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The Market is not a Game

Ashley Revell, a 32-year-old Londoner, accomplished an extraordinary feat in 2004 by doubling the total amount of his financial assets. With only this information in mind, I now ask you the following question: would you be willing to entrust your retirement fund to Ashley Revell?

I am convinced that many people would be open to the idea. At first glance, the proposal seems enticing. Indeed, an investor's main objective is generally to obtain a good return. Whether it's buying a mutual fund or adopting an active trading system, the investor learns about past performance and often makes his decision based solely on the results. However, according to Rolf Dobelli, entrepreneur and writer, human beings attach more importance to a piece of information that is obvious to them, to the detriment of another that is not. To explain this concept, look at the following two series of numbers:

  • Series 1: 724, 947, 421, 843, 394, 411
  • Series 2: 239, 865, 261, 795, 639, 756

According to you, in each of these sequences, what do the numbers have in common?

For Series 1, the answer is simple: each number includes the number 4. As for the Series 2, the answer is more difficult: no number contains the number 4. By virtue of this principle, in the case of Ashley Revell, a little more in-depth analysis would therefore reveal shortcomings in the strategy employed. After selling everything he owned, he flew to Las Vegas. His goal was to bet the total amount obtained, $135,300, on the red color on a single spin of roulette! As you can imagine, he won his bet...

In the market, there are two basic rules to follow. Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.

Warren Buffett

Of course, I strongly advise against trying this experiment. Yet many people behave in much the same way in the stock market. Like a casino, the barriers to entry are negligible: it is possible to trade all year round and obtain explosive returns. Unfortunately, this leads us to abandon risk management. Many investors even claim that the stock market is a game, in that the performance is attractive, but completely random. However, nothing is more wrong.

As Rolf Dobelli would probably remind us, it is necessary to attach importance to the preservation of capital, a less obvious factor over which we have an understanding. Unlike games of chance, the result of a trade is not binary; in other words, there are not only two scenarios: you win a sum of money or you lose your investment. In fact, we can liquidate our investments at any time, which allows us to limit financial losses.

Certainly, lack of discipline is often the cause of a disappointing market performance. It is this aspect that differentiates an amateur from a professional. The latter recognizes, on the one hand, that it is illusory to hope to have only profitable investments and, on the other hand, the asymmetry of return between a profitable position and a losing position. For example, when a stock goes from $8 to $10, it has gained 25%. In the event that it has dropped from $8 to $6, it needs a return of 33% to return to its entry price. That's why it's imperative to be both patient when transactions are winning and impatient when they are losers!

Practical Tip

According to Steve Spencer, one of the founders of SMB Capital, the success rate of a good active trader is about 50%. Knowing that, on average, one trade out of two is losing, it is suggested to establish a maximum amount of loss per position by setting a percentage between 1 and 5% of the value of the portfolio. For example, for a portfolio of $100,000 and a maximum risk of 5%, no trade will result in a loss of more than $ 5,000. Thus, the risk of ruin (that is, the value of the portfolio falls to zero) is greatly reduced. In this regard, according to Option Alpha's Kirk Du Plessis, we only have one chance out of 10,400,000 to make 20 consecutive losing trades with an average success rate of 50%!

Maximum Risk per Transaction According to Portfolio Value

Portfolio value 1% 2% 3% 4% 5%
$5,000 $50 $100 $150 $200 $250
$10,000 $100 $200 $300 $400 $500
$25,000 $250 $500 $750 $1,000 $1,250
$50,000 $500 $1,000 $1,500 $2,000 $2,500
$100,000 $1,000 $2,000 $3,000 $4,000 $5,000

I invite you to take stock investment seriously by adopting a robust methodology, and above all, rigorous risk management, otherwise your efforts will be worth no more than a spin of the wheel...

If you'd like to deepen your knowledge of the subject, attend the presentation I am delivering as part of a seminar tour taking place this fall in Montreal, Quebec, Trois-Rivières, Sherbrooke, Gatineau and Saguenay. For more information, visit disnat.com/avantages/tournee-educative (in French only).

Sources:

  • Kirk Du Plessis. Trade Size & Capital Allocation, Alpha Option, 2018.
  • Rolf Dobelli. The Art of Thinking Clearly, Harper, 2014, 384 p.

The author

Michel Villa

Michel Villa

Speaker, stock market blogger and trading coach