It's not about consistency

Both Bradman and Buffett failed 50 per cent of the time. Yet, they were highly successful. Why?

Financial writers often use metaphors drawn from sports. Sports are usually zero-sum – one party’s gains equal another’s losses. Financial trading is always zero-sum. This is sometimes masked when both buyers and sellers apparently profit from the same transaction.

Say, a share is traded, and then rises in price. The buyer has gained. The seller may also gain if he’s booking profits on an earlier buy, or hedging something else. But in terms of opportunity cost, the seller has lost future profits, which go to the buyer. Zero-sum may also be masked when the gains of one player are distributed as losses across several players’ portfolios. Or vice-versa, there may be several winners picking apart one big loser.

 

One sporting metaphor that’s not used too often is a comparison of consistency versus aiming for explosive big wins. Bowlers and batsmen are good examples of two different functions. A bowler must be consistent and take regular wickets, without gifting runs. A batsman’s function is much more about scoring big to compensate for some inevitable low scores.

Look at Shoiab Akhtar versus Glenn McGrath. Akhtar played 46 tests, logged 178 wickets (3.9 per test) over 82 bowling innings with an average of 25.69. He had 5 wickets in a test innings 12 times. Once in 7 innings, Akthar takes a fiver.

Glenn McGrath – 124 tests, 563 wickets, 243 innings, 29 five-fors and an average of 21.64. McGrath took fivers less often on average (once in 8.4 innings). But he took more wickets per test (4.5) and was cheaper. No contest. McGrath was by far the better bowler.

In contrast, even the greatest batsmen cannot guarantee consistency. Bradman played 52 tests, 80 innings, (99.94 average) with 29 centuries and 13 fifties. He failed nearly half the time. Tendulkar has 47 centuries and 54 fifties in 271 test innings – he scores big “only” once every 2.8 innings.

Should trading/investing styles be modelled on batsmen or bowlers? Most investors and traders try to be bowlers and string together consistent profits with few losses. But the data suggests that going for the occasional big score (coupled with many small failures) is a better strategy.

Great investors and traders seem to operate like great batsmen. They make their fortunes on a few huge wins, while losing relatively small amounts when they take losses. Warren Buffett is extraordinary because he is both a big winner and consistent.

But even Buffett like Bradman, tends to be wrong close to 50 per cent of the time. Some of the most successful traders are correct only 40 per cent of the time, a few even less. Their skill lies in turning winners into big profits.

To take the analogy further, every batsman lives with the risk of facing an unplayable ball. That is like the market where one extraordinary session can wipe out many small profits. You can make winning trades 60-70 per cent of the time and still lose money if the few losses are big and the wins small.

One example of a “consistency” strategy was employed by Victor Niederhoffer. He worked out the average volatility of various derivatives. He sold far-from money options, outside that volatility range, and usually got the premium, since the options weren’t struck. He estimated that he made 2 million trades at an average gain of $70/ trade ( about $140 million). Then he lost $130 million in one session.

Nassim Taleb is the opposite. He often loses small sums for years in succession. He buys cheap far-from money options, looking to be on the right side of the rare, extraordinary swing. Taleb is rarely right but Taleb is rich.

Most players find it difficult to accept inconsistent results. But investing is not about being right all the time, or even very often. Every big investor, even the best, will sometimes stomach losses. Buffett for example, was down 43 per cent in 2008.

He continued to look for the big wins. If he had changed his methods, he would not have bounced back strongly, as he did, in 2009. Consistency in investing/ trading style is important just as it is in batting technique but consistent technique doesn’t guarantee consistent returns.

A batsman with superb technique can be bowled out on the first ball. Similarly, an investor or trader who does it all right must still be prepared to accept losses fairly often. Learning to handle this reality is tough psychologically. But just like cricket, trading/investing is a batsman’s game. Learn to maximise your gains and shrug off the failures.