The Blogfather, Barry Ritholtz, has written a great piece this morning over at The Big Picture about how people often mistake what is possible for something that is probable, and uses the examples of long-term pension funds and venture capital. You can read the whole article here: Possible versus Probable (The Big Picture)
Anyone who’s spent more than 10 minutes talking to me about markets will at some point have heard me make the same distinction. It’s my stock-in-trade response to any notion put to me that I think unlikely.
“Well, it’s possible,” I’ll say, before wistfully adding, “but not probable.”
I look at most things in those terms because I’ve found it to be the most effective way to assess risk and reward. I use it in my day to day life too, I’ve even taught my kids the difference between the two to help them understand decision making. My 9yo daughter likes to look at the weather forecast every morning to help her decide what to wear, and understands how to reference the ‘chance of rain’ in terms of what’s possible vs what’s probable.
In their world they know to give more weight or spend more time concentrating on what’s likely. In trading we have to look at it in a different way. When thinking of upside we need to think in probabilities, when thinking of downside, possibilities.
That way of thinking has probably been further engrained in me since making trend following my main discipline. As a trend follower you get used to having a lot of losing trades, but you keep them small so that the less frequent winners outweigh them. You get used to having low expectations of identifying any trade in advance as being a winner. Even though it looks as good as all the other great trades you’ve had, the chances are it’s still a loser. After a while you don’t bother worrying about what any of them will be, you just activate your process on each and every one until it becomes clear which they are. For every position it’s possible they become the big winner that pays for all the little losers, but it’s probable it’s another loser. That’s a tough mindset for most people to deal with.
I’ve stated before why I don’t use price targets. Having a price target is saying you want to limit your gains, this is the most I want to make on this trade, at this arbitrary point in the future my analysis will suddenly be wrong. As a trend follower my price target for every long is infinity. It’s possible I could have a position that never invalidates and stays with me forever, but not probable. With that ‘target’ as a possibility for every position I’ve naturally got used to seeing my hopes dashed so as to not think about it anymore. But the possibilities of downside, and the probability of each new trade being a loser, I think about it all the time.
I see it as my main job to think about what I could lose on every trade, not what I could win. It’s already probable the trade is a loser, now let’s think of how big a loser it could possibly be. Where am I wrong, what invalidates my rationale, and what if it gaps well below that, could I tolerate it, I know it’s not probable, but it’s possible so I have to account for it, what would I do, how would I react? You have to bring this mindset to every trade you take, consider all possibilities, no matter how improbable.
Once you account for what’s possible, your success becomes more probable.