Get a Better Grip on Understanding Your Returns

Think about this. If someone offered you these two choices, which one would you pick?

A) You make nine trades, and earn a 5% return each time. The average return is 5%.

B) You make nine trades. On six of the trades, you will earn a whopping 50% return each time, but on the other three, you will lose 50% each time. The average return is 16.7%.

Assume that you start with $1,000, invest that entire $1,000 into the first trade. Later, you sell to close the first trade, then you invest the entire proceeds into the second trade, and so on until you have made nine trades with the returns indicated above.

The Answer May Surprise You

As shown in the table, under Scenario A, you would have $1,551, for a total return of 55.1% after nine trades.

Under Scenario B, you would end up with $1,424.

Slow and steady won this race.

Of course, in real life you likely wouldn’t risk everything this way and the returns won’t be so symmetrical. This is just a very simplified example to make a point.

Consistency vs. Volatility

If you are consistently booking gains, even if each gain is boringly small, compared to an aggressive approach with volatile returns, over time you could end up making more money. An analogy would be the trading of options. Selling options would likely give you a large number of small gains while buying options would more likely give you more big winners and big losers.

With the aggressive trading strategy example, even one big loss can make a big difference in the overall return. In our example, if instead of six 50% winners and three 50% losers, you had seven 50% winners and two 50% losers or five 50% winners and four 50% losers, the end result would be dramatically different (+327% and -53%, respectively).

That’s right, even if you make a 50% gain more often than you suffer a 50% loss (five vs. four), overall you could end up losing more than half of your original investment.

In case you are wondering, the order of the wins and losses does not matter. On the table, the order displays a pattern of two 50% winners followed by a 50% loser, but as long as there are six 50% winners and three 50% losers in these nine trades, no matter how you arrange the order of the wins and losses, you will still end up with the same average return, total return, and geometric return as shown in the table.

Simple Average Could Be Misleading

Another takeaway from the example is that simple average can be misleading.

Consider this simple example. If you start out with $100, you lose 50%, you end up with $50. To get back to $100, you actually would need to gain 100%. If you gained 50%, that only takes you back to $75. If you took a simple average, the average return from the two trades would be 0, but you can see that is not true.

Your actual return is 0.5 x 1.5 – 1, or -25%. If you want to go one step further, you can take the geometric average.

To calculate the geometric average, first take the returns of each trade, and then raise the product to the power of the reciprocal of the number of trades and subtract 1.

So in our example, the first step gives you 0.75 (0.5 x 1.5). In the second step, raise 0.75 to the power of 0.5 (the reciprocal of 2 is 1 over 2, or 0.5). That will give 0.866. Finally subtract 1 from that number to get your geometric average -13.4%.

What this average means is that if each of your two trades returned -13.4%, then your total return will be -25%.

Put another way, if you start with $100, and make two trades. If you lose 13.4% each time, at the end of two trades, you will end up with $75. Try this on your own to confirm.

Thus, the geometric average shows you a more accurate picture of what your average return is.

Editor’s Note: The above article provides valuable investing insights, but it only scratches the surface of the financial acumen of our advisors. A colleague who deserves a particularly close look right now is Jim Fink, chief investment strategist of Velocity Trader.

Jim has developed a proprietary investing method that consistently beats Wall Street at its own game, in markets that are going up, down or sideways. His 310F trade is one of the most accurate ways available to double your stake in just three days.

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