How To Invest And Be Profitable Even When You Are Wrong 6 Out Of 10 Times?

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Summary

  1. Have an Edge to deliver profit consistently
  2. Have a Money Management to manage downside by
    a. Having an exit strategy either having a profit target or loss limit
    b. Position Sizing to limit your loss exposure

 

You may be thinking how is it possible to profit when you are wrong in your investment most of the time – To be exact is 6 out of 10 times!

To invest and profit, there is an evergreen formula:

Investment Success = Edge + Money Management

1. What is Your Edge?

Your Edge can be value investing, growth investing, portfolio investing or technical trading, etc. It’s your unique strategy that exploits the inefficiency in the pricing of the asset that delivers you a profitable return over consistent and repetitive buy-sell transaction. In other words:

“You know something that the seller who sold to you do not know about.”

Your Edge should have a reliable and foreseeable return; else it is just a fallacy to use it!

2. What is Money Management Strategy?

Money Management Strategy is a common terminology that often appears in the trading world.  Successful Traders, regardless if they are trading in equities, forex, commodities, options or futures have often stressed the importance of it. It is a cornerstone in generating consistent investment profit.

Let me explain further in the following example.

Assuming you have mastered your investment edge. You know what your entry price and your profit target price is. The difference is your profit.

Your two questions will instinctively pop up at this stage.

  1. How much should I invest in one stock?
  2. How many shares should I buy?

But before that, what is your exit strategy?

2.1 Do you have an Exit Strategy?

Having a profit target is only one part of the answer. What if the investment turns south such as your estimation of the intrinsic value goes way below your margin of safety or your growth projection is way too optimistic? Having an exit strategy is akin to having a Plan B. This will prevent your failed investment in wiping away all if not most of your previous investment profit.

Below is a table that demonstrates that even when you lose 6 out of 10 investments, you can still make a profit out of it. This is based on a loss limit that is 50% of your intended profit target. i.e. Your profit is 2x of your loss.

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Below is a summary of the number of wins you need to have to achieve a positive return when you fix your profit target as a minimum multiple of your loss limit.

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As you can see above, when you control your losses and fix your minimum profit as a multiple of your losses, you do not have to be right all the time. Just 40% of the time!

By knowing beforehand how much is your losses, it has two benefits.

  1. A great relief that the failed investment is just 1 out of 10 investments that do not work out. Your entire investment return does not depend on just one stock. You can sleep better, make a wiser decision, and not subject to sell on impulse.
  2. A positive expectancy knowing that your entire investment portfolio will yield positive result as your portfolio return is back by solid Math, even when you are wrong 6 out of 10 times.

You may be thinking how does this as to do with your two questions ask:

  1. How much should I invest in one stock?
  2. How many shares should I buy?

Read on to know more about position sizing.

2.2 Position Sizing

By knowing what your profit target and loss limit are, you will do your position sizing to decide on how much you should invest and the number of shares to buy.

If your loss limit is $500, you decide on the price that negates your value estimation. In the following example, I use $4.80. What this means is that the price of the shares has to fall by $0.20 to negate your continued holding of the stock and you should exit the investment. Therefore, $500 / $0.20 = 2,500. That is the number of shares you should buy. And 2,500 units x $5 (share price) = $12,500

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Your total investment is $12,500 but your loss exposure is only $500, which is only 4% of your investment. You will only need 4.16% of profit from $4.80 to breakeven.

Through this example, I hope you can see the merits of position sizing as it helps to limit your loss exposure, and let your Edge play itself out; delivering a position expectancy of return over time.

I hope my sharing gives you a glimpse of how a trader’s sound money management can use in managing your downside risk while allowing you to invest for profit confidently and lesser stress.

My parting words for you is:

Without an exit strategy or plan B, you may have to resort to becoming a long term investor when you set out to be a profit investor initially.

If you want to learn more about how to find cheap and good stocks to generate passive income for you, click on the picture below to join our Free Value Investing Masterclass.

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Albert Ho (The Financial Advocate)
Research Analyst, Mind Kinesis Value Investing Academy

Disclaimer: Please note that all information stated in this article is just for education purpose only and should not be used as any form of recommendation or advice.

 

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