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Beyond Recency Bias

During certain time windows the performance and metrics of a strategy will fluctuate due to market conditions within those windows.

You may have a system that offers a 65% trade win rate but in small windows it may drop to 40%. You may have a system that shows an 18% annual return over 25-years, yet in some windows this may decline to 5%.

This is important because most new or inexperienced traders tend to suffer from Recency Bias.

Recency Bias occurs when a small or recent sample of trades is used to draw big picture conclusions.

If a trader has 5 losing trades in a row immediately after starting a new strategy, they may consider that the strategy has no merit. They may tweak and make adjustments. They may abandon it altogether.

Simply put, when we look at a very long term equity growth chart, one that trends nicely, what we don't see are the short term hiccups the system endures.

Consider the two equity growth charts below. Both are from the same strategy, albeit here we're using a random trade generator. The chart on the left shows a 1500 trade sample of Strategy-XYZ.

It would be reasonable to suggest that most new traders would be enticed to start trading this strategy - it shows long term consistent equity growth with minimal downside events.

Yet what they don't see within this larger sample is what happens in the short term windows, such as the example on the right. This 25 trade sample shows a window that doesn't look overly enticing, indeed it looks quite ugly and would be discarded by 95% of new or inexperienced traders.

Which brings me to the Premium Portfolio that is currently under-performing the broader market.

Am I worried?

Should I override the strategy and get fully invested?

Do I change the strategy so I get in earlier?

The answer is NO.

And the reason is my extensive research was to 'look under the hood' and see how the strategy performs over various time windows - good and bad.

Not every strategy will work perfectly all of the time. It certainly doesn't for Warren Buffett so I should swallow my ego and accept that it will also be the same for me.

The following charts show the rolling differential between the Premium Portfolio and the S&P 500 back to 2005.

The first chart is for every 6-month window stepped in 1-month intervals. Of the 164 occurrences the portfolio has outperformed the broader market 86.6% of the time.

The second chart shows every 12-month window also stepped in 1-month intervals. It shows the portfolio beating the broader market in 93% of any 12-month time window.

In summary, using an evidence based approach such as the Premium Portfolio, I can deep dive into performance metrics to reassure myself that what's going on at the moment is nothing to be concerned about and that I should ignore near term 'noise' and remain focused on the long term expectation of the strategy.

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All content available on this website, www.tradelongterm.com (this “Website”), is general in nature, not directed or tailored to any particular person, and is for informational purposes only.  Neither the Website nor any of its content is offered as investment advice and should not be deemed as investment advice or an offer, solicitation, or recommendation to purchase or sell any specific security.  The information contained on the Website reflects the opinions and projections of the authors of the Website (the “Authors”), which are subject to change without notice at any time.  The Authors do not represent that any opinion or projection will be realized.  Neither the Authors nor any of their affiliates represent that the information presented on this Website is accurate, current, or complete, and such information is subject to change without notice.  Past performance is not a guarantee of future results.  Authors may own the stocks they highlight or discuss and, in fact, do own the stocks contained in the Premium Portfolio.

IMPORTANT INFORMATION

Commodity Futures Trading Commission (CFTC) Rule 4.41

HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.

This brief statement cannot disclose all of the risks and other significant aspects of securities and derivatives markets.

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