Whilst travelling during the week I was asked by someone what is the single most practical thing a trader can do to give themselves an edge. The question has an easy answer – trade in the direction of the prevailing trend. As easy as it is most people ignore it completely and all fund managers ignore it all of the time.
I wrote about the discussion revolving holding a blue chip portfolio over time – my contribution to the discussion was simply to post a table of the drawdowns suffered by the stocks that make up the S&P/ASX 20. A portfolio of these stocks would have had a drawdown or underwater equity curve that looks somewhat akin to the one below.
I tend to post drawdown curves as opposed to equity curves because a drawdown curve gives you a true sense of whether you could actually have traded a given system of held a certain portfolio of stocks. Equity curves suffer from optimism bias in that we completely ignore the trajectory of the curve and simply look at how much money we might have made. It would be impossible for the average trader to trade a system that returned 100%pa if during the course of generating that return the system had a 75% drawdown.
Part of the problem of minimising drawdowns can be solved simply by being in the market when it is conducive to owning stocks and being out of the market when it is not. The notion of time in the market is an idea as discredited as the Efficient Market Hypothesis. In deciding when to be in the market it is important that traders actually pick an index that is representative of the market they trade when selecting a tool to guide them.
Consider the three charts below of the Dow, the S&P500 and the Russell 3000.
The wider the index the better the picture you get. The Dow is an historical artefact that has long since lost its relevancy to traders. In the above chart it superficially looks as if it is top heavy whereas the other two give a very different picture. If you were only trading the Dow stocks then it may be appropriate to look at only the Dow. However, I am not even certain if that would be useful to your investing cause.