You can lose money even if you select the right stocks

Yes, you can lose money even if you select the right stocks. This is especially true when you are a trader but not applicable if you are a buy-and-hold investor. For a buy-and-hold investor, accuracy is important as you only select a few stocks and hold them for a long time. You simply cannot afford to pick the wrong stocks. However, a trader makes trades in and out of a market frequently, accuracy is not as important. The key lies in expectancy.

Let me first define what do I mean by accuracy and expectancy. Being accurate means you are able to pick a stock that eventually goes in your favor, generating profits for you. Expectancy is a little more complex than accuracy or even probability. The concept would be easier to grasp through the following illustration:

You have to think in terms of risk-reward ratio.

Let us take the amount of money that you are willing to risk as R. You may choose $1000 as R and you will need to express all your wins and losses in multiples of R.

For e.g., if you risk $1000 and gain $2000, you have 2R profit. If you risk $2000 (2R) and gain $4000, you have 4R profit. Easy? Let’s move on.

Next, you need to find out your average gain and loss. Usually, traders do it with simulation as you need a considerable amount of trades (at least 100) to calculate these figures. If you have already been trading, you can calculate based on your past trading records. What you can do is average out the profits (likewise for losses) that you have and express them in terms of R multiples. It will then look something like this:

Let’s say you made 100 trades and your R = $1000
If your records show total profits of $100,000 and total loss of $50,000.

gain per trade = ($100,000/100)/$1000 = 1R
loss per trade = ($50,000/100)/$1000 = 0.5R

The next step is to calculate your probability of wins and losses. Let’s say out of the 100 trades you have made, 40 are winners and 60 are losers. You will have a win probability of 40% and a losing probability of 60%.

Once you have your “vital stats”, you can calculate the expectancy:

Expectancy = (probability of win) x (gain per trade) – (probability of loss) x (loss per trade)

Your expectancy in this example = (0.4) x (1R) – (0.6) x (0.5R) = 0.1R

As long as your expectancy is positive, you will make money by trading consistently over the long run. The higher the expectancy, the more profitable will be your system.

Why accuracy is not important?

After defining what accuracy and expectancy mean, we are ready to see why the former is not important.

For example, you are very accurate being right 90% of the time (and lose 10% of the time). While, your gain per trade is 1R, and loss per trade is 10R.

Expectancy = (0.9) x (1R) – (0.1) x (10R) = -0.1R

Can you see even if you are spot on with stocks and right 90% of the time, you can still lose money! Hence, the key is to increase your gain per trade and reduce your loss per trade. This is why the mantra of traders is “let the profits run and limit your losses”. Expectancy tells you the true edge that you have when you trade long term.

It is just like baseball…

Swing for the home run even if you miss the ball most of the time. Because the gain in score for a home run more than covers the misses you had.