Monday, January 18, 2010

What Is More Important Than Being Right In Investing?

Here is a list of the major methods of trading or investing:

  • Trend following – If you buy what’s going up, it will probably continue.

  • Value Investing – Buy what’s undervalued because it will eventually become overvalued.

  • Seasonality – The market tends to show seasonal patterns that you can capitalize upon.

  • Band Trading – It’s possible to draw bands to describe the nature of an investment. Those bands will allow you to sell when the price gets too high and buy when it gets too low.

  • Elliot Wave – The market moves in a sequence of five waves up and three waves down, and if you can understand the various levels to this, you can predict tops and bottoms.

There is a multitude of other strategies, but can you notice the relation between all of the above? Every investment method or strategy has its main focus on predicting. Predicting and speculation is what most people believe investing is about, and that is where they place most of there focus. For example, if you are a trend follower, you are predicting that the trend will continue in a certain direction. If you are a value investor/trader you are predicting that what’s undervalued will go up eventually.

However, observing the track record of some of the worlds greatest investors and richest men who use these methods, you will find that investing is not about predicting. These major players often have a winning trade or investment percentage of less than 50%. This means less than half of all investments or trades they make turn into a profit.

So how do they generate consistent double-digit returns year after year, sometimes even several hundred percent returns is they are loosing more trades/investments than they are winning?

It is because they cut their losses short, let profits run, and implement rigorous risk management. It is ultimately the risk management that separates the great investors from the bad. Their has literally been fortunes made on using astronomy (star alignments) for taking investments/trades, but what made the fortune was that they implemented sound risk management.

I have yet to hear anyone say, “I don’t make money picking stocks – I make money by cutting my losses short and letting my profits run. And more importantly, I meet my investment objectives through the judicious use of position sizing.”

Ultimately, it really does not matter what criteria/strategy you use for picking your trades or investments. That is only a small part towards the start of real investment success. What’s really critical is that you understand that you make money by cutting losses short, letting profits run, and employing risk management.

Understand the concepts of position sizing, margin requirements, the max loss you would accept in a given amount of time, the concept of stop losses, and other risk management methodology such as the Kelly Criterion, Variance, Standard Deviation,, and volatility. You do not have to learn all risk management, but just a few. Remember, that the criteria you use for getting in to an investment is not the only thing you should consider when finally entering.

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