[Frank]

Sparrow,

What you mention about spreads and commissions is important. That said, my post was on the 'structure' of analyzing trading strategies you come up with, not on the execution part. Yes, it is up to you to execute efficiently. My 'expected return' is assumed to be net of commission costs and spreads etc... I am discussing this at the structural level here.

Also, I wasn't suggesting this was appropriate for a pension fund. I was merely taking the sophisticated way institutional asset management works and relating it back to trading strategies that we think about every day.

For example, say you write a Tradestation strategy that has great back-tested results --- but it has only generated 50 signals over the past 6 years. Well, this strategy appears a lot better than it is. Why?

Because of the 'structure' of the formula that I presented above. The more signals, the better -- because you get increased 'diversification' of the variance. Expected return, assuming it is accurarte, is compounded out by squaring the number over the number of trials --- but 'variance' increases only at the rate of the square root of the number of trials (it rises but at a slower rate than the return).

Go back to roulette -- this is not an attractive game for the casino in the short-run from a sophisticated money manager perspective -- you could do a lot better with an index fund --- it only gets attractive over many trials. How many trials before it gets attractive relative to others? This is what that formula reveals.

The other big takeaway is simply to keep a healthy respect for the market in terms of how hard it is to find a strategy that will have an exceptionally high return. I quote from my text:

"The first necessary ingredient for success in active management is a recognition of the challenge."[1]

This translates as: the 'return' you expect out of a given strategy should be properly discounted relative to its back-tested results. Finding high-returning strategies is hard -- the competitiveness of the marketplace ensures that.

This thread is actually the 'mantra' of the large quantitative-based firms that participate in the markets with billions every day. I am sharing it here because I think as traders, we should all think about our own strategies in the same way. Trust me on this, I know of what I speak.

The key is to find strategies that offer high returns that can ALSO be repeated many, many times. If you develop strategies that don't have a high number of trials --- you are likely fooling yourself -- your strategy may be profitable, its just not attractive relative to what you COULD be doing.

This is the beauty of that Grinold/Kahn (authors) formula I posted -- you can keep your expected returns reasonable (below the back-tested results) and still seek outsized returns through implementing the strategies that have more bets to them (and therefore diversifying out the variance).


[1] "Active Portfolio Management" Grinold and Kahn, 2000