We were discussing momentum indicators and the importance of trends. He believed the long-term trend was the most important characteristic of a stock. Nothing too controversial, to be sure. It’s what he said next that really surprised me. He said:
“Short-term stock price changes are like flipping a coin.”
Is This As Absurd As It Sounds
About half the time, a flipped coin will come up heads and the other half it will come up tails. It sounds absurd to think that this would occur in the stock market, with the endless variables going into each stock’s daily movements.
But he was confident that, over the course of a year, about half the time a stock will close up, and half the time the closing price will be lower than it was the previous day. To demonstrate that this was true, he would pick two stocks. One was the biggest gainer in the past 12 months. The other was the biggest loser. Then he calculated the number of up days and down days for each.
Initially, he showed me The Williams Companies, an energy company which had a significant presence in Denver. That was the winner.
The loser was Eastman Kodak, another company with a local presence. (He taught me to always focus on local firms in presentations since the examples will stick with the audience.) Despite their vast difference in performance, both had spent only about half the time of the past year rising or falling.
What This Year’s Biggest Winner And Loser Have In Common
I thought of this earlier that week when the True Options Masters team discussed win rates for different trading strategies. We know that win rates aren’t very important to look at, for real traders.
Despite the marketing value to them, most traders aren’t successful because of their win rates, but rather their risk management and ability to spot trends. More on that later. When I brought up the above story, there was some doubt it was still true. We agreed to look at a test.
I sought out the biggest winner in the stock market over the previous 12 months. That stock was Cassava Sciences, Inc. (Nasdaq: SAVA) which has gained over 3,780%.
During that time, the stock closed up on 50.2% of all trading days.
Gaotu Techedu Inc. (NYSE: GOTU) is the biggest loser over the past 12 months, with a loss of more than 96%.
During that time it closed lower 53% of the time in the past year.
Strange, right? You’d think a stock with such an impressively good or bad return would spend most of its time in that direction. This math even applies to meme stocks. GameStop Corp. (NYSE: GME), one of the headline-grabbers from earlier in the year, has been up on 50.6% of trading days in the past year. There’s an important lesson in this data for individual traders…
A 50% WIN RATE IS ALL YOU NEED
You don’t need to be right a high percentage of the time to be profitable. Big gains are possible if you’re right even just half the time. This lesson isn’t lost on hedge fund managers. In a recent interview, Steve Cohen said his investment managers are right between 52% and 55% of the time. Cohen is someone who’s worth listening to. Between 1992 and 2013, Cohen’s hedge fund, SAC Capital, averaged annual returns of 25% a year for its investors. That’s an outstanding return to come out of two financial crises.
These gains debunk another myth that individual investors cling to. Individuals often look for low-cost investments. Cohen’s fund charged some of the highest fees in the industry with an annual management fee of 3% and 50% of the profits. Even with those fees, SAC gained more than 70% a year during the dot-com bubble of the late 1990s. When the bubble burst, the fund delivered a 70% gain by shorting those same stocks on the way down.
SAC shut down after some of the managers in the fund were accused of insider trading. But Cohen wasn’t implicated in the wrongdoing, and he has proven he is still among the greatest investors of all time. In 2018, Cohen launched Point72 Asset Management and earned more than $1 billion in each of the past two years. For over 30 years, Steve Cohen has been generating incredible gains for his investors and himself. And he has done that by being right about half the time.
His performance is another data point showing that traders don’t need to be right 70% of the time or more. They can make large profits being right about half the time. That’s an important lesson to learn, and one that many individuals refuse to accept, despite what the data shows.
In Summary
So long as you’re managing your risk properly — not getting married to your losers and picking trades with conviction — those principles will serve you better than a fabled, flawless win rate.
Michael Carr can be contacted on this link: Michael Carr