Imagine you are invited to play a round of golf. Instead of the normal fourteen clubs in your bag, you have only three: a driver, a short iron and a pitcher. To add to the challenge, the weather conditions on the course are wildly variable, and at least some of the holes are played at night. Ready? Now you have some understanding of the game the Reserve Bank of Australia plays.
This week the RBA released the minutes from the April meeting at which rates were cut, surprising some, including me. Peter Switzer and I often have “robust” discussions on his show about the RBA. Peter regularly takes Governor Glenn Stevens and the board to task, highlighting what he sees as poor decisions and general wrongheadedness. As a professional forecaster I have more sympathy for the RBA’s position – and believe drilling in to the task of the RBA board has implications for every investor.
Traders regularly speak of a mythical trader who never gets it wrong. He always knows why a market behaves in a certain way, and the perfect trade to profit from any move. He’s never had a losing trade. The problem is he only knows all this with twenty-twenty hindsight, and never in time to actually profit from any of his wisdom.
If a trader says to you “nice trade Harry” it’s not a compliment. The trader is suggesting you are wise after the event – as fruitless to investors as it is to traders.
No-one knows the future
As a market educator I regularly speak with aspiring traders who are keen to learn, but lack knowledge and experience. They often have a half-formed mental image of a legendary trading guru, who’s every move is a winner. This creature does not exist. One of the first eye-openers they come across is the fact that every successful trader has losing trades. The reason for this is that NOBODY, no matter how intelligent, hard working or experienced, can know the future.
It’s not whether you have losses that counts, but how you handle them. In this respect, investors and traders are alike. This is a lesson I failed many times in my trading and investing journey. It was not until I gave up a “need” to be right 100% of the time that I experienced real market success.
How do investors and traders deal with the inherent uncertainty of markets? In much the same way that the RBA makes policy decisions. Take a broad view, and consider all the options, risks and possibilities. Discuss with experts. Decide on a course of action that lowers risk while offering maximum benefits under different scenarios. Stay abreast of developments and adjust accordingly. Simple, right?
In investing and in trading, the path to success can be summed up in just four words: Run profits, cut losses. Of course, this is much easier to say than do. However, the job is easier than the RBA’s.
The RBA mandate has two bottom lines – price stability and employment. Investors seek one – superior returns. The three RBA golf clubs referred to in the first paragraph are interest rates (the driver), foreign exchange intervention (the short iron) and the jawbone (pitcher). These are broad measures, not always suited to the problem at hand. However, the range of tools available to investors is enormous, giving much greater opportunity to tailor solutions that suit individual circumstances.
Because both the RBA and investors act in the face of uncertainty, we should expect when looking back we will identify times when decisions were sub-optimal – and at times plainly the wrong thing to do. That does not mean the decision was wrong at the time (although it might). It can reflect the impossibility of forecasting the future with 100% accuracy.
In fact, traders with a track record of winning trades above 66% are above average. Greater than 70% is rare. Traders use money management plans to maximise profit on winning trades, while minimising losers, and can make money even with a success rate less than 50%.
If an investor has a success rate significantly higher than 66% it can be a sign of a problem, and may mean the investor does not exit poor positions, but holds and hopes. A rising market will forgive this investing error, but sideways markets like the current one way may punish a buy, hold and hope strategy. The greatest cost is often lost opportunity. Funds are tied up in market “dogs”, and better investments go begging.
Investors may once again take a leaf from the RBA playbook. Stay on top of markets and developments, and meet regularly with experts (monthly?) to formally review the situation.