Whether you like it or not, we all have to make bets. The bets we make may not involve gambling, lotteries or casinos, but they are sure involving money and uncertainty. Do you want an example? When you buy a car or a house and buy an insurance, you are not making anything more than a bet; You are exchanging an amount (the value of the policy) in exchange for a higher payment (premium) based on the possibility of an uncertain event (a car accident or problems with your house). This is a kind of gamblimg, as well as health insurance, life insurance and investments. The question here is: Are they worth it?
Common sense always leads us to respond an yes at first. But is that correct? Let's take a simpler example, such as the extended warranty offered by the store when we buy any king of electronic goods. I am sure enough that it's a big deal for retail chains, but is it for you too? Some people say no because the chance of any problem occurring with products that go beyond the factory warranty is very small. Others say that it is not only a chance of a problem to happen, but the time you save and the headache you avoid when you need to exchange the product is worth paying the extended warranty. Luckily the rule to understand whether it really is worth it or not has already been developed centuries ago.
And how do I do it? Very simple, you just have some basic understanding of probability theory.
Now imagine that you are in front of a new TV that costs U$ 600 and offer you the extended 5 year warranty for only "U$ 49". It may seems a small value regarding the total value of the TV...but regardless the apparently low value, this extended warrant does not worth it. Why? Just follow the formula:
Honest Warranty = - Risk of Not Missing Nothing x Warranty Price + Risk of Loss x TV Price
If the result of this formula is negative or equal to zero, the extended warranty does not worth it. Considering the value of the TV U$ 600, this would be your total expected loss in case of any problem. The extended warranty is only worth it if it is less than the value of the TV multiplied by the chance you having some kind of problem in the next 5 years. A quick search on Google shows that less than 5% of televisions give some trouble in five years. So your chance of having no problems with your new TV is 95% or more. Therefore, our formula is:
Honest warranty= 95% x 49 + 5% x 600
Honest warranty= -16.55
As the result is negative, the warranty does not worth it. The fair price of the extended warranty based on the chance of any problem happening to you would be 5% x U$ 1,200, then U$ 30.
Now, if you apply the same formula with your car or home insurance, is it worth paying?
See you next post!
Unless you live in another reality or are a beginner and naive, you have realized that being a trader is not easy. I have posted on the blog a series of posts about some fundamental points that challenge you as a trader. In today's post I highlight the 5 most important points you need to keep in mind before you start doing your trades.
1. Know Yourself
It sounds likea philosophy jargon, but it's not. You need to carefully define your risk tolerance and understand your needs. To profit consistently you must, before knowing the markets, know yourself. The first step is to gain self-awareness of your risk tolerance by allocating the adequate capital. I'm not just talking about the famous risk management, but I'm talking about carefully studying your own financial goals and what you really want to gain from trading.
2. Define your goals, keep your plan
Once you know what you want, you should systematically set a deadline and a work plan for your career as a trader. What is failure or success for you? What is your deadline to accept a win/lose situation, perhaps more the lose ones than the winners, as long as you understand that this is an important part of your learning? How long can you devote yourself to your new journey? Do you aim for financial independence or simply want an extra income? These questions must be answered before you actually trade. Answering them is part of establishing your trading plan, your goals. Also, having clear and realistic goals is what will help you succeed.
3. Focus! Do not diversify
Yes, it may seems crazy and go against the common sense. But the truth is that the markets are deep and complicated. It is difficult to master all the different kinds of events taking place in this world, so it is a good idea to restrict our vision to the asset we understand and are familiar with, always remembering to join the most liquid and widely traded assets, whether you are a beginner or an advanced trader.
4. Do not add to a losing position. Do not make average price
Seriously, do not make average price. Sorry, but I had to be very clear about that. Nothing can be said about the future, so you do not know how long a stock will go up or down. If you are at a loss, the smallest one is the first.
5. Take notes. Study your success and your failure.
Have you ever heard about the trading journal? If so, why have not you made one yet? If not, know that the successful trader will keep a journal of his operations, where he will carefully understand his mistakes and successes to find out what works and what does not. This is one of the most important trading tips you will receive from a good mentor.
Thanks and see you next post!