The value of action plan as to be a professional

Predicting the future

All people in the world, at any age, educational background, and social group, try to make predictions on a wide range of issues. Regardless of the experience and knowledge on specific topics, most people develop a point of view about various issues and then based on this view try to assess what will happen in the future. The assessments can range from minor issues to more critical ones. For example, they may try to predict what will be the result of the next football or basketball games between teams, and at the same time may try to make predictions about more difficult issues such as those involving the market direction, business, economic and political, situation for the coming weeks, months and years.

The need of planning

The tendency of people to predict the future is innate, as it stems from their need to plan their future actions. This is a crucial topic because planning the future is one of the critical factors for the high degree of development of human civilization. In fact, lack of planning leads to stagnation and the proof is that, among other things, one of the main differences in how human beings think and act from other beings on earth, is that human beings focus not only on their current or short term or medium-term needs, as animals do. Human beings always have in mind how to plan their long-term needs. Those who focus on the long-term view are the ones who have shown the strongest growth over time.

Studying the effort of people to evaluate the future

The effort of people to evaluate the future is and it will continue to be an important issue in people's activities. And since it is, it is worth studying it.

The first interesting aspect of studying the effort of people to evaluate the future is that most of the time, people fail to make the right estimations about the future. In fact, the ratio of the wrong forecasts to the correct ones, it is against them. However, people continue and will continue to try to predict the future by having the estimations they make, as a guide for their future actions.

Although most of the time, most of the people fail to predict correctly the future, some make the correct assessments. When that happens, these people feel confident and believe that the assumptions they made about their predictions were correct.

On the other hand, if the predictions turn out to be wrong, people feel uncomfortable. The interesting point, in this case, is that for most who made the wrong predictions, they will continue to believe that the assumptions they made to make the wrong predictions were correct. In fact, they will not admit their mistake, so they will try to blame others for the wrong assessments they made. Eventually, they will believe that someone else or some external factors that were difficult to predict are responsible for the failure of their estimates.

Nevertheless, in both cases, the reality is somewhat different. Most of the time, neither those who managed to predict correctly nor those who did not, have made the right assumptions. This is because the assumptions that people usually make to evaluate the future are either too many or too complicated and while they may follow a logical way of thinking, in most cases when they make assessments they get involved with arbitrary judgments and emotions.

Hypotheses need a simple way of thinking and clear rules

For the assumptions to be valuable, a simple way of thinking is needed, and to avoid judgment and emotion, clear rules based on long-term facts are required.

As an example, the assumptions required to assess the direction of stock markets could simply be made by focusing on the GDP of a country to which the market belongs. The rule, based on long-term facts, is that in the long run the correlation between the stock market and GDP is high, to the extent that when a country's GDP growth is consistently positive, stock markets will move upwards in the long run, and vice versa.

In another example, when investors make assumptions about the type of financial instrument in which they should invest, they may need to focus more on the following: how they can invest in a simple way, in a financial instrument, which with overtime it produces long-term positive returns. Investing globally in the major stock indices around the world is probably a good case. The rule is this: the world's major stock exchanges consistently include the most powerful companies in the world. Thus, given that the global economy in the long run continuously expanding, the major stock market indices, which reflect this economic expansion around the world doing the same.

In a third example, when investors make assumptions about how to invest in a company, they need to focus on specific rules that guarantee the company's long-term sustainable growth and therefore generate positive returns. Such rules are, whether a company has a good management team and provides innovative products and services. Thus, profitability and high expected returns on investment in such companies become very likely.

All of these are some good examples that show the crucial role of rules and the importance of simple thinking when it comes to assessing the future.

From the value of forecasting to the value of the action plan

Going a step further, the tendency of people to focus on assessing the future can be upgraded and to a new trend that in addition, people are focused on the strategy of their actions in order to get independent of the outcome of their predictions.

In other words, the main issue is not for people only to be focused on forecasting but also on the strategy of actions to follow in any future outcome. In fact, the action strategy includes six steps, where when they are followed, the future outcomes can be manageable.

1. In the first step, each entity must quantify in advance the amount of the initial wealth that holds and for which future actions will be taken. Quantification of wealth is a fundamental parameter because based on the amount of wealth, the distribution of choices we make can be determined in a way that potential losses will be finite while potential profits can be significant.

