Have you ever wondered how people get rich? It’s a big question, but in a way it is a simple question. All of them have invested (their company, idea, stocks – whatever).
But what is the mental attitude of the rich, compared to everyone else?
There are some very simple insights all hedge fund managers and other professional traders have. It’s so important, that I had to keep repeating it when I used to write my weekly Financial Times column.
When we were promoting my first hedge fund to investors, a decade ago, it was critical we showed of course our profitability, far more than how often we won on our ideas.
You see it’s easy to increase your winning trades. And private investors think it’s some genius. The genius is in making profits.
Let me explain. To increase your winning trades there is a trick, which is not a profitable trick, but can appear so, and private investors fool themselves into thinking it.
You just close, or exit, your profitable trades and only count as wins or losses those trades you’ve exited. Since you never exit losing trades, you only show a very high win rate. Of course professional hedge fund managers cannot do this (or some famous ones who tried, went bust, or to prison, or both).
This strategy simply does not yield profits. What happens is you will have people saying stupid things like ‘no one ever went broker taking profits’ – yes they did if they ignored their bigger losses.
The reason this fake strategy is seductive is that you get to off-balance sheet ignore your losses. You kid yourself losing trades will with time turn around, and some actually will, so you kid yourself even more your strategy works, and at best I’ve seen this strategy deliver 500 consecutive winning (closed, exited trades) BUT the open losing trades still lost you more money than all the profits puts together.
So we really need to think about how to handle losses. And professionals ‘cut their losses’. They do it quick, when they are small. They may re-enter. But professional traders do not care about how often they win. In fact Soros used to lose more trades than he won, because he kept getting out of small losses, and re-entering until the price moved as he thought. So he may have 5 losing trades for every one winning one. But the winning one made 10 and the losing ones each lost 1.
But there is another logical reason we have to cut those losses short which many people want to deny because it is so painful taking a loss.
All human nature loves such things and it is bad. It’s the same buzz from putting off a diet and eating a bad meal, or buying something on credit. Sure, sometimes you win, but ultimately, you’re just kidding yourself. Getting rich is doing this simple thing which most people don’t know.
Alpesh Patel
www.alpeshpatel.com/go
