Monday, June 30, 2014

In this business, if you’re good, you’re right six times out of ten.

You don’t have to be right too often to outperform the markets.  In fact, the strategy introduced in our upcoming book, the one that doubled (almost tripled) a Buy and Hold approach has a win rate of only 47%!  That means it is wrong more than right.  How can that be??  How can you be wrong more than 50% of the time and double the return of the Nasdaq? 

“In this business, if you’re good, you’re right six times out of ten.  You’re never going to be right nine times out of ten.” – Peter Lynch

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Below is an excerpt from my book, Buy and Hope '... how I beat the Pro's and doubled the Nasdaq spending only 1 minute a week and you can too'.  Check it out at Amazon, here
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I list every trade in the appendix over the past 41 years, and what you will see is that when we are right (when the trade is acting well and making us money) … on average we stay in the trade for a long time.  We are in the market for over half the year on our most successful trades, and if you look at all our profitable trades, the average time in the market is 83 trading days (roughly 4 1/2 months).

But, what is most interesting is with our losing trades, while we have more of them, our average losing trade keeps us in the market only 17 trading days (less than 1 month).   Remember … In the stock market you need to leave your ego at the door,  because it doesn’t matter that you are right, just that you make money.  If you have trouble being wrong, then the stock market is not a place for you.  You need to leave your ego at the door.

It is okay to be wrong, it is not ok to stay wrong

Most full time and institutional traders consider a 50% win rate to be quite exceptional, and 60% is just unheard of.  In fact, I have some trading buddies that have less than a 30% success rate (they are wrong on their trades 70% of the time!!) yet they are wildly successful, because their rules get them in when the odds are in their favor and more importantly, protect them when they were wrong. 

How can you be right less than half the time and still make money?  If each winning trade earns more than each losing trade, you end up ahead of the game. 

Imagine if you went to Las Vegas and placed 10 bets.  Of those 10 bets, you had 9 losing bets where you bet $10.00 each time (a loss of $90.00), but on the final bet, you decided to risk everything and you put down a crisp $100.00 bill … and low and behold you won, doubling your bet of $100.00 (a profit of $100.00).  Although you only had a 10% win rate, you made $10.00 profit.

In our case, our average winning trade returned 12%, while our average losing trade only lost 2.8%.  So this means we technically can lose 4 times in a row to every one win and still make a little bit of money (2.8% x 4 = 11.4%, which is still less than 12%).  This means that technically we can have as low as a 25% win rate and still make money. 
 

This is imperative to understand and embrace … how often you are right is less important than how much damage is done when you are wrong.  Creating clear cut rules to protect your portfolio from downside risk is essential for long term success in the market.