The Best Diet is Also the Best Trading Plan

Boris Schlossberg

The Only Place to See Me Live this Year -- and its TOTALLY FREE!

It never ceases to amaze me how dieting and investing are the two great social problems of the modern age. Basically it all boils down to this. In the advanced industrialized world we are all fat and none of us save enough money for our golden years.

Just 50 years ago this was not really a problem. Most of us did not work in sedentary jobs with our butts glued to chair for 12-14 hours per day and we did not consume highly refined sugary foods that deposited 2000 unnecessary calories in our stomachs every day. Cinnabon did not exist.

As to retirement, well smoking and cancer pretty much took care of it. Most of us died within a year or two of retirement so depleting savings wasn’t really an issue.

Now we live forever, speeding around in ridiculous motorized wheelchairs too fat and too weak to walk even a few steps as we worry just how long our money will last. What all of us in OECD world desperately want is to be less fat and more rich, so that we can enjoy our longer lifespan in good health and ample wealth.

Of course the reason that both dieting and investing have failure rates of more than 90% is because they both require Herculean efforts of willpower. They go against all of our human impulses hardwired into our psyches by thousands of years of evolution.

Even when we succeed in either endeavor over the short term we inevitably fail over the long term as our greed for both food and profits derail us from achieving our goals in a sustainable basis.

So are we destined to fail forever at dieting and trading? Not necessarily so. One of the most interesting pieces of recent nutrition research holds insights into how we can succeed on both fronts without radical changes in our behaviour.

What if I told you that you could lose weight without changing anything in your diet? You could eat the greasy tacos, drink the syrupy sweet Southern Iced tea and still have a chance to drop 5% of your body weight.

It’s called an 8 hour diet and it focuses not on what you eat, but on when you eat it. Basically scientists have discovered that reducing the time window for consuming food to just 8 hours a day ( ideally from 9AM in the morning to 5PM at night ) will have greater positive impact on your dieting than all the broccoli you can eat.

The research carried out at the Salk Institute in California showed that mice fed a high-fat diet within an eight hour time frame – for example between 9am and 5pm – were both healthier and slimmer than those given the same number of calories throughout the whole day. Even when obese mice had their eating window reduced to nine hours, they were able to drop 5 per cent of their body weight within a few days – while still enjoying the same amount of calories.

What I find fascinating about the 8 hour diet is how the same advice can be applied to the markets with similarly impressive results.

If nothing else my chat room is an ongoing experiment into the art of day trading and one of our greatest discoveries was that the time you trade is much more important than the strategy you use. In my chat room I have many traders using very different approaches to seek profit. Some use indicator driven strategies. Others use modified versions my fading algorithms that employ several entry and exit points on each trade cycle. And finally other like me have reduced their day trading methods the sparest simplest, single entry/single exit approach. Yet what all of us have in common is that none of us trade round the clock. We all trade very specific hours and then sit still for the rest of the day. That one minor change has had a bigger impact on both the accuracy and the profitability of our ideas than any strategy that we ever designed.

In our world of infinite possibilities, endless resources and round the clock satisfaction of our desires, the ultimate irony is that success depends on knowing when to say no. Less time eating and less time trading can help us become healthier and wealthier without much sacrifice.

Spray and Pray

Boris Schlossberg

When it comes to trading tactics there are only two moves you can make. You can stick to the single entry/single exit strategy or you can do multiple entries into a position until you get a better blended price that helps you turn a profit. I like to call that method “spray and pray”.

Price action by its very essence is probabilistic. It never follows a clear and steady path. That’s why the multiple entry method is so compelling because in theory that is exactly how you should respond to probabilistic opportunities. You can never know the absolute bottom or absolute top of a move so it’s better to spread your bets, to cast your net wide so as to increase the chance of catching the right price for the turn.

