In my previous post (Trading Principles - 2), we discussed two concepts:
(1.) Chance of winning
(2.) Risk:Reward
OK, lets move ahead.
Sometime last year, a friend asked me what I thought about the market direction. I replied that I thought markets would go up in the near term. So he further asked me whether I had bought in anticipation of this move (being long, in trader terminology). I replied in the negative saying that I was actually short on the markets.
My friend appeared puzzled, perhaps he thought I was being a 'wise guy'. In reality, I was being totally honest. But what explained the discrepancy between my views and my action?
Lets say you toss a fair coin. If you get a heads, you get paid Rs. 2. If you get a tails, you lose Re 1. Would you play this game of chance?
For a fair coin, there is a 50% chance of getting either heads or tails.
So if play this coin toss game 100 times, you can expect 50 heads and 50 tails.
For each head, you win Rs. 2. So for 50 heads you will win Rs. 100
For each tail, you lose Re. 1. So for 50 tails, you will lose Rs. 50.
After 100 tosses of this fair coin, you will win Rs 100 and lose Rs 50 for a net gain of Rs 50.
So if you play this game 100 times, you can expect to win Rs. 50.
Hence, the EXPECTED VALUE of the gain from a single toss of the coin is Rs 50 divided by 100 = Rs. 0.5.
You can expect to win 50 paisa for every toss of the coin. This is called the EXPECTED VALUE (E) per toss of the coin toss game. Surely, you would like to play this game, as many times as possible. The more you play, the more money you can make.
Likewise, each investment/trade has an expected value. If the expected value is positive, a profit is expected on the trade and it is worth taking. If the expected value is negative, a loss is expected on the trade and the trade is not worth taking.
Let us take a couple of examples.
Trade A has a 70% chance of winning and a 30% chance of losing. The win per trade is Rs 100 but the loss per trade is 400.
The expected value (E) for this trade is (0.7)*(100)+(0.3)*(-400) = -50
Trade A has a negative E value. i.e. this trade is expected to lose you money even though it has a 70% chance of success. Thus a high chance of success does not equate with making money.
Conversely turn the above trade on its head. Take trade B that has a 30% chance of winning Rs 400 and a 70% chance of losing Rs 100.
E for this trade is +50.
So even with a low chance of winning, the trade makes you money.
Perhaps now it might make sense why I was short on the markets in spite of thinking that the markets would go up. I was expecting that if the markets went up, they would not go up much. But they went down, they would go down a lot. The Expected Value favoured a short position.
It does not matter much, if over the long run, you are more wrong than right (% success rate) or vice versa. What matters is how much you make when you are right and how much you lose when you are wrong (a high average profit:average loss ratio).
So how do we use this to make real life decisions? Suppose you have a one year time horizon. At the end of 1 year, you expect the Sensex to have a 50% chance of going up by 30%. But there is a 50% chance of it going down by 20% as well. Should you buy?
The expected value from this trade is 0.5*30%-0.5*20% = 5%
This is positive. So should you buy since E has a positive value?
Do not forget the opportunity cost. You could put your money into a bank fixed deposit and get an assured 8% (assuming the bank does not default). So in actual terms, the opportunity cost for making the Sensex trade is higher than the expected benefit from this trade.
An investment must then must not only have a positive expected value but it must be higher than the best opportunity cost. Clearly, it does not make economic sense to buy into the Sensex with these kind of statistics.
What if your time horizon is 5 years?
Say, over 5 years, there is a 90% chance of the Sensex doubling in value. But there is a 10% chance of the Sensex going nowhere. The E for this trade is 90. The opportunity cost @8% per annum is 47. So over a longer duration, the trade makes sense.
(Hence the importance of a personal time horizon for any investment.)
So what lessons can we derive from the above discussion?
(1). More important than % success rate is the reward:risk relationship. It is easier to find investments and trades that have a low success rate than one that has a high success rate, provided you obey point no. 2 below, which is
(2). Let your profits run but cut your losses short. Look at trade B above. Many investors do the converse. They sell quickly when they have a profit, lest the profit should evaporate. But they hang on to losing investments in the hope that prices will come back. In effect they follow the strategy, 'cut your profits short but let your losses run'. Typical phenomenon are short term trades becoming long term investments, Buy-and-hope investing, not willing to accept a loss, etc. All lead to the poor house!
