The Trader’s Fallacy: Big Risks=Big Long Term Profits

The Trader’s Fallacy: Big Risks=Big Long Term Profits

Their is one huge difference between the winners and the losers in the market. New traders tend to go ‘all in’ on trades they are just sure will be winners. If a new trader wants to be around long enough to be a rich trader they better manage their risk per trade.

Here is a great example from teacher and trader Van Tharp, he this great example shows the real power of the risk of ruin to traders in a way they can really understand.

You will be ruined even with a winning trading system if you bet too much per trade.

To illustrate the importance of risk management, Van Tharp has participants play a trading simulation game.

  1. Van simulates 50 trades by pulling a marble out of a bag 50 times.
  2. Each marble represents either a winning or losing trade.
  3. You simply bet on whether he’s going to pull out a winner or a loser before he pulls it out.

60% of the marbles are winners, so if everyone were to simply bet the same amount of trading capital on every trade, they’d be highly likely to come out a winner.

But everyone doesn’t come out a winner, because they bet inconsistently on each trade.

Surprisingly, when Van Tharp plays the game, only a 3rd of the people in the room are winners. (This is even with the odds in their favor, trading is much more difficult with the odds being against most discretionary traders due to the counter intuitive nature of price movements).  Also, out of the other two-thirds that lost money, half of them lost it all, they were ruined– in a game with a positive expectancy model, the odds were in their favor, yet they could not capitalize on this due to their inability to manage the risk of ruin. This can easily happen when traders do not manage risk and trade based on feelings and emotions.

Everyone began with the same amount of money, but no two individuals in the room ended with the same amount of money (except those that went bankrupt, zero $’s). This all goes to show that the question, “How much capital do I risk on each trade?” is more important than the more fun questions, “What stock do I trade and where do I enter?”

Van Tharp had two special marbles in the bag to keep things interesting. One was a 10x winner – meaning if you bet $5,000 out of the initial (imaginary) $100,000 you were given to start with, you’d make 10 times your money on that bet, for a profit of $50,000. There was also a 5x loser in the hat. So if you bet $5,000 when Van pulled the 5x loser, you’d lose $25,000. This was a great addition to the game to account for the occasional ‘black swan’ event that happens in the markets when stop losses and position sizing fail to protect you from an excessive reversal.

Consider the Gambler’s Fallacy.

A simple coin toss with 50/50 odds. If a regular coin came up heads nine times in a row, what is the chance it would come up heads on the next toss? Pretty slim, right? Think about it – what are the chances that a coin would land on heads 10 straight times? It’s bound to be tails on the next toss, no?

Actually, the odds are 50/50 – exactly the same as the first coin toss. The coin has no memory of where it landed last time around. Each toss is unique.

This same idea – that each individual outcome is unique – applies to traders as well as players of  the marble game “My last three bets were wrong, therefore chances are I’ll be right on this one.” This thinking is the Gambler’s Fallacy. If you go with your initial feeling and ignore the Gambler’s Fallacy in your trading, chances are, you could end up broke, just like many of the players of Van’s game.

After all, in Van’s game you were practically guaranteed to win. But what are your guarantees in the stock market? There are none.

How did traders go broke in a game they were guaranteed to win? They didn’t understand the impact of “draw downs” and the “risk of ruin”

Let’s say that, after a streak of losers, you had $50,000 left out of your original $100,000. And let’s say you wanted to lay down a big bet to try and catch up with the rest of the crowd – say $10,000?

You may not realize it, but due to the rules of the game, you run the risk of getting wiped out. Let’s say that Van pulls the one 5x loser marble out of the bag, then you’re wiped out instantly. If you don’t fully understand what you have at risk, you will eventually “blow up” your account.

Accounts do not go back up as fast as they go down. Lose 1% of your total trading capital and you only need to get back 1%. Lose 10% and you need a little over 11% to get back to even. If you are down 20% you have to make a 25% return to get back to even. If your account falls by 25% this means that you will be faced with the epic challenge to earn 33% to get back to where you started. If you’re willing to allow your account  a 50% draw down, you’ve got to earn 100% to get back to where you started.  How long does it take you to double you trading account? And if you go ‘all in” and your trading account falls 90%, it has to rise 900% to get you back to where you started. That is the mathematical problem with losing your trading capital.

If you limit your total capital risked to 1% per trade, you will rarely have to deal with draw downs of greater than 10%-20%. This will give you a great advantage over other traders in your likelihood of long term success.

Accounts take the elevator down but the steep stairs back up. Protecting you capital is job #1.