As seductive and as rational as that sounds, the multiple entry tactic is a gateway to trading hell not because of the math involved but because of the ever present psychology of the trader. Whether you like it or not, the more you allocate to a position the more attached to it you become. It doesn’t matter whether you are a seasoned hedge fund manager or a rookie trader we are all subject to the sunk cost bias. Sunk cost bias is simply the impulse to avert recognizing losses. It is perhaps the strongest human behavior pattern in behavioral economics and is primary reason why all classical economic models fail so miserably in predicting outcomes.

This week brings the news of Crispin Odey, one of the more colorful and well known UK hedge fund managers who, in the past four months, lost a decade’s worth of profits betting against the Australian dollar. A prime example of sunk cost bias as Mr. Odey becomes the newest poster boy for the “spray and pray” disaster.

Multiple entry tactic is a perfectly valid way to trade. If you are a fully programmatic trader, it may even be superior to the single entry/single exit approach because of the probabilistic nature of the markets. But if you are trading on a discretionary basis you simply cannot use that method no matter how many times you tell yourself that you have it under control. There will come a point when you will pull a stop and the multiple entry strategy will turn into yet another massive average down pile of losses that will end in a margin call. That will always happen. Believe me. That’s why the single biggest reason to never use “spray and pray” is to make sure that you are never in the position of turning the gun on yourself.

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What’s Better – Technicals or Fundamentals?

Boris Schlossberg

If you are a diehard fundamentalist like I once was, than this recent piece by Morgan Housel from Motley Fool really makes you think twice. In a column published this week Mr. Housel noted a few inconvenient facts about investing.

“1. Coca-Cola is fighting 12 consecutive years of soda consumption decline. Its stock is at an all-time high.
2. Tesla is changing the world, and orders for its new car are off the charts. Its stock is lower than it was 18 months ago.
3. Cigarette consumption has dropped 44% since 1981. Altria stock is up 71,000% since 1981.
4. WalMart net income has tripled since 2000. Its stock has lost 1.5% since 2000.
5. Apple has earned almost a quarter trillion dollars of profit since 2012. Its stock has barely budged.
6. Amazon’s profits round to zero since 2012. Its stock has tripled.
7. 2009 was one of the worst years for the economy in a century. The market rose 27%.
8. 2015 was a good year for the economy. The market rose 1%.
9. Brazil’s economy is a disaster. Its stock market is flat over the last two years.”

To which I can add my own little tidbit.

The US economy is leading G-3 in growth, rates and monetary bias and yet the US dollar is down more than 1200 pips against the yen and 800 pips against the euro this year.

So much for the forecasting power of fundamentals.

But technicals are of course no better. How many failed Head and Shoulders, how many failed moving average breakouts, how many busted Fibonacci retrace patterns have you seen in your life? And if Elliot Wave was so great, name me one, just one money manager that runs a $1 billion dollar book using that technical philosophy alone. I will wait another hundred years and you still won’t be able to provide me with an example.

Technicals are just a shade better than astrology in their ability to predict anything with accuracy.

The reason both disciplines fail so miserably is that context is everything. Investing is not logical -- it’s psychological and once you understand that you can make much more intelligent decisions.

While in and of themselves fundamentals and technicals are often worse than worthless, taken together they can become trading magic because they can provide that most elusive and valuable property of the markets -- context.

The classic good trade is often described as one where technicals and fundamentals confirm each other -- and that is indeed a good set up. But such combinations are rare, precisely because markets are forward discounting mechanisms and reasons for the rally or the selloff are rarely evident at the time of occurrence

Instead my favorite setup is when the fundamentals go one way and technicals do not confirm the move. This week’s action in USD/JPY is a prime example. The data from US Retails Sales was horrid and the change of posture to dovishness from Lockhart one of Fed’s most hawkish stalwarts should have been good for 100 point sell off in the pair. But the pair did not budge, instead it rallied in face of all this negative news. When price action runs counter to the prevailing narrative -- pay attention. That is often a great signal for a move against the consensus view. That is when you often get the best possible glimpse of “context” in action.

So next time someone tells you that they only trade on techincals or that they have never looked at chart in their life -- run the other way from those people -- because those type of traders have basically completely misunderstood the game that they are trying to play.

