Improving Trading Skill: Part 4

Foundation Series

I want to thank

Capital Flows

for name dropping us in his articles. He has been a big supporter of our team and a great friend. Make sure to subscribe to his Substack. He provides terrific macro reports and is one of the best minds I know.

So, can you trade? How confident are you in your abilities? I see a lot of posts on winning trades but a single trade in isolation doesn't mean your trading has the edge. Charles Harris gave a speech outlining his journey as a trader. Some moments are gut-wrenching to watch, but it's a mandatory assignment to watch. These are the actual trials that traders need to endure.

We are now on Project 3 of 7 and this is where you begin to understand your edge.

We are now on Project 3 of 7, and this is where you begin to understand your edge.

Project 3: Accounting for Skill

Summary: The three basic skills managers use to generate excess returns are buying, selling, and position sizing. To improve performance, managers should measure their skills and identify areas for improvement. We will use the concept of ghost portfolios to track 3 different portfolio management skills.

1. Sizing Skill

2. Buying Skill

3. Selling Skill

Action Plan:

1. Identify Name Portfolio: Identify all positions with an active portfolio weight as of the first day of the current quarter. These are the result of your active trading decisions.

2. Identify new buys: New buys consist of all positions in the portfolio with an active portfolio weight on the first day of the current quarter but not on the first day of the previous quarter.

3. Establish the Buy Portfolio: The buy portfolio includes all stocks whose names appear in any new buys in the current quarter or any prior seven quarters.

4. Compute various skill measures for the identified.

   1. Buying Skill: Take your Buy Portfolio and sell all positions based on a fixed holding period.

      1. A sell rule based on a fixed holding period means that each position is sold a specific number of months after its purchase date; use your average hold time. See an example from the book below:

      2. "Similarly, if the actual portfolio also contained stock JKL, which had been sold just 9 months after purchase, its sell date would be delayed in the Buy Portfolio until month 16. (average hold time) This would be accomplished analytically by repurchasing stock JKL back into the Buy Portfolio on the day it was sold, thereby extending the holding period of stock JKL to 16 months. To make room for this repurchase of stock JKL, all of the other positions then in the Buy Portfolio would be reduced pro rata, essentially selling a slice of the portfolio to create the liquidity to repurchase stock JKL. Finally, stock JKL would be sold when its holding period reached 16 months, and these proceeds would be redistributed pro rata across the positions then in the Buy Portfolio."

         1. Ervolini, Michael A.. Managing Equity Portfolios (The MIT Press) (p. 45). The MIT Press. Kindle Edition.

5. Selling Skill

   1. Measuring a manager's selling skills is very simple. Subtract the performance of the Names Portfolio minus the Buy Portfolio.

   2. Computation can get more granular.

      1. Measuring Selling Winning Position Performance vs Losing Position Performance

      2. Trade Durations analysis

      3. Sector Analysis

      4. Etc...

6. Sizing Skill

   1. Sizing skill is the simplest. Compare your Names Portfolio performance to an Equal-weight Portfolio of your active decisions. Subtract the performance of the Names Portfolio to the Equal-weight Portfolio.

Take the time to go through all your trading data and work to measure the 3 critical skills of Portfolio Management:

1. Buying

2. Selling

3. Sizing

Work to diligently to determine your strengths and weaknesses. This will help improve your edge!