Being right is overrated
Joe Weisenthal at Clusterstock points out today an interesting (long) piece by Holman Jenkins at Hoover.org on the financial crisis. The gist of the article is that the financial crisis was by and large a massive financial accident that was unforeseeable.
Jenkins notes that even investors like John Paulson, who many claim to have foreseen the meltdown of the global financial system, did not in fact foresee the crisis. If they had they would have invested quite differently:
But those who bet successfully against subprime did so through elaborate, expensive, negotiated deals to purchase credit default swaps or buy “put contracts” on subprime indexes. Had they really seen what was coming, they would saved themselves a great deal of expense and bother by simply shorting Citigroup, Bank of America, Lehman, Bear Stearns, etc. Their profits would have been huger, their workload and hassle factor much less.
The point of the above quote is not whether the crisis was foreseeable, nor is it a criticism of Paulson. In today’s financial markets traders can express their viewpoints about the future through derivatives and structured products in a very precise manner. If Paulson had foreseen the collapse of the global financial system there were much easier ways to profit from (and express) that viewpoint. (Not that he is complaining.)
Much too much is made in the media about who is right, and who is wrong. (Not that these thing are well tracked.) On television, in print and on the Internet we are inundated with pundits who crow about their prescience, while omitting their missed forecasts. The funny thing is that for investors, being right is greatly overrated.
Investors and traders need only worry about one thing: profitability. Are you generating requisite profits from your portfolio for the risks assumed? Everything else is just noise.
The need to be right is a common error for beginning investors. Any one who has ridden a stock down for a large loss can attest to this. Behavioral finance experts have a term for this: the disposition effect. Investors tend to sell winners too soon, and losers too late. You could even think of this as ‘get-even-it is.’ Investors do not want to admit that they made a mistake.
The fact of the matter is that all investors make mistakes. It is simply a part of doing business. One way traders look at their profitability is expectancy. In a vintage post, Trader Mike does a nice job describing the components of expectancy. The take away is that the percentage of times you are right is only one component in your profitability. In theory, a trader could be wrong much more that 50% of the time and still be profitable, if the profits from their winning trades far exceed the losses on their losing trades. As he writes:
Expectancy, position-sizing and other aspects of money management are far more important than discovering the holy grail entry system or indicator(s).
Stated another way: For traders, being right is overrated. It is far more important knowing when you are right, and when you are wrong, and acting accordingly.
In summary, being right may be a necessary component of trader profitability, but it is not sufficient. Proper money management techniques are required to turn trading decisions into trading profits. While it is difficult some times to take, being wrong is a part of being a trader. Don’t let the need to be right prevent you from becoming a beter trader.
Update 6/5/09: Found in my bookmarks a piece over at CXO Advisory Group. Researchers find that traders are affected more by their win-loss ratio than their actual profitability. Stephen writes:
Individual traders may want to consider whether they are motivated more by being right than by making money.
Filed under: Behavioral Finance, Portfolio Management | 18 Comments