The Best Stock Traders Have Many Small Losses

By Dr. Winton Felt

We once tested more than 50,000 stock trading strategies.  However, the same principles we discovered by conducting these tests would also apply to futures and currencies trading.  We wanted to find strategies that could outperform a buy and hold approach by at least 20% per year in all kinds of markets.  One of the things we discovered was that all the best performing strategies had one thing in common.  By "best performing," I mean that they achieved the best cumulative net return when used on thousands of stocks over a wide range of market conditions and over many years.  That is, they achieved the greatest net return on most stocks most of the time.  The one thing these strategies had in common was small losses..

The trading record of each high-performance strategy showed numerous small losses intermixed with a variety of gains, some small and some large.  The small gains and small losses tended to cancel each other.  What remained were the larger gains.  There were no large losses in the loss column to cancel them.  We found something else that was at first a bit confusing.  Sometimes the losses far outnumbered the gains.  Our immediate question was, "how can we have more losses than gains in a top-performing strategy?"  The answer was, of course, that the losses were tiny in comparison with some of the gains.

The following example was not one of the top strategies, but I will use it to illustrate the point.  Assume that you buy a stock whenever its 5-day moving average crosses above its 20-day moving average and that you sell whenever its 3-day moving average crosses below its 10-day moving average.  Assume also that when you sell you are free to buy another stock that satisfies your condition for buying.  That is, you do not have to wait for the original stock to give another buy signal.  Now, your buy signal requires more momentum buildup than your sell signal.  That means the up-trends are more developed when you buy than the downtrends are when you sell.  Your up-trends are more likely to be durable.  It does not take much of a decline to trigger a sell signal.  Using this strategy, some of your stocks will rise 10%, some will rise 15%, and some will rise over 20% before the stock declines enough to trigger a sell signal.  When the sell signal is triggered, the stock will usually not be very far from its high. 

The result of using this strategy is that all your losses will be relatively small, because the strategy has little tolerance for downside behavior.  Some of your gains will be small and some will be large because sometimes the stock will trend for awhile before the sell signal occurs.  In other words, this strategy will have a record similar to that of the top performing strategies.  It may or may not be as profitable as the best, but the pattern of many smaller losses and gains intermixed with a smattering of larger gains will look a lot like a top-flight system.  Our own stockdisciplines.com traders have similar patterns in their trading results.  We have learned, not only through research but also by experience, that the best trading results are achieved by controlling losses, not by hitting investment home runs.  The larger gains will come as a matter of course over time, but the small losses take work and emotional detachment.  

We have concluded that few humans have the patience and tenacity to rigorously trade in that manner unless they are assiduous in the application of props (like the moving averages in our illustration).  That's because a series of so many small losses would discourage most people.  They would begin to let their emotions influence their trades.  The top-flight trading strategies that we discovered were discovered primarily because a computer was in charge of implementing the trades.  The computer never had an ego with which to contend.  It never felt bad because money was lost on a long string of trades.  It just kept chugging along, following the strategy no matter what happened.

Whether an individual is or is not an expert trader can be determined easily by looking at the size of his or her losses.  An expert's losses will all be small.  An expert trader may actually have more losing than winning trades.  There is nothing wrong with that.  However, the fewer larger gains will more often than not outweigh the larger number of small losses.