When Less Is More for Your Portfolio
Less is sometimes more.
You’ve probably heard that phrase applied to art or music, but it can also apply to your portfolio.
For some reason, the popular picture of a successful trader is the guy who’s hunched over a half-dozen huge computer screens for 14 hours a day, trying to wring a couple of cents out of dozens of trades. That’s why most investors have been conditioned to believe that they always have to be doing something — anything — at all times if they want to beat the market.
But that’s not necessarily true.
For the last few months, I’ve been telling you about an approach to investing called “trend following.” In short, it’s a method of investing based on using hard rules to jump onboard emerging trends — and to ride them as they play out. I’ve already shown you how a simple trend-following approach can pull some enormous profits out of the market.
Today, I want to show you why a more hands-off approach to investing can actually earn you bigger profits.
For starters, we’ve got to tackle the investor fallacy that you’ve got to always be trading. It’s called “action bias.”
Simply put, action bias occurs when traders trade for the sake of trading, rather than to take advantage of a high-probability opportunity in the market. Not surprisingly, action bias adds additional market exposure to your portfolio (and, thus, more risk), and that exposure comes in the form of investments that are inherently worse than regular trades.
You can probably imagine how tons of commissions can add up to eat away a big chunk of your trading gains. But even with zero trading costs, trading too frequently can massacre your gains.
The best evidence for this is a real-world look at the trend-following system I introduced to you back in September.
As a refresher, here’s what the profit chart looks like compared with the S&P 500:
Most investors have a pretty reasonable assumption that if a system works great when it trades once a month, it must be even better when you up the trading frequency to once a week. After all, you make more money when the interest you earn compounds more frequently, right?
But that’s actually not the case here:
It may seem surprising, but using that exact same system with a weekly trading frequency did much worse than our monthly system. In fact, at 11.3% gains, it barely even did any better than the S&P 500. Does that mean you shouldn’t trade on a weekly basis? Not at all — other systems may work best on a weekly or even daily trading schedule. But this does do a good job of showing that sometimes it’s good to sit around and do nothing.
The trend-following system we’re using was designed to pick up on longer-term trends. That’s why a monthly frequency works so well. Up that sensitivity to weekly and you’re basically getting a lot of false signals that wouldn’t still be valid if trades were looked at only a quarter of the time. (Incidentally, those false signals kept you out of trading for too long — which is why the returns stay at zero for the first half of the chart.)
So less trading can quite literally mean more cash for your portfolio.
As investors, we’ve been programmed to think a certain way — and it’s often not the right way. Mistakes like action bias are understandable, but they can also destroy your profits. Don’t be afraid to sit on the sidelines when your system tells you to.
Jonas Elmerraji, CMT
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