(3). Seek and act on only those investments that have a positive E value. Finding such trades requires possessing an edge in the markets. An edge comes from experience, vision and ability to foresee, access to information, plan and discipline, patience, perseverance, or all of the above, and more.
Till next time, happy investing!
Sunday, February 15, 2009
Friday, January 30, 2009
Trading Principles - 2
Ok, so outcomes in the market are uncertain and there always is a chance of losing money. Investors need to think in terms of probabilities.
But how does one do that?
First, never invest with the thinking, "this will surely go up". There is no sure thing in the markets. Avoid the lure of the 'sure'.
When faced with a choice to invest or not to invest, ask yourself the question, "What are the chances of the price going up/investment working out and hence what are the chances of the investment not working out? Is it 80%? 60%? 40%? 20%? By doing so, you immediately get into the mental framework of assessing possibilities and awarding probabilities to outcomes.
So you might think that a particular investment has a 70% chance of making you money and a 30% chance that you would lose money (neglecting the possibility of the investment going absolutely nowhere) in a given time frame.
The key question is how do we assess these probabilities? Unfortunately there is no easy answer. Investors mostly depend upon their knowledge, experience and judgment.
But to help you make an assessment, you could look into history to see what happened under similar circumstances. So if a particular outcome X occurred 7 times out of 10 when conditions A, B and C were satisfied, you can say that maybe the chance of outcome X happening again, given the presence of conditions A, B and C is 70%.
Important to note however is that the past is merely indicative of the future. Never is the future exactly like the past. There could be factors that we miss out that could produce an entirely different outcome when compared to history. For example, it is commonly believed that an increase in money supply causes inflation. In an inflationary period, gold prices go up. So with all the trillions of dollars being thrown at the current economic problems worldwide, people expect the prices of gold to go up sometime in the future. But maybe, just maybe, we are not looking at the even greater amount of money being destroyed off balance sheets. So there could be a net money contraction and maybe gold prices do not go up.
You might be wondering whether experienced investors actually assess the probabilities in terms of such percentages. They don't do this on paper, but at a subconscious level, they get a sense of the odds. They may not be able to exactly spell out the probabilities, but in their minds, they are aware of the chances, at least at an approximate level.
Fine! So, at what percent chance of winning does an investment become a good investment?
If you flip a fair coin, there is a 50% chance of getting heads and a 50% chance of getting tails. These two outcomes are random in nature and depend purely upon luck. So if a random choice gives you 50% chance of winning, should an investment with a higher than 50% chance of winning be a better investment? After all should the odds of winning not be greater than random outcomes? Also, is an investment with a 80% chance of making money a better investment than that with a 70% chance of making money?
Not necessarily!
In reality, it does not matter much if you win or you lose. What matters is how much you win when your investment works out and how much you lose when it does not work out.
The amount you end up winning is your reward. The amount you were willing to lose is your risk.
A good investment is one which if it goes wrong, it goes a little wrong; and if it goes right, it goes significantly right. In other words, the reward to risk ratio is high.
Look for an investment/trade that has a high reward:risk ratio. Elementary, my dear Watson.
But why should an investment with a 70% chance of making money not necessarily be a good investment and why should an investment with a 70% chance of losing money not necessarily be a bad investment?
That is the topic of my next post...
But how does one do that?
First, never invest with the thinking, "this will surely go up". There is no sure thing in the markets. Avoid the lure of the 'sure'.
When faced with a choice to invest or not to invest, ask yourself the question, "What are the chances of the price going up/investment working out and hence what are the chances of the investment not working out? Is it 80%? 60%? 40%? 20%? By doing so, you immediately get into the mental framework of assessing possibilities and awarding probabilities to outcomes.
So you might think that a particular investment has a 70% chance of making you money and a 30% chance that you would lose money (neglecting the possibility of the investment going absolutely nowhere) in a given time frame.
