will you need to reach your goal, and how long will it take? Those are your real questions.

No matter how long you will trade, with whatever amount you started with, using whatever trading methods generating whatever number of trades, the above equation will still prevail. It is not a matter of opinion, taste, secret sauce, or anything else.

A two-minute course would be sufficient to explain its limitations. You have an equal sign on the table which says (viewed from that equal sign): that is all there is. Any trading strategy can be resumed using those 3 portfolio metrics.

If at any time you reach A(t) < 0, you will have lost the game. This might probably be why point B is identified as A(t), as some future goal, a distant outcome. Reaching your termination time, you can only have n∙u∙PT more (or less) in your trading account than what you started with.

This also implies that your trading strategy has a signature: this is all it does. This is how it sliced and diced those price series and generated: n∙u∙PT in profits or losses. It will depend on if you had an edge or not: PT >? 0. And how long did this edge last?

For instance, if you design a trading strategy, do a 10-year backtest and obtain: A(t) = A(0) + n∙u∙PT. Then, a 20-year test should simply double the outcome. It took 10 years to generate n trades. In 20 years, it should generate twice as many. If it does not, you know the pillars and foundation of your trading strategy are cracked. If your trading strategy breaks down, there are reasons for that. You better find out why because the next 10 years are at stake.

... to be continued...

Created... January 7th, 2017,   © Guy R. Fleury. All rights reserved