Two Bullets and Baron Rothschild
/ Learn to Trade Dec 09, 2011 - 09:52 AM GMTBy: Richard_Mills
I've read the following articles so many times I can just about recite both from memory. I found them years ago, there were no author's name attached, no credit given, but anon thank you, you've helped keep me focused.
I hope readers find both pieces as useful as I did.
Richard (Rick) Mills
Two Bullets
Several years ago, I met someone, Trader Joe, who was an expert technical trader. I call him an expert because he lived off of his profits, he was financially independent, and he frequently went on random scuba diving and bird watching vacations at the drop of a hat.
Since this was a time when I was diligently honing my trading skills, I often corresponded and spoke with him about trading. I already had a system in place, so that's not what we concentrated on. Instead, he helped to educate me about the mental side of trading. And what he shared with me has helped to define my success as a trader.
To that point, I had never really acknowledged that there was a mental side to trading. After all, I was just looking at charts and playing the setups. But I have to admit, playing the setups wasn't working out too well.
At the time, I was making about 7-10 trades per month. Most didn't do so well, but the ones that did always made up for the losses and kept me at a small gain. My account was up, so I figured I was doing okay. But I also knew that the great traders like Paul Tudor Jones and Ed Seykota were able to consistently make many times the returns I was making. In case you're wondering, Seykota increased one of his clients accounts by 250,000% over a 16 year period (after withdrawals) and Jones realized five consecutive triple digit return years.
I knew there were flaws in the way I was trading, but I didn't understand what I was doing wrong. So, I shared my predicament with Trader Joe. I asked him why in the world I could not make a yearly gain over 12%.
He laughed... and then he gave me some of the best advice I've ever received.
But he didn't tell me directly. He imparted his wisdom in the form of a story:
I immediately understood what he was saying."Imagine that you're a deer hunter and you only have two bullets. You cannot get any more bullets until next month. If you miss your shots, you won't be able to eat any meat this month. But if you make one of the two shots, you'll eat well.
"Now every time you walk into the forest you patiently wait... and wait... and wait. Most of the time in the forest you don't even see a deer. Some days you might see an occasional rabbit hopping around. Do you shoot at the rabbit hoping that later you can get a deer? Or do you wait?
"If you hit the rabbit you can eat for a day. But if you miss, you have just wasted one of your bullets on the chance for a small meal. You decide the rabbit is too small for the risk involved, so you keep waiting.
"A few days later you see a deer, but it's not a clear shot. Do you shoot? If you miss, you'll have only one bullet left. You decide the risk in missing the shot is too great, so you wait.
"The next day, you see a big buck in clear sight about a hundred yards away. Now the shot is nearly guaranteed. You take your shot and you nail it."
I'm the hunter, the market is the forest and my money is my ammunition. Once I run out of money, game over. But if I choose only the best shots, I will do well. In other words, you only want to trade when the odds of winning are heavily in your favor.
In my case, I was trading on setups that were mediocre. To pull the trigger, I needed four of my indicators to line up and scream buy or sell. But when I looked at my past record, I discovered that most of the trades I entered were not based on my system. I would become impatient, often trading when only two of my signals lined up, instead of all four.
In other words, I was shooting at rabbits and taking difficult shots at deer that were out of range. Sure, I might have made a lucky shot here and there, but the odds were not in my favor.
By simply reducing the number of trades and only making those that were optimal, I dramatically increased the profits I earned.
Trader Joe told me I wasn't alone in making these mistakes. He said new traders do this all the time, perhaps that includes you.
Maybe you become impatient, looking for excitement and feeling that you are missing opportunities if you're not in the market. Nothing could be further from the truth.
By simply limiting the number of trades you make to those which put you at the greatest odds of winning, you will save money on commissions AND put more money in your account. After all, trading isn't about excitement; it's about making money.
There's no question that Trader Joe's advice has improved my success. I can't thank him enough. And I hope that you will benefit from his advice as well. So the next time you're looking at your trading record and you see less than optimal results on a high number of trades, just ask yourself:
You only have two bullets. What do you do?
Author unknown
Baron Rothschild
Let's play a little game - it's called "Baron Rothschild," who once said "I made my fortune by selling too early" (a comment also made by Bernard Baruch). It's a lot like various kids' games where you know something bad will happen but you don't know when. These include "Musical Chairs," "Don't Break the Ice" (where you take turns hammering out little ice blocks hoping that you won't cause the whole surface to collapse), or "Kerplunk" (where a load of marbles rests on sticks that have to be removed one by one). My impression is that investors are playing this sort of game here.
Suppose that the dealer lays cards down, one after another. Each is an annual market return. At any time, you can call out "Baron Rothschild" and go to a defensive position, or you can gamble and get the market return the dealer shows next. The gain cards read - 15%, 20%, 25% and 30%. If you're in a defensive position you lag the market by 10% when the market return is a gain, but you get 5% if the market return is a loss.
There is one -20% loss card. Once it appears, the game ends and everyone counts their dough.
It turns out that if the loss comes anytime before the 5th card, you're almost always ensured to beat or tie the dealer by immediately blurting out "Baron Rothschild" even before the first card is shown. For example,
20%, 20%, 20%, 5% beats 30%, 30%, 30%, -20%.
15%, 15%, 15%, 5% beats 25%, 25%, 25%, -20%.
20%, 10%, 5%, 5% beats 30%, 20%, 15%, -20%.
5%, 5%, 5%, 5% ties 15%, 15%, 15%, -20%.
You can easily prove to yourself that even for a six-year market cycle, you still generally win even if you call out "Baron Rothschild" after year two. Meaning it just doesn't pay to risk the big loss.
The point of this isn't that investors should always take a defensive stance - some market conditions are associated with very strong return/risk profiles that warrant substantial exposure to market fluctuations. The point is that the avoidance of significant losses is generally worth accepting long periods of defensiveness - the mathematics of compounding, large losses have a disproportionate effect on cumulative returns.
Remember that historically, most bear markets have not averaged 20%, but approach 30% or more. A 30% loss takes an 80% gain and turns it into a 26% gain. It's difficult to recover from such losses.
The avoidance of significant losses is typically worthwhile even if, like Baron Rothschild, one is defensive "too soon."
Author unknown
If not, maybe it should be.
By Richard (Rick) Mills
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