Reinvestment of Returns and Geometric Growth Concepts 103
may be profitable on a nonreinvestment basis. However, if a system is good
enough, the profits generated on a reinvestment basis will be far greater
than on a nonreinvestment basis, and that gap will widen as time goes by.
If you have a system that can beat the market, it doesn’t make any sense to
trade it any other way than to increase your amount wagered as your stake
increases.
There is another phenomenon that lures traders away from
reinvestment-based trading. That phenomenon is that a losing trade, or
losing streak, is inevitable after a prolonged equity run-up. This is true by
inspection. The only way a streak of winning trades can end is by a losing
trade. The only way a streak of profitable months can end is with a losing
month. The problem with reinvestment-based trading is that when the in-
evitable losses come along you will have the most contracts on. Hence, the
losses will be bigger. Similarly, after a losing streak, the reinvestment-basis
trader will have fewer contracts on when the inevitable win comes along to
break the streak.
This is not to say that there is any statistical reason to assume that
winning streaks portend losing trades or vice versa. Rather, what is meant
is: If you trade long enough, you will eventually encounter a loss. If you
are trading on a reinvestment basis, that loss will be magnified, since, as a
result of your winning streak, you will have more contracts on when the
loss comes. Unfortunately, there is no way to avoid this—at least no way
based on statistical fact in a stationary distribution environment, unless we
are talking about a dependent trials process.
Therefore, assuming that the market system in question generates inde-
pendent trades, there is no way to avoid this phenomenon. It is unavoidable
when trading on a reinvestment basis, just as losses are unavoidable in trad-
ing under any basis. Losses are a part of the game. Since the goal of good
money management is to exploit a profitable system to its fullest poten-
tial, the intelligent trader should realize that this phenomenon is part of the
game and accept it as such to achieve the longer-term rewards that correct
money-management techniques provide for.
MEASURING A GOOD SYSTEM FOR
REINVESTMENT—THE GEOMETRIC MEAN
So far we have seen how a system can be sabotaged by not being consistent
enough from trade to trade. Does this mean we should close up and put our
money in the bank? Let’s go back to System A, with its first two trades. For
the sake of illustration we are going to add two winners of one point each.