Execution is everything. We can plan and work and research and do all the little things well, but at the end of the day, the results are what pay the bills. Complexity is the enemy of execution, which is why it is so difficult for novice traders to grasp the concept of simplicity in regards to trade setups.
Anyone can get lucky and win the lottery. Anyone can randomly pick a winner. But very few achieve long term success. If you want to be one of the few, you need much more than luck. The best traders aren’t lucky. They have a different set of beliefs. They have a different strategy. They do things differently than everyone else, which is why they’re in the small percentage that succeeds.
The elite investors understand these principles must become their obsessions. Second nature. They are a part of their daily routine. Our main principle is 5 to 1 Risk Reward. With this aim, we have the ability to be wrong 75% of the time while still making money. Now on the flip side, the average Vegas gambler (or rookie trader) aim for the elusive 2-1 bet. People anchor to that risk/reward like it's the last life vest on the Titanic.
The fact of the matter is that this is a LOSER’S STRATEGY. To make money, you need to be right more than you’re wrong, and contrary to popular belief --- the odds are never in your favor. Why do you think there are sayings such as “The house always wins” --- because they do.
It doesn’t matter if it’s blackjack or a stock trade, being right more than you’re wrong is a very difficult task. Why do you think we focus on big wins and small losses? So we don’t HAVE to be right more than we’re wrong.
“Rule #1: never lose money. Rule #2: never forget #1.”
Notice how this famous Buffett quote doesn’t say “make money” focusing on the upside, but instead says “never lose money” focusing on his downside risk. If we’ve said it once, we’ve said it a million times, this game is about risk management & longevity.
If the richest man in the world’s most famous quote focuses on downside risk, shouldn’t that speak volumes in how important protecting it is?
This simple analysis pretty much sums up our whole trading strategy. Big wins & small losses. We gladly take four 1% paper cut losses in a name to capture 15% when we finally get it right.
Novice traders often forget to focus on the downside --- they just want to think about how much they’re going to make. If you don’t focus on your risk, your account will be wiped out quicker than you could imagine.
Tight sell stops are like seat belts. I can get into 1000 fender benders with my seat belt on. Even in a big accident my odds of surviving are dramatically increased. However, the cool guy not wearing his seat belt needs one bad accident to just end it all. ONE 50% loss needs a 200% gain just to break even. FIVE 1% losses need a 10% gain to break even - you do the math.
Wear your seat belt. Focus on downside risk.
“The most important thing for me is that defense is 10 times more important than offense. You need to be very focused on the downside at all times.”
Paul Tudor Jones
They say you never learn a lesson like losing money -- and it’s true! Losing money is a painful experience.
“I don't look to jump over 7 foot bars, I look to step over the one foot bars.”
The majority of new traders gravitate towards the wrong mindsets in the beginning. What are those, you might be thinking? They end up buying the cheap stocks. Now this is another one that blows my mind, like the 2-1 blackjack gambler.
Where, anywhere in life has the cheap thing been better than the real thing? Gas Station Sushi, anyone? Nosebleeds vs front row? Celebrity vs nobody? Rich vs poor?
Never once has the cheap option been the play. But why do novices do it? Because their perception is off. In their mind, it’s EASY for a $1 stock to double and become a $2 stock. So SIMPLE! Notice where the focus is --- the upside. Rookies never put the main focus on the downside risk. When you’re trading these highly speculative (fake) companies, all it takes is a bad news article to wipe them out of business leaving you with a 100% loss. Tough to trade with no money!
That is why we focus on the rich names -- the Ferrari’s, the Louie Weekender’s, the Rolex’s of the world. We will gladly let the limo drivers keep the cash tips while we're charging the clients $1,000 an hour.
So in these cheap names, the dollar names, you really think they're all going to $5 and that you’ll be able to stay in long enough for that grind to $5? Or will you sell your winner fast like most new traders as soon as it gets to $1.10? They then kick themselves as it continues to climb only to buy it back at $2, only to get scared and sell it as soon as it comes back down to $1. The roller coaster ride new traders just love so much.
Now, what do you think is more likely of a $100 stock; it goes to $0 or to $200? It is much more likely for the $100 stock to go to $200 than it is for the $1 stock to go to $10. These are not opinions, these are facts. $1 stocks more often go to $0 than even $2. Fact.
That’s where the Asymmetric Risk Reward comes in. For every dollar I am risking, there is a far greater chance the upside can be even higher than expected. Just like when you look at a $20 stock you're like there's no way it could be a $100 stock in a year. Then you fast forward a year and you’re looking back like “How the fuck was this stock $20 a year ago?” (NVDA anyone?)
Let's think of a seesaw for a minute. When one friend jumps off, they rise while the opposite side falls. This seesaw could be Smart Money vs Dumb Money, Growth vs Value or even Stocks vs Bonds. The most broad debate has been debt vs equity. In the college professor’s perfect world, stocks and bonds should move like two people on a seesaw in opposite directions.
In our current Federal Reserve economy, the equity side has an extra friend on their side holding the seesaw in their favor. Now that is one fat fucking friend. Why? Because the Bond market weighs 10 times the amount of the stock market. Meaning for every $1 in the stock market, there are $10 in the bond market.
With the Fed raising rates, it adds more friends to the stock side of the seesaw. Over time, the bond market gets lighter as the equity gets fatter. So when people say, “The market’s too high to get in right now”, which is the same thing the 2-1 gambler says, they are not understanding the full dynamics of the situation. All they see is the market going up, but they don’t understand the money from the sidelines coming into play. If all the fat kids are jumping on the equity side it will continue to win until everyone is on one side.
Think back 5 years ago, what were some of the hottest fashion trends?
These trends are probably no longer in style today, correct? It isn’t very likely. The same thing happens with stocks, one year's high flyers can be the next years duds. Everything is cyclical, what is hot now can turn into ice before you or I know it. One of Ray Dalio’s greatest secrets to his approach, his holy grail so to speak is to have 15 or more good, not great, uncorrelated bets. In other words, it comes down to owning an array of attractive assets that don't move in tandem. By having yourself spread out across different asset classes, Ray states that you can reduce your overall risk by 80%.
When it comes to diversification, there are 4 staples that we follow:
- Diversify across different asset classes - example stocks, bonds, real estate, etc.
Diversify within an asset class - don't put all your money in one tech stock like Apple and think that you have the tech sector covered.
Diversify across markets and countries - we live in a global economy, there can be attractive opportunities just over the pond.
Diversify across time - we would love to be right every time however we know that it's just not realistic. When dollar cost averaging or building into positions you can really get a feel for how the trading is working, sure sometimes you are perfectly right and it never looks back -- but that's a problem I would love to have more often.
Do you have balls?
What was something you were extremely passionate about 5 years ago that you could care less about today?
POST IN TRADING PSYCHOLOGY CHAT
What was an investment years ago that you felt was a sure thing that now you just laugh at the thought of it?
POST IN TRADING PSYCHOLOGY CHAT
You are almost there, just 10% left and you will be passing the finish line!