How many times do you need to be right when investing ?

 

Simple question: you buy a stock at 100$. The price goes down 50% the same day, then goes up again 50% the next day. How much is your stock worth?

 

The obvious reason is of course -50 + 50 = 0, the stock is worth 100$. Wrong. The real answer is 75 $.

 

Day 1 : 100 $ – 50 % = 50 $

Day 2 : 50 $ + 50 % = 75 $

 

If the order is reversed, you have a 50% win first day and then a 50% loss second day, the result is the same:

 

Day 1: 100 $ + 50 % = 150 $

Day 2: 150 $ + 50 % = 75 $

 

In order to break even, you need to have a win to loss ratio of 2 to 1, so if you lose 50% one day, you must make 100% to win it back.

 

Day 1 : 100 $ - 50% = 50 $

Day 2 : 50 $ + 100% = 100 $

 

This is why when people talk about risk management in trading, there is the ubiquitous rule of Risk- Reward of at least 2 to 1.

 

Fair enough. But how many times do you need to be “right” to make money?

 

This is a chart of the % of winning days of the S&P since 1928.  So this includes the Great Depression, the Dotcom bubble all of the good and the bad of the last 90 years plus. 

A winning day is when the closing price of a day is higher than the closing price of the previous day. So 50% on this chart means that over a specific year, this scenario happened half the time.

 


The lowest annual value was 40.4%, and the highest was 61.9 %. Even in the worst days of the 1929 Great Depression, the market has been winning at least 40% of the time. On the other hand, even in the massive 10-year rally after the 2008 crash, the stock market has been down 40% of the time.


The big question is, how many times do you need to be "right" to make money on the stock market?Imagine that you are a robot with no intelligence, a monkey who bets at random and gets the average winning rate of a year, can you still make money? Meaning you would be right between 40 to 60% of the time depending on the state of the stock market.


It all depends on your risk-reward ratio. The risk-reward ratio is the ratio between the target profit you are trying to make on a trade vs the amount your a willing to risk. If I make a trade aiming to make 100$ and put my stop loss to lose 50$, I have a risk ratio of 2 to 1.


If you maintain a risk ratio of 2 to 1, you will break even if you are accurate 33.3% of the time. So if we factor commission fees, you could still make money on the worst year having only 40% positive days.



Now let’s say you maintain a 1:1 risk-reward ratio, how many times do you need to be accurate? Through the magic of Excel, we obtain the magic number of 50%. If you are right more than 50% of the time, you will make money.




And if you maintain a risk-reward ratio 1:2, you will have to be right 66.6% of the time to break even, probably 70% of the time to make money.

 



Personally, I find this mathematics astonishing. Over the last 90 years, the average number of winning days per year has been 52.4%. That means if a person can maintain a risk-reward ratio of 1:1, chances are this person will make money. 

There is also the question of psychology. The main reason why retail traders lose money comes from the approach human being have of loss and gain. When it comes to psychology, human beings are rigged to do the opposite of what should be done to make money.

In future articles, we will delve deeper into these topics in order to help traders make more money investing.


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