EL SEGUNDO, CA (Oct. 14, 1999) -- For a while now people such as TMF Elan have been warning investors not to invest in monthly trading strategies without having significant start-up cash. In my last article, I showed you the equation I use to switch reported strategy results to real life results. As a review here are those formulas:
Actual Return = (Strategy Increase - Costs) * (1 - Tax Rate)
Where Tax Rate = Marginal Federal Tax Rate + Marginal Local Tax Rate
Costs = Round Trip Trading Cost + Spreads
When we looked at the costs we saw that they are fairly small when you are trading once a year, but they can add up significantly when you are following a strategy that calls for monthly trades.
To illustrate how these costs add up, let's first look at the spread cost for monthly strategies. Tuesday, I gave some guidelines that are useful for quick comparisons between various returns, but today we will ignore those and look at actual spreads.
To do that, follow along as I select stocks and collect prices in real time for this week's RS-26 stocks. Here are the Bid and Ask prices that a typical investor would have seen for those stocks last Friday morning as soon as the data for the list was available.
Stock Bid Ask Spread QCOM 208 3/4 208 13/16 0.03% TTN 14 9/16 14 11/16 0.86% PMCS 89 5/8 89 11/16 0.07% SYMC 36 1/4 36 1/2 0.69% Avg. Spread 0.41%Are these typical spreads for these screens? That is open for debate but they are the actual ones when it counted. An elephant like Qualcomm tends to lower the spread. If lower-priced stocks are selected, the spread would could easily double. On the other hand, with all higher priced stocks, the spread could end up under 0.10%.
Now let's put the whole picture together using the RS-26 month screen. For this example, I will assume that the investors are using a discount broker that charges $10.00 a trade. The RS-26 (1-4) monthly strategy has a CAGR of 42.0%, which is equivalent to a monthly increase of 2.97%.
So let's start by looking at the $2000.00 investor. We will consider that this is his first year's contribution to a Roth IRA so taxes aren't in the picture. To get into the screen he pays $40.00 in commissions to buy the first 4 stocks. That leaves $1960 for the stocks. (Actually, he won't be able to put all of his $1960 into stocks because the prices never add up to exactly how much you have to spend. In effect, a small amount of cash that could theoretically be invested is left "on the table" each month further eroding your gains, but we will ignore that problem for now.)
As shown below the cost for the first month is $44.02 and the return is $58.21:
Costs = Round Trip Trading Costs + Spread
Round Trip Trading Costs: 2*$20.00 = $40.00
Spread: $1960/2 * .0041 = $4.02 [$1960/2 because only half of the portfolio was sold]
Cost: $40.00 + $4.02 = $44.02
Return: $1960*0.0297 (2.97%) = 58.21
Thus the Actual Return in a tax-free account is = $58.21 - ($40.00+$4.02) = $14.19
Monthly Return = 14.19/1960= 0.72%
So the investor starts the second month with $1974.19. The RS-26 Monthly strategy averages 28 trades per year. Repeat the above procedure every month for a year, throwing in a third trade every quarter to bring you up to the 28 trades per year average, and you end up with a portfolio worth $2066.66. Even in a tax-free account, you lost to most money market funds and probably to some interest-paying checking accounts.
Start the program with $10,000 and things change. Start with $20,000 and they start to look much better. But start out small, and you'll stunt your growth with a monthly strategy.
Next week we will compare after-cost returns for various screens at various levels of investment so that you can judge for yourself where you best fit.
Until then, Fool On!