What Is The Correct Benchmark In Trading?( Essential Considerations)
Unlike investing, which focuses on long-term appreciation and wealth accumulation, trading is centered around capitalizing on short-term market fluctuations or exploiting price differentials and inefficiencies. To assess the effectiveness and performance of trading strategies, traders often rely on benchmarks that serve as yardsticks for comparison. While there is no one-size-fits-all benchmark for trading, understanding the correct benchmark and why you are trading (and not investing) is crucial. Then, what is the correct benchmark in trading? How should traders evaluate their performance?
To sum up, we believe there is no correct benchmark in trading, it all boils down to personal preferences.
In this article, we discuss some relevant issues to consider if you are trading. How do you judge your trading performance, and why do you trade?
Related reading: – A library of stock trading strategies
First, let’s define what a benchmark is:
What is a benchmark in trading?
In trading and investing, a benchmark refers to a standard or reference point against which the performance of a portfolio, investment strategy, or individual security is measured. It serves as a yardstick for evaluating and comparing the returns and risk of an investment.
A benchmark can take various forms depending on the specific market or asset class being assessed. Common benchmarks include market indexes such as the S&P 500 for U.S. stocks or the FTSE 100 for U.K. stocks. These indexes represent a broad market or specific sector and serve as a benchmark for assessing the performance of investment portfolios or funds. The MSCI World Index is also frequently used.
Traders, investors, and portfolio managers use benchmarks to evaluate how well their investments are performing relative to a designated market or sector. By comparing the returns of their portfolio or strategy to the benchmark, they can assess whether they are outperforming or underperforming the market.
Benchmarking helps investors gauge the effectiveness of their investment decisions and provides a basis for making adjustments to their strategies if needed.
As it turns out, research shows that most fund managers underperform their benchmark. Likewise, most DIY investors and traders fail miserably.
Such a benchmark is relevant for a fund manager and investor. But what about short-term traders? Is a buy and hold index a relevant benchmark?
That depends, and further in this article, we’ll discuss if a benchmark is relevant or not, and if so, what is the best benchmark.
What are the most commonly used benchmarks?
The most popular benchmarks are probably S&P 500 and the MSCI World Index.
Trading vs. Investing
To discuss a relevant benchmark we need to understand the difference between trading and investing.
Uncorrelated returns
Traders want returns that are not correlated to the overall stock market. Traders want a steady return, not random rewards (which you get from buy and hold despite the long term upward trend).
We bring up this chart from the Swedish hedge fund group Brummer to show you the difference:
The thick red line shows Brummer’s steady and consistent returns, while the grey line is the World Index which is “all over the place”. We are investors in Brummer, and the sole reason for that is uncorrelated returns. The correlation of Brummer’s return to the MSCI World Index is a low 0.12, which in practice tells us there is no correlation, precisely what we’re looking for.
Trading might be a hedge against tail risk
A good trading strategy should mitigate or partially offset so called tail risk (black swans) liable to long-term investors. How has the strategy performed under financial turbulence? How does it perform under a major bear market?
Trading is more scalable than investing – if you are good
Short-term trading, particularly for small individual traders, offers scalability that can be leveraged to their advantage. When successful and profitable strategies are identified, traders have the opportunity to achieve scale through automation or increased position sizes using leverage. Of course, given that you actually know what you are doing.
Furthermore, by utilizing automated trading platforms like Amibroker or Tradestation, small traders can incorporate a vast number of systems into their trading approach. There is power in automation! The advantage of automation allows for efficient execution of trades and the simultaneous operation of numerous trading strategies.
However, both automation and leverage comes with risk. A lot can go wrong, and we all know leverage can be ruinous.
- Leverage trading – Leverage Trading Strategy
- How to trade leveraged ETFs
- How to calculate risk of ruin
Diversification
We believe the majority of traders do both trading and buy & hold.
We do both. The reason is, as explained above, due to uncorrelated returns. We have explained further below in the article how we do it.
Trading is more challenging than investing
Let’s admit it, trading is more fun and challenging than buying and holding. If you succeed at trading, you are one of the few (most trades fail).
How do I choose a god benchmark?
Personally, we don’t use buy and hold as a benchmark for our trading. We trade “on top” of our long term investments. This is how we do it:
We have a margin account in Interactive Brokers where we keep some of our long term stock portfolio which is invested almost 100%. We then use trading strategies which is all leverage (gearing), but never more than 10%. For example, if we have 1 000 in the account, we never have more than 100 worth of short term positions.
Needless to say, with increased interest rates, this is not as attractive as it once was over the last decade.
Our aim is to have uncorrelated returns that we can add to total performance no matter the stock market’s performance.
Is buy and hold a relevant benchmark for traders?
Let’s show you an example of how a short-term trading strategy creates uncorrelated returns.
Strategy #4 has performed well on QQQ since year 2000 (the strategy was published in the summer of 2015 and republished in October 2020, although there is no guarantee it will continue to perform well in the future – this is just for illustrative purposes):
The 228 trades have returned an average of 1.37% per trade, but the best period was before 2010 when the markets went sideways for over a decade.
Let’s zoom in and show you the performance since 2010:
It’s still performing well, but the average gain has dropped to 0.87%. However, while good, the performance is still behind buy and hold: 7.1% vs 16.8%.
Let’s compare the compounding effect of buy and hold vs. the short-term strategy:
Ouch.
Because of the compounding effect, it underperforms drastically. Is the strategy just garbage? Does this mean that the strategy is “useless” since it lost to buy and hold?
We don’t think so. You have to consider that the strategy is only invested 11.5% of the time and you should always trade several complementary strategies. Also, max drawdown is 11% vs. 35% for buy and hold. Thus, this is like comparing apples and oranges.
Second, it’s a buy the dip mean reversion strategy, and such a strategy will undoubtedly underperform in a raging bull market, as we have witnessed since 2010 when quantitative easing and zero interest rate policies fueled assets worldwide. Underperformance is to be expected in situations like that. Opposite, during the sideways markets between 2000 and 2010 the strategy outperformed (by a lot).
Third, the strategy’s performance is mostly uncorrelated to buy and hold.
Mixing buy and hold and a trading strategy
Let’s end the article by showing a simulated portfolio that is invested 80% in SPY and the the remaining 20% is left to trade strategy 4 in QQQ.
We picked SPY because it’s a more diversified ETF (index) than QQQ (Nasdaq 100).
The equity curve below show two simulations: 100% buy and hold SPY vs. 80% buy and hold SPY + 20% trading QQQ (mixed strategy). The drawdowns for the mixed strategy is substantially lower (30 vs. 55%). It’s still high at 30%, probably more than most trades can stomach and handle, but we hope you get the idea.
What Is The Correct Benchmark In Trading? Conclusion
The conclusion is that it isn’t a correct universal benchmark in trading, it’s all about personal preferences and what you are trying to achieve.
FAQ:
What is the primary difference between trading and investing?
Trading focuses on short-term market fluctuations, exploiting price differences, while investing aims for long-term appreciation and wealth accumulation. Traders capitalize on short-term opportunities, unlike investors who hold assets for the long term.
Why is choosing the correct benchmark crucial in trading?
Selecting the right benchmark is essential for evaluating the performance of trading strategies. Benchmarks serve as reference points for measuring portfolio, strategy, or security performance, helping traders assess if they are outperforming or underperforming the market.
What is the role of benchmarks in assessing trading strategies?
Benchmarks provide a basis for comparing the returns and risk of trading strategies against a designated market or sector. Traders use benchmarks like the S&P 500 or MSCI World Index to gauge the effectiveness of their investment decisions and make adjustments if needed.