Wednesday, October 14, 2009

When ROI Really Isn't ROI

Return on Investment (ROI). It is a rather important number to know, especially if you want to make a good financial decision. Unfortunately, to the novice investor, ROI isn't really ROI. I have been following the stock market and learning about investing since I was in the 4th grade. When I was in high school and college, the dawn of day trading occurred. (Actually, it has always been around but with the internet and low cost online brokerage firms, day trading became something that the "average" investor could participate in). I have always been a buy and hold kind of person. I'll have some funds available for short term trading if I see an opportunity that presents itself, but, 90%+ of my investment funds are for the long haul. Short term trading strategies (i.e. <90 align="left">

First thing that you should understand is where the owners/operators/inventors of these systems get their money. They do not get their money from actually trading with their systems, they get their money from selling you the system. Now, there is nothing inherently wrong with this. You just need to realize that while the creator of a certain system may boast of the great returns that are possible, it doesn't mean that he is willing to put his own money on the line. STS (again not the real name) sells for $350 to 600 per year depending on how long of a contract you buy. Judging by the website and having run a web business before, I would say that STS could get by with 3 people working full time. If they had 5000 paying customers, the company would gross at least $1.75 million. Assuming company expenses of $250K (this is just a computer program in the end), it would leave about half a million dollars for each of the 3 people. Not a bad salary at all, and that is without actually making a single trade. Don't you love capitalism?!!

Like I said before STS has done a far better job of providing their potential customers the resources to evaluate their system than most people. Which brings us to the next step. Investing in any system has to beat the market average, or else you are just wasting your time. I happen to use the S&P 500 as my benchmark. Any day the markets are open I can buy or sell S&P Depository Receipts (SPY) which is an exchange traded fund that tracks the S&P 500 index. Therefore, any system has to advertise that it beats the market average. STS does this and boasts a 36% annual rate of return (using their data I calculated 31%) while the S&P over the same period had a 4.0% annual rate of return.

After seeing that they boast a return that beats the average, I look to see if they have a substantial track record. STS has a 14 year history (which coincides with the beginning of the tech bubble in the late 90s). Any system (or mutual fund) should have at least a 10 year history to be properly analyzed. The longer the better. This allows one to look back and see how the system did in both good times and bad. If you are a novice, only look at systems that have more than a 10 year track record.

The last step before looking further is to see the year by year performance. While you know that the average annual return is beating the market, what you need to do now is see how year by year it compares. I like to look at this as an honesty check. No one can beat the market all of the time. So, I am looking to see that in a few years, the return was negative and in a few years, the system didn't beat the market. I would be very suspicious of any system that never had a down year or always beat the market. Madoff did that and his investors were happy taking their checks to the bank. Until it all came to light that there was no investments. It is possible that there is a system that always wins. But why risk it? STS had 2 years with negative returns and 2 years with underperforming the market. So from this angle it looks legitimate enough to examine further.

To continue on with any analysis, the system will have to provide you with a history of trades (either actual or recommended). STS has tens of thousands of recommendations in its history and operates on the basis of buying and selling at the market open. I took a random sample of their trades to make sure that the prices matched the historical values. No discrepancies. Another positive thing that I noticed is that all of the trades were from companies on the two big exchanges NYSE and NASDAQ. Several trading systems rely on over-the-counter and penny stocks and are really just a place to gamble your money away.

So, my initial impressions of STS are that they definitely believe in their system and are willing to provide the trade information to back it up. Now, that doesn't mean I'm recommending it, just that I haven't thrown it in the trash yet. I downloaded all of the reccommendations and went through the STS website to re-calculate all of the numbers that I could. I came up with similar numbers to what they had, so I will use the numbers I calculated in my spreadsheet from now on. ROI is the percent return on a given investment. If I invest $100 and sell it for $110, then my ROI is 10%. This is from the following formula:
100 * (Final-Initial)/Initial
However, when calculating the ROI for a series of stock trades, one has to find the return for each trade ( (Sell -Buy)/Buy) and then average all of those trades. For STS, I found it to be 0.86% per trade. Now in order to compare this to the return of the S&P 500 (4% per year over the lifetime of the STS system), I also calculated the average length of time a trade was open (8.2 days). Dividing 365 days (1 year) by 8.2 and then multiplying by 0.86% I get 31%. So in the end, 0.86% per trade may sound small, but since each trade occurs over a period of just 8 days, it adds up.

This is where the analysis comes of with some problems. First, the ROI is based on the opening and closing prices only. However, there are two major expenses to consider when trading short term: commissions and taxes. A commission is paid each time a stock is bought or sold. If all of the STS reccommendations were acted on, over a 14 year period, with a $10 commission, an investor would have paid $220K to his broker. This should be the first clue that this system is geared towards investors with several hundreds of thousands of dollars to invest.

Second, I did an analysis of the number of positions that were open at any one time, I found that a maximum of 501 positions were open at one time. This would indicate that even with a nominal investment of $1000 for each reccommendation, one would need at least $500,000 to be able to use this system. So I went back to the website to see if these issues were addressed.

In the question and answer section, the creator of the system addresses commissions in the first question. Basically, he says that you are trying to minimize the percentage of the trade that is paid in commission - this is good advice. Unfortunately, for the small time investor, this means increasing the amount invested on each trade. STS recommends at least $8000 per trade. (So to cover the maximum of 501 open positions, one would have to have $4 million to use). I found this odd, since in the statement above he says that you could profitably participate with as little as $10000.

