Is accuracy an important factor for an investor/trader to be profitable?
Beginner investors chase accuracy. Does accuracy matter in the game of investing
When I started investing/trading in the equity markets, I was chasing the wrong metrics. I was chasing "accuracy". I wanted to be right all the time. I wanted all my trades to be profitable and go in my direction. This is a very common mistake that most beginners make when they start investing/trading. Most get discouraged after a streak of losses and end up giving up on investing or trading completely.
Why do most people chase accuracy?
Our society conditions us to be right all the time. Our schools, universities and the entire education system are structured in such a way to encourage people to be right all the time and also punish us when we make mistakes. So, when people start trading they naturally pursue accuracy and try to avoid losing trades. In behavioral economics, this is referred to as loss aversion.
Pain of losing is psychologically about twice as powerful as the pleasure of gaining.
Humans go to great extent to avoid the pain of losing. They will hold on to their losing trades or investments far longer and will sell their winners far too early especially in investing. They are playing the wrong game. Let us try to understand the game of trading and find out what really matters.
Let us look at two hypothetical traders - Sonny and Michael (sorry for The Godfather movie reference). Sonny has an accuracy of 90% and Michael has an accuracy of only 50%. Who do you think will be profitable? Let us look at their trades in the table shown below. As you can see though Sonny has a high accuracy, he is not profitable. Whereas Michael is profitable even though he is right only 50% of times.
Trade Sonny Michael
1 200 200
2 200 200
3 200 200
4 200 200
5 200 200
6 200 -100
7 200 -100
8 200 -100
9 200 -100
10 -2000 -100
Profit/Loss -200 500
Why is Michael profitable even though he has an accuracy of 50%?
Michael has a better Profit/loss ratio when compared with Sonny. Profit/loss is average winning trade divided by the average loosing trade.
Average winning trade
Michael: 1000/5 = 200
Sonny: 1800/9 = 200
Average loosing trade
Michael: 500/5 = 100
Sonny: 2000/1 = 2000
Profit/loss Ratio:
Michael: 200/100 = 2: 1 = 2
Sonny: 200/2000 = 1: 10 = 0.1
As you can see what matters is profit/loss ratio or in other words
how much you make when you are right and how much you lose while you are wrong is what matters.
Both of which are under a trader's control. Though the math or logic behind this is simple, it is difficult to stick to the rule due to psychology. By this logic, traders should try to maximize their winning trades and limit their losses. However, traders do the exact opposite. They try to sell their winners too early to stoke their ego of being right (limiting their profits) and hold on to losers with the hope that the trade would magically turn and become a winning position some day in the future.
Hope in a losing trade does only one thing - it maximizes loss.
So the actual game that traders or investor play is one in which the intent should be maximize the profits from winning trades and limit the losses on losing trades. Trying to be right all the time (holding on to losing trades to turn around) is the wrong game. Most people assume that to be a good trader or investor is one who has highest accuracy. However, the truth is far from that. Most successful traders have an accuracy of 40% or 50%. Even in investing, there is a famous quote by Peter Lynch, one of the best investors in the world.
"In this business, if you're good, you're right six times out of ten. You're never going to be right nine times out of ten."
That's the thought I would like to leave with you today. If you are right six out of ten, you will be a good investor trader/investor. Don't be discouraged by a streak of loosing trades. Limit the losses on losing trades and maximize the gains from winning trades. Learn everyday and be a better trader/investor to trade the markets tomorrow.