What’s the catch?
They say (and I’m not sure who “they” are) that the average retail investor hates to book a loss, and takes profits too soon. The reverse of the “cut your losses early and let your profits run” mantra of the momentum crowd. But how bad is this “never book a loss” (“NBAL”) method anyway?
Let’s propose a system, just for fun. You, the uninformed retail investor, vow never to sell at a loss. You will buy at the close of a down day, and sell at the close of the first profitable day. If it’s not profitable, you refuse to sell, so that you can tell your spouse that you never lose money. That system generates the graph above…on a per-trade basis. No drawdowns, because there are no losses.
Oh but wait, let me throw the dates in there.
That doesn’t look quite right, does it? That’s because there are long periods where the market is down from its peak. In this system, you end up buying at a market high, and then sit and wait for the market to come back. After the dot-com bust, you’d be waiting over six years! That’s a lot of time sitting and waiting for your money to do something.
In the NBAL system, the vast majority of your trades are one or two days long. But every once in awhile, the music stops and you’re the one without a chair. And your daily equity looks very different to your per-trade equity.
Apologies for the different chart styles…anyone know how to export daily equity from AmiBroker?
[Thanks to everyone who chimed in with suggestions on exporting the equity curve!]
As you can see, your daily equity curve looks suspiciously like buy-and-hold:
That said, you’ll notice that our NBAL system made a little more profit than buy-and-hold, and the current drawdown is not quite as bad. However unless your trading fees are almost nonexistent, the NBAL system would have fared worse. For the purposes of this discussion though, we’ll pretend either a) your grandma owns a brokerage and lets you trade for free, or b) you’re trading with these guys.
(At this point, you’re thinking “what moron would trade like this?!” That’s because you’re a sharp trader – or is that Sharpe trader? But bear with me, because it gets interesting-ish.)
Can our NBAL system be improved? What if we tried to book more profit before we sold? This flies in the face of our naive investor who wants to sell at the earliest sign of success. But let’s say we convince this investor to hold onto his/her money until the closing price is x % over the purchase price or greater. What would that look like?
Turns out our naive investor was correct. The best returns occur when you set your profit target just above 0:
These are the optimization results for profit target, testing between 0 and 10 in .1 % increments. As you can see, the .1 % target shows the best results. That’s a win of sorts for the Naive Investor.
Let’s say we talk this person into considering a maximum time to hold a position. Yes, that’s right, we convince him or her to book a loss. That will be hard battle, because there will be drawdowns. The spouse might even find out about these booked losses. This concept is going to be tough. But perhaps charts will convince our investor to consider this option.
Above is a chart optimizing for maximum days in a trade before selling. As you can see, there are quite a few durations that yield a higher profit potential than the NBAL system. The best is at 9 days, but this is a) spiky optimization results and thus probably an anomaly, and b) benefits from hindsight.
Just for fun, what if we use the NBAL system, but exit after 9 days and start over if we didn’t book a win? Here’s what our daily equity chart would look like:
That’s a nicer looking equity curve! Profit is much higher, and the drawdowns are much smaller than either the NBAL system or buy-and-hold. All accomplished with the simple addition of a time-based ‘stop’. You still had a painful 2008 – but less so. And you still had an extended drawdown after 2000 – but shorter.
I hope it’s obvious that the 9-day duration is not something that’s guaranteed to work in the future. And this is yet another Stupid System that is intended only as an exploration. This does show though that taking losses can make you more money in the long run.