(Boris Schlossberg and Kathy Lien, two of the leading experts on foreign-currency trading and other investments, join the Money and Markets Afternoon Edition team. Once a week, we will present their financial insight after the day’s market close. Today, Boris Schlossberg gets us started.)
Dollar-cost averaging is simple: buying a set dollar amount of an investment on a regular schedule, regardless of the price. Brown shows how this consistent and steady buying of an equity index will beat any hedge-fund return anywhere, anytime.
The idea is that some of your capital will have massive double-digit returns as you scoop up assets at fire-sale prices. Some of your capital will have average returns, and some of the capital may even have negative returns as you pay up during market rallies, but the overall value of your holdings will almost certainly rise over any 10-year period.
|One investment strategy stands out above the rest.|
The only way that this strategy would fail is if stocks slowly but surely drifted to zero over a 10-year period, in which case you probably would have much bigger issues to worry about. As long as equities have an upward drift, you simply can’t do better as an investor than dollar-cost averaging into the index.
The dollar-cost averaging strategy of success relies on two factors — the natural upward drift of equity markets and the much more important idea of the law of large numbers.
The law of large numbers simply says that outcomes will almost always reach their expected end, as long as you have enough samples. For example, if you flipped a quarter three times in a row, chances are good that you could get all heads or all tails. In fact, 12% of the time that’s exactly what would happen.
Does that mean that the coin is rigged? No. It just means your sample size is very small and highly biased. Flip the same coin 1,000 times and the probability that heads or tails will fall within a few basis points of 50% are almost assured. Do it 10,000 times and they are practically guaranteed.
|“The underlying concept behind the law is that you need to trade SMALL.”|
The law of large numbers is an amazing principle. It essentially tells you all you need to know about how to get rich. Just chop up risk into tiny little pieces and take many (hundreds or even thousands) samples of that risk, and over time you will be much wealthier than you are now.
Of course, this little mind experiment assumes that the risk you consider is actually worthy. For example, if you dollar-cost averaged gold for the past 50 years, you would still be worth a lot of money (if for no other reason than you would own a lot of gold!) but not nearly as much money as if you had bought the S&P 500. Still even in that example, you can see the power of this principle in action.
That’s why it always amazes me that traders routinely ignore this foundational idea of risk control. In fact, I think the primary reason why most traders lose money in the market is that they don’t appreciate the power of the law of large numbers.
The underlying concept behind the law is that you need to trade SMALL. There is actually some poetic irony in that dynamic. You need to do a lot of trades in order to assure yourself of long-term success, and the reason you need to trade small is precisely because you need to be able to withstand the bad runs that will inevitably occur.
The first thing that I do in order to improve a trader’s performance is to make them trade so small that it seems almost miniscule.
Frankly it almost doesn’t matter what system they trade; reducing size has an instant and dramatic impact on performance. They stop panicking and execute the strategies much more effectively.
Marry the law of large numbers with a sound trading algorithm and you have nearly a fool-proof recipe for success. Don’t believe me? Look at high-frequency firms, like Virtu Financial (VIRT), which trade millions of shares per day, 100 shares at a time, and haven’t had losing days in years. As an individual trader, you don’t need to mimic the hyperkinetic pace of HFT shops, but you do need to slice risk into tiny increments just like they do.
It’s truly unbelievable that the answer to 90% of our trading problems lies in size rather than strategy, yet so few traders take advantage of the key law that governs the markets.
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Astronaut Scott Kelly returned to Earth after 11 months in space with Russian colleague Mikhail Kornienko, having traveled some 144 million miles in space. He also made 5,440 trips around the globe in his 340-day journey. When he blasted off in March of last year, Scott Walker and Jeb Bush were considered the GOP’s leading presidential candidates and Donald Trump was known as a reality TV show. Few people outside of Vermont had heard of Bernie Sanders. The price of oil at that time? About $50 a barrel. The mission was to test Kelly for the long-term effects of living in space. Kelly took his own blood samples and performed other tests — the results will be compared to those from his twin brother, Mark, a retired astronaut who remained on Earth.
Forbes magazine has released its World’s Billionaires List for the year, with the total net worth of the 1,810 people listed nearing $6.5 trillion. The richest person in the world, with a net worth of $75 billion, was Microsoft co-founder Bill Gates. But it’s not all good news for Gates – his net worth actually declined in the year from $79.2 billion. Poor guy. The list can be found here.
Retailer Sports Authority filed to reorganize its debt and operations under Chapter 11 bankruptcy. The company said it had debts exceeding $1 billion. It identified 140 stores and two distribution centers it would close in the coming months to streamline its operations.
The Money and Markets team