The key question is how do we assess these probabilities? Unfortunately there is no easy answer. Investors mostly depend upon their knowledge, experience and judgment.
But to help you make an assessment, you could look into history to see what happened under similar circumstances. So if a particular outcome X occurred 7 times out of 10 when conditions A, B and C were satisfied, you can say that maybe the chance of outcome X happening again, given the presence of conditions A, B and C is 70%.
Important to note however is that the past is merely indicative of the future. Never is the future exactly like the past. There could be factors that we miss out that could produce an entirely different outcome when compared to history. For example, it is commonly believed that an increase in money supply causes inflation. In an inflationary period, gold prices go up. So with all the trillions of dollars being thrown at the current economic problems worldwide, people expect the prices of gold to go up sometime in the future. But maybe, just maybe, we are not looking at the even greater amount of money being destroyed off balance sheets. So there could be a net money contraction and maybe gold prices do not go up.
You might be wondering whether experienced investors actually assess the probabilities in terms of such percentages. They don't do this on paper, but at a subconscious level, they get a sense of the odds. They may not be able to exactly spell out the probabilities, but in their minds, they are aware of the chances, at least at an approximate level.
Fine! So, at what percent chance of winning does an investment become a good investment?
If you flip a fair coin, there is a 50% chance of getting heads and a 50% chance of getting tails. These two outcomes are random in nature and depend purely upon luck. So if a random choice gives you 50% chance of winning, should an investment with a higher than 50% chance of winning be a better investment? After all should the odds of winning not be greater than random outcomes? Also, is an investment with a 80% chance of making money a better investment than that with a 70% chance of making money?
Not necessarily!
In reality, it does not matter much if you win or you lose. What matters is how much you win when your investment works out and how much you lose when it does not work out.
The amount you end up winning is your reward. The amount you were willing to lose is your risk.
A good investment is one which if it goes wrong, it goes a little wrong; and if it goes right, it goes significantly right. In other words, the reward to risk ratio is high.
Look for an investment/trade that has a high reward:risk ratio. Elementary, my dear Watson.
But why should an investment with a 70% chance of making money not necessarily be a good investment and why should an investment with a 70% chance of losing money not necessarily be a bad investment?
That is the topic of my next post...
Saturday, January 24, 2009
Trading Principles - 1
Can you have a process behind investing and trading?
Can you carry out these activities systematically, in a logical manner?
Can you invest and trade based on sound principles?
You bet, you can!
Of course, you can also trade on the basis of news, gut feel, whims, some research report in the newspapers, tips from friends, rumour, etc, or a combination of the above. In my opinion, this mostly leads to grief and lost money over longer periods. I am sure that anyone who has had some experience in the stock markets would have fallen prey to one or more of the above sometime in the past.
So if there are sound principles that one can follow, what are these principles exactly?
Starting with this post, I propose to discuss these principles over a series of posts. The purpose is to highlight the process of establishing a framework for making decisions under uncertainty. Hopefully, it will establish a method to trade logically.
But as we all know, there is a difference between knowing the path and walking the path.
Perhaps this is why business school professors are not good businessmen, or why few doctors are in good shape physically, or why new year resolutions often remain grounded. We all know that if we seek good health, we must control what we eat and drink, exercise and remain physically active, and minimise tension and stress. Knowing is easy, it is the doing part that is so difficult.
Successful investing, like any other activity, comprises (1) knowing exactly what to do and (2) doing what you need to do, time after time. A good process needs to be correctly implemented.
The second point is responsible for 99% of trading success.
This is no exaggeration. People think that if they get a good method to invest, the money taps will automatically be opened for them. They think that if they know when and what to buy and sell, stock market riches are within their grasp. Nothing can be further from the truth.
Successful implementation is largely predicated on proper investor psychology. But psychological talk is something most novice investors and traders tend to dismiss as unimportant. Lest readers of this blog are also put off by psychological issues at the outset itself, I propose to cover the method first and discuss psychology later. Bear in mind however that methods are nowhere as important as personal psychology. At some stage, every trader realises this and internalises it. The less successful ones keep searching for methods.
Two points before we begin. Both would undoubtedly be known to all readers, yet deserve a mention.
