Stock Trading & The Race that Stops a Nation (original) (raw)

It is commonly dubbed as the race that stops a nation and does it ever. It’s by far Australia’s National Day and it’s hard to stress its importance. It overshadows all other holidays and unites the country. Melbourne Cup is the horse racing event that draws more than 100,000 people, who flock to Flemington Racecourse to enjoy a day of festivities. The race is televised live to an audience of about 650 million people worldwide where everyone stops what they’re doing at 3pm to watch the race and place bets on any of the 24 horses that run. Betting and horse racing go hand in hand. People have been betting on horses since horses have been running and it can be quite a fun and profitable event if you know what you’re doing. The principles of horse betting and stock investing are very similar. In-fact there are a few things you can learn from horse racing than you can apply to the stock market.

1. Analyse the playing field

The first thing to do is analyse the entire market as you would do with the final field in the Melbourne Cup. Putting it into context the ASX is a much bigger playing field than the Melbourne Cup. The ASX has over 2000 stocks whereas the Melbourne Cup runs only 24 horses. Therefore your odds of picking a winner are much higher in the Melbourne Cup than they are in the stock market (4.16% chance in Melbourne Cup vs 0.05% chance in the ASX). But with the ASX there can be more than one winner, whereas with the Melbourne Cup there can only be one. So it’s much of a muchness. That’s why many limit their field to the ASX 50 or ASX100 or even the ASX 200. But even then, that’s still a huge number of components to keep on top of.

2. Limit your playing field to a handful - Scratch the duds

With horse racing and investing the next thing to do is to limit your playing field to just a handful of hopefuls. Scratch the duds, so to speak. In horse racing the best way to do this is by scratching out horses that have virtually no chance of winning. While there is no hard and fast rule to eliminating potential duds, you can with a bit of confidence eliminate horses that are longshots. They are the 100-1 or 50-1 horses. These duds are longshots for a reason. Of-course you get the occasional upset win like last year with Michelle Payne, but anything with low odds stay well clear of. The fact that no savvy punter wants to back these camels is reason enough. In the share market – the same analogy is staying clear of penny stocks or companies that have little or negative earnings. They are usually worth nothing and have a small market capitalisation. Now I’m not saying there is no value in trying to pick the next Blackmores, it’s the odds of being able to do that are so are slim. So for the majority of investors going with a diversified stock picking strategy will likely yield the best results.

3. Play the Favourites

It’s a well-known fact that by playing the favourites you have a 31% chance of winning. Betting the race favourite to place (comes in 1st or 2nd) pays off 53% of the time and betting the race favourite to show (comes in 1st, 2nd, or 3rd) pays off 67% of the time. Therefore there is merit in picking favourites but a lot of people assume that the most favourite horse is always the most likely to win. This is not the case. A horse can be the clear favourite but it still might not win. There are all kinds of other factors that affect the likely outcome of a race. But by narrowing your playing field to horses that have good odds, you increase your chances of picking a winner. What-ever you do though, don’t bank all your money on one horse. Spread your risk among a few. Only bet on horses where the odds aren’t worse than 30-1. This is a similar strategy that can be used in picking stocks. When picking a portfolio of stocks you want to limit it to stocks in the ASX 200. Don’t be lulled into making too many bets, it will prove hopeless. Having too many stocks in your portfolio means you need to be on top of every company. Stick with 7-15 quality stocks.

4. Look at the fundamentals and trend

Whilst there is a lot more to picking stocks than horses, there are some close similarities. With horse picking you will need to look at the past to work out their ability to win. This means looking at what races the horse has previously won and its preferred running conditions. It will also mean looking at the trainer’s skills and the jockey’s past performance. The past performance is always a good indication of how well and consistent a horse will run on the track. You will also look at weight penalties. The same goes for picking stocks. Research and be selective. Look at stocks that have positive and consistent earnings growth. Stocks that have beaten expectations in the past and filter your hopefuls on the quality of earnings, cash flow, dividends, trend, ROE and EPS growth. What you should end up with is a handful of quality stocks that are clear favourities.

5. Know when to lock in your takings

Whilst you may be good at picking the right horse, the problem is knowing when to lock in your profit and when to walk away. You may be on a roll and it’s a great feeling when you’re on top of the world but it’s at that moment of overconfidence that you can lose it all. While you’re on a winning streak it’s time to play it cool. Don’t go to the ATM and empty you’re bank account because you’re kicking butt, it will get the better of you. The worst thing you can do is start to chase your losses. Investing in stocks is much the same. It’s all about money management. With share trading, you’re not going to pick winners all the time. Many of the stocks you pick may go sour for one reason or another that you couldn’t foresee. That’s fine. It’s being able to manage the losers and stop losses from becoming big losses and letting your winners run. The best way to do this is by employing a rolling or trailing 2 x Average True Range (ATR) stop loss. The ATR is the average of the price range over a selected period of time. You can use 14 days as standard. Let’s say if the average range over the last 14 days is say $0.20, then you don't want to set your trailing stop at 1 x ATR, because you would be stopped out on an average ranging day. If you put your stop at 2 or 3 x ATR, all you need is a bit of a wider ranging day and you will be stopped out. By definition a trailing stop loss automatically rises as the share price rises. This provides the investor with greater flexibility to profit, or limit a loss. As long as the share price remains above the stop loss and is in uptrend nothing happens. When the stock changes and crosses the stop, the position is exited.

Whilst horse racing is a game of probability and chance, it takes years of experience and being in the know to really have great prospects for betting and even then nothing is guaranteed. So whilst there are similarities with stock market investing, horse racing is a form of gambling and should not be seen as an investment. Stock investing is investing your money into a real business offering profitable returns whereas betting on horses is a game of chance, betting on the outcome of something involving probability. Investors aren't just betting on which companies will succeed but they’re providing capital and funding to those companies that need to accomplish their goals. That’s the big difference. Gambling isn’t making the same sort of positive contribution. But then you could argue: What about CFD trading and shorting? Isn’t that gambling on an outcome? Yes it is. It’s a grey area, so we’ll classify CFD trading as sophisticated gambling.

That said. Below is my list of favourites for the Melbourne Cup.

With a little care and research you can certainly get better chances than the random draw at your office sweepstake and remember gambling can be a lot of fun, but that’s all it is. Don’t let it compromise your wealth creation strategy. If you want to make money – have a chat to our financial planners who have years of stock picking experience. They can help you pick a winning portfolio.