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You Don’t Sell Insurance in a Hurricane

Boris Schlossberg

Since the start of February USD/JPY is down more than 1400 pips. For those of you in the lottery business -- congratulations. Your once in longtime payout has hit paydirt. You can take your bow and walk off the stage with pockets full of profits. But if you are in the insurance business then this is definitely not the time to play.

Trading at its core is a very simple business. You only have two choices. Trend and Anti-trend. Every time you bet you are effectively predicting one of two possible paths -- the next move will be the continuation of the present one or it will be a reversal of it.

Since trends are much rarer than ranges all of trading essentially devolves into two models -- the lottery model where you make many small bets and lose most of them with the hope of hitting a ten bagger trade on just one of your tries and the insurance model where you win almost all your small bets and try take as few big losses as possible.

Most gurus teach the lottery model, but in real life especially in day trading the lottery model fails miserably. Since most of the currency dealers operate on the insurance model lottery traders become an easy opportunity to make money as market makers run stops day in and day out slowly collecting all of the lottery capital.

So in my chat room we trade the insurance model. We bet on anti-trend. We trade with negative risk to reward ratios and we try to win more than 75% of the time. So far so good. After more than a year of trading we are up in double digits while drawing down less than 3%. John Hancock would be proud. This year many of the new traders in my room are trading much better than me having fully absorbed my “insurance” principles and some are up 30% already.

But there is a time when the insurance model of day trading fails miserably. When volatility spikes and trends take over, trading against the move is a sucker bet. Volatility is exactly like a hurricane. It’s basically when price just like wind starts to move at 3, 5, 10 times its normal rate. The cardinal rule in the insurance business is that you don’t sell policies as the wind starts to blow and you certainly don’t stand in the middle of a full blown hurricane offering to cover the damage. Which is why when Yen went crazy, the first thing we did in our chat room was step away which was probably the best decision we made all week.

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Ignore Money – Get Rich

Boris Schlossberg

In his wonderful blog a www.wealthofcommonsense.com Ben Carson tackles the day to day frustrations of life in the markets. One of my favorite Carson posts is called “How to be Wrong as an Investor” where he literally lists a litany of problems that can befall an individual investment idea:

You can pick the right stock but in the wrong industry.
You can pick the right asset class but in the wrong geography.
You can pick the right country but in the wrong currency.
You can nail the direction of a trade but not the timing.
You can time things perfectly but invest in the wrong stocks.
You can invest in the right market but in the wrong style of stocks.
You can nail the macro but miss the micro implications.
You can optimize your asset allocation based on past experiences but be blindsided by new risks in the future.

The list goes on and on and it’s worth reading in its entirety because it rings so true. Anyone who has ever tried to make money from capital markets has been victim of several if not all of those failures and has certainly paid the price at the school of hard knocks. Yet for those of us who day trade the true problem lies with money rather than being wrong.

Allow me to explain.

A few years back I overheard an old time Chicago options market maker describe in complete detail exactly how he would win money from a golf player who was much more skilled than he. “First” , the market maker said, “you never play for penny ante odds. You put serious money on each hole and then you keep raising the pot by doing double or nothing with the guy. Eventually even the best players will crack because they are not longer playing the game but thinking about the money.”

This guy was a master manipulator who understood human psychology better than an Harvard professor I’ve met. And in the day to day battle of pit trading he excelled precisely because he knew how to make other traders “think about the money rather than the game.”

Although the floor days are long gone, the principles of trading remain the same. Think back to your worst trading mistakes and they inevitably turn out to be a pathetic melodrama of chasing the market at the worst possible moment because you wanted to “get the money back”.

The best traders have an almost ethereal ability to separate their decision making process from the P&L statement. For the rest of us -- that’s not so easy, which is why I recently started to do something interesting with my account that has helped a lot. I literally cover up the money. Or more accurately I remove the P&L module from my software so that I have no idea what my account is worth at any given moment. Yes, it’s a cheap psychological trick but it helps because it forces me to focus on the only thing that matters on a day to day basis -- making pips.

