This is an excerpt from the whitepaper “Exaggerated Returns: How Trading Newsletters & Services Can Make Such Outrageous Claims, and How to Spot Them” by Joshua Wilson, CMT, AIF. Download the full document here.
Let’s look at another way newsletters and services can confuse investors. This time, the confusion here comes from “cumulative returns.” With cumulative returns, they simply add the returns of all trades together.
Rather than run through a long example over the course of a year or longer, for the sake of simplicity, I’m going to use example 3 again. This time, however, I will calculate cumulative returns. In example 3, we had four trades (+100%, +50%, -100%, +10%). If we add those together, we get 60% for the month! But remember, the account is actually down $2,700 — -2.7% loss in account value!
Even if all the trades all work out well, we run into that trades overlap each other, which causes the numbers to still be confused. Said differently, we don’t have all our money in each and every trade.
- Example 4: We made 20 trades this month, risking $5,000 on each trade. We made 5% on each trade for a cumulative return of 100%!
Now, you see how they report a 100% return (5% x 20 trades = 100%). But what actually happened in the account? Each trade risked $5,000 and returned 5%, meaning each trade made $250 (5% of $5,000). So overall, 20 trades that make $250 each comes out to a total profit of $5,000, which is 5% of the $100,000 account. Any reasonable person would call that a 5% return, which is a far cry from 100%!
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