The total open positions issue is addressed in another question. STS acknowledges that to exactly match the ROI, one would have to put equal amounts of money in every recommendation. They also acknowledge that this isn't practical since in some cases you would have to have millions of dollars in your account (which is what I showed above). So, they say you should develop your own strategy based on their recommendations to approximate the ROI. Alright, this is starting to sound like the "system" doesn't work. In other words, their system will shrink my possibilities each day from 5000 down to 2-100. It is then my responsibility to come up with my own system to select from their system. Well, I'll continue and see how it goes.

So, how much of that 31% return does the commission eat up? Well, it all depends on how high of a commission your broker has, and how much you are investing in each buy. But in short, it can eat up all of your money when you are constantly trading (as the STS system advocates). Additionally, unless you are trading in a tax advantaged account (IRA, 401K, etc), you are going to end up paying a portion of your earnings in taxes (the higher the return, the more in taxes you will pay). Based on the average return per trade, I calculated what the minimum amount one would have to invest in each trade to match the S&P 500 return (afterall, if you can't beat the S&P 500, you are better off just buying an index fund or ETF and then spending your time doing something else).

In a nutshell, if your discount broker charges you $7.50 per trade, then to just match the S&P500 return using the STS system, you would need to invest $2000 in every recommendation. If you factor in a 35% tax bracket for short term gains, then the minimum amount increases to $2150 per recommendation. (In order to get the 31% ROI, you would need to be investing at least $200,000 per trade). Since the maximum number of positions held at one time is 501, you would need $950,000 (or probably $700,000 in a margin account) to buy each of the recommendations. This is not something for the small time investor. Furthermore, making 1100+ trades a year does take time, and that is only to match the S&P 500.

So while the 31% (by my calculation - 36% by their's) ROI sounds good, it looks like those with $1 million will only be able to get 1/10 of that amount. But, even that isn't true. It all has to do with how the ROI is calculated. With the S&P 500, if I have $1 million to invest, buy it and hold it for 14 years, I will average 4% per year. In other words, at the end of 14 years, I would have $1.73 million. However, using the STS system, if I dedicated $1 million and bought $2000 of each reccomendation for 14 years, I would only have $1.035 million at the end of 14 years for an average annual return of 0.26% - less than 1/100 of the 31% nominal ROI. Why? Because with the S&P500, my money is fully invested the entire time, so all of the money is constantly growing. With the STS system, only a portion of my money is invested at any one time (although the entire amount is needed for the few times when 500 positions are open). I did an analysis and found that 75% of the time, less than 20% of the $1 million is actually invested.

Well, why not divide the extra amongst the stocks that are owned? That would increase commisions as portions of the stock would need to be sold to invest in new recommendations. What about investing the money in a money market? Well, most brokerage accounts do this, and those money markets have a return of 0.5-2%. Granted this would increase your overall ROI (of the entire $1 million) from 0.26% to 1.8% (assuming a 2% money market), but if your money market account is making more than the STS system, why not just invest in that. And therein lies the problem with almost every stock trading system. The ROI boasted about is based on hypothetical accounts and only considers the amount actually invested in the stock picks, they do not reflect how a real investment account would operate.

The question and answer section glosses over this issue indirectly. One question was whether a mutual fund could be set up. The answer given is no because the large sums of money ($50 million+) would cause to large of movements in individual stocks. I disagree. The reason it wouldn't work is because the mutual fund would hardly ever be fully invested. If you look at any mutual fund's holdings, a small portion (5% or less) is kept as cash to take advantage of new positions. When a stock is sold, something else is almost always bought immediately. The STS system doesn't work like this. The system may spit out 0 recommendations or 200 recommendations in a single day. Based on my review of their published recommendations, there would almost always be a significant (80-90%) cash reserve in the fund (which is needed to capitalize on the trade recommendations) that severely limits the earning potential. In other words, while the STS system has a 31% ROI in theory, if it were started as a mutual fund, that would plummet 2-3% or less because the funds in the account would largely remain uninvested.

Up to this point my analysis relied on the assumption that all recommendations were acted upon. The STS founder admits that this is not practical for most people, so let me test some of the statements that he makes such as choosing as many as 20 positions to approximate the return or that someone with as little as $10000 could profitably participate. Remember, stock systems get their money from selling the stock system not necessarily from actually trading with the stock system. So, it is in their best interest to make the system as "workable" for as many people as possible. If they started off by saying that you needed $1000000 to just match the S&P 500, then they wouldn't get many people buying.

Without a system (which would need to be analyzed separately) to select which of the STS recommendations to act on, I selected randomly. First, I picked every third, ninth, and eighteeth recommendation to determine how much difference the ROI would change. The nominal ROI per trade was 0.86%. For every third recommendation it was 0.83%, for every ninth recommendation it was 0.73%, and for every eighteenth recommendation it was 0.89%. Some below, some above, but no changes in an order of magnitude. Remember, that when I put the STS system into actual account conditions, the return I calculated was 1/100th of the return from the S&P500.

To test it for actual account conditions, I chose an account with $300,000 and a commission of $5 per trade.





Per Trade ROI





Trade Amount





Maximum # of Positions





Actual Annual ROI





Not so impressive compared to the S&P500. It does appear that the more money per trade, will increase the ROI. However, the total funds needed will increase as well. In fact, after going over 50+ scenarios using their recomendations I am of the opinion that there is no way to even beat the market over the long term with the STS system. Sure, you may be able to for one or two years, but throwing darts is just as effective as a method for choosing stocks. Bottom line is that the STS system requires too much money to be held in reserve (ergo not making money).

And frankly, that is the problem with almost every stock picking "system" out there that I have examined. 1) Too much cash is left on the table for the next stock that may come along. 2) The constant changing of positions severely desreases the return from commissions and taxes. That is why long term investing has remained tried and true for centuries.

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