The E-Factor

• Efficiency — The ratio of signals your system generates that are correct and (we hope) profitable versus those that are neither. Even a system that is accurate only slightly more than 50% of the time can be profitable — with good money management.
• Effectiveness — The ratio of your profit sizes to loss sizes. The investor who is trying for the one big trade is not practicing a winning investment strategy. Instead, his or her goal should be to produce reasonable returns and to manage and control losses.
• Emotion — The ability to enforce the rules that define your system and not give in to your impulses. An individual can succumb to fear and moments of wavering conviction at any time; therefore, the challenge is to replace emotion with logic and reason.

To build up equity, an investor must use both risk management and good money management skills in addition to making sound investment choices. To be successful, the investor must always be ready to assess and adjust each element of his system and the implementation of the system signals, and in more extreme cases, to change his investment strategy as dictated by the system's performance profile. The fundamental goal is simple: to achieve the highest win/loss ratio while also securing effective returns for each investment or trade. Efficiency is the most important element of the e-factor; the objective of making correct choices outweighs the opportunity of big profits.

Emotion is the wild card in your investment strategy. It is human nature to believe you can rationalize the market. Inevitably, investors second-guess their strategies in the face of changes in the market's direction. They expend their energies chasing the market, but rarely get ahead of it.

Eventually, if an investor succumbs to emotion in trading, his returns and his investment capital will begin to erode. Thus, the investor needs to eliminate his greed and fear from the equation. In addition, he must continuously evaluate the investment signals generated by his trading system, and always follow its rules.

The following algorithm is designed to manage and quantify the investment process:

QL = Pk * C / M * (1 - e^-R(N*T))

where:
QL = Quantity limit (number of units invested)
Pk = Personal confidence
C = Total cash available
M = Market value of one unit
R = Risk profile
N = Efficiency quotient
T = Effectiveness quotient

There is still another input based on an aspect of emotion, and that is confidence (Pk). This is defaulted at 1% or 100%. Pk is a variable to be used by those whose system is not at optimum, or who are unsure about a trade or data regarding that trade. Pk can also be factored in when the system is ineffective for a while or breaking down. For example, an investor could reduce Pk by 25% for two successive losses or by 50% for three successive losses.

Each component of the system should be reviewed often to maintain optimum performance, since the markets are always changing. However, the elegance of any system, and for that matter of risk management and money management, is in its simplicity. The ease with which the formula can be executed is the measure of a successful program.

Money management is the exchange of some potential profits in order to have better control of your capital. The money management system should have acceptable liquidity and the ability to handle downturns without any significant negative repercussions. Risk management is the task of evaluating the probability for success versus failure, and becoming comfortable with the costs related to the negative outcomes.

Investors should understand that the market will always be right: It will always define its limits and direction. Therefore, you must go with the market, enforcing your entrance and exit strategies without exception.

It is inevitable you will suffer some losses. The challenge is to control their magnitude and frequency. Your level of experience, and the way you understand your system and what affects it most, are critical to success.

The risk profile in Figure 1 may be used to rationalize and quantify emotional responses to investment strategies.

Figure 1: Risk profile. Here you see the risk curves representing conservative to aggressive strategies. Where do you fit in?

Typically, a novice investor with little experience would invest conservatively. Later, after he gained confidence, he would increase the allocation of equity as his performance data mounts and he establishes a winning track record. The investor could continue to allocate more funds under the system rules that had proved profitable. However, he or she should be careful not to be misled by short-term successes.

The most adverse influence on any trading system is not adhering to its rules. Systems should be dynamic; you should review and adjust it constantly, optimizing it to the current market situation. The science in any system arises from the investor's understanding of the factors that influence the system and its response. The art lies in the execution or the logical response to the changing factors in the market as related to one investment or even the entire portfolio. Risk/reward analysis must be performed constantly.

A 50% loss requires a 100% gain to recover, so consider your choices. A step back, followed by two steps forward, gets you nowhere! Even after exploring various technical indicators and fundamental inputs to develop your system, you must still choose the mechanism with which you will manage your money and control risk. Your objective is not just to retain the capital you have invested, but also to gain and retain profits.

Both the position that an investor takes and the level at which the funds are allocated have and always will have an emotional component. The challenge is to quantify the effect of your emotional influences and remove that factor from the decision-making process.

One of the biggest emotional hurdles is the temptation to hold on to a losing position, hoping that the market will come back enough for the investor to break even. A well-chosen loss, with a proper reinvestment alternative, can result in a very profitable outcome. So the investor must have the guts to take the loss when it is the right choice.

The markets are not stagnant, but dynamic, so it is imperative you assess the fluctuations and cycles in a commodity, sector, and the market as a whole. Be diligent in examining the current market and understanding its ebb and flow and the causes for its movements.

Profiting in the market depends on many factors; studying the e-factor can help you get a better perspective and understanding of some of the major ones and improve your chances for investment success.

Joe Goncalves is a trader, developer of the $entinel and Future$ investment tracking systems and president of The Granite Owl Group (www.graniteowl.com). He may be reached at jgoncalves@graniteowl.com.

Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.