Trading isn’t black and white, it can’t be bundled up into a nice package, and it rarely makes for a good sound bite. Let’s be frank, no matter what size account you’ve got, trading it is filled with uncertainty. But while investors might hate uncertainty, markets can’t exist without it, plain and simple. Although we attempt to put the odds a little bit in our favor through diligent analysis, we can never eliminate the risk involved in any investment decision. After awhile, even when you’re right, it can really start to get on your nerves.

Up until a couple of years ago, the biggest risk in the market seemed not to be losing money, but losing out on the seemingly limitless upside of growth stocks. Like a roller coaster, many were expecting a bumpy, albeit ultimately profitable, ride. Then the bubble burst and the major averages nose-dived. Reality reared its ugly head in a painful reminder of the market’s inherent uncertainty.

Despite the recent 20% rally in major indexes, risk is still more prevalent than ever — both within the market and in our portfolios. What if the stock market continues to rally? What if it falls? What if we go to war? What if we don’t?

When it comes to your portfolio, uncertainty usually leads to frustration. Indeed, before there was Moore’s Law there was Murphy’s, and whether I’m too greedy or too fearful, overweight in value stocks or still loaded up on growth, it always seems as if the market is, well, out to get me. Indeed, as Gilda Radner famously said, “It’s always something.”

And although many investors are beginning to question their allocations to passively managed index funds, even more are discovering that, generally speaking, actively managing your investments is kind of a drag. When we make money, we could’ve made more. When we lose money, we should’ve lost less. When you do well, someone always did better. No matter at what level you play the game, the stress of trading can become rather, well, grating.

And if you think Teamsters have lousy job security, try being a trader, where you’re only as good as your last (quarterly) performance. Bernie Ebbers might not be accountable to his shareholders, but you need to be especially if you’re the only one. We can pontificate until we’re blue in the face, but at the end of the day it’s all about absolute return. Everything else is conversation.

Trading isn’t about eliminating uncertainty, but dealing with it — and as strange as it sounds, when it comes to soliciting outlooks about the market, I’ve often found that less is more. There’s always a bull and a bear argument for every stock under the sun, and too many opinions, even from reputable sources, can be more of a hindrance than a help. Stock tips, like caffeine or carbohydrates, are an ultimately debilitating habit in which we often just can’t resist the urge to indulge.

But the truth is that nobody knows exactly where the markets are going. If you’re bullish then be bullish. But don’t second-guess yourself every time someone offers an opposing viewpoint. Let the market prove you wrong — as it inevitably will at times — not Barton Biggs or Abby Joseph Cohen. You’ve got to approach the markets with the realization that no matter how airtight your analysis, something is always going to go wrong within your portfolio. Every trade can’t be a winner.

And because it’s always going to be something — the trick is to make sure that a soggy trade doesn’t sink your entire portfolio. Trading the appropriate product relative to your capital, and the right position size relative to the product, ensures that the inevitable losing trades are an annoyance, not a death sentence.

Finally, realize that while your positions might not be there for the long haul, as an investor, you are. And although it’s easy to get depressed after a big loss or missed opportunity, cut yourself some slack and get back to basics. A winning strategy is less focused on making money than not losing it, and because you can’t invest in everything, you’ve got to pick your points. For both your portfolio’s and sanity’s sake, if you aren’t 100% confident in a trade then don’t make it.

– Originally on Aug 26, 2002 by Jonathan Hoenig

And so it goes in trading. Some people are biased toward playing stocks from the long side. Others seem to be perennially short. Should I buy or sell Oracle (ORCL)? Or perhaps do nothing at all? Even nondecision is an active choice governed by your personal market biases.

What distinguishes the successful trader is that he understands his biases and knows how to overcome the ones that harm the bottom line. To help you do the same, here’s a look at the three biggest sources of trading bias.

The most common way biases are formed is through *previous experiences*. As a kid, it only took one serious burn for me to realize that touching fire wasn’t a very pleasant thing. More recently, we all learned that companies with a dot-com suffix have a strange tendency to deflate, decline or just disappear altogether.

But too often what we learn from a past experience and what we should learn are two very different things.

For example, after losing money when the technology stocks dropped in 2000 and 2001, many investors have developed a distinctly antitech bias. These days, technology companies, dot-coms or any company that isn’t posting a profit has been shipped to stock-market Siberia. For many people, anything tech is now off-limits in their portfolio.

It’s an illogical bias (just as the 1999 frenzy for anything tech was an illogical bias). These days, I talk to many investors who’ve sworn off everything from emerging markets to metals simply because they lost money before in that sector.

But as we often point out, trading success isn’t a function of what you trade but how you trade. The real lesson of the tech wreck wasn’t that you shouldn’t invest in speculative companies or companies without earnings, but that you should do so intelligently, and with proper trading technique.

Those who lost big money in tech got creamed not because they were in speculative stocks, but because they had big positions. And as hard as it is to hear, the same goes for the unfortunately loyal employees of Enron (ENRNQ) who had the majority of their 401(k) money loaded into company stock. The lesson of losses isn’t to trade particular securities, but to trade them in a smarter way. Indeed, when I lose serious money, it isn’t because I bet on any particular sector, but because I bet with bad form.

Another large part of people’s trading bias comes from *long-term price performance*. The most worthless investing insight is the idea that stocks are the best long-term investment on earth. It’s the mantra of millions of investment advisers and the thinking behind billions of dollars allocated to index or indexlike investments.

But the uncomfortable reality is that we have no certainty that the market will be higher over the longest of long terms. We have even less certainty that equities will outperform during our actual holding periods, which for most investors are decidedly shorter than the 72 years on which much of the long-term credo is based.

