Variance in the Stock Market
Variance, according to the dictionary, is “an event that departs from expectations.”
Let’s play a game to see how variance relates to the stock market. We’ll flip a fair coin four times, and each time the coin lands heads up, I’ll give you $100; each time the coin lands tails up, you’ll give me $100. Now, the expectation of this game is even money - that’s straightforward. When we play the game, however, 50% of the time will result in one of us beating the other. This means that - while the game is even money in terms of expectation - one of us could very well be ahead of the other! As you increase the number of times you flip the coin, the chances of one of us beating the other goes down.
This concept of variance applies to the stock market. Let’s say that (theoretically) each trade that you make has a 50% success rate and that your risk to reward ratio is 3:1. You’re expected profit is positive. Last month, you placed four trades with this new strategy you just discovered and have taken losses on all four trades.
Does this unfortunate outcome mean that your strategy is worthless? Maybe. Maybe not. You could be unlucky due to variance or you may have made a mistake in your analysis of your strategy. You may be asking, so how can you ever really know if your strategy works or not? The answer is you’ll never know for sure. But the more trades you make, the more accurate your actual results will reflect the theoretical value of your strategy.
Key Stock Investing Lesson
You’re never going to be able to fully determine the theoretical value of any strategy. There is always uncertainty and variance in play. If you’re not the mathematical type, just use your gut when it comes to reviewing your stock performance and strategy. Make sure you have a decent sample size and compare your results to what you expect the outcome to be. For example, if you just made ten losing trades in a row and believe your success rate is 50% (the chance of this happening is less than 0.1%) , then it’s pretty likely that you need to reconsider your strategy.
As a last note, make sure that you compare your results to the overall performance of the stock market when reviewing your performance. If all of your ten trades went down, but nine out of ten S&P500 stocks fell in the same time period, then your strategy may not be completely flawed after all.
[…] I thought that it might be a potential option to explore. I did realize, however, that the sample size for my trading was so small that I could not base a long-term career off of my recent […]
[…] Variance in the Stock Market Losing money does not equate to a losing trading strategy and system. Find out how variance affects your performance and how you should view the market behind the lenses of luck. […]