The Three Things You Need To Get Right In Every Trade
As we have so often pointed out, investing is really simple if you take it for what it is. You are taking a bet, which you believe has a (high) chance of working out in your favour, on a random set of outcomes. It is why investing is so often compared to gambling. True, in both cases you are playing the probabilities, but there is one major difference. And that has to do with the wonderful tools you have as an investor to skew the probabilities in your favour. So, without further ado, here is how anyone can become a successful investor.
Part One: Input – Not surprising, everything starts with an idea. We must have some sort of signal as to why we want to invest and buy shares in Vodafone, for instance. Do we like the company, or their products, or do we think markets are poised to go up and telecom stocks will benefit the most? As you will remember from prior posts (What Actually is Alpha? and The Prediction Game), there are many ways to come up with investment ideas, using fundamental analysis, macroeconomics, technical or quantitative methodologies. Please also remember that there are inherent flaws of using any of these methodologies, as no one can predict the future. But anything can work sometimes and that is what we are trying to exploit by playing the probabilities. All we really need from an input is that it performs (however slightly) better than average.
Part Two: Trading – Now comes the tough part: how to trade our new baby. And I do mean that literally. People love their input, people get excited about their ideas and everyone thinks they can do better than 50/50. But that is another discussion, so let us just assume that we agree, and Vodafone is going to go up. Well what do we do if it goes down? Say we buy at 100 and it goes to 90, do we cut the trade or reduce our position? Do we buy more? What about if it goes to 120, do we sell out or take profit and sell half? There are endless ways to trade any investment and therein lies the problem: the movements of Vodafone are random. You could certainly be 100% right that it goes up, but you could lose money if you sell out at the wrong time. What’s the answer? Consistency. Whatever you do, do it the same way every time you make an investment. Only then do you have a chance of making the rather paltry statistics work in your favour.
Part Three: Capital – We finally get to the most important decision to make: how much of our capital do we risk on each trade? It all goes back to the input and how strongly we feel about the statistics. What are the chances of being right on our call on Vodafone, or buying a 10 year gilt, or a house, or shorting cryptocurrencies? More importantly, what are the risks to my investment when I am wrong? In other words, you would trade Vodafone much differently than you would Bitcoin, given the different risks of the underlying investments. Whatever you do and as we explained in a previous post (Size of Bet), it is clear that most importantly you stay in the game and “never risk thy whole wad” on any one trade.
Summing it all up, you could have a bad input, but trade it right and get lucky on your capital allocation. Or you could have a great input, trade it right, but only allocated an insignificant part of your monies. Fact is, no one ever gets it all right and I think that is the big lesson here. However, we can still make a lot of money as long as our input is slightly better than average, and we stick to a consistent trading and capital allocation model.