ACTION PLAN: When investing in trading markets, the amount of total capital held in a trading account must be determined in advance, as the total capital will determine the distribution of positions in a way that as will see in the next step, the possible negative results will be finite while potential positive outcomes can be significant.

- As an example, it is assumed that the amount of total capital held in a trading account is set $10,000.

2. In the second step, if a negative scenario occurs, the limited percentage of wealth that could be lost for each choice we make is determined.

ACTION PLAN: When investing in a financial instrument, in the event of a decrease in the value of that financial instrument, it is predetermined a limited loss for that investment. Loss is calculated as a percentage in relation to the total amount of the entity's initial wealth.

- As an example, it is assumed that for a trading investment position the maximum loss as the percentage of total wealth is predetermined 2%. That is, using the previous example 2%*$10,000 = $200 which is the limited capital loss for a trading investment position.

Therefore, at any time in the future for an investment trading position, the potential losses from trading in a financial instrument are locked at a predetermined level relative to the total investment capital. In the example, a potential loss cannot exceed 2% of the total investment capital which is the $200 potential loss for one trading position.

3. In the third step, the size of the investment trading position in a financial instrument needs to be calculated. To do this, the amount of the predetermined capital loss as it has calculated in the previous step is divided by the maximum price decline in an investment trading a financial instrument, which in other words is the stop-loss limit. The maximum price decline corresponds to the difference between the entry price and the stop-loss order.

ACTION PLAN: In each financial instrument, where an investment trading position is taken, the maximum loss value, must be set. That is the limit price against the expected direction of a Financial instrument (Stop Loss Order). The maximum change in price versus expectations is a critical number as it is the number that divides the number of loss capital per investment position for a financial instrument. The larger the Stop Loss limit for a financial instrument, the smaller the size of the investment position's exposure to that financial instrument.

- For better understanding, consider the follow example:

Let us look at the case of investing in a financial instrument such as a stock, where it is assumed that the entry price for that stock is $28.

If the stop-loss order is at the level of $26.4, then the maximum loss per share is $1.6. Based on the amount calculated in the previous step, where the maximum loss per investment position is $200, the number of shares in this position is calculated as follows:

200/1.6 = 125 shares

If the stop-loss order was at the level of $ 27.2, then the maximum loss per share would be $ 0.8. Therefore, in this case, the number of shares in this position will be:

200/0.8 = 250 shares

Finally, if the stop-loss order was at the level of $23, then the maximum loss per share would be $5. Therefore, in this case, the number of shares in this position will be:

200/5 = 40 shares

The key point in this step is that regardless of the size of the investment trading position the maximum loss cannot exceed the amount of $200.

Therefore, given that in all three of the above cases the maximum loss limit is the same, i.e. $ 200, it is easy to understand that it is important to choose investments on financial instruments where a potential decline in their value as defined by the limit price of stop-loss order, should be as smallest as possible. There are different techniques for calculating the maximum price of stop-loss order, such as the one that includes the volatility measure of financial instruments. The remarkable point is that the smaller the potential loss from a financial instrument -as defined by the stop loss-, the greater the size of the trading position in that financial instrument. This is crucial because the largest the size of the trading position in a financial instrument, the bigger the return on investment will be if a financial instrument reaches the expected return for that investment while the maximum expected loss regardless of the size of the position on a financial instrument, remains in any case stable.

4. In the fourth step, it is determined the significance of the Profit/Loss Ratio. Profit/Loss ratio is calculated by dividing the expected profit with the expected loss. For an investment trading position to be worth, this ratio should produce a result greater than 1. The higher the ratio, the better the investment trading position. That means the expected return must be much greater than the expected losses. Expected losses as shown in the previous steps are predetermined to a certain level that is independent of the size of an investment trading position. Therefore, it is important to use that model which indicates the high expected return, and a small drop to activate a stop-loss order.

ACTION PLAN: It is needed is to determine the positive expected return. Expected returns can be determined using specific models with simple rules that indicate positive outcomes when specific circumstances are met. to measure the efficiency of the model it needs to be calculated the distance between the entry price, the target price, and the stop-loss order, as these numbers produce the result in the profit/loss ratio. In fact, in reliable models, the entry price and the target price are set in a way that the target price needs to be as much as higher than the stop-loss price.