First, like everything in life, outcomes in the markets are always uncertain, perhaps more uncertain than real life outcomes. Hence the first thing an investor or trader should focus upon is thinking in terms of probabilities and not in terms of certainty. There is no sure thing in the markets. Yes, we all want our investments to go up and most investors are focused on the profit side of the investment. But investments do go wrong and it is important for investors to think also about the possibility of things not going their way. This needs to be done not only on an intellectual plane, but at an emotional level as well. This is a concept that every investor needs to embrace, not just give it lip service.
Secondly, trading or investing, is a profession like any other. Success in this field requires the same commitment, perseverance and practice that any other profession requires. Unless you are a genius, a whole lot of effort is required to do well in trading. People should not live under the wrong assumption that their sporadic forays into the stock markets will fetch them longer term success. If you are serious about making money in the markets, you need to be serious about your effort in trying to do so. I can almost guarantee you that you are NOT going to become an investing genius merely by studying and understanding investing principles and the process. It takes much more than that.
But we all know the above two points, I only wanted to reiterate them.
So where do we start?
We start off in my next post. So keep an eye on this space...
Can you carry out these activities systematically, in a logical manner?
Can you invest and trade based on sound principles?
You bet, you can!
Of course, you can also trade on the basis of news, gut feel, whims, some research report in the newspapers, tips from friends, rumour, etc, or a combination of the above. In my opinion, this mostly leads to grief and lost money over longer periods. I am sure that anyone who has had some experience in the stock markets would have fallen prey to one or more of the above sometime in the past.
So if there are sound principles that one can follow, what are these principles exactly?
Starting with this post, I propose to discuss these principles over a series of posts. The purpose is to highlight the process of establishing a framework for making decisions under uncertainty. Hopefully, it will establish a method to trade logically.
But as we all know, there is a difference between knowing the path and walking the path.
Perhaps this is why business school professors are not good businessmen, or why few doctors are in good shape physically, or why new year resolutions often remain grounded. We all know that if we seek good health, we must control what we eat and drink, exercise and remain physically active, and minimise tension and stress. Knowing is easy, it is the doing part that is so difficult.
Successful investing, like any other activity, comprises (1) knowing exactly what to do and (2) doing what you need to do, time after time. A good process needs to be correctly implemented.
The second point is responsible for 99% of trading success.
This is no exaggeration. People think that if they get a good method to invest, the money taps will automatically be opened for them. They think that if they know when and what to buy and sell, stock market riches are within their grasp. Nothing can be further from the truth.
Successful implementation is largely predicated on proper investor psychology. But psychological talk is something most novice investors and traders tend to dismiss as unimportant. Lest readers of this blog are also put off by psychological issues at the outset itself, I propose to cover the method first and discuss psychology later. Bear in mind however that methods are nowhere as important as personal psychology. At some stage, every trader realises this and internalises it. The less successful ones keep searching for methods.
Two points before we begin. Both would undoubtedly be known to all readers, yet deserve a mention.
First, like everything in life, outcomes in the markets are always uncertain, perhaps more uncertain than real life outcomes. Hence the first thing an investor or trader should focus upon is thinking in terms of probabilities and not in terms of certainty. There is no sure thing in the markets. Yes, we all want our investments to go up and most investors are focused on the profit side of the investment. But investments do go wrong and it is important for investors to think also about the possibility of things not going their way. This needs to be done not only on an intellectual plane, but at an emotional level as well. This is a concept that every investor needs to embrace, not just give it lip service.
Secondly, trading or investing, is a profession like any other. Success in this field requires the same commitment, perseverance and practice that any other profession requires. Unless you are a genius, a whole lot of effort is required to do well in trading. People should not live under the wrong assumption that their sporadic forays into the stock markets will fetch them longer term success. If you are serious about making money in the markets, you need to be serious about your effort in trying to do so. I can almost guarantee you that you are NOT going to become an investing genius merely by studying and understanding investing principles and the process. It takes much more than that.
But we all know the above two points, I only wanted to reiterate them.
So where do we start?
We start off in my next post. So keep an eye on this space...
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