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...