It doesn’t matter what your strategy is. Every single strategy that is successful over the long term gets 2 key ingredients right:
- Have probability on your side
- Add risk management in case a low probability event happens
You need to have probability on your side when investing. People who consistently invest against probability will underperform in the long run. It doesn’t mean that investing against probability won’t work in the short run. E.g. if you bet on something that has a 30% chance of success, the probability of you winning twice in a row is still 9%. But if you bet on a low probability event 10 times, you will lose overall. That’s how probability works.
For example, I once had this person comment belligerently on my blog “how dare you say that RSI divergence doesn’t work. You are such a liar. RSI divergence could have predicted this correction!” I replied “I showed you the backtest, the chart, and the data. Look at the facts. Objectively speaking, RSI divergences have a <50% probability of being successful. So what you’re saying is ‘Troy, how dare you say that I can’t flip a coin! Flipping a coin worked this time!” I don’t ask people to trust me. Blind trust is stupid. I’m asking people to look at the data and facts. Facts are facts, regardless of who it comes from.
Everything in life is really about probability. We all make decisions in our every day lives based on expected value for probability, whether you realize it or not.
- Why do people get married? Because they think there’s a high probability that it will work out. Nobody goes into a marriage thinking “it’s most likely that this marriage won’t work out, hence I’ll get married”.
- Why do people choose their career? Because they think they will have the biggest chance at success in this field. No one goes into a career thinking “I think I’m most likely to fail in this career, hence I’m going to go into this field”.
- Why do people start a business? Because they believe “I think I can make this business work. This idea is my best shot at success.” No one starts a business thinking “I’m probably going to fail. Let me pick the business idea that I’m most likely to fail with”. That’s just ludicrous.
- Why do people choose a certain route to drive to home? Because they think “this route most likely has the least traffic”. No one purposefully chooses the route that they think will have the busiest traffic.
Not everyone knows how to measure this probability correctly. Most people don’t consciously ask themselves “what’s the most likely outcome” when making each decision in their life. But in the back of their minds, that’s what they’re doing. They’re making decisions based on what they deem to be the most favorable outcome from a probability perspective.
In many ways, how you trade/invest is how you should live. If you use probability in your life and day-to-day decisions, doesn’t it make sense to also use probability when you’re investing your life savings? It amazes me how many people put less thought into where they invest their life savings than what phone they’re going to buy when their existing contract becomes due.
So many professional traders, investors, and mainstream financial media play the “I’m worried” game. “I’m worried about this, I’m concerned about that.” I’m worried that the sun might not come up tomorrow, but it doesn’t mean that it will happen. “Worrying” doesn’t mean anything. What matters is probability. Everything is a “possibility”, so what matters is probability.
This is a point that Ray Dalio mentions in his book Principles:
“Don’t mistake possibilities for probabilities. Anything is possible. It’s the probabilities that matter. Everything must be weighed in terms of its likelihood and prioritized. People who can accurately sort probabilities from possibilities are generally strong at “practical thinking”. They’re the opposite of the philosopher types who tend to get lost in the cloud of possibilities.
The human mind has 2 big flaws. You have it, I have it, we all have it. That’s why we use machines (trading models) to eliminate this flaw:
- Recency bias. We remember recent events more vividly, which means that we incorrectly assume the recent past has a higher probability of repeating than it actually does.
- Extreme bias. We remember outlier events and scenarios more vividly. You see this everywhere, and it is propagated by the media. E.g. everyone remembers 2008. But how many people remember 2010, 2011, 2012, 2013, 2014, 2015, 2016 etc? By giving excess attention to outlier (low probability) events, we exaggerate how likely it is for these events to happen.
Risk management is also important. If you have a 80% probability of success, you still have a 20% probability of failure and a 4% chance of 2 consecutive failures. That’s just how probability works. 4% is not zero.
You need to make sure that a low probability event doesn’t kill you, because once you’re dead, you’re dead. There is no making a comeback.
The actual % probability of multiple failures in a row is often higher than what you think because “success” and failure in the markets is not randomly distributed.
