Earlier I wrote an article called “Margin of Safety: A Probabilistic Approach”. I wrote that to have a winning investment strategy, the expected value of our investments needs to be positive, that is:
Probability(Winning Investment)*(Average Win) > Probability(Losing Investment)*(Average Loss)
A positive expected value therefore occurs when
The Win to Loss Ratio > (1 - Batting Average) / Batting Average
Where
Batting Average is the percent of times you successfully make a winning investment, and
The Win to Loss Ratio equals the average gain of your winning investments divided by average loss of your losing losing investments
I generally aim for a 2:1 Win to Loss ratio. Why? Because, if we can achieve that, we can be wrong two out of every three times, and still make money! That’s a pretty good margin of safety.
But there are many ways to manifest this 2:1 Win to Loss Ratio.
What is optimal?
Well, the answer may surprise you.
A few years ago, I was playing around with some numbers and here is what I found:
The optimal ROIs are highlighted in green. Notice how different they are given a combination of batting average, average gain and average loss.
For example, if I aim for a 40% batting average, the optimal ROI would occur when winners average +20% profits, and losers average 10% losses. But if my batting average drops to 35%, then my optimal ROI drastically changes. Now, the optimal ROI occurs when winners average +4% profits, and losers average 2% losses. In fact, at a 35% batting average, the 20/10 2:1 ratio would result in negative returns!
Didn’t see that coming…
This isn’t super intuitive, at least it wasn’t for me, but seeing the data really makes the point.
I don’t talk much about “trading” in this newsletter. But perhaps this table is even more helpful for shorter term traders. It highlights that seeking home runs from trading is clearly not an optimal strategy.
Happy Investing!
In the last cell (last row, last column), the result is -100%. With a 45% win-ratio & 2:1 profit/loss ratio, how did you arrive at -100% conclusion?
Does it have something to do with compounded nature of the bets? I feel I am missing something.