Most inexperienced traders believe the key to successful trading lies in having superior predictive abilities. They think the pros must simply be better at picking the winners, and associate correct predictions with brilliance. However, successful trading is much more about money management and controlling risk than it is about being able to predict the future. The reality is, NOBODY knows what the future will bring, not even the most successful traders on the planet. What sets the pros apart, is that they don’t let the times they are wrong destroy their portfolio.
In 1860, a cousin of Charles Darwin by the name of Sir Francis Galton was looking for a simple way to demonstrate the mathematics of probability in a physical way that would be easy for the average person to comprehend. What he came up with is now known as a “Galton Board.” A Galton Board is a device similar to what is shown in the photo, where beans, balls, or marbles are dropped from a funnel at the top, and as they fall, they randomly bounce left and right off a series of pins before finally coming to rest in a bin at the bottom. Assuming the board is constructed properly and enough marbles are dropped in, the eventual result will be a bell curve. We know a lot of you get excited when you read words like probability and bell curves, but bear with us.
A Galton Board can also be useful in describing the outcome of plying a specific trading strategy over a series of trades. Trading and dropping marbles into a Galton Board are very similar in one respect; the moment the marble is dropped—or the trade is entered—the final outcome is unknown. With a Galton Board it is a series of pins that knock the marble left and right, while with trading it is other traders’ buy and sell orders that knock your trade back and forth between a win or a loss column—orders that are placed for any myriad of different reasons. Sure, studying charts and following the fundamentals can give us a competitive edge, but in the end, we are still trying to predict something that hasn’t happened yet, and that is something that is simply not possible to do with absolute accuracy. If profits depended solely on our ability to predict the future, we would be doomed to failure. The reality of trading without a system is that after a series of enough trades, we would find a similar result in our portfolio as we see in the board on the right above. A majority of our trades would fall in the middle at plus or minus a couple of percent. As we move toward the edges of the board (the left side representing large losses, and right side large gains), we notice there are fewer marbles. It is the same in our trading in that it is much less common that we have huge wins or losses when we enter a trade.
If we were doomed to this probability, and were unable to alter it in our favor in any way, then it would hardly make any sense to trade at all, because at the end of the year we’d have a bunch of small wins and losses that basically cancel each other out. Sure, we’d bag a few big wins, but they’d be offset by an equal amount of frustratingly large losses. Perhaps we would be break even, until we remembered to add the cost of commissions, slippage (the difference between the bid and the ask), and taxes. This would almost guarantee consistent losses. So after taking on all that risk, spending all of that time, and giving ourselves an ulcer or two, at the end of the year we would have paid for the privilege of staring at a bunch of charts. Yippee.
But, what if we could modify the bell curve a little? Look at that Galton Board one more time, and ask yourself what would happen if we could block the three slots on the far left so that the marble had no choice but to drop into the fourth slot? Would that change the end result? In that altered state, we would have a few more small losses, but we’d have no large, catastrophic losses. We do however, still have those big wins over on the right side. And that, my friends, is what moves our portfolio into the green. When we look back at our trade results for a year, we usually find that it was a few big wins that made the difference for us. As long as we don’t offset those wins with big losses (the three furthest slots on the left), we slowly move the marble (and our portfolio) forward. That is what we achieve when we strictly adhere to our stop losses, and by only entering trades that have a very minimum of a 2-to-1 reward-to-risk ratio. Those two key components of our philosophy effectively eliminate the three slots on the left side of the board.
Now let’s talk about the right side of the board for a moment. We know it is frustrating to enter a trade, watch it climb a few percent, and then watch it fade back to break even or a small loss. It’s easy to think, “Why not just sell it after it goes up a few percent and take the profit?” The problem with this line of thinking is that by selling early, we won’t ever get our marbles to fall into the slots that are furthest to the right. Those are the ones that will really push our portfolio forward over time. A stock on its way to a 30% gain looks just like a stock that is going go up only a few percent before turning back down. At the 2 or 3% mark, we have no way of knowing which one is going to continue on, and which is going to give up its gains. If we don’t give it a chance to perform, we will end up with a ton of small wins, offset by small losses, and only the broker would have made any money.
It is important to understand this, because there will be periods where we are “churning” small wins and losses that basically offset each other. Unfortunately, just like the bell curve, this is how the majority of trades end up. Without a firm understanding of the mechanics of trading, it would be very easy to get discouraged and frustrated during periods like this. But if we look at our results since we started this newsletter, we can see that in addition to some nice wins, we have kept our losses small. And just like the board shows, our big wins are less common than the small wins or losses. However, they do come, and as long as we use a stop-loss—and stick to it—to assure that we never have equally large losses, portfolio gains will happen over a series of trades. Trading is a very emotional craft, and having an understanding of how the profits accumulate can really help us to mentally roll with the punches.