The ceiling of trading performance

Another question investors often ask, is what the maximum achievable trading performance is. While there is no general answer to this question, I will still attempt to provide some guidance.

There are so many ways of trading, leading to quite different results, that we first have to define our constraints:

Let’s assume we are in possession of a magic algorithm, that can perfectly predict the future. It will only trade long positions, and every quarter it will identify the best performing stocks from a universe of the 300 most liquid stocks. From these best performing stocks, it will pick 1, 3, 5, 10, or 20 to achieve various degrees of diversification.

Plotting the quarterly performance, along with SPY for comparison, leads to this chart:

The first thing we notice, is that the ceiling to investment performance is quite high. Over the past 10 years, we could have made around 35% each quarter, while still being diversified over 20 stocks!

Next, we notice that even from Q4/2007 to Q1/2009, when S&P was incurring huge losses, we could still have made money with long positions. Also, we find that even the best picks have a positive correlation (beta) with S&P. While for these stocks, performance does not become negative, we still see dips in the same places as with S&P.

Diversification is another interesting aspect. Overall, the difference in performance between the single best stock, and the top 20 stocks is about a factor of 2. More interestingly, when S&P makes a local minimum, the spread between the top 1 stock, and the top 20 stocks becomes very narrow.

Even when constantly picking the best stocks, we will still face drawdowns. Our particular algorithm, switching stocks only once per quarter, will very clearly show the volatility of the stocks selected. The following chart shows the maximum daily drawdowns within each quarter:

Here we notice, that even with our magic predictive algorithm, our drawdowns amplify the market, unless we diversify. It seems that at 5 stocks, the drawdown is for the most part on par with the market. Again, we see a strong correlation between the market and the drawdowns of our stock picks.

Of course there is no magic, but this thought exercise still leads to important takeaways:

  • there is always something worth trading, even with a long-only strategy
  • even the best stocks have a clear positive correlation (beta) with the market
  • best performance is not synonymous with lowest volatility
  • even when focusing on the best stocks, diversification is crucial