What’s ultimately the most predictive element of a stock isn’t its long-term past performance, but its more recent action. The fact that Kmart (KM) was a market leader 30 years ago didn’t stop it from crashing and burning, and if you held onto Enron because of its past glory, then you missed the technical signals predicting its more perilous present situation.

Yet I can’t tell you how many investors pass up good opportunities just because of their long-term past performance. While I respect the old maxim that those who forget history are doomed to repeat it, the truth is that those who dwell on the past often live there as well. The best trader’s bias isn’t toward the historically best stocks, but the currently best ones. As we’ve pointed out before, trading is like bar hopping: You’ve got to go where the action is.

Finally, many traders unfortunately have a bias toward *popular consensus*. There is nothing more brainless than following the herd, and for many traders following a pundit is much easier than taking the time and emotional responsibility for their own actions.

So they avoid stocks that a major brokerage has recently downgraded, or even those that have merely been the subject of criticism or doubt. It’s the Nuremberg school of investing: “It wasn’t my fault I lost money. I was just following orders.”

Because they harbor a bias toward the crowd favorites, they tend to focus on the most seemingly “safe” ideas by buying the most widely owned names. The truth is that an investor wants to seek out risk, not avoid it altogether. The game isn’t about avoiding risk, but learning to manage it better. So my bias is generally tilted toward those stocks or sectors that everyone avoids, because while it may feel more comfortable to follow the crowd, the biggest opportunities tend to reside in the least popular places. There’s a reason they call it “Heard on the Street.”

Because trading is ultimately about having an opinion, bias isn’t something we should avoid, but shape. It’s emotionally easy to avoid investments simply because of a previous bad experience or a bit of negative buzz. But the truth is that the past doesn’t always repeat itself and that the crowd is usually dead wrong. In the final analysis, the best bias is toward an open mind.

– Originally on Mar 04, 2002 by Jonathan Hoenig

What saves me, however, is that the profits from my winning trades are bigger than the losses from my losing ones.

Simply put, you don’t have to win more often than you lose. You do, however, need to win bigger than you lose. I have found that when it comes to allocating a portfolio, the old “80-20″ rule tends to apply: 80% of your profits tend to come from 20% of your trades. To that end, the point isn’t to search for trades with a high probability of winning, but with a high probability of a large return.

Returns, large or otherwise, are few and far between these days. A vast majority of mutual funds lost money in the first half of 2001, and after another couple of bruising months in the market, it isn’t a surprise that most people aren’t looking to take on major risk. Listen to the vox populi these days and you’ll find dividends are very much back in vogue. Bonds and “defensive” sectors, like pharmaceuticals for example, are all the rage. These are just a few of the once-boring investments that are now seen as safe moves for precarious times.

But the notion of safe stocks is a misnomer, because if you’re trading stocks, then the truth is that you want to seek out high-risk situations. After all, that’s where the payoff is. As a trader, your job isn’t to avoid risk, but to manage it. (Let’s get one thing straight, though. I’m talking here about risk capital, which is the only kind you should be trading with. There’s a vehicle that pays out consistent, safe returns, and it’s called savings.)

Being naturally risk averse, however — and even more so in recent months — most people place their wagers on the seemingly safe favorites. Sounds reasonable, right? Indeed, most people feel confident knowing that their money is riding on the stock with the best odds…i.e., the best chance of “winning.”

And although we often interpret odds as probabilities, the reality of markets is that anything could happen. Whether posted in the Racing Form or in a pundit’s research report, odds don’t tell you what horse is going to finish the race first, nor what stock is going to move higher. Over short time periods, a “risky” stock has just as much chance of paying off as a “safe” one, especially when the risky stock is showing some sort of technical strength. Sometimes the long shot wins, or the public favorite falls. Trading is just like life — anything can happen.

Odds simply reflect the payoff schedule of a particular event at a particular time. Less probable outcomes are given more attractive (read: lucrative) odds. So assuming you’re using appropriate position size, the actual risk in buying either the “risky” or “safe” stock is actually quite similar. Consider the horse-racing example: Whether you put down a $2 bet on the long shot or a $2 bet on the sure thing, the risk is still $2. What’s different, of course, is the payoff schedules dictated by the odds. Horses with “good odds” might pay one to two, or $1 for every $2 bet. Long shots, the track’s version of “risky” stocks, might pay 30 to one, or $30 for every $1 bet, an exponentially better payoff.

This is precisely the problem with betting the favorites. Good odds, by definition, mean lousy payoffs.

Sticking to “safe” bets is actually a recipe for underperformance, because tiny payoffs don’t compensate for the inevitable losses that go along with any type of speculative endeavor. The truth is that what most people think of as good odds are actually lousy odds. In reality, the stock that’s perceived to be “safe” has all of the downside of a “risky” stock with a fraction of the upside.

So instead of focusing on making winning trades more numerous, try and make them more profitable. Think like a mom-and-pop store: high margin, low volume. “Risky” stocks, such as those based in emerging markets, biotechnology or junk bonds, are highly volatile, but it doesn’t mean they should be excluded from even supposedly “safe” portfolios. As with most elements of trading, success comes down to proper technique.

Most people don’t assume risk — they manufacture it. For example, they don’t just buy a closed-end fund that focuses on emerging markets, they put 25% of their portfolio in at one price, on one day, and without the benefit of a well-defined trend or a diversified portfolio. That isn’t risk — it’s recklessness.

“Safe” trading isn’t about avoiding risk, but managing it. We can’t control the market, but we can control the size, timing and types of bets we make. And while it may be psychologically comforting to bet with the crowd, real payoffs come not from continually playing the favorites, but from playing the field.

– Originally on Oct 29, 2001 by Jonathan Hoenig