Comment On Trading Systems

Occasionally I run into people who claim to have a "system" for making consistent excess profits in the market--for example, 200% annual returns from buying and selling options on large cap tech stocks, or 40% annual returns year after year from short-term trading of a single stock on margin, or very consistent 1% monthly returns from index trading--all with extremely high Sharpe ratios.

When I ask these people to explain what they do, they generally become a little cagey, telling me that they really are not at liberty to provide detail on their methodologies, sometimes because they have signed a non-disclosure agreement with a partner or company, other times simply because they do not wish to give away "trade secrets." Usually around this point our conversation stalls, and we then go our own ways--they (presumably) back to their trading labs to continue along their paths to millions of dollars of new-found wealth, and I back to my office, wondering if such "systems" really exist at all.

I try to maintain an open mind and temper my skepticism. However, if such "systems" really exist, my guess is that these people would be a lot more wealthy than they actually are. Another odd thing is that they tend to limit the percentage of their portfolios that they allocate to their trading systems, or no longer choose to invest their money the same way, even though they "know" their systems work. I wonder why, if they really have truly reliable systems for generating excess profits, they don't proceed to put all of their money to work so that they can move into the billionaires' club a little sooner.

At this stage in my own study of and participation in the markets, I would say that I am an "agnostic" on the validity of trading systems for generating consistent excess profits. I do not deny that they exist but also, having not yet had the privilege or good fortune of encountering a systematic methodology that produces excess profits with high reliability, I have no reason to believe in them either. In my own investing, I continue to search, trying to learn a little more each day, hoping that one day my own success as a practitioner will allow me to become a believer in some system as well. (Some might say that I have the order reversed, i.e., that I need to believe first and then success will follow--but, no, thank you, I am not ready to turn my investing into a religion!)

The best analogy that I can now think of for what it takes to become a successful investor is Ichiro, the baseball player. Ichiro, through a combination of his focus, hard work and talent, is redefining what it means to be a "great" baseball player. With Ichiro's new 2004 record for the most hits in a single season, consistently high on-base percentage, speed on the bases, and close to error-free fielding, baseball fans have gained a new respect for baseball as a "base hit" game. Baseball is no longer solely a power sport worshipping home-run kings.

I think it is interesting that Ichiro, as reported by the media, is not really able (even though he seems willing) to explain clearly how he gets the hits that he does. In other words, he has no set formula, no well-defined "system" that others can follow. Instead, what Ichiro has is discipline, the ability to make "adjustments" when needed, and unwavering perseverence. Essentially, Ichiro does his work but harbors no "trade secrets" about how he does it. We all watch him and marvel at his finesse on the field, but when we try to do the same, we find that somehow we fall short--our bodies just do not work the way his does.

My guess is that investing is a lot like playing a professional sport, as Ichiro does. A combination of inherent talent and regular practice will allow just about anyone to improve and some even to excel at the game. Devotion to the game can give a dedicated investor an "edge" over others who are less focussed. In my own daily activity as an investor, I continue to keep an eye out for reliable trading systems, some methodology that will allow me to achieve consistently high excess profits. While I remain optimistic that one day I might stumble across my own "holy grail," I am at the same time very realistic, expecting that the time and effort I put into the game will most likely allow me to hone my skills and improve my investment returns incrementally over the years--just as I have found in baseball, tennis, skiing, long-distance running and other sports I engage in.