Back to the Future

An important aspect of any iterative process, like investing, is to look back and evaluate each step in the process to determine where there is room for improvement, not only in each specific step but the overall process.

With that in mind, the focus of this week’s commentary is a look back at the performance ofTWR during the 2014 calendar year and then discuss a framework for reviewing your own investment process in the hopes of improving your investment returns during 2015.

This performance and trade review requires that I honestly evaluate all of my trades, most importantly the trades that turned out to be wrong. Generally speaking, 50 to 60% of my trades are losers.

The trade ideas in TWR over the last year are no different, with 60% of the ideas being unprofitable. This ratio of losers to winners is right within the bounds of what I would expect from my process.

However, the one trade stat that I’m not pleased with is the ratio of average profit per winning trade ideas to the average loss of losing trade ideas, which is approximately 1.5-to-1. 

This ratio should be at a minimum 2-to-1 and ideally would be closer to 3-to-1.

Part of the reason for this result is the lack of trade ideas over the last 12 months. Even though the focus of TWR is a minimalist approach, I would like to have an average of between 1 and 2 trade ideas initiated each week. This past year we initiated 36 trade ideas, or an average of less than 1 a week.

I’m going to make a concerted effort to improve both the quality and quantity of our trade ideas. Having said all of that, I’m very pleased with the overall performance of TWR during 2014, which finished the year up 5.3%.

I’m exceptionally pleased that we were able to perform this well with less than 1 trade each week. TWR performed extremely well when compared to “professional” money managers such as mutual funds and hedge funds. Here’s how TWR’s performance stacks up relative to the competition. The 2014 performance puts TWR in the:

Top 22% of all 1,627 mutual funds tracked by Morningstar in their “Alternative” category.

Top 13% of all 537 mutual funds tracked by Morningstar in their “World Allocation” category.

Top 26% of all 307 mutual funds tracked by Morningstar in their “TacticalAllocation” category.

Top 32% of all 5,766 hedge funds tracked by Morningstar.

Top 27% of all 308 hedge funds tracked by Morningstar in their “Multistrategy” category.

Top 29% of all 174 hedge funds tracked by Morningstar in their “Global Macro” category.

TWR’s relative returns are very solid on their own.  The returns become more impressive when you factor in the low commission costs of implementing the trade ideas.  There are a low number of trades with long holding periods, less than 1 trade each week with an average holding period of 19 days. 

It’s important to note that the commissions mutual funds pay to trade are not reported in the performance number that Morningstar publishes. Given the steep learning curve associated with not being able to intervene during the week; I think the future performance of TWR is quite bright.

 

The Review Framework

I’ve put together a 7-part framework that you can use to evaluate your own investment process. It will be helpful for you to evaluate you process and your 2014 results within the context of these guidelines.

INFORMATION PROCESSING- Consistently gathering critical information that is relevant to your trading.

TRADE IDEA GENERATION- Engaging in creative thought to turn that critical information into non-consensus trading ideas.

TRADE IDEA CHARACTERISTICS- Expressing the trade ideas you generate in #2 as trades with risk-reward characteristics skewed in your favor.

EXECUTION- Entering trade ideas based on pre-determined criteria and exiting trade ideas at pre-determined targets.

POSITION an RISK MANAGEMENT– Allocating capital into each trade idea appropriately for risk control and choosing acceptable risk prices and profit targets.

OVERALL PORTFOLIO MANAGEMENT- Assembling trade ideas into a coherent whole portfolio where each trade idea is driven by a different catalyst and as such offers the potential for unique returns. Markets are dynamic and constantly changing, you should monitor correlations across positions and the ever changing risk-reward of each individual trade idea.

SELF-MANAGEMENT- Keeping yourself in optimal mental, physical, emotional, and spiritual condition to make sound decisions.