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Monday, August 8, 2016

Expectations

Expectations: A topic that will never get old.


We have discussed expectations in trading several times in the past (you can read for example this article written in 2012, back when I didn't have a single gray hair and all was good with the world).

Being an engineer, of course, I don't like to use generalizations: "Oh, you know it depends on your zodiac sign and how you manage your bla bla bla". I like the numbers. The hard and cold numbers. What can be realistically achieved by the absolute best traders of the universe, regardless of the type of strategy they use, whether it is long stocks, or The 8 legged-octopus ratio Condor? Why is it so hard to give a straight answer?

It's a topic we have to go back to from time to time, and perhaps the most important realization one can make to start to consistently be profitable as a trader; without risking the moon; focusing on his level of play and forgetting about constantly wasting time in the search of the perfect Holy Grail. A reader recently made me go back to this inescapable subject.

"Hi LT,

I recently discovered your site and like your down to earth attitude. I only wished you wrote more often. Anyways, I'm trading options on an 80K account and my plan is to obtain 5% monthly returns. Is this reasonable? Please, protect my anonymity." - Biyombo


Free trading counseling and demands of anonymity? Damned traders!
By the way, are you Biyombo, the ex-Toronto Raptors basketball player? This site reaches unsuspected peaks every week.

This is the subject that nobody wants to talk about, especially trading newsletters. It is necessary for the dream and the illusion to stay alive, and there is no easier way to kill it than saying +10% per year is actually very good in the long run. So, as a newbie, one remains in the shadows wondering what is actually possible. When everyone talks about return on investment on a particular play, the new guy quickly thinks a 6000% annual return is possible. Audited performances however, show a very different picture.
But first, let's answer your question.
If your account grows 5% every month, it is 60% annual growth without compounding (79.6% compounded). So, no. It is not reasonable.
If we look at audited returns of hundreds of professional traders over decades, and not anecdotal evidence on StockTwits, it is very easy to see that 10% per year is actually pretty good! I know this sucks, but it is what it is. Using Barclay as our main source, we can see that discretionary traders have averaged 7.58%; Systematic trading programs (robots, algorithms) 7.69%; Currency Traders 6.71%; Audited CTAs (which most of the times use combinations of trend following strategies in different asset classes: commodities, bonds, equities, etc) 9.84%

Note: this article was written 3 weeks ago, therefore the numbers may be a little different when you read this. But still, it is the average over several decades, so, these numbers won't change much from one day to the next).

Of course, big funds need to deal with the psychology of their investors, and they need to avoid large draw-downs at all costs in order to keep their participants happy. You, on the other hand can take more risk, as much as the freedom granted by the founding fathers allows you. There is also a second factor that plays a determinant role, which is portfolio size. It is much harder for a billion dollar fund to obtain extremely good returns, than it is for you to be up 30% on any given year in your $80,000 account. However, at the same time, the above numbers reflect funds that are still alive. So, there is a bit of survivor-ship bias there, and I'm more inclined to think the averages are a bit lower when considering all the ones that have gone bust over the years, or that simply are not willing to have their results audited and published every month.

Another interesting point is that, in almost all cases, the max draw-down in the long run has been twice the average return. In other words, to obtain a 7.5% average annual return, you had to eventually suffer a 15% draw-down. It's the all important ARR to Max Draw-down ratio that almost nobody talks about. This would tell you that there is a limit to profitability at the professional level of around 50% average annual return. A point at which, eventually, the fund is likely to suffer a 100% draw-down.

A 60% annual return is not something to be expected year after year. It may be reached once here and there, but expecting it every year is not realistic. It exposes you to too much risk. This is not particular to one strategy. 60% account growth implies unsustainable risks for any type of strategy in the financial markets. Again, not impossible one year, but unsustainable in the long run.

It is said that 90 to 95% of retain traders lose money. I don't have the university research to point you to verify that number; but I also have no reason to not believe it is probably the truth. Year after year, most professionals (75% to 95%) fail to beat the markets. 7% is usually an accepted number for historical stock market returns with dividends included. So, if you make more than 7%, year in and year out, you are better than 95% of retail traders (because they lose money), and you are also better off than the majority of professional money managers, because they fail to beat the index.

Finally, the super successful. If you read the book "Market Wizards", you won't see any trader with better than 50% average annual returns sustained for several years. The book was written a while ago, numbers have changed, but the fact remains: this is a tough game.

Using more up to date numbers, Bill Dunn has averaged a tad below 15% in the last couple of decades. Warren Buffet's Berkshire Hathaway 9.7% average in the last twenty years. He had periods of +20% annually, which is truly phenomenal, but lately his numbers have come down to earth. Ed Seykota, to me the greatest trader ever, averaged a bit above 20% in his career, which, based on the surrounding evidence, is obviously remarkable. So, we're talking about the elite of the elite here, and in order to achieve these results they had to go through extreme amounts of pain frequently, something I talked about in The Torture earlier this year.


As an individual you can take more risk. You can use more leverage. With a smaller account, you can also target greater returns. To me, 20% to 30% a year, on average, or around 2% a month, is a more realistic expectation than 5% a month. You average that 2% per month for a decade and you sir, are an ELITE trader. You can make 5%, 6%, 7% in a given month. Just don't expect it to happen every single month.

I know it may disappoint you, just as it did to me when I decided to deeply study this subject. But it is what it is. The markets are not so inefficient. Not as much as we would like them to be. They are full of noise and randomness, preventing any particular strategy from indefinitely generating alpha in such magnitude.

Confusion is common, also expected with the over saturation of information on the Internet. There are just too many websites in a world where, really, the-lazy-trader.com plus two or three other sites would be enough to cover your trading needs, plus free marital advice when needed.

LT


Related Articles:
Trading with Realistic Expectations
The Torture
How much capital do you need to trade for a living


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