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Steve Sjuggerud's note: Dr. Van Tharp helped me dramatically improve my own investing. I first read about him in the legendary book Market Wizards. He's just re-released a revised and expanded version of his own classic book Trade Your Way to Financial Freedom. Among other things, this book teaches the specifics of trailing stops and position sizing to improve your results. Check it out!
Trade Your Way to Financial Freedom
By Dr. Van Tharp
March 12, 2007
Most investors believe there is some magic secret of the markets that will make them rich.
They think only a few people know this secret – those people who make vast fortunes from the market. Consequently, these people spin their wheels trying to discover the elusive secret so that they too can become wealthy.
Such a secret does exist. But the answer is where you would least expect it to be.
Over the last 20 years, I've worked with some of the top investors in the world. I've completed thousands of psychological evaluations on all types of investors. I use this experience to coach investors to help them achieve peak performance.
During my research, many of my own beliefs about the market were shattered. For example, when I started out trying to define the "model" of a successful investor, I thought I would find an investment system or a set of indicators that represented the true secret to their success.
But after interviewing about 50 of them, I discovered that none of them used the same methodology.
I learned that investors make money by thinking independently and by being unique, not by asking their friends and neighbors for advice and confirmation. I also learned that, even though most investors have a strong desire to be right about every trade, the real money is made through intelligent exits – which allows investors to cut losses short and let profits run. Ultimately, I came to the conclusion that all successful investors make money in the markets because they have what I call "internal control."
This internal control allows successful investors to accept both wins and losses. They don't equate losing on a trade with failure. Rather they realize losing is an important part of the winning process.
The problem for most of us is that controlling risk goes against our natural tendencies. We're taught in school that anything below 70 percent is failing. Yet successful speculators usually win less than 50 percent of the time. They are not successful because they predict prices well. They are successful because their profitable trades far exceed the size of their losses.
YOU CAN BE RIGHT AND STILL LOSE MONEY
Ralph Vince once did an experiment with 40 PhDs. They were asked to play 100 trials of a simple computer game in which they were guaranteed to win 60 percent of the time. They were each given $1,000 in play money and told to bet as much or as little as they wished on each of the plays.
How many of them made money? Only 2 of the 40 participants – a mere 5 percent – had more than their original $1,000 at the end of the game. None of the PhDs knew about money management (the effect of bet size) on the performance of such a game. For example, if they had wagered a constant $10 per bet, they would have ended up with about $1,200.
The results of the PhD experiment may surprise you. In fact, it was actually a good example of human nature. People tend to bet more after an adverse run, and less after a favorable run. Let's say your first three $100 bets are losers. Already you're down to $700. You think, "Since I've had three losses in a row, the odds are 60 percent in my favor, I'm sure it's time for a win." So you raise your bet to $400, and suffer and even bigger loss.
The PhDs didn't understand the effect of position sizing on your success. In my opinion, position sizing accounts for most of the variation in performance among money managers. A simple position sizing strategy of "betting" a percentage of capital, not a specific dollar amount, would have been the difference between making money and losing money for the PhDs.
A successful trade is made up of two parts – a buy and a sell. But nobody talks about how to sell – how to successfully exit. Good traders understand this... Good traders understand that it's not just about buying a "low P/E" stock, or a stock with a big pile of assets.
In order to have extraordinary performance, good traders know the importance of these three items as well to their investment success:
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The importance of exits to your profits and losses (i.e. trailing stops) |
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The importance of position sizing to your equity (so you don't end up like those PhDs) |
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The importance of discipline (assuming total responsibility) to make it all work. |
Once you understand and implement these key items, your investing success will improve tremendously. You may just trade your way to financial freedom.
To learn the full story on risk-limiting strategies, like position sizing and stop losses, check out Van's revised edition of Trade Your Way to Financial Freedom. You can order a copy here.
Good investing,
Dr. Van Tharp for DailyWealth |
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