The popular perception is that a good trade is one where your purchase goes up after a buy and down after a sale.
This is wrong.
The Key Principle
Professional investors behave in accordance with principles based upon process, not short-term results. Here are two brief descriptions of the theory. I will then turn to several key examples.
While investing is not gambling, studying games with many cases and odds that can be calculated helps in learning the underlying reasoning. David Sklansky, in a poker book widely regarded as the best of all, states his “fundamental theorem of poker.” I’ll cite the Wiki page, which is a good summary, but anyone really interested should read the entire book.
Every time you play a hand differently from the way you would have played it if you could see all your opponents' cards, they gain; and every time you play your hand the same way you would have played it if you could see all their cards, they lose. Conversely, every time opponents play their hands differently from the way they would have if they could see all your cards, you gain; and every time they play their hands the same way they would have played if they could see all your cards, you lose.
This is an approach based upon expected value, not specific results.
Placing the principle in an investment context are James Montier and Michael Mauboussin.
We have no control over outcomes, but we can control the process. Of course, outcomes matter, but by focusing our attention on process we maximize our chances of good outcomes.
And this anecdote ---
Paul DePodesta of the San Diego Padres and Moneyball fame relates the following story on playing blackjack:
‘On one particular hand the player was dealt 17 with his first two cards. The dealer was set to deal the next set of cards and passed right over the player until he stopped her, saying: ‘Dealer, I want to hit!’ She paused, almost feeling sorry for him, and said, ‘Sir, are you sure?’ He said yes, and the dealer dealt the card. Sure enough, it was a four.
The place went crazy, high fives all around, everybody hootin’ and hollerin’, and you know what the dealer said? The dealer looked at the player, and with total sincerity, said: ‘Nice hit.’ I thought, ‘Nice hit? Maybe it was a nice hit for the casino, but it was a horrible hit for the player! The decision isn’t justified just because it worked…’
(I also strongly recommend Michael Mauboussin’s book on untangling skill and luck, once again using sports data to help in business and investing. Farnam Street has a good review.
Here is the relevant matrix.
Relevant Investing Examples
In many situations, both participants in a trade are “winners” in the sense of following a good process.
- Risk/arbitrage. Suppose there is a takeover bid and the target stock jumps, but not to the final price of the bid. Average investors, especially cautious ones, are already big winners, but their risk/reward has changed. Unless they are experts on the relevant companies and possible regulatory rulings, their process indicates a sale. They should not hold on for the last few points of possible gain. Some professional traders specialize in situations like this. They do many such positions. While they are not right in every case, their basket approach allows them to reach “deserved success.”
- Changing goals. Suppose an investor, edging closer to retirement or the need for a big expenditure, seeks to reduce risk. Selling a high-beta stock and moving to a safer choice is good process. This remains true even if the stock continues higher after the sale. On the other side of the trade may be an investor for whom the attractive valuation is more important than the risk. Both are winners.
- Investors vs. traders. XLNX disappointed on the last earnings report. The outlook also dimmed. Despite the major decline in the stock, investors had better choices available (something we discussed on FATrader). The very next day, Holmes, my dip-buying trading model signaled for a buy! Holmes has a good process. Buying for a short-term rebound works very well if you do many such trades and don’t mind short-term gains. Holmes might have bought stock from a fundamental seller, and both were right!
- Headline news. This is an important example since we see it almost daily. A story crosses the wires. Let’s suppose it is a rumor from a Chinese source that the trade talks are not going well. Trading algorithms pounce on this news with immediate sales of stocks they have in their “China basket.” Human traders join in. Fund managers may sell related ETFs. They all may be correct if they have a short-term time horizon. Investors, by contrast, may have buy orders below the market for China stocks they see as good long-term values. They can buy what the traders are selling. As in the other examples, both buyer and seller are correct – acting with a sound process. The short-term market reaction does not matter to this evaluation.
Do results matter? Of course – in the long run. And the long run is measured not by time, but by the number of decisions. It is longer than most people think. If you have a good process and maintain confidence, you will be a winner regardless of the immediate stock reaction.