Rule 2: Consistency is the Key

For most individual traders and investors, the single most important criteria for judging the performance of a trading methodology is total return. Consequently, when you look at ads selling trading systems and methodologies, you see a lot of wild claims of 80%, 100%, or even 300% average annual rate of return.

It's ironic that in talking to the vast majority of traders who've made their millions through trading, total return is the very last number they look at when judging the viability of a trading strategy. What matters more to this elite class of trader is risk, maximum draw-down, the duration of draw­downs, volatility, and a wide assortment of other risk-oriented benchmarks. Only when all their risk criteria is met do they consider total return.

The typical trader might wonder if these traders are just overly cautious and conservative. But that is simply not the case. As a whole, they are just as fanatical about the accumulation of wealth and financial freedom as anyone else who trades.

What has caused these traders to shift their focus to this winning strategy is that they've worked through the numbers. Doing so, they find:

• Total return is only a valid measure of performance when risk is taken into consideration.

I credit my success as a money manager to my voracious study and practice of this concept. Let me show you a simple example that you may find surprising. Even though I use investment funds in my example, this concept I'm illustrating is directly applicable to all traders no matter how short-term their orientation is:

1. Over the past 30 years, investment Fund A has returned 12 percent annually on average, has a strategy that is not dependent on any particular market doing well, and has had a 5 percent worst-case historical drawdown.
2. Over the past 30 years, investment Fund B has returned 17 percent annually on average, has had performance highly correlated with U.S. stock indexes, and has had a 15 percent worst-cast historical drawdown (both investments are vastly superior to the S & P).

Which fund would you invest in?

Most traders and investors would be most attracted to Fund B, which showed greater total returns over the 30 year period. In justifying this they'd say: "I have no problem accepting a worst-case 15 percent hit because I'll come out ahead in the end. The extra protection in the Fund A doesn't help me that much.

Now--check this out. Most professional traders who understand the math would select Fund A. With the lower maximum drawdown, they would simply concentrate more fire power in Fund A by buying it on margin (putting 50 percent down). Doing this they were earn a 19 percent annual return after margin costs and sustain only a 10 percent expected drawdown risk, compared with a 17 percent return on Fund B with a 15 percent expected risk.

But there's even more to it.

The Smoke and Mirrors Behind Average Annual Returns

Whenever any trader, trading system vendor, or money manager brags about their performance in terms of Annual Average Return, they are--whether or not they know it--engaging in smoke and mirrors.

What is concealed in this statistic is the harm that is wreaked upon capital growth by drawdowns and losing streaks. In Rule #1, "Minimize Losses," we talked about how the difficulty of making up for a large trading loss is seemingly disproportionate to the magnitude of the error that caused the loss in the first place. That factors greatly into how much money you wind up making.

The real truth behind how much money you make is to be found in "Compounded Annual Return." That is, calculate your annual return by adding every gain and subtracting every loss that occurs during the course of a year. This is illustrated in the following table:

Let's consider the following table:

Year

Volatile Returns Annual Returns(%)

Principal

Dependable Gains Annual

Principal

			Return (%)
1	21	1,210,000	18	1,180,000
2	35	1,6333,500	18	1,392,400
3	20	1,960,200	18	1,643,030
4	-26	1,450,500	18	1,938,780
5	32	1,914,720	18	2,287,760
6	12	1,347,450	18	2,699,560
7	42	3,045,170	18	3,185,480
8	-16	2,557,950	18	3,750,887
9	31	3,350,910	18	4,435,460
10	56	5,233,000	18	5,233,850

Average Annual Return = 20.7% Average Annual Return = 18%

Compound Annual Return = 17.98% Compound Annual Rate = 18%

As you can see, the fund that makes a steady 18% per year actually makes you more money than the one that posts spectacular gains eight out of ten years. The damage caused by the two losing years is quite evident.

Again, this example is applicable whether you are a day trader or a long-term investor.

The vast majority of trading strategies that boast spectacular gains, also take great risks. This means greater drawdowns and more volatile performance. To be successful as a trader, you must ignore the flashy statistics and work through the numbers. Evaluate your strategy by calculating on paper where your total trading equity would hypothetically be for every trade over a period of several years.

You will find that it is far, far better to use strategies that earn steady and consistent returns year after year after year. You will inevitably find that the annual returns of these strategies are far less spectacular than those that are widely advertised, but the math makes it clear that you are far more likely to be laughing your way to the bank this way.

Oh yes, you'll sleep better at night now. For successful traders, consistency is the key.