To Evaluate Stock Trading by Jack Schwager
Benchmark comparisons are a standard technique for the
performance of a trading system. One particular benchmark
is the buy-and-hold approach. This noted market analyst
looks at the steps to using it.
Just because a trading system
makes money in the stock market
doesn’t mean it’s a good
system. After all, it is possible
for a system to do well but still
fall short of the results that could
have been realized by a simple
buy-and-hold approach. The key
question in testing a stock market system is: How does the
system compare with the buy-and-hold approach?
Answering this question is not as simple as it might appear.
In my previous article, we showed why a constant share size
trade assumption led to severe distortions in testing trading
systems and why a constant dollar trade size assumption was
far preferable. The problem, however, is that system results
based on a constant dollar trade size — for example, $1,000
— cannot be directly compared with buy-and-hold results for
the same number of shares as the first trade.
To understand why, assume a stock is trading at $5 at the
start of the test period before it then advances to $50 by the
end of the survey period. In this case, 200 shares, which equal
$1,000 at the start, would equal $10,000 at the end. In
contrast, the constant dollar trade size system results would
continue to assume a $1,000 trade size on each signal.
As a result, the buy-and-hold case would assume a much
larger average position size as time elapsed. Consequently, a
comparison between the system results and buy-and-hold
results would be that of the proverbial apples and oranges.