Another Kentucky Derby is in the books, and as usual, some things about this past weekend’s 144th running of the world’s most-watched race were just as scripted, and others were complete surprises. For example, it wasn’t a shock to see Justify end up in the winner’s circle, but it was a bit surprising to see the highly-regarded Mendelssohn end the race dead-last.
It just goes to show you…. anything can happen. That’s why they actually run the race rather than rest on the odds.
There’s much to be learned from 2018’s Kentucky Derby though, and not just by trainers and amateur betters. There are also some critical reminders to stock traders from this weekend’s sloppy run. We’d all be wise to embrace these ideas. In no particular order…
The Risk/Reward Ratio Isn’t Always What it Seems
The math of weighing risk and reward is simple enough, if math is the only matter at hand. A $2.00 bet on Justify would have returned $6.00 to the better, but had Justify not won the race, the $2.00 bet would have ended up being a $2.00 loss. Ergo, the risk/reward ratio was – in this instance – a 3/1 ratio.
That wasn’t actually a better’s risk/reward ratio.
Yes, a ‘win’ translated into a tripling of a better’s money, but the odds of a win were only one in 20; any of the other 19 horses could have won.
But not all of the other entrants were real contenders? There’s some validity to that idea, so let’s be realistic and say only ten of the horses of the 20-horse field even had a shot, and even among those ten, only four others were plausible threats. Even then, there was only a one-in-five chance that $2.00 bet would turn into $6.00. There was a four-in-five chance the $2.00 bet would become nothing. As such, the realistic risk/reward ratio wasn’t 3/1, but closer to 3/5.
Obviously looking at the matter in this light requires some arbitrary assignment of risk, but it’s a reality nonetheless. About two-thirds of the time the favorite does not win the Kentucky Derby (or any other horse race).
Diversity Still Makes Sense
With lesson #1 fully digested, the second one makes plenty of sense…. the smartest betters are playing more than one horse, and giving themselves more than one chance to win.
It’s the same reason long-term investors own stocks from multiple sectors. They know that some will do better than others, but they don’t necessarily know which sectors will outperform, and which ones won’t. So, they’ll take on exposure across the board.
Short-term traders are generally less likely to worry about things like diversification, preferring to only take on one or two trades at a time. That’s fine – whatever works. But, even when you only own relatively small positions and aren’t actually taking huge risks by being in one trade at a time, relying on one position at any given time can affect how you see things. Specifically, it may make you more likely to stick with an ill-advised trade because you’ve got nothing else working for you at the time.
By holding several trades at once, it’s psychologically easier to pull the plug on the clear losers and continue to hold your best prospects. It’s a cycle though, requiring constant replenishment of old traders with new ones.
The Pareto Principle Always Applies
Never heard of the Pareto Principle? Actually, you probably have without realizing it. It’s also the 80/20 rule. For traders, it’s a nod to the reality that 80% of your profits will come from only 20% of your trades. The other 80% of your trades will only drive 20% of your profits. Much of that other 80% will even work against your bottom line.
The lesson to be learned by traders is, as much as we like to think we can spot a triple-bagger in the pipeline, we really have no idea how any of our trades will pan out once we’re in them. Most of them will be mediocre, some will be busts and only a few of them will be huge winners. Our job is to maximize our gains on those rare winners.
That’s a tough reality for fragile egos! After three, four, or even five or six losing trades in a row, most traders are ready to quit or dramatically alter their strategy. Big mistake. A well-reasoned, proven strategy usually isn’t the problem. The problem is a willingness to stick to the system, just like a better at the track has to be willing to suffer a few blown bets on long-odds horses to get to that rare, monster-sized payoff.
Some Things Can’t be Predicted, or Controlled
Last but not least, one can’t help but wonder how the Kentucky Derby would have panned out had the track been dry rather than sloppy mud on Saturday. The derby isn’t something that can be rescheduled though, so it was going to be run that day – horses and jockeys just had to deal with it.
In the same sense, traders have to deal with curve balls they’re thrown by the market. Right or wrong, an unexpected market turn can up-end a trend that was supposed to develop, but wasn’t allowed to. Three out of four stocks move in the same direction as the market on any given day. So, if you’re betting against the broad market tide with an individual stock, you’re fighting the tide.
And just like the weather is unpredictable, the broad market is more than capable of stopping and turning on the dime. The right or wrong headline can do shocking things. That’s why you always have to be prepared for all contingencies, at the track or on front of your trading screen.
Bottom line? As traders, and humans, we have the tendency to oversimplify or overcomplicate things. We should do neither, and yet we should probably do more of both.
More than anything though, these four lessons should remind all of us that trading is still more subjective than objective, and requires us to be wise and aware that for all we think we know, there’s still more that we don’t know.