The most shocking lesson I learned when I started really studying successful traders was this:
The best traders and investors are actually losers… They’re only “right” about 40% of the time.
I was stunned when I first read this.
It made me realize that we weren’t taught anything at all in school about what makes successful investors successful… Instead, we were just taught the “theories” of making money through investing, which mostly weren’t related to the truth about making money.[ad#Google Adsense 336×280-IA]Each year, I’m wrong in many investment ideas. But that’s alright with me… I know the very best investors are, too.
The thing is, it’s how you handle those losers that matters. That’s exactly what separates the very best investors from the very worst.
I do two things each year to get better…
1. I expect to make money in a position. But I know not every position will work out. So for each of my losers in a year, I try to figure out what went wrong… I try to figure out what I missed so that won’t happen again.
2. I always set myself up to keep my losers small and my winners big. Think about it this way… Let’s say a trader places three trades: Two trades end up as small losers, down 5%. The other trade is a big winner, up 50%. Is this trader a winner or a loser?
He was wrong 67% of the time. But the gain on the winner was big. And the losses on the losers were small. So his overall return on those three trades wasn’t bad at all: about 13%. This trader’s ratio is good. I always want to improve the ratio of the gains on my winning trades versus the losses on my losing trades.
Let’s look at each of these closely…
For No. 1, when I look back at my 2011 loser, I see I made the same basic mistake over and over again… I was trying to “force” a bull market when it simply wasn’t there. My investing mantra is to buy what’s “cheap, hated, and in the start of an uptrend.” But the legitimate uptrends were hard to come by in 2011. I would buy in – and then I’d get stopped out.
The lesson for me is, be more patient!
It might make headlines to “call the bottom” in something and get it right. But it’s safer and smarter to be patient, let your thesis start to unfold first, and then put your money down. I need to do more of that in 2012.
When it comes to No. 2, I want to keep the losers small and let the winners ride.
In 2011, I did a great job letting my winners ride. I don’t have trouble with this at this point in my career. But I can improve on my losers… I was too confident. I set my worst-case exit point too wide – as wide as 50% in some cases. So I ended up getting “stopped out” of a few positions with losses close to 40%.
My reasoning was sound… I want to have three times the upside potential as the downside risk I’m taking. So if I’m taking 50% of downside risk, I expect to earn at least 150% on the upside. But the “beatings” I took were simply unacceptable.
One way to “fix” that problem is to start using a tighter stop loss when I first buy a stock, in addition to using a trailing stop as shares move higher.
In college, nobody ever talked about things like how to successfully exit a position, winning percentages (which are below 50% even for great investors), and how to manage winners versus losers. But this is incredibly important stuff.
I urge you to do what I do…
1. Look at all your losers and think about what you can do to do better next time.
2. Think about how you can improve your ratio of gains on winning trades versus losses on losing trades.
It is not just the fundamentals of the trade that matter. It is how you trade it. A winning trade is made up of a good buy AND a good sell.
Are you evaluating your buys and sells each year and thinking about how you can do better? If not, how do you expect to improve?
I’ve been doing this for two decades. It takes constant refinement. You’ve got to do it. Get to it…
Source: Daily Wealth