The Secret Law That Governs The Markets

[thenews]

By Boris Schlossberg

In one of the best investment columns written this year titled "How to Make Volatility Your B-" Josh Brown goes through the step by step process of dollar cost averaging demonstrating why it is the single greatest investment strategy ever created. Brown shows how consistent and steady buying of an equity index will beat any hedge fund return anywhere, anytime.

The idea is that some of your capital will have massive double digit returns as you scoop up assets at firesale prices and some of your capital will have average returns and some of the capital may even have negative returns as you pay up during market rallies but the overall value of your holdings will almost certainly rise over any 10 year period of time. The only way that this strategy would fail is if stocks slowly but surely drifted to zero over a 10 year period in which case you probably would have much bigger issues to worry about. As long as equities have an upward drift you simply can't do better as an investor than dollar cost averaging into the index.

The dollar cost averaging strategy of success relies on two factors -- the natural upward drift of equity markets and the much more important idea of the law of large numbers. The law of large numbers simply says that outcomes will almost always reach their expected end, as long as you have enough samples. For example if you flipped a quarter 3 times in a row chances are good that you could get all heads or all tails. In fact 12% of the time that's exactly what would happen. Does that mean that the coin is rigged? No. It just means your sample size is very small and highly biased. Flip the same coin 1000 times and the probability that heads or tails will fall within a few basis points of 50% are almost assured. Do it 10,000 times and they are practically guaranteed.

The law of large numbers is an amazing principle. It essentially tells you all need to know about how to get rich. Just chop up risk into tiny little pieces and take many ( hundreds or even thousands ) samples of that risk and over time you will be much wealthier than you are now. Of course this little mind experiment assumes that the risk you consider is actually worthy. For example if you dollar cost averaged gold for the past 50 years you would still be worth a lot of money ( if for no other reason that you would own a lot of gold!) but not nearly as much money as if you bought the S&P 500. Still even in that example you can see the power of this principle in action.That's why it always amazes me that traders routinely ignore this foundational idea of risk control. In fact I think that the primary reason why most lose money in the market is that they don't appreciate the power of the law of large numbers. The underlying concept behind the law is that you need to trade SMALL. There is actually some poetic irony in that dynamic. You need to do a lot of trades in order to assure yourself of long term success and the reason you need to trade trade small is precisely because you need to be able to withstand the bad runs that will inevitably occur.

The first thing that I do in order to improve a trader's performance is to make them trade so small that it seems almost miniscule. Frankly it almost doesn't matter what system they trade, reducing size has an instant and dramatic impact on performance. They stop panicking and execute the strategies much more effectively. Marry the law of large numbers with a sound trading algorithm and you have nearly a full proof recipe for success.

Don't believe me. Look at high frequency firms like Virtu that trade millions of shares per day 100 shares at a time and haven't had losing days in years. As an individual trader you don't need to mimic the hyperkinetic pace of HFT shops, but you do need to slice risk into tiny increments just like they do. It's truly unbelievable that the answer to 90% of our trading problems lies in size rather than strategy, yet so few traders take advantage of the key law that governs the markets.