DESPITE HOURS OF THOUGHTnowhere at all
What saves me, however, is that the profits from my winning trades are bigger than the losses from my losing ones.
Simply put, you don't have to win more often than you lose. You do, however, need to win bigger than you lose. I have found that when it comes to allocating a portfolio, the old "80-20" rule tends to apply: 80% of your profits tend to come from 20% of your trades. To that end, the point isn't to search for trades with a high probability of winning, but with a high probability of a large return.
Returns, large or otherwise, are few and far between these days. A vast majority of mutual funds lost money in the first half of 2001, and after another couple of bruising months in the market, it isn't a surprise that most people aren't looking to take on major risk. Listen to the vox populi> these days and you'll find dividends are very much back in vogue. Bonds and "defensive" sectors, like pharmaceuticals for example, are all the rage. These are just a few of the once-boring investments that are now seen as safe moves for precarious times.
But the notion of safe stocks is a misnomer, because if you're trading stocks, then the truth is that you want to seek out>Let's get one thing straight, though. I'm talking here about risk capital, which is the only kind you should be trading with. There's a vehicle that pays out consistent, safe returns, and it's called savings
Being naturally risk averse, however and even more so in recent months most people place their wagers on the seemingly safe favorites. Sounds reasonable, right? Indeed, most people feel confident knowing that their money is riding on the stock with the best odds...i.e., the best chance of "winning."
And although we often interpret odds as probabilities, the reality of markets is that anything could happen. Whether posted in the Racing Form or in a pundit's research report, odds don't tell you what horse is going to finish the race first, nor what stock is going to move higher. Over short time periods, a "risky" stock has just as much chance of paying off as a "safe" one, especially when the risky stock is showing some sort of technical strength. Sometimes the long shot wins, or the public favorite falls. Trading is just like life anything can happen.
Odds simply reflect the payoff schedule of a particular event at a particular time. Less probable outcomes are given more attractive (read: lucrative) odds. So assuming you're using appropriate position size, the actual> risk in buying either the "risky" or "safe" stock is actually quite similar. Consider the horse-racing example: Whether you put down a $2 bet on the long shot or a $2 bet on the sure thing, the risk is still $2. What's different, of course, is the payoff schedules dictated by the odds. Horses with "good odds" might pay one to two, or $1 for every $2 bet. Long shots, the track's version of "risky" stocks, might pay 30 to one, or $30 for every $1 bet, an exponentially better payoff.
This is precisely the problem with betting the favorites. Good odds, by definition, mean lousy payoffs.
Sticking to "safe" bets is actually a recipe for underperformance, because tiny payoffs don't compensate for the inevitable losses that go along with any type of speculative endeavor. The truth is that what most people think of as good odds are actually lousy odds. In reality, the stock that's perceived to be "safe" has all of the downside of a "risky" stock with a fraction of the upside.
So instead of focusing on making winning trades more numerous, try and make them more profitable. Think like a mom-and-pop store: high margin, low volume. "Risky" stocks, such as those based in emerging markets, biotechnology or junk bonds, are highly volatile, but it doesn't mean they should be excluded from even supposedly "safe" portfolios. As with most elements of trading, success comes down to proper technique.
Most people don't assume risk they manufacture it. For example, they don't just buy a closed-end fund that focuses on emerging markets, they put 25% of their portfolio in at one price, on one day, and without the benefit of a well-defined trend or a diversified portfolio. That isn't risk it's recklessness.
"Safe" trading isn't about avoiding risk, but managing it. We can't control the market, but we can control the size, timing and types of bets we make. And while it may be psychologically comforting to bet with the crowd, real payoffs come not from continually playing the favorites, but from playing the field.
Jonathan Hoenig is portfolio manager at Capitalistpig Asset Management, a Chicago-based hedge fund.>