Random probability and normal distribution are based on the assumption that the universe is mechanical and linear. In reality, the universe isn’t mechanical and linear. Salesmen inherently know this. E.g. let’s assume that a salesman has a 50% probability of success (closing rate). Does this mean that he will get one YES, then one NO, then one YES, then one NO….? No. He is far more likely to get 3 YES’s in a row, then 3 No’s in a row, then 3 YES’s in a row, then 3 No’s in a row….. That is why streaks exist. Streaks exist not just in humans, but in nature. That’s why “when it’s raining, it’s pouring”. Bad cycles feed on themselves to the point of exhaustion, and good cycles feed on themselves to the point of exhaustion.
This means that if you have a 66% chance of putting on a successful trade:
- You are unlikely to have 2 successful trades, 1 failure, 2 successful trades, 1 failure, 2 successful trades, 1 failure…
- You are far more likely to have 12 successful trades, 4 consecutive failures, 12 consecutive successes, 4 consecutive failures.
This is because every trading strategy has a market environment that is most suitable for it. When the current market environment is very suitable for the strategy, it will experience a string of consecutive wins. When the current market environment is not very suitable for the strategy, it will experience a string of consecutive losses.
What’s more important? Probability or risk management?
What’s more important? Should you focus on maximizing high probability trades, or should you focus more on risk management?
They’re both equally important, but in different ways.
- Probability focuses on maximizing your upside
- Risk management focuses on protecting your downside so that you don’t die.
While on the surface it looks like probability is more important, one cannot live without the other.
- Probability is a long term game. Play the long term game. Probability needs repeated attempts (multiple “N”) to play out to their “true mean”
- Risk management is a short term game. Focusing on the long term is generally better than focusing on the short term. But sometimes, you need to focus on the short term. If you don’t focus on the short term and you die, there won’t be a long term left.
Here’s a simple example of “you cannot have one without the other”. I have a family friend who’s very successful. They’re billionaires, and they own a whole chain of real estate, auto manufacturers, and auto dealerships. For many years, the husband ran the business, while the wife mostly helped out her husband. Sometimes it was helping out with the business, sometimes it was managing the household.
On the surface, it looks like the family’s success came from the husband. On the surface, it looks like all the big $$$ deals were created and signed by the husband. But without the wife’s support, there was no way the husband could have gotten to where he is today. One cannot live without the other, regardless of which one seems more important on the surface
Here’s our version of “what works”.
Our strategy for “what works” has 3 main components.
- First and foremost, avoid as much of the bear markets as possible.
- Try to avoid some of the “big corrections” if you can. This isn’t mandatory. But you need to make sure that the big corrections you avoid don’t exceed the rallies that you miss. Otherwise you will lag buy and hold.
- Ignore the small stuff. Focus on the forest, ignore the trees.
In short, the key is to focus on medium term and long term, while not buying and holding.
One of my favorite lines from Reminisces of a Stock Operator is “the final 1/8 is the most expensive 1/8”. This means:
- If you have a position and want to sell, don’t wait for the BEST price. Sell when it’s “good enough”. Don’t get too greedy. There will always be more opportunities in the future.
- If you are waiting to enter the market, don’t wait for the BEST price (ie. the exact bottom/ top). Buy when it’s close to your target, when it’s “good enough”.
Great is the enemy of good. If you keep aiming for “great” trades, you will either miss too many good opportunities or overextend a winning hand.
The world’s wealthiest investors don’t care about the small stuff. They don’t care about exact tops and bottoms. This is partially because their size is so big that they cannot buy at the exact bottom and sell at the exact top. But more importantly, this is because there is no way to consistently and accurately predict the exact top and bottom. These guys hire thousands of the brightest minds in the world to do their trading, build models, and do research. If these people can’t do it, do you think 1 trader in his room drawing lines on a chart can consistently pick exact tops and bottoms? Highly unlikely.
I’m going to show you how to use fundamental and economic analysis to predict the stock market’s long term direction in the rest of this membership program. Fundamental and economic analysis are more useful than technical analysis, which has a LOT of false signals (e.g. fake head and shoulder patterns). A lot of technical analysis is just “reading the tea leaves”. That’s why many technicians do not better than buy and hold in the long run.