A pip (percentage in point) is the fundamental unit of measure in the currency market and as long as I focus on my pip count I retain a certain level of control. Of course there are still terrible days when I may lose a hundred pips on a series of ill advised trades, but it is far easier to regain your composure by focusing on making a few pips back a time rather than obsessing over the loss in your account.

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The great irony of the financial markets is that money -- the very thing we all seek -- is truly the root of all evil when it comes to trading. To win you need to trade for process not profit and that literally means that money doesn’t matter.

The Chocolate Chip Cookie Day Trade

Boris Schlossberg

If you are a red blooded American male of a certain age eventually your metabolism will simply stop working. It doesn’t matter that you bench press 350 pounds every week. It doesn’t matter that you take 20,000 steps each day. It doesn’t matter that you eat only boiled eggs for breakfast. You will start getting fat. The belly will expand, the suit pants will be a little tighter and you will look nostalgically at those high school photos of yourself when you could swallow a whole pizza for a snack and still maintain body fat of less than 5%.

Such is life. If you want to stay anywhere near your fighting weight you will have to become much more disciplined about your diet. You will eat only two meals a day. You will avoid desserts like the plague and carbs will now become your enemy number one, even though without them you turn into a raging maniac at work and home.

But no matter how well you diet. No matter how healthy you eat. No matter how committed you are to your daily regimen you will come across the magic smell of a chocolate chip cookie sooner or later and unless you have the willpower of Gandhi you will take a bite of it and wolf it down like the red blooded American male that you are.

If you day trade 20 hours a day like I do than this is what to do.

You keep your size small. You always honor your stop. You keep an ear out for news and have one eye on price action at all times. And most importantly you trade your setup. Over and over again.

But sometimes the markets are slow. There are no setups to trade. You get restless. Antsy. You become bored and you need to connect with the market to keep your focus sharp. So you start playing the “what if” game. What if I went long here? What if I went short the cross to offset it? Looks good -- let me just give it a try…

There is no day trader in the world that hasn’t done the “bored trade” at least once every few days or weeks. The “bored trade” is the chocolate chip cookie of day trading. You know it’s bad for you. You know you will just pay for it with empty calories or lost dollars but in the end you don’t care. You need to do it. You need that small hit of guilty pleasure.

And you know what?

That’s ok.

In trading as in life you should never let the perfect become the enemy of the good. We are not robots and don’t have to be in order to succeed. As long you eat just one or two cookies, or make just one or two dumb trades a week you’ll still maintain your fighting shape and will be ready to tackle both life and markets no worse for the wear.

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What I Learned From Making 10,000 Trades in The Currency Market

Boris Schlossberg

A few years back Malcolm Gladwell wrote a book called Outliers which became an instant bestseller forever etching the value of the 10,000 hour rule in our social consciousness. In the book Gladwell stated that practice far more than talent was responsible for a person’s success and that to achieve mastery in any field it was necessary to practice the skill for at least 10,000 hours.

The 10,000 hour rule has since been proven to be bunk (sorry talent and luck really do matter more), but it’s easy to see how in our Puritan work ethic society the concept took a life of its own. In any case practicing something for 10,000 hours certainly doesn’t hurt and does in fact make you at least proficient in your field of study so Gladwell was on to something.

The other day I realized that I had completed approximately my 10,000th trade since I started in the FX business, so I thought it may be worthwhile to see what if anything I learned from the experience. I can’t say I’ve discovered the secret to a perpetually rising equity curve or that I have learned how to fully master all of me demons, but after so many trades there are a few tricks of the game that I think are worth knowing.

First and foremost most people will ask -- do I really need to do 10,000 trades to learn how to day trade? The answer is yes. It’s not that 10,000 trades will give you the magic answer to how to master the markets, it’s more that after 10,000 trades you will learn just about every way you can possibly fail which is a value in and of itself.

