Do You Need to Be Abnormal to Trade Successfully?

Includes: DIA, QQQ, SPY
by: Valulicious

Michael Mauboussin is Chief Investment Strategist at Legg Mason Capital Management. He periodically publishes investing essays which I recommend for their unique perspectives and practical, yet research-driven, conclusions.

Mauboussin's latest essay is "The Failure of Arbitrage." Not essential for his thesis in this particular essay, but still interesting to me are comments he made on trading. He discusses two ways to use human emotion for generating outsized investment returns. One is to ride it, which is what momentum traders do, and the other is to exploit it by finding price/value gaps, which is what value investors and stat arbs do.

Mauboussin wrote this regarding momentum trading:

"The goal is to catch profitable price trends by responding to the market's moves. But the majority of trades lose money. For example, a trend-following simulation over 20-plus years shows that nearly 70 percent of the trades generate losses. Observers report similar hit rates for some of the greatest traders of all time.

The key to the strategy's success is nipping losses at the bud and letting winners run. While there are more losing trades, the profits from the larger winning trades more than offset the many small losses from the unprofitable trades. For example, a trend-following trader explained a sequence where the system generated 28 total trades (average size $10,000 - $15,000) from April 1998 to February 1999, producing a total profit of $56,000. But of the 28 trades, 24 were unprofitable (average loss of about $930) while 4 were profitable (average gain of $20,000). Even more difficult, the first 17 trades in a row lost money.

This frequency and magnitude dynamic is one reason adopting a trend-following approach is so psychologically and practically hard. Normal people are uncomfortable being wrong such a high percentage of the time, and the probabilities of this approach assure periodic and sizeable capital drawdowns."

Why is this interesting to me? Two parts got me thinking.

Note that last sentence, "Normal people are uncomfortable being wrong such a high percentage of the time." I guess you do have to be different to trade (or invest) successfully. I wouldn't say that you have to be abnormal, but do think that you have to have a unique emotional makeup. There's lots to say on what goes into that emotional makeup is, but I think (1) awareness, and (2) control are a good start.

The other comment that interested me is in traders often being 70% wrong. I'd say many investors target the inverse--being right much more often than being wrong. Are us longer term folks holding ourselves back by trying to be right too often? My bias is to say no and tell you that I hate losing money. But I still find it interesting to objectively revisit my investing beliefs.