Why Consider Active Trading?

Good question. You hear about traders -- there are "rags to riches" stories; there also stories about those who mortgaged the house, only to lose it in a day trading account?

What are my beliefs about active trading, versus buy and hold?

Consider the following scenario?

• You have been given a balance of 100,000 to invest. Let's also assume you can earn a "risk-free" rate of return (U.S. treasury bills) of around 3% (let's ignore the ravages of inflation for now because that hits any investment denominated in US Dollars). If you do nothing else, you will earn this 3% per year.
  
• You have been convinced by a friend to start actively trading a small piece of your account. You've told your friend that you are willing make one trade at a time, but you are limited to investing 10% of your portfolio (using the balance at the beginning of the year for this calculation). The other 90% you are going to keep in the T-bills.



• In this friend's "system", you will have streaks of winners and losers, but on average throughout the year you will earn on average of 1% return per trade (after commissions). Each trade will on average last a week, or five trading days.
  

For simplicity's sake, let's assume there are 240 trading days in a year.

Let's calculate the rate of return on your portfolio with hypothetical system assuming our returns are "smooth" -- that is, we earn the average on every trade, have no taxes involved (what a world!) and occur exactly as planned.

• 240 days/5 days per trade = 48 trades per year.
  


• 10% of the portfolio is in active trading...assuming a rate of 0.5% average return per trade over 48 trades = 1.0% x 48 x 10% = 4.8%



• 90% continues to be in the risk free investment, so 90% times 3% = 2.7%



• 4.8% for 10% of portfolio + 2.7% for 90% = 7.5%

So in this example, risking 10% of our portfolio, our total return has gone from 3% to 7.5%!! And we were 90% in T-bills.

Now, you say, c'mon, tman, get real...you couldn't really achieve returns like you discuss in your example. Let's discuss the concerns.

These types of returns don't occur uniformly each year -- there are some major ups and downs, just as in long-term investing. This is most certainly true -- we would have to endure some major swings with that 10%. But if over long periods of time, if we could achieve these types of returns, and our drawdowns weren't any higher than they would be being "buy and hold" investors (and let's be honest, there are some big drawdowns in "buy and hold" stock investing), we could probably live with that concern. Remember in our hypothetical account we were also holding 90% T-bills - which give us some cushion for the other 10%.

What makes you think there are systems that can achieve that rate of return? Good question. The only thing is I can say is that I have seen these types of systems and have developed and tested some of them myself. And some of them have opportunities to make even more money than 1.0% per trade.

So, this might give some insight as to why I am at least interested in pursuing the benefits of active trading. I might be willing and able with a piece of my portfolio to increase my returns and reduce my risk. If I am willing to swing for the fences, I even increase the amount I put into it. Who can resist the thought? I, for one, cannot.