Being Right and Making Money Are Not Equivalent
Trading Wisdom from Van K. Tharp on "being right":
How important is it for you to be right? Let’s say I could guarantee that you would make money by the end of the year — lots of money — but you would probably lose money on 90% of your trades. Would you like that? Could you tolerate that? Would you accept that? Most people would probably answer "no" to all three questions. And if that is you, you probably are denying yourself the opportunity to make money simply because being right is more important than making money.
Some of you might be saying, "How could you be wrong 90% of the time and still make money?" The solution goes back to the golden rule of trading, "Cut your losses short and let your profits run." Let’s say that 90% of your trades lose money and that your average loss is $100. On the year you make 100 trades so you end up losing 90 of them for a total loss of $9,000. However, let’s also say that your average winning trade is a big R-multiple. It’s an R-multiple of 100 or a $10,000 winner. You have ten of those in a year, so you end up making $100,000 on your winning trades.
If you subtract your winnings from your losses, you’d end up with a profit of $91,000 at the end of the year. You make $91,000, yet 90% of your trades are losers. My guess is that 99% of the trading population could not trade a system that would produce those kind of results. The reason is because they don’t get to be right enough. They have too many losing streaks. They have losing streaks that are longer than five in a row. Most people cannot tolerate long losing streaks. When they occur, they totally abandon what they are doing.
In such a system you could easily have 25 consecutive losses. At that point you become certain that your system is broken, and you try something else. Let’s look at the opposite end. Suppose you got to be right 90% of the time. Suppose your average win was $100 and that your average loss was $2,000. This means that you’d have a total of $9,000 in winnings and $20,000 in losses. You would lose $11,000. Would people trade that system? Yes, they would. They would probably trade it for a number of years until they went bankrupt. Why? Because they get to be right most of the time and that is very rewarding.
You might be saying, but how could people possibly tolerate losses of $11,000 after 100 trades? It is easy, they turn the losing trade into a long term investment in their mind and say "it’s only a paper loss." For example, I’ve had workshop attendees who were probably way above average in terms of sophistication.
However, I asked them to raise their hands if they had an investment in their portfolio that was only worth 50% or less of what they paid for it. Eleven people raised their hands—over a fourth of the class. And my guess is that among the overall population of investors, most people are sitting on a number of big losers, hoping they will come back. Why? Because they cannot stand to be wrong on an investment and they are waiting to be right on those losing trades.
What is the cost of having losing investments in your portfolio? It’s major. First, you are using valuable capital up with nonproductive investments. Second, you are missing many good opportunities. There are two primary reasons why we focus on being right.
First, we are conditioned to be right by the school system. Second, everyone in the trading industry gives people what they want – ways to be right – which tends to perpetuate the myth. Let’s take a closer look at these two reasons.
First, we are conditioned by the school system to the importance of being right. In school you are taught that there are right answers and wrong answers. What is a right answer? If you learned how to survive in the system, you learned that a "right" answer is whatever the teacher wanted. Your performance is measured periodically through tests in which you are asked to pick the right answer.
If you cannot get more than 70% right on the test, you are labeled a failure and ostracized. Your humiliation might even be in public in front on all your friends. And if your humiliation isn’t public, it certainly is semipublic. Your "poor" performance goes home in the form of a grade with a comment that "Johnny is a little slow or Johnny is bright, but he just doesn’t try."
Usually, at this point, the most important people in your young life get involved - your parents. Even if you understand the system and work hard to know the right answers, you still might be taught that your performance is not good enough. It usually takes 94% right to get an excellent grade. But how many children go home and show their 94% test to Dad only to get the response, "Why didn’t you get 100%?" Thus, it is no wonder that traders want to be right all the time. And being right usually costs them dearly in terms of profits.
Whether you’ve been through 20 years of schooling and have a graduate degree or less than 10 years of schooling, you still have the same conditioning about being right.
The second reason people want to be right is that service providers for traders and investors feed the bias to be right. First, software vendors tend to provide systems that can be highly optimized. Once you’ve optimized your trading, you can lay a line over the prices and see exactly where you should have bought and sold. It seems obvious. However, the same optimized system does very poorly when applied to the real world.
At investment conferences, the hottest speakers are those who provide information about high probability entry techniques. If you say "trade with the odds on your side" and show someone a technique that is right 75% of the time, you’ll get a large audience. Yet most techniques of this nature usually have big losers and may not even have a positive expectancy. Nevertheless, being right 75% of the time is all is takes to get people to trade them.