Focus on improving the risk:reward ratio

Moralists condemn recreational gamblings though it is a very popular activity. However, an understanding of gambling games can help every investor or trader. Any gambling game has certain basic principles.

Gambling wins or losses occur via uncontrollable events that have exact probabilities. For example, you may need to draw a specific card or roll a specific number with a dice. So, the win:loss ratio is known in a gambling game. Payoffs and losses are also exactly known. In the long run, winning gamblers calculate those odds better and play accordingly.

Hypocrisy aside, this is directly applicable to secondary market investing and trading. When you buy or sell a share, there is a roughly 50 per cent chance of taking the correct decision. So, the win:loss ratio is approximately 1:1.

 

One way to improve your returns is to try and push the win:loss ratio in your favour by picking the right trade. If you are correct, say, 60 per cent of the time, you could be very successful. A fundamentalist tries to do this by assessing variables associated with rising or falling share prices. A technical trader does pure price-volume analysis for the same purpose.

The other key probability is the risk:reward equation. If the payoff on the right decisions is higher than the losses on the wrong decisions, you can be highly successful, even with a 1:1 win to loss ratio. A 2:1 reward:risk ratio, in conjunction with a 1:1 win:loss ratio, would work out to 50 per cent gain in the long run.

Shifting the win:loss ratio in your favour is quite hard. Even the greatest traders and investors tend to lose quite a few of their bets. You cannot predict where a given share price will go with any great degree of certainty. There are too many variables involved and all of them are out of your control.

Pushing the risk:reward ratio in your favour is comparatively easier. It is always your decision to reverse a position. If you set a stop-loss before you enter every position, you can hold potential losses to an acceptable level. If it is a trailing stop-loss which is moved up (or down) with a winning long position (or short position), losses can be held to a minimum, while letting winning trades run for higher profits.

In investing and trading, it is much easier to improve your risk:reward ratio than it is to improve the win:loss ratio. The good gambler instinctively understands this, since he is used to playing games where it is impossible to improve the win:loss ratios without cheating. But most investors persistently focus on trying to improve the win:loss ratios and more or less ignore the easier task of improving reward:risk.

The author is a technical and equity analyst