Thursday, November 29, 2012

Are the Odds in Your Favor?

One of the biggest problems with traditional buy and hold investment strategies is that markets are not static.  During uptrends the odds of making money are largely in the investors favor while the odds of losing money are low.  However, during downtrends the odds of losing money are high and the odds of making money are low.  That doesn't mean that an investor can't make money when the odds are against him and it doesn't mean that an investor can't lose money when the odds are with him.  In any uptrend there will be plenty of down days, weeks, and months.  In any downtrend there will be plenty of up days, weeks, and months.  So, in an uptrend a buy and hold investor won't make money all the time, but if they stick with their strategy they will make money overall.  If we only had uptrends in markets then buy and hold would be a valid strategy but that is not how markets work.  In a downtrend a buy and hold investor won't lose money all the time, but if they stick with their strategy they will lose overall.  During the days, weeks, or months when they can make money they assume they are following a smart investment strategy, but this is not the case as it is never smart to invest in such a way that stacks the odds against you.  Over time this is why most investors end up going nowhere.

A good analogy to this is in Blackjack.  Blackjack has a certain set of "rules" (when to hit, when to stay, when to double down, etc) that if you abide by them give the card player pretty much equal odds with the house.  Anyone who has played Blackjack before knows there is always someone at the table who doesn't play by the rules, they hit when they aren't supposed to or stay when they should hit.  Every once in a while this person wins.  Does that make what they are doing smart?  Not at all.  Over time if they follow this strategy it puts the odds substantially in the house's favor. 

The key to investment success if reallly quite simple, always keep the odds in your favor.  Take the most risk when the odds are in your favor and reduce or eliminate risk when they are not.  You won't win all the time.  Sometimes it will be emotionally difficult to stay on the sidelines during an upside correction in an overall down market.  If you keep the odds in your favor over time you will end up much better off than the traditional buy and hold investor who sometimes has the odds on his side and often doesn't.

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