The Cost of Being Wrong
Stockscores.com Perspectives for the week ending July 28, 2006
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In this week's issue:
We all want to be right, when picking stocks we emphasize picking the right one. It feels good to consistently hold winners but traders may not be aware that being right does not necessarily mean making money.
To make money, you have to have the right risk return ratio. Being right 80% of the time will lose you money if you make $100 when you are right and lose $1000 when you are wrong. That is why controlling risk is so important.
Perhaps, then, it is better to pick a strategy that focuses on low down side risk for good upside potential. What if you could make ten times what you lose when you are wrong? You would only need to be right 1 time out of ten to make money over the long term! Surely you could be right 2 or three times out of 10 and make nice profits.
When looking at stocks, consider this idea. What is the downside risk versus the upside potential. If that ratio is very high, maybe it is worth taking the trade, even if you don't expect to be right. You can still expect to make money.
The expected value of a trade is what is important. Over a portfolio of stocks, it is the expected value of the trades and the standard deviation of those expected values that determines success. If you have a lot of positive expected values in your portfolio but a high standard deviation (how much the returns vary) then you can have big draw downs that will hurt your performance, and your confidence.
All of these concepts combine to make the following important:
Control losses, small losses when you are wrong are important. That means plan your losses and take them when the market tells you that you are wrong. There is nothing wrong with being wrong so long as you don't ignore the truth. Don't let small losses grow in to big losses.
Let profits run, when you are right let the momentum of the market work for you. It feels good to take a profit so work hard to not be swayed by emotion and sell your winners early. Sell your winners when the market tells you that the stock is now more likely to go lower than higher.
Track your performance and work to have consistently small losses and consistently large gains. If you have some large losses among your small losses you will have a high standard deviation and that will hurt your performance. Success is all about controlling risk effectively.
Don't worry so much about being right, worry about making money. Judge your success by your profitability after 10 or 20 trades rather than after one trade.
When you look at trades, ask your self three questions. How much will I make if I am right? How much will I lose if I am wrong? What is the expected value based on my expectation for being right versus being wrong? If that value is positive and the chance of a small loss turning in to a big loss is minimal then you are looking at a good opportunity.
Even if you probably going to be wrong.Back To Top
With market conditions as they are the goal for many investors is capital preservation. If we can manage a gain through the weakest time of the year in preparation for the market's traditionally strong period of November to May then we are ahead of most. With that in mind, I did a simple strategy this week that anyone with a Stockscores membership can do.
First, create a Watchlist of Exchange Traded Funds using the Stockscores Watchlist Creator. The symbols and an explanation of what Exchange Traded Funds do is available from a past edition of this newsletter, and can be found here.
I did a market scan on the my ETF Watchlist for those that had a Sentiment Stockscore of at least 55. This scan found 18 candidates. I looked at the individual charts of each to find those that have decent chart patterns and lower levels of risk. That process produced my picks for places to park some cash in an uncertain market.
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1. XLP
The XLP is the Consumer Staples sector, even in a weak economy people have to buy the basics. This sector is in an optimistic pattern and has a historical yield of 1.9%. Looks more likely to go up rather than down, but don't expect big capital gains here. Support at $23.90 has to hold.
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2. XLE
The Energy sector typically starts to show strength at this time of year as investors look toward third quarter earnings which usually are good given the summer demands for oil and gas. The XLE is a sector ETF that is showing optimism, it still has resistance that needs to be broken but so long as support at the last bottom of $54 can hold, I think it is worth considering.
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3. TLT
Bonds are a good place to be when there is uncertainty in stocks. The TLT is an ETF that holds long term bonds and the chart is showing a possible break of the long term weakness and perhaps a move back up. It also pays a yield, which historically is 4.8%.
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References
Get the Stockscore on any of over 20,000 North American stocks.
Background on the theories used by Stockscores.
Strategies that can help you find new opportunities.
Scan the market using extensive filter criteria.
Build a portfolio of stocks and view a slide show of their charts.
See which sectors are leading the market, and their components.
Disclaimer
This is not an investment advisory, and should not be used to make
investment decisions. Information in Stockscores Perspectives is often
opinionated and should be considered for information purposes only. No
stock exchange anywhere has approved or disapproved of the information
contained herein. There is no express or implied solicitation to buy or
sell securities. The writers and editors of Perspectives may have positions
in the stocks discussed above and may trade in the stocks mentioned. Don't
consider buying or selling any stock without conducting your own due diligence.
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