Positive expectation is good obviously. However, negative expectation bets can be good if they improve the risk/return of your portfolio. A good example is buying puts after significantly extended up-trends - may be a net loser, but if it reduces your drawdowns more than your returns, it is positive for overall risk-adjusted performance.
Same bets over and over are fine as long as you combine them and adjust your size accordingly. E.g. if I have two great stock ideas, but they have 0.7 correlation, then it is better to go long both than just long one - I get some non-correlated diversification. The only mistake is if I go too long without accounting for the correlation.
Sizing is easy. Work out your 'career ender' loss, using conservative estimates on all variables. Then, size your bets such that maximum expected loss, to a high level of confidence, is less than your 'career ender' loss. Trade accordingly. Worst case scenario is you don't have enough capital to earn a higher income than your expenses - but that's still ok, just grind for 2-3 years then take your fabulous CAGR/max DD ratio to various hedge funds and get hired on 100k+ and if you keep up the performance you will be rich in 3-5 years. The only way to lose is if your CAGR/DD ratio is not good.
By contrast, if you try to break out quickly, by taking more risk, you are more likely to blow up for good, and you may bias your trading by 'reaching' for big-shot trades, overtrading on marginal bets, and other psychological errors.
If you are decent at trading, and have 250k+, then 20% a year is 50k per annum. That's enough to 'survive' for 2-3 years, which is long enough to prove you can make 20%+ per annum with <20% drawdowns, which is an excellent record and should get you hired at one or more trading shops. And if you are really good than you are looking at 2:1 or better CAGR/DD ratio, which is enough to get snapped up, or (setting your max DD to 20%) bang out 40%+ per annum, which is enough to grind your way to greatness as a one-man band, unless you spend like a maniac.
Quote from darkhorse:
Trading Wisdom 12: Three Iron Rules for Risk-Takers
"There are three iron rules for risk takers. Since your plan is to arrive at an outcome near expectation, you must be sure that expectation is positive. In other words, you must have an edge in all your bets. Expectation is only an abstraction for risk-avoiders. If you buy a single $1 lottery ticket, it makes no practical difference whether your expected payout is $0.90 or $1.10. You'll either hit a prize or you won't. But if you buy a million tickets, it makes all the difference in the world.
"Second, you need to be sure you're not making the same bets over and over. Your bets must be as independent as possible. That means you cannot rely on systems or superstitions, not even on logic and rationality. These things will lead you to make correlated bets. You must search hard for new things to bet on, unrelated to prior bets, and you must avoid any habits. In many cases you find it advantageous to make random decisions, to flip coins. For risk avoiders taking only a few big chances, correlation is a secondary concern and flipping a coin for a decision makes no sense.
"Finally, risk takers must size their bets properly. You can never lose so much that you're taken out of the game; but you have to be willing to bet very big when the right gambles come along. For a risk avoider, being taken out of the game is no tragedy, as risk taking was never a major part of the life plan anyway. And there's no need to bet larger than necessary, as you are pursuing plans that should work out if nothing bad happens, you're not counting on risk payoffs to succeed."
- Aaron Brown, Red-Blooded Risk: A Secret History of Wall Street
JS Comment:
Do you understand and apply the concept of 'expectation,' also known as EV or expected value?
The second paragraph is controversial. Do you agree that "flipping coins" is sometimes appropriate for risk-takers?
What are some intelligent ways to address the correlation problem (that donât necessarily involve randomness)?
Do you vary your position sizing? If not, why not? If so, by how large a factor between your smallest and largest positions?
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