Sunday, July 08, 2007

What I Think Doesn't Matter

When it comes to the market or to a specific trade, what I think does not matter. It probably doesn't matter what you think either. Just because you or I or an analyst or a network broadcaster thinks the market or a stock is going to go up doesn't make it so. In a fascinating book, The Black Swan, author Taleb, points out the impact of the highly improbable and demonstrates, in part, the importance of what we don't know. We may have a grasp of all the fundamental information that exists at the moment and may find the perfect technical entry into a stock position, but that does not guarantee or assure that the stock will move as we expect. The next moment could bring news that results in movement directly opposite to what we predicted.

Anything can happen and none of us can predict what it will be. When we buy a stock, we are predicting that the price will go up. Many times we will be right. The company may have solid fundamentals and be climbing an uptrend. We are the beneficiary of a successful prediction when we buy the stock and it continues to follow the trend up. Suppose the company was engaged in a diamond mining operation just below the surface and that there was an abundance of diamonds. Neither the government nor labor posed any problems and the price of diamonds had been rising steadily. Our company had no debt. Sounds like a great company and it could be a scenario for a strong stock price move. As the stock price climbs, we applaud ourselves for such a marvelous prediction. We may even brag to our friends about what a successful investor we have become. Suddenly, seismic activity becomes apparent in the area of the mine and within days, a volcano erupts destroying the mine and covering the diamonds in molten lava. Now, how good was our prediction.

If you think the example I dreamed up is far fetched, how many investors predicted the events of 9/11 and if you did, did you also predict the date it would occur? The highly improbable does occur and when it occurs, it usually has an effect. How do we avoid those circumstances? We probably can't. What we do need to recognize is that all trades will not go your way --period. Mathematical trading systems, for example, ordinarily do not take into account the improbable (at least beyond two or three standard deviations) and the psychological so it seems that the creation of an infallible system is far beyond our current abilities. No matter what anyone tries to do, some trades are destined to be losers.

We need to accept that some trades will lose. We should not beat ourselves up because a stock went the other way. What we can do is manage our trades and manage our trading money so that we are able to stay in the game and so that our gains exceed our losses. I have written about Money Management and Reward to Risk ratios in the past and refer you to those archived articles to refresh your knowledge if you are interested. Those two concepts, reward to risk ratios plus proper money management are as important as any in trading. To my mind, they are much more important than trying to find a specific asset to buy or sell. Since we know we must suffer losses, let's work to keep them to a minimum and, once done, use a reward to risk plan that will help us enable to profit overall even if we only enjoy winning trades 50% of the time (or even less).

Bill Kraft, Editor
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