Qualitative aspects Michel Pireu     | Business Day Tuesday, January 29, 2019
The great secret to succeeding in the market may be selling, not buying. There’s only one time when selling is easy: when you've lost faith in your investment. If you sell when a stock is down in price you’re taking a loss and it feels like you’re giving up on something that you shouldn’t. It’s even more difficult to sell when a stock’s price is soaring. But even the staunches of buy-and-hold investors need to know when to sell.

“We sell when things become grossly overvalued,” says Martin Whitman. “We are just not that good at selling when things are moderately overpriced. I’ve been doing this for a long time and I’ve held securities for three years and sold them after they’ve doubled only to see them triple over the next six months. When you don’t know what you are doing, doing nothing is the best course of action.”

“Any idiot can buy, but if you don't know when or how to sell, you will never make money,” says Albert Thomas. “As a floor trader, when I took a position in anything, whatever it was, I immediately put an open stop loss order on that position. That way I knew exactly how much I was willing to lose, rather than how much I was going to make. Everybody thinks when they buy something they’re going to make a fortune with it. I'll tell you this: nine times out of ten you're not, and probably higher than that. You can't believe all of this stuff that they write, because they are constantly pumping up stocks.”

Combine what Thomas is saying with what Whitman is saying and you have the ubiquitous market mantra: “Cut your losses short and let your winners run”.

As Wikipedia puts it, “The results-orientated investor follows his plan for buying and selling whether it means selling at a gain or at a loss. He never sells a stock that is making a new high, since his concern is not in selling the top but rather in letting his winning positions run their course. He does not mind selling a stock after it has retreated in value, if being patient through price corrections is what allows him to capture the occasional big gain.”

When probability plays a large role in outcomes, it makes sense to focus on the process of making decisions rather than the outcome alone. In that process, allowing for periodic and inevitable bad outcomes is crucial. But there has to be more to it than that: Obviously, to be sustainable, the profits from your winning trades have to be bigger than the losses from your losing trades. That’s not to say that you have to have more winning trades than losing trades. It’s easy to have the wrong idea about making money in trading; to assume that you have to be right more often than you’re wrong. A study of the best traders shows that doesn’t have to be the case. A good example is Peter Brandt, a trader featured in the Market Wizards series by Jack Schwager, who averaged annual returns of 77.8% over 18 years, despite the fact that he was right only 35% of the time. In his worst year Brandt made a loss of 8.4%, in his best year he made a profit of 604%.

Something a lot of investors don’t realise when they assume they can simply cut their losses short and let their winners run: in order for it to be sustainable you need your average profit to be much bigger than your average loss, because while you have some control over your average loss you have almost no control over your average profit. Although individual trades might generate unavoidably large losses (a stop loss is not always the answer), over a series of trades your average loss can be adjusted to be profitable - made tight enough to cover a series of many more losses than wins.

As for achieving sufficient wins … well, that’s an altogether much harder thing to do.

Nick Radge, an Australian trend follower, in an ATAA presentation some years ago said it’s about looking in the right places, or, more importantly, learning how to look. In this regard, he talks about two facets of trading: quantitative and qualitative.

Radge explains the difference between the two using the analogy of driving a car. “The quantitative aspects of driving include things like putting your foot on the accelerator to go forward, turning the steering wheel to turn, using the brakes to stop, changing gears to go faster. They are teachable. You can take driving lessons and learn to do them. To come back to trading, it’s the sort of thing you can learn from books, seminars and courses: entry patterns, indicators, risk-taking, trade durations, etc. But that’s not what’s going to make you a successful trader. Because all you’re learning is the quantitative aspect of trading. What you haven’t been taught, and maybe it can’t be taught, is the qualitative aspect of trading. In the car analogy, the quantitative aspects of driving would include things like understanding the flow of traffic, anticipating what the other drivers around you are going to do, gaining a sense of a dangerous situation - and so it is with trading. We go to seminars and courses and we buy the books, but all too often fail to succeed as traders for the simple reason that we haven’t learnt the qualitative aspects of trading. As a result, to give a few examples, we tend to underestimate the impact of sample significance, whereby we make decisions on the outcome of too few trades; we don’t allow for the fact that, at a 50% win rate, at some stage we’re more than likely going to experience a losing streak of 16 trades in a row; we miscalculate our ability to take losses by assuming we’ll be safe provided we don’t put more than 2% of our money at risk on any one trade, overlooking the fact that a losing streak of 16 trades will compound to a 32% loss – which will likely prove difficult to deal with.And we underestimate the level of work required on an on-going basis to succeed as a trader.

Between 1988 and 2008 Bill Eckhardt achieved an annualised return of 25% - turning a $10,000 investment into $448,600. But in that 20 year period he suffered four losing years, six losing streaks of four months or more and, on average, completed 1,119 round trades a year.

“We all want to be a Eckhardt,” says Radge, “we all want a 25% annual return, but bugger if we want to go through the pain to get there.”
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