“A prudent question is one half of wisdom.”
— Francis Bacon
Prior to discovering the effectiveness of simple trading, we thought a high win rate was paramount. It’s well settled that if you win more than you lose as a trader, you’re bound to make money yes? If you win substantially more frequently than you lose, you will make lots of money right?
We recently had a gentleman reach out with a problem he was experiencing in his trading. The essence of our conversation is paraphrased below. We pick up after the pleasantries:
Trader: So I can’t seem to make any headway with this trading thing. I do the research and only buy good companies, but my account stays around breakeven at best. Any thoughts?
TAOST: I would have to look at your trades in detail, but I’m guessing you need to lower your win %.
Trader: I need to WHAT? You mean raise my win % don’t you?
TAOST: No… I mean lower.
Trader: Uhhh… I think you better explain that one.
TAOST: It’s simple… I’m guessing you do about as well as anyone else picking stocks, but you fall victim to the need to be “right… ” So you keep losing stocks way too long and jump out of winning positions too quickly. Jumping out of stocks helps you feel good and probably keeps your win % north of 50 or 60%…
Trader: (proudly) 73%
TAOST: But doesn’t add anything to your bottom line.
Trader: I don’t get it…
TAOST: Think of it this way, if I give a you choice between a system that wins $1 99% of the time and loses $99 1% of the time or a system that makes $99 1% of the time and loses $1 99% of the time, which would you want?
Trader: $1 99% of the time? That means a 99% win ratio? That’s the one I would want for sure, but I’m guessing this is a trick question…
TAOST: No… it’s not a trick question… although it IS a bit tricky for most investors. It has to do with the way most of us have been taught since early childhood. The higher “win” percentage has always been better because it was the result that was rewarded. The higher “win%” got the better grades, the better sports record… the better “life.” It would seem that we could simply transfer that framework to trading and press play… Doesn’t work that way. In trading, the magnitude of the wins and losses matters just as much as the net result. In the case of the 2 systems above to win $1 99% of the time with a chance of losing $99 1% of the time seems like the better bet because you get to be “right” way more often than not. However, if you were to simulate that system over lots of “trades” you would find that the net outcome would be a loss. Alternatively, if you simulated the results of the 1% chance of winning $99 to the 99% chance of losing $1 over a large number of trades, the net result would be positive. This is what’s known as expectancy and it is way more important than just a win loss %.
Trader: OK… I think I get that. But how does that mean I need to lower my win%?
TAOST: (Laughs)… I said need for effect… all else equal, a higher win % is always better. The point was to get you to focus less on keeping your win % high and more on the size of the wins relative to the losses… In other words, cutting your losses short and letting your winners run. I tell my students that you want to lose fast and win slow… as long as the losses are quick, small losses and the winners are slow, big wins.
Trader: Ohhhhh… I see… So, in other words, you HAVE met someone who went broke taking a profit…
TAOST: Maybe not broke… but they certainly didn’t make any money when their average loss was larger than their average win.