Dear Davidl,
Thanks for posting the interesting and thought-provoking article. It makes many important points. I especially like the "Golden Rule" of investing. I agree with virtually everything in this article, except for his concept of "expectancy" which is flawed. His mathematics are faulty. He adds together losses and profits as a multiple of risk and then averages them. He then asserts that this expectancy number will be the average gain per trade over many trades. This is not true. This is not how it works when one trades with a constant risk factor. The losses and gains aren't added together, they are multiplied by each other as one compounds one's losses and gains.
For instance, in his ten marble example, if the risk factor is a% (example: a = 5%) then the seven -1R marbles will produce a loss of capital of (1-a) to the seventh power. The one -5R losing marble will produce a loss of (1-5a), and the two winning marbles will produce gains of 1+10a twice, multiplied by each other, not added. The total change in capital will be (1-a) EXP 7 * (1-5a)*(1+10a) EXP 2
In this example, if a=5%, then the net change in capital will be 1.18 times initial capital, over the course of 10 trades, which represents an average gain of 1.67% per trade. However, Van Tharp's false theory says that one would earn .8R return per trade, which in this example would be .8*.05 = .04 = 4% per trade.
Thanks for posting the interesting and thought-provoking article. It makes many important points. I especially like the "Golden Rule" of investing. I agree with virtually everything in this article, except for his concept of "expectancy" which is flawed. His mathematics are faulty. He adds together losses and profits as a multiple of risk and then averages them. He then asserts that this expectancy number will be the average gain per trade over many trades. This is not true. This is not how it works when one trades with a constant risk factor. The losses and gains aren't added together, they are multiplied by each other as one compounds one's losses and gains.
For instance, in his ten marble example, if the risk factor is a% (example: a = 5%) then the seven -1R marbles will produce a loss of capital of (1-a) to the seventh power. The one -5R losing marble will produce a loss of (1-5a), and the two winning marbles will produce gains of 1+10a twice, multiplied by each other, not added. The total change in capital will be (1-a) EXP 7 * (1-5a)*(1+10a) EXP 2
In this example, if a=5%, then the net change in capital will be 1.18 times initial capital, over the course of 10 trades, which represents an average gain of 1.67% per trade. However, Van Tharp's false theory says that one would earn .8R return per trade, which in this example would be .8*.05 = .04 = 4% per trade.