I wrote the original version of this for the Currensee blog, but it has a broad based focus, so I wanted to post it here as well.
A thread was begun by a member of the BabyPips community on the subject of measuring and comparing trading system performance. The author had earlier initiated a discussion as to whether active portfolio management (in this case specifically talking about forex trading systems, but the same ideas apply across markets and methods) was of any value given the Efficient Market and Random Walk premises. That latter subject matter predictably generated a rather intense debate. I won’t take that up here, but I do want to discuss the upshot of it. Forum members wanted to know on what basis a system could be judged as to whether it was better than a passive approach. The performance measurement thread took that up.
Here’s the premise.
Performance of any active approach to taking on the markets must be measured against performance of a passive approach. I did a hatchet job on the original poster’s primary recommended metric because it was mathematically flawed, but his overall idea is legitimate. If you’re going to actively play the markets, then it needs to make sense doing so.
Volatility of Performance
Now, this isn’t quite so simple as comparing your own trading returns to that of the S&P 500, or sets of system returns against each other. This is where “risk-adjusted” comes in. The various markets have different levels of volatility (see Looking at Volatility Across Markets), and the same can be said of trading and investing methods. Volatility is the standard measure of risk, so we need to incorporate that into our comparative analysis.
How you measure volatility varies. In academia it’s common to measure the variation of period returns over time. That tends to focus on the consistency of performance. You could, however, use a measure of the size and/or length of drawdowns, which more focuses on the impact of adverse periods. There are other metrics as well. The important thing is identifying the one that makes the most sense for your objectives.
With a metric in place, you can then assess the performance of different approaches to the market on a risk-adjusted return basis. That would let you know that System A, with a 15% annualized average return and a 7% average drawdown, is probably better than System B, with its 16% annualized return and a 10% average drawdown. And then you can look at where System A falls within the sweep of potential uses of your money which runs from low return/low risk (like T-Bills) to high return/high risk (like penny stocks).
The Cost of Time
Assessing a given approach to employing your money is more than just looking at risk-adjusted returns, though. You must also account for the amount of time and effort you put into the process. For something like sticking your money in CDs or investing in an index fund, the time element will be small. For an active day trading strategy the time element is going to be high.
For that reason, it’s worth having a separate metric for looking at this time element. A simple $/hr calculation will suffice. Once you’ve figured out the hourly return of your trading/investment activities, you’ve got another basis for comparison – and for looking at the best application of your time overall.
But beware that the time element of trading/investing cannot just be viewed in cost terms because things like entertainment and education value come in to play. For example, when I first started coaching volleyball I calculated what my hourly rate was when factoring in all the time I was putting in to it. The result was below $1/hr. It bothered me not one bit, however, because I enjoyed the work and was developing myself as a coach such that I could increase my effective hourly rate moving forward. This is a particularly important consideration for new traders – otherwise no one would ever even think about getting into trading!
To Go Active or Passive
The bottom line here is that you need to look at whether being an active trader or investor makes sense in terms of risk-adjusted returns and the amount of time you have to put in to it all. If it’s not, then you’re going to want to look in to a passive approach.