People Think It’s All About Prediction -- But It Is NOT!

 by Van K. Tharp, Ph.D.

Let’s look at some of the major methods behind investing or trading and see what they can tell us.

- Trend following – If you buy what’s going up, it will probably continue.

- Value Investing – Buy what’s undervalued because it will eventually become overvalued.

- Seasonality – The market tends to show seasonal patterns that you can capitalize upon.

- Band Trading – It’s possible to draw bands to describe the nature of an investment. Those bands will allow you to sell when the price gets too high and buy when it gets too low.

- Elliot Wave – The market moves in a sequence of five waves up and three waves down, and if you can understand the various levels to this, you can predict tops and bottoms.

While there are many other methods, notice how all of these particular methods are related. What is the common element? All of these methods tend to predict, to a certain extent, what the market will do next. So if you are a trend follower, you are predicting that the trend will continue. If you are a value trader you are predicting that what’s undervalued will go up eventually.

Yet if you look at the track record of some of the major players who used these methods, you’ll find that they are often right less than fifty percent of the time. Good trend-followers, for example, might make money in about 40% of their trades. But when they are right, they make huge amounts of money.

Elliot wave traders look brilliant when they are correct, and the media wants to interview them about what will happen next. But when they are wrong, they can look really stupid and people start to laugh about their predictions.

My point in mentioning all of this is to show the importance people place on prediction. Countless books have been written about how to “pick the right stocks.” The media tend to interview professional traders about what stocks they are picking and why. And perhaps they’ll even show what happened to the last set of picks and ask what happened with the losers.

I have yet to hear anyone say, “I don’t make money picking stocks – I make money by cutting my losses short and letting my profits run. And more importantly, I meet my investment objectives through the judicious use of position sizing.”

Your trading style forms a basis for your beliefs about how to enter the market. This is important because you really only trade your beliefs about the market. It’s very hard to trade something that’s going up if you believe it is overvalued. Similarly, it’s very hard to trade something that’s considered undervalued, if you believe (because it is going down) that it will continue to go down.

But it really doesn’t matter what framework you select for picking your trades or investments. That’s only the starting point for real success. What’s really critical is that you understand that you make money by cutting losses short and letting profits run. This will give you a positive expectancy system. And if you can do it in such a way so as to develop a good system, then you can probably achieve your objectives through the appropriate use of position sizing. And if you can continue to do this without making many mistakes, then you’ll probably be happy with the results. These are the real keys to investment success.