Why Investors Should Stop Focusing So Much On Their Batting Average
Imagine standing 60 feet away from Hall of Fame former baseball pitcher Randy Johnson. He’s about to hurl a 100 mph fastball across the plate, and you have one shot to hit a home run…
What do you think your chances of success will be? My guess… very, very small. Almost nil.
Of course, you could get lucky, close your eyes, and swing as hard as you can. Who knows, maybe you’ll knock it out of the park. But even if you didn’t know that Johnson was one of the most feared pitchers in Major League history, most people would agree that it would be very difficult to get even a base hit, let alone a home run.
Fun fact: baseball fans might recall that an unfortunate bird once flew directly into the path of Randy Johnson’s fastball in a pre-season game in 2001. It basically pulverized the bird.
Even the best batters in the world fail mightily against the top pitchers in baseball. Take Mike Trout of the Los Angeles Angles, for example. The highest paid player in baseball, Trout is a three-time MVP. He just turned 30 recently, but is already generally considered one of the best to have ever played the game.
Trout’s career batting average? .305. That means he failed 69.5% of the time.
Stop Focusing So Much On Your Batting Average
Why do I bring this up? Well, baseball and trading stocks have a lot in common.
The biggest similarity is that the most successful traders — and batters — know they won’t hit a home run or even get a base hit every time. In fact, there’s a good chance that they’ll strike out more often than they hit a home run. But the good traders know that it’s not what their batting average is, per se, but how much money they make when they’re right and, more important, how little they lose when they’re wrong.
Unfortunately, most investors approach the market with the mindset that they’re going to hit it big with the next stock. They put an outsized portion of their funds on the line. It’s not until it’s too late that they they realize they’re facing Randy Johnson’s fastball and there is a good probability they will strike out.
I bring this up because focusing on win/loss percentage is a common misconception I often see from investors and traders alike. I get emails from prospective and current subscribers asking what my “win percentage” is. And while I’m happy to give them the stats, I usually know that if they are asking that question, they likely won’t be a good fit for trading equities.
You see, the biggest hurdle investors face is their own emotions. If you want to be right 70%, 80% or 90% of the time, then it’s going to be extremely difficult to grow your wealth. That’s because it will be tough for these sorts of investors to cut their losers. These are the exact folks who watch a small loser morph into a big loser. Soon that 20% loss turns into a 60% loss. And now the great game of “hope” begins. They hope that it gets back to even so they can sell it without losing any money. They won’t take a loss, because that admits defeat.
But let me ask you… do you think Mike Trout considers himself a “failure” because he only gets a hit 30% of the time? Absolutely not. He knows it’s a part of the game — and he is one of the best to ever do it.
Just A Handful Of Stocks Drive Markets Higher
This brings me to a little secret about the market. Call it an “ugly truth” if you will.
I came across this study from Hendrik Bessembinder of Arizona State University a couple of years ago that tells us a lot about what drives markets higher…
Bessembinder looked at the roughly 25,300 stocks that traded between 1926 and 2016. He found that during this time period these stocks generated nearly $35 trillion in shareholder wealth. However, more than half of these stocks delivered negative returns. Just 42.6% of the stocks outpaced the returns offered by risk-free Treasury Bills.
What’s more, just five companies (Exxon Mobil, Apple, Microsoft, General Electric and IBM) accounted for 10% of the total wealth creation. And 100% of the wealth creation came from just over 4%, or 1,092 stocks.
In other words, even had you bought every single stock in the market you still wouldn’t come out with a positive winning percentage. But you would be richer if you had spread your bets evenly. And you’d be downright filthy rich if you simply allocated more to the big winners (Exxon, Apple, Microsoft, etc.) than the losers.
So here’s my advice. Instead of worrying about how often you’re right, start focusing on making money. You do that by letting your winners run and cutting your losers short.
You don’t always have to be “right” with every single one of your picks in order to do well. Even when your picks aren’t panning out the way you hoped, you can still come out ahead. But only if you cut your losers short and let your winners ride.
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