The Babe Ruth Effect - Ground Report

On Thursday, the Dow closed down 390 points, its second worst fall in 2007.  The last such massive plunge this year came in February when bluechips fell a whopping 416 points.
NASDAQ closed 56 points lower while the S and P 500 fell 44 points.
Crude was lower by about half  a dollar, while gold finished more than $13 dollars down.
Hedge fund Black Mesa reported huge selloffs of portfolios, while France’s biggest investment bank, BNP Pairbas froze three of its hedge funds due to subprime lending defaults in the U.S. Both the European Central Bank and the Bank of Canada pumped money into the financial sector.
<a title="/www.turtletrader.com/magnitude.html" href="http:///www.turtletrader.com/magnitude.html">Turtle Trader</a>:
<h5>The Babe Ruth Effect: 
Frequency versus Magnitude</h5>
Download the <a title="Babe Ruth pdf" href="http://www.turtletrader.com/babe-ruth.pdf">Adobe .pdf report</a>.
Michael Mauboussin offers clarity on frequency versus magnitude. Must reading for all traders. Download the white paper above. “In the real world there is no ‘easy way’ to assure a financial profit. At least, it is gratifying to 
rationalize that we would rather lose intelligently than win ignorantly.”
 
- Richard A. Epstein. The Theory of Gambling and Statistical Logic
 
 

<h5><a title="Afraid to Trade.com" href="http://blog.afraidtotrade.com/">AfraidtoTrade</a>: <a rel="bookmark" href="http://blog.afraidtotrade.com/frequency-vs-magnitude-in-the-markets-and-in-life-2/">Frequency vs Magnitude: In the Markets and in Life</a></h5>
“If you had to pick between consistent, steady small trading gains with large losses, or a handful of winning trades that result in large gains, but also consistent small losses, which would you choose? 
<img alt="" align="left" src="http://blog.afraidtotrade.com/wp-content/uploads/2007/08/080807-0338-frequencyvs12.jpg" />If you search yourself honestly, your answer would likely be “I prefer winning more times than losing more times in the market;” however, this does not take into account the larger picture of probability and expectancy. 
Specifically, the above conundrum comes down to a debate between the issues of “Frequency” and “Magnitude,” and there are no easy answers to be found when it comes to the markets, and there are always trade-offs. 
In a summary, the “Frequency” aspect entails how often your trades show a profit or a loss. 
The “Magnitude” aspect entails “how large” or “how massive” are those gains vs those losses in your overall trading system/plan. 
The Turtle Trader.com site provides a wonderful, <a href="http://www.turtletrader.com/magnitude.html">detailed analysis of these concepts</a> by Michael Mouboussin and discusses how they relate to life and the markets. 
First, let’s consider the “Babe Ruth” effect as translated into the world of trading. We all know of Babe Ruth and consider him an American baseball legend because of his homerun record. But how many Americans also know that he also – at one time – held the league’s record for strike-outs? In fact, Babe Ruth struck out at bat thousands more times than he hit homeruns! 
Ruth is a legend because of the “magnitude” of his accomplishments – in terms of his record-breaking amount of homeruns batted out of the park. 
In the trading world, we also recognize legendary traders because of their accomplishments, but often these accomplishments would be far overshadowed by a trail of losing trades if we took the time to study those as well and not focus on the few major wins of the individual. In fact, many of the profiled “Market Wizards” confessed of major equity blow-outs or other major hardships during their career – and not always the early part of it! 
Without giving too much away from the article, I will relay a portion of a story told by Mouboussin where a company’s treasurer decided he must eliminate some of the firm’s underperforming money managers. The criteria he set was the percentage of stocks held in a given manager’s portfolio that beat the S&P 500 that year. Managers who held a significant percent of stocks that underperformed the benchmark were eliminated. 
A strange situation occurred when the firm’s best performing manager – from a percentage return standpoint – was to be eliminated because of a great number of stocks held in his portfolio that underperformed the S&P 500 that year. What was the manager to do? What did he do wrong? How could this situation be possible?
<img alt="" align="left" src="http://blog.afraidtotrade.com/wp-content/uploads/2007/08/080807-0338-frequencyvs21.jpg" />The lesson to take home from this example is that frequency of correctness in the market (or in life) does not matter; instead, it is the magnitude of correctness that ultimately matters. “

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