One of the widely accepted conventions of trading is that erratic returns are just
part of the game. Some trades will be great, some will be mediocre, and some will be
awful. But if you want to make it big in trading, you have to be willing to take some
losses if you want to make some big profits, right?
Think again. When given the choice, you may want to be consistently profitable in
small ways, rather than hit the occasional 'homerun'. In the following example, we'll
compare the difference between the two.
In our first scenario, we start with a trading account worth $10,000. We'll say we
get a 5% return each month on the previous month's balance. After doing this for
twelve months, we end up with an account balance of $17,103, or a 71% return for the
year. That's not bad for an average monthly return of 5%.
Consistent Account - Average of 5% per Month
On the other hand, we could 'go for broke' with our $10,000 account. Here we'll be
highly aggressive in search of big rewards, and we'll just deal with the fact that
some months will be rough. That, after all, is the price you have to pay to get those
stellar returns. After twelve volatile months, we've actually gotten our average
monthly return up to 8% instead of the consistent 5% we saw before. That 3%
difference in the average monthly return over twelve months should make a big impact
to our bottom line, right? Wrong. Even with a better monthly average, those few bad
months really took their toll. This volatile account only achieved 48% return - much
less than our boring account that only gave us 5% per month.
Inconsistent Account - Average of 8% per Month
This is a testament to the importance of consistency, and capital preservation. In
our second scenario, the reason the great months didn't help was because we had less
capital to invest following a losing month. (By the way, it doesn't matter how you
sequence your gains and losses in scenario two - the average monthly return and the
bottom line remain the same. Don't plan on taking your losses early and 'making up
for them later', as it just won't help any.)
Not every winner has to be huge, but a few huge losses can sure knock you out of the
game. Using tight stops and setting reasonable targets will help you stay consistent.
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