When trying to judge the success of traders there is nothing more definitive than the rate of return they have been able to demonstrate. Regardless of what other explanations or justifications you might consider, a trader that has achieved a 50% return over the past year has been objectively more successful than another who generated a 5% return. Money talks and you know what walks.
But does this mean that they are a better trader? Given that trading returns are likely to fluctuate in the short term, we should avoid trying to lionize those who have experienced short term success. What any seasoned trader will tell you is that consistency is what matters above all else. Indeed, it is far more desirable to consistently generate a low but reliable return over the long term, rather than experience short and intermittent periods of high growth interspaced with periods of loss – especially when you plan to support yourself through trading. Besides, seemingly low rates of growth are far more achievable and can nevertheless compound to produce excellent results over time.
To demonstrate the point, let us assume that a trader claims he can achieve a reliable return of 10% per week by assuming only moderate levels of risk (I have actually met many traders that claim to be able to generate significantly more than this). In order to understand the validity of such a claim we need to understand the power of exponential growth and its implications. Let’s say that you invest $1000 at the start of the year and reinvest your profit along the way. After the first week you will have $1,100 (10% of $1,000 plus the initial capital). The following week you will have $1,210, then $1,331 etc. By the end of the year, the trader would have a trading account worth almost $130,000. That’s an annual return of nearly 13,000%!
So when someone claims they are able to make 10% each week, what they are saying is that they are able to make 13,000% each year. Not impossible, but extremely unlikely. Consider the case for someone who claims to be able to make 20% per week. Their initial $1,000 will grow to $10.9 million dollars in just one year! Again I’m not saying this is impossible, just highly improbable.
Of course experienced traders will be quick to point out some flaws in this reasoning. The first one is that you don’t always manage to get your targeted rate of return each week. So this just means that if you expect to make consistently high returns week in and week out you will be setting yourself up for massive disappointment. If expert traders acknowledge that a 10% weekly return can never be completely reliable, then you too should view such expectations as highly unreasonable.
The second point professionals will point out is that you should never reinvest your entire trading account each week and expose yourself to such high levels of risk. And they are of course completely right. However let’s say that you don’t reinvest your entire trading account, but rather only ever maintain the initial position size. If we again assume 10% each week, that means we make $100 each and every week from our $1000 investment – or $5,200 each year. That’s an annual return of 520%. Again, I view such an outcome as unlikely and extremely difficult to maintain. I know of no single example in the entire history of share market investing where anyone has ever managed to reliably and consistently generate 500% each and every year over the long term. In fact, the record demonstrates that even the best professionally managed hedge funds have never exhibited returns even close to this – consistently, that is.
Of course, many people and funds have achieved these kinds of returns and more for particular years but the point is that these massive rates of return do not appear to be sustainable and reliably replicable. Certainly those that have achieved super-massive returns can never guarantee that they will continue.
If you look at the Australian market since inception, that is since the late 19th century, the average annual growth is just 5% (this excludes income from dividends). That equates to less than 0.1% per week. Your common sense will tell you that anyone who claims to be able to reliably achieve significantly more than this, during good times and bad, is not being entirely reasonable. For example even a 2% return each week will allow you to double your investment capital each and every year without having to increase the position size, yet there are few examples of traders that consistently double their money each and every year.
Of course you also need to account for transaction costs – that is the costs associated with buying and selling. Depending on your trade size, this could mean that you need to generate a significantly higher return to account for these costs. For example, a trade size of $2000 will require you to experience 4% growth per week to account for brokerage (in this example $20/trade), and still maintain net growth of 2%.
The moral to this story? Be reasonable and realistic in your trading targets, and beware the false profit. It’s easy to get excited about big returns, but the point is that you are better off targeting lower returns that are more likely to be sustainable. It’s always nice to experience a big pay off from a particular trade, but we need to appreciate that this is the exception to the rule. After all, if it was that easy to make consistently big returns, people like Warren Buffet would be far more common.
Make the markets work for you