From the previous article 'How does a casino get so rich?', we have learnt that casinos are operated based on 2 simple principles:

1. it has a slight edge over the players and
2. it takes large number of small bets (law of large numbers)

We also know that in the short run, a casino may lose money, but in the long run it is guaranteed to win. It is amazing that the casino's strategy can be so powerful, when all it has to do is to follow these 2 simple principles. Upon closer investigation, it is not difficult to realize that the casino's principles are comprised of 2 elements, namely probability and risk management. For traders and investor, understanding the importance of these 2 elements is key to successful trading and investing.

1. Probability: You must have an edge over the market

It does not matter if you are a trader or investor, or if you belong to the technical analysis camp or the fundamental analysis camp. What really matters is that you must have an edge over the market. In other words, whenever you buy a share, you must have more than 50% chance that it will rise instead of fall. This may sound easy, but in reality it is much more difficult.

Unlike the casino's edge which can be easily determined mathematically, the main problem for us traders and investors lies in the inability to scientifically and precisely measure our chance of success. This problem manifests itself when we are hit by a streak of bad or good luck. We may have a good system that gives us an edge, but when a streak of bad luck hits us we may lose confidence in the system and give up on it. Similarly, we may have a bad system but it is possible to make money in the short run purely by good luck, and this can lead to over-confidence and hubris. Over-confidence and hubris is very dangerous as it can lead to catastrophic losses.

Another problem faced by traders and investors is: when to take profit? Unlike a casino which takes profit automatically at the end of each game, a position taken in a share will realize profit only when it is sold. Since our purchase is based on probability, it makes sense for the sale to be based on probability as well. In other words, we should sell when the share has risen to a point when we feel the probability of rising has sufficiently diminished, or when we have identified other opportunity with better odds.

Apparently, for every position we take, we need two intuitive assessment on the odds, one for buying and one for selling. (Hardcore buy-and-hold investors may need only one, but how many people can truly hold a share till they die?)

Remember that even masters like Warren Buffett and George Soro make mistakes, but at a much lower frequency than us. Unless you have stock pick skills similar to the masters', you must face up to the fact that you are going to make a lot of mistakes in your assessments of odds along the way. This high frequency in wrong assessment coupled with the probability of being hit by bad luck, makes risk management indispensable.

2. Risk management: How you handle the probability of losing is going to make a huge difference

If Bill Gates is to place a single $1billion dollar bet in a casino, the casino will not accept his bet although it has a higher chance of winning. To a casino, the perfect risk management is to simply take large number of small bets and avoid taking large bet. By so doing, the casino may lose some money in the short run but is guaranteed to win in the long run.

It is important to remember that a trader or investor can't be correct 100% of the time and losing money is unavoidable even if we have found our edge in the market. Hence, risk management must be put in place so that we can maximize our profits in the long run.

The most common form of risk control is diversification. Diversification is similar to the casino's method of taking large number of small bets. However, diversification has additional limitations. Firstly, there is a limit to the number of shares that we can realistically monitor, hence in practice it is impossible to benefit fully from the law of large numbers like the casinos. Secondly, diversification also leads to more transaction costs, hence eroding our edge.

If you are a top-down investor or trader, i.e. you look at the economics environment of markets/industries or study charts of indexes/industries, then a more viable form of diversification will be low-cost index fund or exchange traded fund (ETF). These investment vehicles offer broad based diversification with low transaction and maintenance cost, and you do not have to monitor the performance of multiple shares.

Cutting loss is another form of risk control that is commonly employed by traders. For traders, a long position is entered when the probability of rising is expected to be higher than the probability of falling. When the share turns out to be against the trader's expectation and the share falls to a pre-determined amount, the trader should sell off his position immediately.

Selling at a loss is easier said than done, after all, it is easy to hope for the share to rebound, hence allowing you to recover your losses. In this case, hope is your biggest enemy. Most of the time, we disagree that the price should fall and cannot find an explanation for its decline (we had performed our analysis after all). In such scenario, always remember the famous mantra of George Soro: Sell first, investigate later.

Previous Article: How does a casino get so rich?