AT THE CLOSE
The Measure Of A Trader
What makes a successful trader?
In 1973, Burton Malkiel published a book titled A Random Walk Down Wall Street, where he argued that asset prices typically exhibit signs of random walk behavior and that we cannot consistently outperform market averages.
Independent of the questions raised by this and subsequent works, the idea that should concern you is that it is impossible to consistently outperform the market averages. If that is true, then why are we all wasting our time? Further, is that really true?
How do you measure success?
If you want to measure your success as a trader, there are three critical components. The first is that you must consistently outperform the average of the indexes that you trade. This is very close to what Malkiel said was impossible to do. A little later, I’ll deal with why this is quite possible.
The second component is that not only do you have to outperform the average of the indexes that you trade but your overall returns must be positive. It doesn’t mean anything if you were to outperform the average of the indexes when the indexes lost 40% and you only lost 25%. Losing 25% of your money is a failure, no matter how you look at it. In fact, the way you consistently outperform the indexes over a long period of time is that you don’t ride the market up and then back down, losing most or all the gains you made over the years. The real key to making money is keeping it!
The final component is that your gains have to outpace inflation. Now, we can argue what to use as an accurate measure of the real rate of inflation, but that’s an argument for another time. Your returns need to outpace the consumer price index (Cpi), if not some tougher measure. If the returns are not greater than the rate of inflation for the period being measured, then you are not really getting anywhere; instead, you are losing ground.
I would argue that those three components are the correct view of how to measure your success as a trader. Now, what time frame do you measure your performance with? The typical period is year-over-year and that’s fine, since it forces you to keep drawdowns in your portfolio to a reasonable level. What really matters, though, is how you perform over the life of your trading career.
Measuring the success of a trader over many years is critical because over the longer term, a trader is much more likely to have to navigate large swings in absolute gains and losses as measured in the markets that they trade. How you navigate those swings will most likely define your true success or failure.
A random walk
Given Malkiel’s theory that asset prices typically exhibit signs of random walk and that we cannot consistently outperform market averages, I have to ask, “So what?” but not really flippantly. So what if it’s a random walk down Wall Street? So what does it matter if the market moves in a random direction over time? Is that really important?
Even if the random walk theory is true, it doesn’t necessarily follow that you can’t consistently profit in such an environment and outperform the markets over time. In fact, as long as you can walk randomly with the random market for reasonably profitable periods, you can outperform the markets!
Malkiel’s theory assumes that you are using some method of picking and choosing to purchase certain stocks that you believe will outperform the market — in the future. The theory makes several assumptions that are indeed not representative of the real world. The theory implicitly assumes that:
- You are buying and holding stocks for a period of time that is identical to the market you are comparing yourself to.
- Your gains or losses are all or nothing; that is, you are buying all your stock equity at the prevailing price and then selling it all at some future price.
- You cannot short stocks or exchange traded funds (Etfs) that short the market or market sectors.
- You have no process for managing your risk and your positions.
All of these assumptions are implicitly contained in the assertion that nobody can consistently outperform the indexes. These assumptions are not the reality for a successful trader.
Do I believe that anyone can predict the future accurately? Yes, but it’s unlikely. Can you be a successful trader (as defined previously) if you have a methodology that you religiously follow regarding entry and exit, portfolio, and risk management? Absolutely!
If you have a methodology that encourages you to avoid large drawdowns in your portfolio, over time you will easily outperform the averages of the indexes you trade. That’s the easy part. The hard part is always producing positive returns and outpacing inflation for the period being measured.