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The Profitable Investor
Let's look at the
differences between profitable and unprofitable investors. Is it
a question of experience, or are some folks just born with the
talent to play the markets successfully? How does risk tie in
with profitability? Are profitable investors more willing to
make riskier trades?
Author Mark Douglas talks about three stages in becoming a
profitable investor. First you learn how to find promising trade
setups. Second, you learn how to enter and exit those positions
at the right time. Third, get to a point where you build equity
on a consistent basis. The secret to this third step is really
no secret at all. You master the discipline required to follow
your methodology, plan or system.
Investors need to make an important choice early in their
careers. They can decide to follow a specific method that forces
them out of the market during unfavorable conditions. Or they
can master a broad range of skills, and then apply the right one
at the right time. Neither approach is right or wrong, but both
require paying close attention to the profit-and-loss
feedback.
Most unprofitable investors rely on a poorly matched execution
style, or a good one they haven't mastered yet. Very often they
fail to recognize critical errors in their methodology because
it was learned in a book, or through inappropriate conditioning,
i.e., making money on bad decisions. Realize that profitable
investors know all the weak points in their strategies and
exercise damage control at all times.
You can't understand your methodology until you analyze your
profits and losses. Identify its weaknesses quickly, and then
decide if it really works at all. You may discover that your
whole approach to the market isn't right for your lifestyle,
emotional nature or long-term goals. For example, you could be a
scalper with the disposition of an investor, or a daytrader who
hates risk. Bad things will happen when your system doesn't
match your personality.
Investors hate to think about discipline. After all, it's not as
sexy as just becoming a market gunslinger. But the bottom line
is that most of us don't follow our own rules. This is ironic,
because the folks who ignore the reasons they lose money are the
same ones who spend thousands of dollars attending investing
seminars. Personal discipline is the one thing you can't learn
sitting in an audience.
Discipline and money management go a long way toward becoming a
profitable investor. But let's be realistic. However you invest,
you must be confident in the positive expectancy of your
style or methodology. This poorly understood concept refers
to how much profit you can reasonably expect to make vs. each
dollar risked on a trade. Gamblers know this equation as the
player's edge in a casino. The problem is that most of us don't
understand our strategy well enough to determine whether or not
it has a positive expectancy.
System traders use backtesting to gauge the positive expectancy
of their systems. Retail traders choose entry and exit without
this methodology, so they need to compensate through extensive
record-keeping and analysis of each trade result. Even so, they
could be fooling themselves into believing they have an edge in
their pursuit of profitability.
The sell side of the positive expectancy equation is more
important than where you buy. Research suggests that a very
profitable system can be built using random trade entry. Yes,
you heard that right. It's possible to make money in the same
way as a chimp who throws darts at a dartboard. But the hairy
primate still has the same problem as the losing investor: He
doesn't know when to take money off the table.
Positive expectancy requires a robust exit strategy. But you
already knew that, didn't you? Volumes have been written about
money management techniques, such as cutting your losses, riding
your winners and trading adequate reward/risk. But somehow,
losing investors continue to outnumber profitable ones by a very
wide margin.
One aspect of positive expectancy is more difficult to manage
than any pure numbers game. All investing styles experience
drawdowns, and profitable ones are no exception. Investors
routinely abandon profitable methods because they hate to lose
money. They stop following perfectly good rules because they
aren't getting the instant gratification they want from the
markets.
If this all sounds like a big loop from the top of our
discussion, it's meant to be that way. Losing investors get
stuck in a vicious cycle. They want to profit from the market so
they come up with a strategy to make money. They trade the
strategy until it frustrates them to the point they abandon it
and go looking for another strategy. In the process, they never
take the time to find out whether or not it had positive
expectancy in the first place. In other words, they don't let
their methodology mature enough to watch its real potency bear
fruit.
Which brings us back to discipline. Sure, it's boring to plan
the trade and trade the plan. But it's the only way to break
this losing cycle and get on the road to consistent
profitability.
Alan Farley |
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