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March Madness and Your Trading Decisions

March 04, 2013 | About:
All investors want to believe their superior research and intelligence will steer them towards making good trades. Well-informed buy and sell decisions form the basis for any chance at outperforming the indices.

Few of us have unlimited investable resources. That means we often have to triage our holdings when we uncover what we see as a new great stock to buy. We are required to exit our least promising existing position to raise the money to fund our newly discovered gem.

The concept of selling one stock to buy another is not rocket science. The ability to actually improve our overall results is much harder than it would intuitively seem.

Think about an NCAA tournament basketball player who shot a respectable 70% from the free-throw line throughout the entire season. Our gut instinct when he walks to the line "shooting two" is that he’ll probably make both shots most of the time.



Statisticians in the crowd know better. Each shot is a separate event from a probability standpoint. The chance that he will sink both free throws is calculated as 0.7 x 0.7 = 0.49. A 70% overall success rate translates into making both ends slightly less than half the time!

When you sell one stock to buy another, you’ll need to be right on more than 70% of your decisions to see a better than 50-50 chance of goosing your portfolio’s return. Why? Consider the various possibilities.

The shares you sell could go up more than the newly acquired ones. Despite your optimistic viewpoint, the new holding might go down more than the one you decided to jettison. In a real worst-case scenario, the company you exited might surge higher while its replacement tanks.

Add in the frictional costs of bid-ask spreads and commissions and it’s even a little tougher than the 71% or better implied decision-making success rate I mentioned earlier to get a positive impact.

If investing was easy, we’d all be rich already.

Good luck to all in your investments as well as your NCAA and NIT brackets.

About the author:

Dr. Paul Price
http://www.RealMoneyPro.com
http://www.MarketShadows.com
http://www.TalkMarkets.com

Visit Dr. Paul Price's Website


Rating: 2.0/5 (7 votes)

Comments

batbeer2
Batbeer2 premium member - 1 year ago
Thanks for an article worth reading.
paulwitt
Paulwitt premium member - 1 year ago
Yes, March madness is here. Check out CYIG. Might be a world record for free throws!

paulwitt
Paulwitt premium member - 1 year ago
Anyone ever see a stock go up 88,000% in one day?

Check out CYIG. Quite a thrill watching!

swnyc2
Swnyc2 - 1 year ago
Dear Paul,

Forgive me, but I don't think your free-throw analogy applies to trading one stock for another.

When one trades one stock for another, there is a probability that the stock you sold will do better than the stock you purchased or vice versa. Neglecting frictional costs, if one knows nothing about the stocks, the probability is 50% that the trade will increase the value of your portfolio and 50% that it will decrease it.

I believe a more important issue is that it is often difficult to determine in retrospect whether it was prudent to sell one stock to buy another -- because the answer often depends on timing. In other words, when should one determine the success of the trade? After one month? After one year? If one is a long term investor, perhaps the time frame should be longer? In many cases, a trade will be profitable for certain time points, but not others. When this happens, it can be difficult to determine whether the right decision was made.....

Regards,

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