One of the most misunderstood aspects of successful investing is the concept of frequency versus magnitude. If you asked someone to invest in a strategy that loses money 65% of the time, they might think you had lost your mind. However, the preceding information tells you nothing about the efficacy of the overall investment strategy. In the end, it comes down to frequency and magnitude.
Radio signals are typically transmitted in one of two ways, frequency modulation (FM) or amplitude modulation (AM). To carry the information in the signal you can change either the frequency (periodicity) of the radio wave or the amplitude (strength) of the wave over time. It just so happens that the very same factors play into the success of an investment strategy. The frequency of gains and losses combined with the size of those respective gains and losses determines the efficacy and hence the total expected return. Let us look at an example to illustrate. For simplicity sake, we will assume that the investor starts the year with $100 and over the course of one year makes 100 different investments. She made profits on 60% of those investments and on average earned $1. Her losses were also consistent, and she lost $1 on each. At the end of the year, she could expect to earn $20 or a 20% return on her portfolio. A successful result by any measure.
| Gain | Loss | |
| Frequency | 60% | 40% |
| Magnitude | $1.00 | $(1.00) |
| – | ||
| Sum of Gains and Losses | $60.00 | $(40.00) |
| – | ||
| Rate of Return | 20% |
An underappreciated aspect of investing is the psychological toll it takes. It has been widely studied in behavioral analysis that the pain of loss is much greater than the pleasure felt by locking in a win. It is why many investors have trouble taking losses and prefer to avoid them. It feels much better to lock in a gain and hope that the loss comes back than to crystallize the failure. Investors’ losses are often, on average, larger than their gains. Even if one manages to be profitable 60% of the time, they may find it difficult to make money if their losses are 50% bigger than their gains as in the example below.
| Gain | Loss | |
| Frequency | 60% | 40% |
| Magnitude | $1.00 | $(1.50) |
| – | ||
| Sum of Gains and Losses | $60.00 | $(60.00) |
| – | ||
| Rate of Return | 0% |
The most successful investors utilize frequency and magnitude to their advantage. By keeping losses controlled, they search out processes or opportunities that can deliver asymmetrical gains. In the example below, one can be profitable only 35% of the time and earn an attractive rate of return in that the gains are three times the size of the losses. Investors tend to avoid strategies that produce gains less than half of the time because it is a blow to the ego and can be difficult to implement, especially during the inevitable losing streak. However, strategies that have a high magnitude of gain to loss are robust and allow for a wide variety of outcomes to still be profitable.
| Gain | Loss | |
| Frequency | 35% | 65% |
| Magnitude | $3.00 | $(1.0) |
| – | ||
| Sum of Gains and Losses | $105.00 | $(65.00) |
| – | ||
| Rate of Return | 20% |
It turns out that when it comes to investing, what matters is how much you make when you are right and how much you lose when you are wrong. If there is a secret to successful investing, that is it.