The Cost of Being Wrong
Stockscores.com Perspectives for the week ending July 28, 2006
We all want to be right, when picking stocks we emphasize picking the right one. It feels good to consistently hold winners but traders may not be aware that being right does not necessarily mean making money.
To make money, you have to have the right risk return ratio. Being right 80% of the time will lose you money if you make $100 when you are right and lose $1000 when you are wrong. That is why controlling risk is so important.
Perhaps, then, it is better to pick a strategy that focuses on low down side risk for good upside potential. What if you could make ten times what you lose when you are wrong? You would only need to be right 1 time out of ten to make money over the long term! Surely you could be right 2 or three times out of 10 and make nice profits.
When looking at stocks, consider this idea. What is the downside risk versus the upside potential. If that ratio is very high, maybe it is worth taking the trade, even if you don't expect to be right. You can still expect to make money.
The expected value of a trade is what is important. Over a portfolio of stocks, it is the expected value of the trades and the standard deviation of those expected values that determines success. If you have a lot of positive expected values in your portfolio but a high standard deviation (how much the returns vary) then you can have big draw downs that will hurt your performance, and your confidence.
All of these concepts combine to make the following important:
Control losses, small losses when you are wrong are important. That means plan your losses and take them when the market tells you that you are wrong. There is nothing wrong with being wrong so long as you don't ignore the truth. Don't let small losses grow in to big losses.
Let profits run, when you are right let the momentum of the market work for you. It feels good to take a profit so work hard to not be swayed by emotion and sell your winners early. Sell your winners when the market tells you that the stock is now more likely to go lower than higher.
Track your performance and work to have consistently small losses and consistently large gains. If you have some large losses among your small losses you will have a high standard deviation and that will hurt your performance. Success is all about controlling risk effectively.
Don't worry so much about being right, worry about making money. Judge your success by your profitability after 10 or 20 trades rather than after one trade.
When you look at trades, ask your self three questions. How much will I make if I am right? How much will I lose if I am wrong? What is the expected value based on my expectation for being right versus being wrong? If that value is positive and the chance of a small loss turning in to a big loss is minimal then you are looking at a good opportunity.
Even if you probably going to be wrong.
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