January 24, 2011

We often hear that over 80% of traders are on the losing side of the stock market game. Therefore, the first question is why so many traders fail. I believe it is in the way they play the game.

A few years back a professor (forgot his name, sorry) made up a test for his bright graduating students (most in management and economics). The game was simple and described as follows:

    1.  Each student was given 100 points.
    2.  They could place bets on the outcome of a 100-coin toss.
    3.  They won, it doubled their bet; they lost, well, they lost their bet.
    4.  The coin had a 60% chance of turning up head.

The students agreed to the rules and the winner (the one with the most points) would get the real money prize. The similarities with a stock market game were relatively close: an upward 10% drift with Gaussian volatility. The toss was the same for all, and no player could do anything about it.

Where it gets interesting is in the results. 80% of the students lost their entire stake. Even though, the only viable strategy, which was obvious to all, was to bet head on every toss. This is like playing the stock market game with a 60% hit rate. And if you look at the math of the game, a 10% edge can be considered impressive, if not outright alpha-generating. Then why did most students fail?

The answer is in the way the students played the game: for most, their trading strategy was mathematically biased to fail. Their betting method did not respect the game for what it was. The outcome of any toss was still a gamble even with 0.60 odds. Doubling up or doubling down (playing martingales) were sure ways to end up at the bottom of the heap. Playing using optimal-f, or by the Kelly number where also almost sure ways to fail. The dip-buyer lost, the doubling down player lost, the optimal-f trader lost, the big bet at every turn lost. What got them was the variance of the game. They would go broke long before they had a chance to profit from the upward bias.

Those who won (the 20%) were those playing with smaller bets and the biggest winners where those improving on their bet size as profits increased. It was with their position sizing methodology that they won the game. They played within the constraints and stayed within the variance barriers. The overall winner was still a lucky student, and no one could have predicted who it would have been from the beginning of the game. He played with a long-term view; he knew his expected outcome, the variance of the game, and placed his bets accordingly. 

Many of the principles learned from this simple game have been applied in my trading methodology. Small bets spread over many stocks, so as to reduce the impact of any one bet while staying very well within the variance of the game. You generate alpha by your position sizing methodology which is reinforced by the reinvestment of part of the generated profits. 

So, the first thing to do is stop playing the game the way the 80% fails. Look at the “investment” game with a long-term view. Spread your bets and reinvest part of your profits just like you would dividends. Study the game for what it is and let it teach you how to play. Then, play the game under your conditions, within your constraints, and by your own rules.

You don’t play the game to be right, you play the game to win.

Created on ... January 24, 2011, © Guy R. Fleury. All rights reserved.