Trading Without a Time Machine
“If time travel is possible, where are the tourists from the future?” – Stephen Hawking, world famous theoretical physicist, cosmologist and author of ‘A Brief History of Time’.
How many times have you heard “experts” claim that a particular stock which they selected a few weeks or months ago has given 50% or 100% returns in a short time? How many times have you heard people talk about investors who became multi-millionaires by investing in the stock market?
Hindsight is always 20/20
“I know a person back in 1980s who invested 10,000 rupees in Wipro company and now after 35 years it turned into 535 crores. Yes, not thousands of lakhs, it's crores. His name is Mohammad Anwar Ahmed.”
It is very easy to say, “Look this stock has doubled in the last 6 months.” But it is nearly impossible to say, “Look, this stock is going to double in the next 6 months.” If you check the prices of thousands of listed companies on a regular basis, you will find a handful of such multibaggers every month. But to predict which stocks are going to give such exceptional returns in the future, especially in a short time, is nearly impossible! You will even find a number of “experts” who claim to predict future stock prices. All you have to do is track their predictions for a year, and you will realize that their success rate is no more than that of a coin toss!
If it were that easy...
There are many people out there sharing “simple” trading strategies that can make you rich in a few months. They give you a few basic rules to buy and sell, and top it off with a couple of sample charts that validate the brilliance of the strategy! And then there are those who claim to have developed “advanced” algorithm-based trading strategies that can make your money grow faster than mushrooms in a dark, damp basement!
“Rs. 1,00,000 invested in this Algo in Jan 2008 has made Rs.9,00,000 by December 2015. That is more than 900% returns in just 7 years.”
Before going in to the many possible mistakes of the trading strategies themselves, let’s understand what kind of people share these strategies in the first place.
- Those who don’t know any better, OR
- Those who do know and are deliberately trying to fool you.
Both these categories of people are equally dangerous. Following the advice of either of them will eventually end up with you losing your hard-earned savings or worse, money that you couldn’t afford losing in the first place! Some of these people genuinely believe that they are helping you because they themselves have no idea how financial markets work.
Let’s take the example of the guy who claims that he can make 900% returns in 7 years. The basic problem with this claim is that, the way it is presented, it is quite misleading. It seems to imply that if you invested 1,00,000 in their “algorithm”, you would end up with 9,00,000 in profits after 7 years. But it fails to mention trading costs, slippages or fees involved in using this algorithm. Another major issue is that it doesn’t say anything about the risks or possible downsides of the algorithm. If there is a chance of losing your money, then it might not be suitable for majority of common investors.
“Beware of false knowledge. It is more dangerous than ignorance.” – George Bernard Shaw.
The biggest problem is that, in all likelihood, this claim is outright false. I am not saying that the person making the claim might be lying. They could very well be in the first category of people who aren’t aware of the mistakes they made when designing the strategy. Here are some of the most common mistakes people overlook when creating trading strategies.
Data overfitting – This is by far the biggest and hardest problem to tackle when creating a trading strategy, especially an algorithm-based one. You can only test the performance of trading strategies on historical data. A lot of times, people end up creating strategies that perform exceptionally well on historical data by tinkering with the parameters. This is known as overfitting and such strategies fail drastically when applied to live market conditions.
Market impact / execution risk – Another common mistake people make is not considering the market impact of executing a strategy. If someone builds a strategy where it is required to buy 10,000 shares of a stock that trades 100-200 shares daily, then there is a substantial chance that their strategy will not be executable or will have a major impact on the stock price.
Market conditions – Often people assume that if a strategy has done well in a 2 to 3-year period, then it will continue to do so in perpetuity. What they haven’t considered is that the market is in different phases and a successful strategy must perform well in all kinds of market conditions. A buy-and-hold strategy will perform well in a bullish market but will not be suitable for bearish conditions.
The reason why it is so hard to build successful trading strategies is that there are too many people doing the exact same things all around the world. Simple strategies never work because everyone already knows about them and others with faster computers and networks, like hedge funds and investment banks, will use them before you ever get the chance!
Complex strategies do exist and are used by savvy traders. But personally, if I ever developed a trading strategy that could generate 40% to 50% returns every year irrespective of market conditions, I would keep the code for that strategy in a secure vault and use it to multiply my own money! In just 10 short years, I would have 27-times of my initial capital… more than enough for a comfortable retirement. The reason why complex strategies are not available to public is that there is a very small window of opportunity to make money with them.
So, anyone who has a genuine strategy would rather use it to make money for themselves rather than give it to common investors for a small fee!
As an investor looking for the biggest bang for your buck, it is very tempting to listen to such experts claiming that they can double or triple your money every few months. Whenever you find yourself getting attracted towards such claims, just ask yourself a simple question – does it sound too good to be true? Because if it does, then it most probably is!