It's Managing The Losses That Makes You Profitable

Successful market participants are successful because they focus on, and manage, their losses. Whilst fixating on profits is an enjoyable past-time, it will do little more than make you feel good. A survey in the United States showed that 20% of people in the stock market succeeded in making money over the long term and this coincided with the fact that only 20% of the people used risk management techniques. It has also been proven, on more than one occasion, that risk management combined with random share selection can generate profits.

On this basis, we shouldn't have to make any assumptions about the performance of our market strategy in order to manage risk. There are 3 elements that we can manage when we are buying or selling shares and they are:

1. The balance of probability
2. The scale of payouts - i.e. the value of winning vs the cost of losing.
3. The size of our positions - i.e. the size of our wagers

Although I don't want to in any way confuse buying and selling shares with gambling, it is useful for the purpose of illustration to compare share trading with simple games of chance. Most of us at some point have played the game of tossing a coin. One person wins if head comes up and the other person win if tail comes up. Let's look at how the three elements apply to this game.

1. The balance of probability: even or 50-50

Tossing a coin is considered to be a fair game as both players have an equal chance of success. For every toss of the coin where head wins, there is an equal number of tosses where tail wins.

2. The scale of payouts: typically 1 to 1

Both players wager the same amount of money on each toss of the coin, and the winner takes back his or her original wager and the corresponding wager of the other player.

3. The size of the positions, i.e. the size of the wagers or bets

Typically in a friendly game of coin toss both players will use the same size bet for every toss of coin. This means that for each toss of the coin, they will always wager a set of amount of money and not increase nor decrease the size of the wager as the game progresses.

This harmless game of chance is often played by children who wager for matchsticks or similarly innocuous commodity. If the game is played in the manner I have described, then the chances of winning or losing are equal and it is considered to be a fair game. If you play for long enough, you should always breakeven, and ultimately there will be no winners or losers. We can now look at how we can increase our chances of winning by managing the 3 elements of the game.

We cannot alter the probability of the outcomes (the 1st element), and our chances of winning each toss of the coin will always be 50-50. Of course, if our opponent is silly enough we can set an uneven payout scale (the 2nd element) -- where in the event we win, our opponent pays us two dollars, and if we lose we pay our opponent one dollar. But it is highly unlikely that our opponent would be agreeable to such an unfair arrangement.

However, it is imperative that the size of our wager (the 3rd element) allows us to remain in the game long enough to win. If we are losing the game, we can continue to play until we return to the breakeven point. But the moment we are in front, we should quit. We may walk away with a black eye, as many have done when playing two-up, but we will be in profit. The chart below shows the balance of the outcomes of tossing a coin 100 times.

Over the course of our 100 tosses, the balance of outcomes swung around the breakeven point of zero. At specific moments during the process either heads or tails had the balance tipped in its favour. Having performed this experiment we can conclude that the balance of outcomes can reasonably be expected to deviate by four in either direction and can peak as high as seven during the course of 100 coin tosses. Using this information, we can now establish a set of rules for managing the risk of a simple game of tossing a coin:

- We must be prepared to play the game 100 times.
- We must be able to sustain a maximum of 7 losses.
- We must quit as soon as we are winning by 4 tosses.

(Note: The experiment of 100 tosses is inconclusive and has been used for illustrative purposes only.)

Thus, tossing a coin, although a fair game of chance, can be managed to increase our probability of success. The risk of loss is virtually eradicated providing the probably outcome of a game is, at worst, breakeven and providing we can continue to play the game for as long as we like.

Surprisingly, in the stock market the probability of success is actually tipped in our favour. If we were to randomly select a portfolio of blue-chip shares and hold them an indefinite period of time, then the probably outcome would mirror the average performance of of the entire stock market.

Alan Hull
Author of Active Investing
http://www.alanhull.com