….and they say you don’t learn much at the casino. Richmond Quantitative Advisors expound on the power of a small edge.

WHEN BLACKJACK MEETS INVESTING – A LOOK AT THE POWER OF A SMALL EDGE

What this great article points out is that individual return streams only need a small edge when held as part of a wider portfolio of uncorrelated return streams. You then just need to compile them together to deliver powerful risk adjusted returns as a portfolio solution. This ‘small edge requirement’ therefore allows you to play a different game to the traditional trader looking for a single whiz bang strategy to generate their fortunes.

The small edge requirement allows you to adopt far simpler trading strategies that in isolation would be totally unappealing to the trader who is looking for a single solution to deliver cashflow and wealth building returns. The retail trader would typically throw these strategies in the bin stating that they were under-performing . This therefore puts you in a totally different realm to your competitors where you can diversify a vast array of simple strats that others would have simply discarded as ‘not having a sufficient edge’.

What we usually find for a single return trader is that a robust solution over a long term horizon that delivers bang for buck is a fiction. No strategy delivers profitable outcomes in all market conditions. This therefore encourages the trader to delve into the world of ‘convergent trading styles’ such as mean reversion, grid trading or martingale techniques to up the ante and deliver the necessary juice to keep them happy. Even worse, because they only have a single solution, they will typically leverage up this solution to generate unrealistic returns that end with account ruin.

All these convergent solutions have a very finite shelf life and are curve fit for a particular class of market condition. If the market condition changes, this style of strategy falls off the cliff. This is where most retail traders end up…..either strategy hopping looking for the next ‘juiced up’ curve fit solution or using a money management method to warehouse risk while waiting for market conditions to hopefully return to the previous favorable state.

If you learn how to construct diversified portfolios of simple but very robust strats that deliver a small edge over a very long lifetime, then this traditional trap is avoided and the game suddenly becomes so much easier. All that is required is therefore a strategy that with the Law of Large numbers holds up and delivers that small edge and lot’s of them. This is a different story to the single solution long term strategy that delivers enough bang for buck to generate cash flow and be a wealth builder in the long term.

Provided that you have uncorrelated return streams at the portfolio level (all with a small edge) then the uncorrelated nature of these return streams allow for a steady growth in the ascent of the equity curve at the portfolio level providing consistent returns while offering long term wealth building. You never find a single strategy offering the linear ascending equity curve over the long term as it has to be able to successfully navigate a range of different market conditions…..and pink unicorns do not exist…..but at the portfolio level, the composite of uncorrelated return streams effectively guarantees a more linear and steady ascent of equity into the future.

Once you learn how to compile a portfolio of robust divergent strats (such as trend following strategies with a small edge in the long term) what you find is that you then invest your time in always improving your portfolio and never having to return to scratch to start again. The stop start nature of a traditional trader looking for the current ‘best’ solution is what creates the issues as the losses incurred when strategies fall off the edge and the long delays before you find the next best ‘current’ solution is the central reason for so many failures in this trading game.

In an efficient market, the best you can hope for at the individual strategy level is a very small (sliver) of an edge over the long term. You cannot do anything with this small edge in isolation, but with a portfolio of 100’s of uncorrelated return streams with a small edge, you have a totally different story and end game.

Trade well and prosper

Rich B