By knowing the Target price, the Stop Loss, and the Size of the Position, the Potential Profit/Loss ratio is calculated. The smaller the limit of stop-loss, the higher the exposure to that financial instrument -as we saw in the previous step-. And, the largest the size with positive Profit/Loss Ratio the more powerful is the financial instrument that we invest or trade.

- For example, in a long position, if the potential upper movement of the price of the share of the previous example is $4 and the stop loss order is activated when there is a decline $1.6 then the Profit Loss Ratio is 4/1.6= 2.5.

As the number of shares that are held is 200/1.6= 125 the potential profit is $500 (125*4=500) while the potential loss is $200 (125*1.6=200).

• Stop loss order activation $1.6
• 125 shares
• $500 Potential Profit
• $200 Potential Loss
• Profit/Loss= 2.5 > 1

If the potential upper movement of the price of the share of the previous example is $4 and the stop loss order is activated when there is a decline $0.8 then the Profit Loss Ratio is 4/0.8= 5.

As the number of shares held is 200/0.8= 250 the potential profit is $1,000 (250*4=1,000) while the potential loss is $200 (250*0.8=200).

• Stop loss order activation $0.8
• 250 shares
• $1,000 Potential Profit
• $200 Potential Loss
• Profit/Loss= 4/0.8=5 >1 or 1,000/200=5 > 1

If the stop loss order is activated when there is a decline $5 then the Profit/Loss Ratio will be 4/5=0.8.

As the number of shares held is 200/5=40 the potential profit is 40*4=$160 while the potential loss remains $200 (40*5=200) which results in Profit/Loss Ratio = 4/5= 0.8 or 160/200=0.8.

• Stop loss order activation $5
• 40 shares
• $160 Potential Profit
• $200 Potential Loss
• Profit/Loss= 0.8 < 1

Therefore, the smaller the potential drop of the price of a financial instrument that determines the stop-loss order, the greater the position in this instrument, and the greatest the potential profits, therefore the stronger the ratio Profit/Loss.

5. In the fifth and final step, as the actions include different types of choices, for these choices to be manageable, a finite number of choices are selected and maintained. This number is based on the degree of correlation between choices.

Regarding investment positions in a portfolio, a certain number of financial instruments must be selected and maintained to protect the portfolio, as, in each direction, a finite maximum loss rate is determined.

ACTION PLAN: In the investment trading position it is recommended that the maximum number of financial instruments selected and maintained per direction, long and short, be between four and eight. Four financial instruments per direction are recommended (i.e. 4 long and 4 short) if there is a high correlation between them. That means the maximum loss of the entire portfolio should not be more than 8% (4 positions multiplied by 2%, as this number determines the maximum loss as the percentage on total wealth, therefore the result is 4*2= 8%) for each direction. The loss of wealth from 8% to 10% has been found to be for most people the greatest possible loss that a person can tolerate and manage in a rational way.

If there is a lower correlation between the financial instruments, the number in each direction can increase to 6 long and 6 shorts. In the case where there is the lowest correlation between the financial instruments traded in them, the number in each direction can further increase to 8 Long and 8 Shorts. The above positions can increase from 4 to 8 as long as the correlation of positions, produces in relation to total wealth, maxim losses of 8%.

Therefore, if an investor buys shares belonging to a sector, it is recommended to buy shares from just four different companies, as they are highly correlated. But it could buy more than four financial instruments if they were not as closely correlated such as probably stocks, currency pairs, or commodities, or cryptocurrencies.

Therefore, in the fifth step, the number of financial instruments and the correlation between them are determined in order not to exceed the maximum number of trading investment positions in one direction depending on the correlation between the financial instruments.

In summary, determining the total wealth we hold, the percentage we risk in relation to that wealth for each choice we make, the exposure (size) to that choice in relation to the risk of this choice and in relation to the risk as to the total wealth, in addition by determining the expected return and losses, to find the right ratio and by determining the maximum amount of choices, doing all these actions, we will be able to handle any possible future outcome that could affect the choices that are made.

All the above designations are the action plan that ultimately leads a person to act as a professional. By having the appropriate tools to implement these actions, a person can effectively and sustainably deal with any future outcome in investment trading for any kind of financial instrument, and thus, he or she is acting as a professional portfolio manager.