How Can You Honestly Evaluate Your Trading Activity?

by: Disturber

To Buy and Hold or Trade Actively, That Is the Question

Followers of Seeking Alpha are exposed to a broad array of opinion, analysis, prognostication, and crystal ball gazing with both negative and positive sentiments. Sorting through all of this is what we do and we hope to be right considerably more often than we are wrong. One of the great tensions in securities investment philosophies is between the "buy and hold" school and the "actively trade" school. While I will confess that I belong more strongly to the former, I can't criticize the latter. However, I must insist that regardless of which camp you are in, or indeed, if you are somewhere in the middle, it is critical to regularly and honestly conduct a reality check on your own performance. The purpose of this article is to provide a very simple approach to evaluating your own performance over time. It requires some discipline and a bit of preparatory homework. However, the suggested tool provides an ongoing objective analysis of just how you are doing compared to the indexes.

Before considering my approach, I want to proselytize on a number of considerations that I believe are essential to a meaningful analysis:

  1. Honesty: Fishermen never tell you about the days when they have caught nothing. You will hear about the ones that got away, and inevitably, the triumphant occasions when they removed a marauding giant from the deep. It is human nature to remember the good days and forget the bad ones. If you are going to truly evaluate your performance, you have to be honest and include every single transaction and every single holding in the mix. No excuses, no exclusions and no self-delusion.
  2. Income Taxes: Pretending that gains are not taxable is another exercise in self-delusion. True, gains and losses of the same character can be netted against each other and surplus losses can offset a limited amount of non-investment income. However, when it comes to writing that check to the tax men (Federal and state), that is real money and it shall not be forgotten. Every dollar paid in taxes reduces your capital base. You must include the tax consequences of your trading activity.
  3. Trading in Deferred Accounts: I often hear investors claiming that their tax deferred accounts are ideal trading vehicles because their gains are not taxable. Be very careful here. There are two critical considerations. First, while gains are not taxable, losses are useless. Secondly, you are limited in the amounts that can be contributed to tax deferred accounts and if you experience a significant trading loss, it may be years before you are able to replenish your tax deferred capital base. Don't forget that you will likely live longer then your parents, and that Social Security only goes so far. Retirement accounts have a specific purpose and one should never lose sight of that purpose.

The advent of index ETFs has given us a real time metric with which to compare the buy-and-hold strategy to our trading results. As the stock market has moved from the lows of the recession to the present, there has been a determined march upward. For example, on January 3, 2012, the S&P 500 stood at 1257.60. By the end of that year, it had risen to 1430.15, a gain of 172.55 points, or a respectable gain of 13.72%. From May 22, 2012 the S&P 500 was at 1316.63. One year later - so that the investment gains qualify for capital gains treatment, the index stood at 1655.35 a gain of 338.72 points, or 25.73%. Finally, on January 2, 2013, the index stood at 1430.15 and on May 22, 2013, 1655.35, a gain of 225.20 points, or 15.75%. All of these figures are from Bloomberg. These percentages provide an objective metric against which to measure your trading performance in the same market and in the same time frame. You can tailor this approach to any time frame you desire.

If we assume that an investor purchased the S&P 500 ETF on any of those beginning dates and held it for the entire period, we have an objective, external metric for anything else that the investor may have accomplished by trading during the same period. (I strongly suggest that every investor take a small buy and hold position in SPY so that its performance is necessarily included in the following analysis.)

Because there will have been no realization of profits in the buy-and-hold scenario, there will be no tax liabilities incurred. That means that if a trader is going to compare his trading performance (which does generate tax liabilities) to that of the index , he has to subtract from any net realized trading gains, the amounts that were or will be owing to the taxman. Conversely, if the investor wants to make the comparison on an after-tax basis, he will have to take into account the holding period for the "index" investment, presume that any gains are realized, and then adjust for the resulting taxes. But remember, that taxes are subtracted from your capital base, and if you want to truly consider how each strategy positions the investor for further gains or losses, allowing for taxes when no taxes will be due is potentially a flawed analysis. By not incurring taxes, the capital base remains larger and has the potential to generate larger absolute returns. Thus, long term holdings should be considered on a pre-tax basis in the analysis.