The most common trading mistake -- and one that I still make to this day ( though far less frequently) -- is moving your stop. The Murphy’s Law of Life and Trading is that no matter how far or how frequently you move your stop, the market will always rise or fall just to the point of taking you out and will then snap back in your direction. You may escape the market’s sting once or twice or even three times, but in the end the stop will always get you and usually at the worst possible moment and at the biggest possible cost to your equity.

That’s why if you are daytrading and losing it is always better to stop out and get back in with bigger size that to continue adding to your position in hope of a turnaround. Stopping and starting may not feel good and may not even turn out to be profitable -- but trust -- me it will be far less un-profitable than adding to a trade.

After years and years of trading I have narrowed my stop down to just 25 pips. If you stick to that level it’s amazing how well you can survive in the market long enough to maybe even become profitable.

The next common mistake is that most traders start out way too large and get even larger if they add to the position. My starting trade is never more than one times my equity and I never scale up to more than four times equity at any given time. That means my biggest loss should never be more than 1% (25 pipsX4). Again, you can do a lot of foolish trades at 1% max and still live to fight another day.

Lastly, the key to winning as a daytrader does not lie in your ability to forecast direction (in fact the less you think about direction the better) but in your ability to maintain proper market posture. That means you let the market come to you rather than chasing it like a dog.

I am old enough to have survived the 1987 stock market crash and what almost no one remembers about that day is that it was the single biggest stock market rally in the history of S&P. A little after noon that day stocks stabilized and started to stage one the most vicious momentum rallies ever. If you had gotten long at that time and let it run until about 2PM New York time the gain was more than 10%. In daytrading it’s not important if you are long or short. The only thing that really matters is the quality of your entries. The better your entry, the better your trade.

Which is why after 10,000 trades in the market I still spend all of my time researching and trying to improve my entries. It’s not glamorous, it’s not thrilling but it’s what works. Every thousand new trades I get better.

How To Win From Losing

Boris Schlossberg

In the world of sports there is no more paranoid position than being a hockey goalie. You are, for intents and purposes, a human shield used for target practice. Your job is to stop the angry sting of rubber puck flying at you at more than 100 mph as you try to make sense of the constant swirl of motion in front of your goal.You play on a team, but are essentially alone. You cannot win games, but only lose them.

Little wonder then that hockey goalies tend to be a bit “peculiar”. In my own misspent youth minding the net, I wouldn’t hesitate to throw my mask, glove, stick -- anything that I could get my hands on -- at my poor defensemen, when I was even slightly displeased with their positioning. I would heap a torrent of verbal abuse on them that I would never unleash on my worst enemy. And yet these big, beefy guys, who under different circumstances could snap my neck in two without breaking a sweat, meekly absorbed all of my rants. Such is the power of a hockey goalie.

A few years ago NY Times ran an article talking about what sociologists call “non-normative” traits of being a hockey goalie. There was Bernie Parent, the famed keeper of the Broad Street Bullies, who took a nap with his German Shepard every day. Another NHL goalie compulsively stripped off his uniform between each period to take a shower as an elaborate superstition ritual. My favorite however was Gilles Gratton, who as New York Times writes, “bounced around in the minors in the ’70s before ending his career with the St. Louis Blues and the New York Rangers. Gratton liked to skate in the nude sometimes, wearing just his goalie mask, and refused to play if the stars did not line up properly. He believed that in a previous life he was an executioner who stoned people to death, and that he was fated to become a goalie — someone on the receiving end of a stoning, so to speak — as punishment.”

Although, goalies rarely if ever score a goal, any hockey player worth his weight will tell you that you can’t win the game without a good one which is what makes the story of Martin Brodeur so interesting. Brodeur was the inimitable netminder of the New Jersey Devils who spent more that 20 years in the league. He is no doubt one of the more talented goalies in NHL history, but what makes Brodeur unique is his ability to recover from losses.

