Frequency vs Magnitude: In the Markets and in Life

If you had to pick between consistent, steady small trading gains with large losses, or a handful of winning trades that result in large gains, but also consistent small losses, which would you choose?

If you search yourself honestly, your answer would likely be “I prefer winning more times than losing more times in the market;” however, this does not take into account the larger picture of probability and expectancy.

Specifically, the above conundrum comes down to a debate between the issues of “Frequency” and “Magnitude,” and there are no easy answers to be found when it comes to the markets, and there are always trade-offs.

In a summary, the “Frequency” aspect entails how often your trades show a profit or a loss.

The “Magnitude” aspect entails “how large” or “how massive” are those gains vs those losses in your overall trading system/plan.

The Turtle Trader.com site provides a wonderful, detailed analysis of these concepts by Michael Mouboussin and discusses how they relate to life and the markets.

First, let’s consider the “Babe Ruth” effect as translated into the world of trading. We all know of Babe Ruth and consider him an American baseball legend because of his homerun record. But how many Americans also know that he also – at one time – held the league’s record for strike-outs? In fact, Babe Ruth struck out at bat thousands more times than he hit homeruns!

Ruth is a legend because of the “magnitude” of his accomplishments – in terms of his record-breaking amount of homeruns batted out of the park.

In the trading world, we also recognize legendary traders because of their accomplishments, but often these accomplishments would be far overshadowed by a trail of losing trades if we took the time to study those as well and not focus on the few major wins of the individual. In fact, many of the profiled “Market Wizards” confessed of major equity blow-outs or other major hardships during their career – and not always the early part of it!

Without giving too much away from the article, I will relay a portion of a story told by Mouboussin where a company’s treasurer decided he must eliminate some of the firm’s underperforming money managers. The criteria he set was the percentage of stocks held in a given manager’s portfolio that beat the S&P 500 that year. Managers who held a significant percent of stocks that underperformed the benchmark were eliminated.

A strange situation occurred when the firm’s best performing manager – from a percentage return standpoint – was to be eliminated because of a great number of stocks held in his portfolio that underperformed the S&P 500 that year. What was the manager to do? What did he do wrong? How could this situation be possible?

The lesson to take home from this example is that frequency of correctness in the market (or in life) does not matter; instead, it is the magnitude of correctness that ultimately matters.

A quick example of how this might have happened would be if this particular manager held 30 stocks in his portfolio and 20 stocks underperformed the returns of the S&P that year, but while five of the remaining stocks barely outperformed the S&P, the final five stocks outperformed the benchmark by percentages upwards of 25% each.

Because of the contribution of these five stocks (out of a portfolio of thirty), the overall portfolio could have easily beat the market benchmark and secured his status as the firm’s top money manager… while he had a “frequency of correctness” under 33%.

You could carry the scenario further with 25 of the 30 stocks underperforming the benchmark, yet 5 stocks outperforming by a magnitude of 35% or more which would result in a ‘frequency correctness’ of 17%!

Would you want to invest your wealth with a money manager who has a track record of only 17% of his picks outperforming the S&P 500? Why not guarantee yourself market returns by purchasing and holding the SPY ETF?

Why not? Because the 17% of stocks that beat the index actually “hit a homerun” and shatter the index returns, pulling the overall portfolio “out of the park”… or at least out of the realm of the return of the SPY that year.

Transfer this line of thinking to any performance endeavor and think of celebrities/athletes with whom you are familiar and consider the ‘darker side’ of their accomplishment.

Consider all of Tiger Wood’s double bogeys; consider Michael Jordan’s “airballs”; consider Tom Cruise’s or Matt Damon’s thousands of outtakes; consider the billions of dollars lost by Warren Buffett (not even he can ‘bat’ 100% in the market).

Learn to think in terms of magnitide, not frequency, and you’ll be miles ahead of the other traders who are striving to find the best indicator that can’t be wrong; the best strategy that works in all market conditions at all times on all time frames; the best market guru who’s never wrong.

Accept that you won’t be right all the time but make it your goal that when you are right, you are right BIG.