How is this analysis accomplished when the trading account is a moving target? This question introduces another element of discipline which, in turn, guarantees that the elusive "honesty" mentioned above is not hedged. Every investor should maintain a Excel spreadsheet in which every single transaction, whether a buy or a sell or a dividend receipt, etc. is noted in date sequence. (The SA portfolio tracker provides a good starting point for the structure of the spreadsheet.)

I am amazed at how many traders never maintain this kind of record. If you add a few more columns in the spreadsheet showing the value of the S&P index on each date, with a dynamic calculation of the percentage change for any relevant time period, and at the same time if you maintain an ongoing dynamic calculation of how your trading is performing, you have a real time measurement of how you are doing against the market. By incorporating dynamic cumulative values for gains and losses (both realized and unrealized) across your portfolio , you have an absolute figure to compare to the S&P 500 data. You might need some help building the spreadsheet model, but it is worth the effort. Excel easily handles all of these considerations.

While I don't want to try to explain the mechanics here, it is also relatively straightforward to include a column in which the real time quotations are dynamically updated so that they can be included in the calculations. This allows all open positions to be marked to market on a real time basis. The spreadsheet can be linked to Yahoo Finance or any one of the many sites that allow you to set up a portfolio and download it into Excel. One click on the "update data" button in Excel and you will be current in your pricing.

This approach allows you to pick the time periods to analyze and to create a historical starting point from which to measure your performance. You may have to enter a lot of historical data or you may be able to download your historical trading data into Excel from your broker's site. However that is accomplished, it is worth the effort. I use the SPY pricing in my analysis even though it reflects some expense factors and may differ marginally from the S&P 500 quotation. I do this because I can dynamically link the quote into the spreadsheet.

This simple and dare I day, obvious tool forces on a trader a real time awareness of exactly how they are doing as measured against the market as a whole. If you are not consistently beating the S&P 500, it is time to reconsider your strategy. A rising market has a way of hiding traders' sins. Without this kind of tool, your sense of how you are doing is almost inevitably going to be distorted by the fisherman's perspective noted above.

I have both a tax deferred account and a taxable account. I am not generally a trader. My approach over a 40 year period has been to put together a "base" of no-load mutual funds that comprise a well diversified portfolio. (Remember that ETFs are of relatively recent vintage and I believe that well selected mutual funds can offer an easier path to diversification). That base comprises about 35% of the portfolio in the taxable account and about 85% of the portfolio in the tax-deferred account. I adjust the mutual fund holdings from time-to-time to rebalance or to respond to macro trends.

On top of that base, I have put together a group of very solid dividend paying large cap issues (See following paragraph). These comprise the balance of the tax deferred account and 25% of the taxable account. I will occasionally sell these issues when a better opportunity arises or where the specific industry begins to change negatively. For example, there was a time in the distant past when I held a large position in GM (GM). I exited profitably when it became clear that the foreign auto makers had arrived at GM's lunch table and were making pigs of themselves.

Finally, my taxable account is topped off with the index ETFs: SPY, MDY, and QQQ. I am largely a buy and hold investor who occasionally and carefully will take a position in what I perceive is a solid special situation. For example, I accumulated COP before the PSX spin off because I felt and still feel that it is an exceptionally well run company. I am holding those positions, and am accumulating BP in the belief that once the Gulf spill is behind it, it will resume a normal evaluation with respect to the other oil majors. I have respectable positions in MRK, BDX, and BMY. All of these are good dividend plays.

Disclosure: I am long COP, BP, PSX, QQQ, SPY, MDY, BDX, MRK, BMY, GE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.