contributed by Price Headley of BigTrends.com.
The Problem With Swinging For The Fences
December 7, 2004
of the widely accepted conventions of trading is that
erratic returns are just part of the game. Some trades
will be great, some will be mediocre, and some will be
awful. But if you want to make it big in trading, you have
to be willing to take some losses if you want to make some
big profits, right? Think again.
When given the choice, you may want to be consistently
profitable in small ways, rather than hit the occasional
'homerun'. In the following example, we'll compare the
difference between the two types of trading.
first scenario, we start with a trading account worth
$10,000. We'll say we get an 5% return each month on the
previous month's balance. After doing this for twelve
months, we end up with an account balance of $17,958.56,
or a 79.6% return for the year. That's not bad for an
average monthly return of 5%.
Consistent Account - Average of 5% per Month
On the other hand, we could 'go for broke' with our
$10,000 account. Here we'll be highly aggressive in
search of big rewards, and we'll just deal with the fact
that some months will be rough. That, after all, is the
price you have to pay to get those stellar returns,
right? After twelve volatile months, we've actually
gotten the same monthly average return of 5% - we've
just done it erratically. Even with the same monthly
monthly average, those few bad months really took their
toll. This volatile account only achieved a 75.6% return
- considerably less less than our consistent account
that gave us 5% per month.
Inconsistent Account - Average of 5% per Month
This is a testament to the importance of consistency,
and capital preservation. In our second scenario, the
reason the great months didn't help was because we had
less capital to invest following a losing month.
Remember, it takes a 100% gain to offset a 50% loss. And
while the difference between these two returns may seem
trivial, if you compound this over several years, it
suddenly won't seem trivial. In fact, the difference
between these two portfolios after five years of the
same kind of consistent (or inconsistent) returns is
By the way, it doesn't matter how you sequence your
gains and losses in scenario two - the average monthly
return and the bottom line remain the same. Don't plan
on taking your losses early and 'making up for them
later', as it just won't help any.
every winner has to be huge, but a few huge losses can
sure knock you out of the game. Using tight stops and
setting reasonable targets will help you stay
consistent, and that's critical to trading success.
Headley is author of the #1 Amazon Investing Bestseller
Big Trends in Trading and founder and chief analyst of BigTrends.com,
which provides real-time option and stock advisory