In profile of him by New York Times, the paper wrote,

“Hockey people say that Brodeur’s particular strength is his ability to bounce back from a bad goal or a bad game and not let it gnaw at him. Hockey was locked out for the first half of this season, and during the Devils’ truncated training camp last month, you could see that he hates to be scored on even in practice, rapping his stick or ducking his head in disgust after letting one in. But the cloud passes in an instant, and then he’s bouncing on his skates and looking for more pucks to swat away. Lou Lamoriello, the Devils’ general manager, says, ‘Marty’s mental toughness, his ability to overcome a bad game, is just phenomenal.’ “

The older I get, the more I realize that there is simply no greater skill in life than the ability to recover from adversity. This is doubly so when it comes to financial markets, which like a hockey puck traveling at 150 miles per hour will do their best to knock you off balance every single day.

When we are young we think we are invincible and therefore never give much thought to recovery, assuming that our body and our mind will just snap back. But as we get older and hopefully a bit wiser we begin to pay more respect to the process of recovery. When I was young I had the bad luck of catching six pneumonias before I was twenty years old. The net result was that my lungs were shot and whenever I caught a cold it usually turned into a month long bronchial infection that made New York winters a constant misery.

But I as I got older I began to take my condition more seriously. Instead of trying to “gut it out”, I would drop everything at the first sign of sniffles, get in bed, drink 6 liters of water and try to sleep for 12-14 hours at a time. Doing this, I’ve managed to cut my recovery time from an average of three weeks to just a few days and have had far fewer colds in my 50’s than I did in my 30’s.

When it comes to trading, the ability to recover is far, far, far more important than the ability to win. No matter how hard you try, no matter how good you are, no matter how robust your strategy -- you will lose. And it’s at that point that true success will be determined.

Just like with my colds, I’ve learned over time that recovery from your trading losses depends far less on you being “right” and far more on you being “small”. Smaller trades lead to smaller absolute losses which give you time to assess the markets with a much cooler head. You don’t rush into the same trade, you don’t try to win it all back at once and you don’t carry the burden of your losses for days on end. Like Martin Brodeur, you realize that the darkness passes and tomorrow brings another day of opportunity to go toe to toe with the market.

Warren Buffett – Daytrader

Boris Schlossberg

At first glance there seems to nothing common between Warren Buffett and the chaotic frenzy of the day-trading world that I inhabit. But on closer inspection I realized that there are some striking similarities between the way Mr. Buffett approaches investing and the way I look at trading every day. Both of us try to stay away from risk as much as possible.

The Gordon-Gekko-I-am-Master-of-the-Universe stereotype of Wall Street is actually not how true wealth is built.“Have a hunch, bet a bunch” is not the the cornerstone of success of the great investors.

If you listen carefully to what Buffett says you realize that wealth is built by giving yourself a much bigger “margin for error” than most people think is necessary. In his latest letter to the shareholders, Buffett talks about the insurance business. He states that it is not enough to just understand the risks involved in the transaction and to price that risk correctly. To be truly successful in business you need to be able to walk away if the buyer of the policy isn’t willing to pay your price.

This I think is the core secret for all trading and investing success. Simply put, Mr. Buffett’s advice boils down to just two simple ideas -- know the full cost of your risk and don’t chase price. When you look at the way Mr. Buffett invests it has very little to do with picking a great stock ( although he certainly tries to do his homework) and much more to do with picking a decent stock at a good price.

As investors and traders we all have our narratives for where the market will go. But if we are honest with ourselves we’ll admit that no matter how much research we do, the accuracy of our forecasts is largely taken out of our hands. The world is too complex, developments happen faster or slower than we think and of course human beings are rarely rational and their behaviour is often bewilderingly unpredictable.

Even if you are right you can be wrong.

