Sunday 1 April 2012

Success in using Trading Strategies

Success in using Trading Strategies

While going through what's probably an ancient book (by today's standard of viewing a week-old article as "old"), I came across a very interesting study - the Ralph Vince Experiment. For those who are interested in the name of the book, it is "The Complete Guide to Day Trading" by Markus Heitkoetter.

First, the details of the experiment:

The Ralph Vince Experiment

Ralph Vince is a well-respected and well-known financial investor and educator. He's published a number of books on trading and the trading industry, and he also performed a very famous experiment known as the Ralph Vince Experiment.

Mr. Vince took 40 Ph.D.s and set them up to trade with a computer game.

Now, these 40 people all had doctorates, but Mr. Vince made sure that none of their doctorates involved any sort of background in statistics or trading. In the game, each of them were given $1,000 and 100 trades, with a 60% winning percentage. When they won, they won the amount of money they risked. When they lost, they lost the amount of money they risked. Simple. As you can see, ALL of them had a profitable trading strategy.

So, after all 40 had completed their 100 trades, how many do you think made money?

Only 2 - Just TWO

Only 2 doctorates out of 40 were able to make money. The other 38 failed to succeed.

Source: CSI News Journal, March 1992

I've been in the investment world for over a couple of decades now. With reasonable success. As an investor - not as a trader. Certainly not as a day-trader. I'm aware that a vast majority of investors end up losing money in the stock markets. I should admit that I've periodically wondered why?!?!??!

While it is true that I've always been surprised by this, I'd not bothered to think much about it till I started reading up and doing some research in the field of Behavioural Finance.

Here are a few reasons for such high overall failure rates:

  • Traders hate - Hate - HATE to book losses - Intellectually they know that they should "cut their losses" and "let the profits run". Practically, they often fail to "cut their losses". Instead, they let the losses run due to:
    • Ego hassles - they don't like to admit even to themselves that they were wrong
    • Loss aversion - they don't like to actually incur the loss - as long as it is a paper loss, it is OK!
    • Hope - Surprisingly large number of traders almost have a belief that "Hope" can be a winning strategy!
  • Greed - Traders love profits - Hence, traders commit one of two cardinal sins:
      • They often book profits very quickly - only to see the stock run on in an upward trajectory after they've sold out or ...
      • They want to catch the "Peak" - And wait till eternity, only to see all their paper profits evaporate
    • And they repeat the above two sins every day, week, month and year - without fail.
  • Traders don't learn lessons from history.
    • Despite knowing that guys of the calibre of Warren Buffett, Rakesh Jhunjhunwala, etc. earn "ONLY" x% p.a., they seek to earn 3x, 5x, 10x% p.a.
    • Despite knowing that old story of the inventor of Chess (who asked for 1 grain on the first square, 2 on the second, 4 on the third, 8 on the fourth, 16 on the fifth square, etc. - only to make the king realise that his entire kingdom will never be able to meet the demand of the inventor of chess), traders still fall for every single Ponzi scheme that comes their way
    • They firmly believe in the "Greater Fool Theory" - Not once do they begin to wonder if they will end up being the "Greatest Fool"!!
  • Traders seldom bother to invest time, money and energy to learn - In virtually every other field ranging from law to medicine to engineering to agriculture to fishing to cricket to singing, people put in enormous efforts to learn - BEFORE they start performing. Unfortunately, trading and investing in equity is one field which everyone tends to assume "is easy". They literally follow the NIKE slogan - Just do it!
And most importantly, a vast majority of traders KNOW all the above points and still continue to make virtually EACH of the above mistakes

Do we still wonder as to why many old-timers equate "Equity investments" with Gambling???



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