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The Buy Side

How to tell if in-and-out trading is for you Add to ...

One of the toughest jobs for any value investor is deciding how frequently to trade. Unfortunately, no one answer is right for everyone.

Value investors believe that stocks ultimately converge to their true value. If a stock trades much below its real value, it should eventually rise; if much above, it should eventually fall.

If you are a private individual, this usually results in a simple strategy - you buy high quality stocks when they sell below value, and hold them for the long term. But a money manager would likely trade in and out of the same stocks several times during the same period.

Why? Because as an individual you only have to worry about making money, but a money manager must also aim to keep his clients. Therefore, he must not only maximize returns, but also minimize temporary losses (or "draw-downs") that can scare away customers.

To do this, a money manager reduces his position as a stock becomes temporarily overvalued, and buys it back as the stock declines into better value. This may hurt the manager's results because of taxes and trading costs, but helps retain clients. However, if done well, such in-and-out trading can actually improve returns.

To decide whether such trading can help you too, I suggest you put your abilities to the test by tracking your return when you trade in and out of a stock, against the return that you would have produced by a simple buy-and-hold strategy.

The simplest way to begin is to chart two lines for the investment period. The first line traces the stock price itself. The second line follows the stock price when you own it but turns into a flat line when you don't.

Compare the rate of return, the draw-down and the maximum time between peaks of an in-and-out strategy to the stock's own price line. If your buying and selling improve these three parameters, you're doing better than buy-and-hold.

And if the results look positive, you can even go further and put a number on just how good a trader you are. Assume a stock rises from $10 to $40 over a decade. The gain is 300 per cent over 10 years, or 15 per cent a year- a nifty return.

Volatility

But what if the stock is volatile, given to steep plunges and abrupt recoveries?

If you're a money manager, you would be at risk of seeing your clients panic and redeem if you simply hold the stock. You would therefore increase and reduce your positions, based on your estimate of its value, to minimize the draw-down.

To make it simple, assume you either own a full position or none. The question becomes twofold. First, how much of the gain did you capture? Second and equally important, what was the total time you owned the stock?

Assume you had captured only half the gain - a "capture ratio" of 50 per cent. But what if you had captured this while owning the stock a total of only four years, a mere 40 per cent of the decade? Your "trading efficiency" would be 125 per cent (50 per cent of the potential gain divided by 40 per cent of the time).

Trading efficiency of this magnitude can be highly profitable, because it allows you to use your capital elsewhere during the times you're not invested in the stock.

Real Costs

Of course, real life is not as simple as this example, because frequent trading means earlier taxes and increased commissions. Reflecting this reality, professional managers rarely go totally in or out of a stock - they usually increase or decrease positions based on value.

To get the most accurate measure of your ability, you should calculate your trading efficiency by using prices net of taxes and trading costs. If you're really good, you may find it's better to pay early capital gains taxes and higher commissions than to risk a steep draw-down.

But that is rare. Nine out of 10 investors will find that frequent trading isn't worth their while. Most have a trading efficiency of much less than 1. In such a case, you should forget trading. Stick to holding superior stocks for the long term, and suffer the occasional draw-down like a mensch.

 

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