A few months back you may have seen The Big Short. Christian Bale portrays Mike Burry who as one of the heroes of the film walks away with billions in profits by betting on the subprime crisis. Yet what is lost on almost everyone in the audience is the fact that Mr. Burry only won his bet by literally taking his investors money hostage. Although he was absolutely right in his investment thesis, the markets refused to move his way for a very long time. Meanwhile he was forced to pay premiums to keep his bets alive, which led to near term losses and calls by his investors to abandon the strategy. Had Mr. Burry not had the clause in his contract that allowed him to lock his investors money -- in short had he not had the “margin of error” to consider the absolute worst scenario -- his bets would have ended worthless and he would have been just another woudda-coudda-shoudda chump on Wall Street instead of becoming a celebrity investor.

What Mr. Buffett teaches is that we can only control two things -- the amount of risk we take on and the price we are willing to pay. One is intimately tied to the other.

Mr. Buffett and I could not be more different. As a long term investor he trades time for money while as a short term trader I try to time my money and flip it over as fast as possible. But I’d to think that we both have a healthy respect for risk and more importantly the discipline to never chase price which hopefully puts me on the same road to financial success albeit via a different path.

The Secret Law That Governs The Markets

boris Boris Schlossberg

In one of the best investment columns written this year titled “How to Make Volatility Your B-” Josh Brown goes through the step by step process of dollar cost averaging demonstrating why it is the single greatest investment strategy ever created. Brown shows how consistent and steady buying of an equity index will beat any hedge fund return anywhere, anytime.

The idea is that some of your capital will have massive double digit returns as you scoop up assets at firesale prices and some of your capital will have average returns and some of the capital may even have negative returns as you pay up during market rallies but the overall value of your holdings will almost certainly rise over any 10 year period of time. The only way that this strategy would fail is if stocks slowly but surely drifted to zero over a 10 year period in which case you probably would have much bigger issues to worry about. As long as equities have an upward drift you simply can’t do better as an investor than dollar cost averaging into the index.

The dollar cost averaging strategy of success relies on two factors -- the natural upward drift of equity markets and the much more important idea of the law of large numbers. The law of large numbers simply says that outcomes will almost always reach their expected end, as long as you have enough samples. For example if you flipped a quarter 3 times in a row chances are good that you could get all heads or all tails. In fact 12% of the time that’s exactly what would happen. Does that mean that the coin is rigged? No. It just means your sample size is very small and highly biased. Flip the same coin 1000 times and the probability that heads or tails will fall within a few basis points of 50% are almost assured. Do it 10,000 times and they are practically guaranteed.

The law of large numbers is an amazing principle. It essentially tells you all need to know about how to get rich. Just chop up risk into tiny little pieces and take many ( hundreds or even thousands ) samples of that risk and over time you will be much wealthier than you are now. Of course this little mind experiment assumes that the risk you consider is actually worthy. For example if you dollar cost averaged gold for the past 50 years you would still be worth a lot of money ( if for no other reason that you would own a lot of gold!) but not nearly as much money as if you bought the S&P 500. Still even in that example you can see the power of this principle in action.

That’s why it always amazes me that traders routinely ignore this foundational idea of risk control. In fact I think that the primary reason why most lose money in the market is that they don’t appreciate the power of the law of large numbers. The underlying concept behind the law is that you need to trade SMALL. There is actually some poetic irony in that dynamic. You need to do a lot of trades in order to assure yourself of long term success and the reason you need to trade trade small is precisely because you need to be able to withstand the bad runs that will inevitably occur.

The first thing that I do in order to improve a trader’s performance is to make them trade so small that it seems almost miniscule. Frankly it almost doesn’t matter what system they trade, reducing size has an instant and dramatic impact on performance. They stop panicking and execute the strategies much more effectively. Marry the law of large numbers with a sound trading algorithm and you have nearly a full proof recipe for success.

Don’t believe me. Look at high frequency firms like Virtu that trade millions of shares per day 100 shares at a time and haven’t had losing days in years. As an individual trader you don’t need to mimic the hyperkinetic pace of HFT shops, but you do need to slice risk into tiny increments just like they do. It’s truly unbelievable that the answer to 90% of our trading problems lies in size rather than strategy, yet so few traders take advantage of the key law that governs the markets.