Don't we all want a skeleton key that can get us into any door, anywhere, anytime? What are those keys in any business, what are the keys that will open any door.
Many years ago, my mentor pounded into my head the need for any investment to have these key elements, and in the right order.
Those three elements are:
First, let's define those terms:
- Probability is nothing more than quantified possibility. Anything is possible, but probability is the statistical likelihood that something will happen.
- Risk is the capital that one is willing to lose in search of a return on investment.
- Leverage is using a small amount of capital to control a larger amount of capital for investment purposes.
The most important thing is doing these in order, because most businesses that fail do so because of the lack of clarity with respect to these three things.
If you imagine a large organization, and their decision process for a large investment, there is often a process that is followed:
If a large restaurant company is looking to open a new location, they will evaluate many factors (population, traffic, etc.) in order to get a statistical measure of the probability of being successful prior to opening.
Interestingly enough, if the probability is extremely high there will be more risk required to get into the investment due to the competition for the location.
Typically then, the company will use leverage in the form of credit to finance the opening of the business.
Now, let's look at most investors and traders. How do most investors gauge probability in their trades?
How do they measure the probability of success? Without understanding and utilizing probability, how can someone truly and accurately assess risk? Once someone engages the market, does he or she use leverage? And when does he or she use it?
Most investors engage the market by using mutual funds, and those mutual funds present a problem when looking at this successful system.
Think about the market in general, which most mutual funds will follow. Over any given period of time the market can go up, down, or sideways.
Mutual funds are positioned long only, meaning they can only make money in up markets. Already from a probability standpoint, these essentially have a 1 in 3 probability of success.
Now, look at the risk associated with mutual funds. As I have written in the past, I firmly believe that the key to success over time as a trader or investor is the proper use of stop losses.
A major downfall of mutual funds is the inability to place automated stop losses on mutual funds; so the risk is high.
Finally, there is no way to use leverage with mutual funds which prevents successful trades from being amplified.
The argument against leverage is that it will also amplify losses, which is made even worse without the ability to place stops.
How can an investor or trader combat this? Having a system to assess the probability of success before entering into a trade is key to knowing whether or not to get in.
That system must be rules based and focused on what truly moves markets: supply and demand.
By accurately assessing supply and demand, an investor can use a system that can help assess the probability that the investment will work out for them.
Additionally, if someone has a strong understanding of supply and demand they then open themselves up for positioning themselves both long and short.
Once someone has a quality understanding of probability, it is easier to accurately assess risk.
This brings us to the magical issue of leverage, and by leverage I mean margin, leveraged ETF's, or even options.
Many people fear these products, but usually this fear is only based on anecdotal evidence failures and disaster from inexperienced traders and investors.
I would venture to say that the top reason for this using the leverage without the proper understanding of probability and risk.
Doing those in reverse is a recipe for disaster.
If you really want to increase your results, learn what odds enhancers will help you with probability, manage risk, and embrace the power of leverage!
Originally published on Equities.com.