Flying back from New York last weekend I sat next to a young man who I noticed was wearing a Liverpool (the English Premier League Soccer Team) jersey. Since I watch the EPL quite regularly I asked him if he was fan, he replied that he was, and as it turns out he also plays soccer for his high school in Connecticut. I was quite impressed with this young man because at age 17 he was able to carry on a good conversation with a much older person. When he asked what I did for a living I told him that I was a trader and that I also worked for an educational firm that teaches people how to properly look at how the markets really work, and thus gives them a strategy to trade. At first, he seemed a bit skeptical that we could predict in what direction the stock market would go in the future. I told him that nobody can predict with exactitude where the market would go, but rather that it was a game of probabilities, and that similar to soccer, strategy, practice, sizing up the opponent, and execution was the key to success.
As I mentioned earlier this young man was not your typical seventeen- year- old as he was quite bright and his inquisitiveness was well directed. But just like many people he had many of the false beliefs about trading and investing that are common amongst the average investor. Many of these beliefs are formulated because of the misinformation that’s propagated throughout the financial services industry and media.
One example of this is that people want to believe that pundits can accurately forecast the direction of markets, which we know can be a futile endeavor when practiced over long periods of time. Another belief is that as a trader, one must be right most of the time in order to be profitable. This belief leads traders to hang on to their losing trades in the hopes that the market will come back and make them whole. And to their detriment, sometimes that does happen, but more often than not the market exacts so much pain on these individuals that they end up selling near the lows. Moreover, when these traders have a small profit they tend to take it quickly. Emotionally, taking small profits may feel good, however, small profits followed by large losses just don’t add up mathematically.
To continue to elaborate on the aforementioned mathematical issues, if you think about what leads traders to these emotional responses it is the fact that most traders put the emphasis on the end result and spend less time on the process of devising a sound strategy that is high in probabilities.
Let me explain: when it comes to games of skill and competition, we first have to learn the process that is involved in the particular endeavor that we are going to compete in. Secondly, our chances of winning are based on how skilled we are against our competition, and because in the trading arena there is constant uncertainty, the game becomes about managing risk, and assessing probabilities.
Much like in sports, a novice has little or no chance of winning against a professional. There is a remote chance that perhaps the Pro has an off-day giving the novice a glimmer of opportunity, but that is very unlikely. In other words, the odds are very low. In trading it is the same. In the competitive world of professional sports, an athlete finds a winning strategy that he practices intensely until he masters it, but when in competition his total focus is on execution with less emphasis on the result of each play. As an example, a professional Tennis player makes sure that he hits every shot accurately but he understands he won’t win every point. What he does understand however is that the larger the sample size of shots the higher his chances of winning becomes. This comes with the provision that he is more skilled, and that his strategy can dilute his opponents strengths as well as expose their weaknesses. The final and most important element to being victorious is to have the self-discipline to execute regardless of the previous outcomes.
For traders, this means the in the short-term outcomes are almost random so there’s no need to fret over each trade when the true test of a system comes over many trades (large sample size) as long as the strategy is proven over many cycles.
The bottom line is this: As traders we should continue to perfect the process and let the beauty of mathematical probability work its magic over a larger sample size. This is done by letting the chips fall where they may on every trade, and making sure we manage risk so that we stay in the competition.
Until next time, I hope everyone has a great week.