of positions, and so on. Moreover, it ismy experience that you need to collect a good deal of data across dis-parate sets of market conditions in order to get a true feel for execu-tions  quality  differences  across  transactions  agents;  so  if  you  dodecide to go down the analytical path (and if you have the time, energy,and resources, I think you should), you’ll have to keep at it for awhileif  you  expect  it  to  confer  any  benefit.  There  is,  however,  a  happymedium between using approaches involving costly statistical evalua-tion and ignoring the issue altogether. My advice is to keep your ear tothe ground, talk to your friends and colleagues, and watch your fills onan anecdotal basis. If you sense you are getting your “face ripped off”(another charming industry epithet), you’re probably right; and there’sno reason (1) not to complain and (2) to change brokers if the situa-tion doesn’t improve.
Finally, it is important to take into consideration the other servicesthat your brokerage houses provide to you when you evaluate the qual-ity of your executions relationships. Often, you will find that the enti-ties that will lead you most directly to your maximum profitability are
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those  that  provide  the  best  research,  market  flow  information,  andother nonexecution type benefits. It is very important that you do whatis  necessary  to  understand  these  benefits  and  that  you  manage  yourexecution flows accordingly.
• Don’t  accept  inferior  service;  if  necessary,  vote  with  your  feet.While this may surprise you, the brokerage industry wants every dimeout of your pocket that it can possibly extract. This doesn’t make themevil or unethical; quite the opposite—it’s their responsibility to maxi-mize the profitability of your account from their firm’s perspective. Asa  result,  the  only  way  that  you  can  ensure  fair  treatment  is  to  placeyourself in the right position to critically evaluate their performance,to voice your displeasure when you perceive that they could have donea better job for you, and, ultimately, to move business away from themif they fail to respond in an appropriate manner.
Don’t  let  personal-relationship  considerations  interfere  with  thisprocess.  Just  as  your  brokers  and  trading  counterparties  have  anobligation to extract every dollar they can from you, so it is your obli-gation to maximize the return you get from a dollar invested in yourrelationship with them. You are on your own in these battles, but youare not unarmed. Your account and those of your peers comprise theentire raison d’eˆ tre for your brokerage entities. If you are prepared totake the necessary steps to obtain the level of service you deserve, itis in your power to achieve this objective.
Practice Thorough, Sound, and Consistent Risk Control. Thisis simply a catchall phrase instructing you to pretty much take all of theadvice I have offered in these many chapters. However, it is now possible,at long last, to be a little more specific. What I’m really trying to say hereis that whatever risk management program you have in place, it is impor-tant to apply a measure of discipline in sticking to it. There are many waysto attack the challenge of risk control, and the best programs don’t comefrom  textbooks  but  rather  are  specifically  tailored  to  the  portfolio  man-agement conditions under which you operate. As such, your risk controlshould be based on your experience over the years, with specific consid-eration given to the markets you trade, the amount of time you are able todevote  to  the  portfolio  management  process,  your  own  personal  (or,  ifapplicable, professional) tolerance for risk, and other factors. Hopefully, itmakes use of some of the concepts we have discussed in this book, includ-ing volatility management, trading in a wide range of names on both sidesof the market, and the disciplined application of stops.
The point is, ultimately, that just as only you can determine what riskmanagement program works best for you, you and only you are in a posi-tion to implement the plan. Whatever specific risk control steps you believe
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make the most sense, you will never achieve maximum profitability unlessyou faithfully apply the program. If you are undisciplined in this regard, Ican almost guarantee that your results in terms of the ratios we discussedin this chapter will be less than they could otherwise be. By definition, thismeans your overall performance will be suboptimal as well. From time totime,  it  will  be  useful  to  critically  review  your  risk  management  program(particularly in periods of disappointing performance) to ensure that it isefficiently  oriented  to  your  specific  trading  framework.  However,  unlessyou diligently adhere to whatever control regime prevails at the time, youare almost guaranteed to leave significant money on the table.
Profitability Concentration (90/10) Ratio
Some years ago in my observation of P/L patterns, I noticed the followinginteresting  trend:  For  virtually  every  account  I  encountered,  the  over-whelming majority of profitability was concentrated in a handful of trades.Once  this  pattern  became  clear  to  me,  I  decided  to  test  the  hypothesisacross a large sample of portfolio managers for whom transactions-leveldata was available. Specifically, I took each transaction in every accountand ranked them in descending order by profitability. I then went to the topof the list of trades and started adding the profits for each transaction untilthe total was equal to the overall profitability of the account.
What I found reinforced this hypothesis in surprisingly unambiguousterms. For nearly every account in our sample, the top 10% of all transac-tions ranked by profitability accounted for 100% or more of the P/L for theaccount.  In  many  cases,  the  100%  threshold  was  crossed  at  5%  or  lower.Moreover,  this  pattern  repeated  itself  consistently  across  trading  styles,asset classes, instrument classes, and market conditions. This is an impor-tant concept that has far-reaching implications for portfolio management,many of which I will attempt to address here.
To  begin  with,  if  we  accept  the  notion  that  the  entire  profitability  ofyour account will be captured in, say, the top 10% of your trades, then it fol-lows by definition that the other 90% are a break-even proposition. Thinkabout this for a moment: Literally 9 out of every 10 of your trades are likelyto aggregate to produce profits of exactly zero. It almost makes you wantto pack up your charts and go home, doesn’t it? Indeed, the main danger inbeing  aware  of  this  concept  is  the  tendency  to  misinterpret  its  implica-tions. For this reason, we want to be very careful about how we use thisinformation in driving the portfolio management process and all of its sub-components.
Most  people’s  first  reaction  when  they  see  their  “90/10”  score  is  toassume that it is a problem that wants correcting. This is simply not so; andif they respond by trading less, concentrating their portfolio exclusively on
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what they feel to be their best ideas, they are likely to be disappointed bythe results. The 90/10 rule is hard to overcome, and so I think the betterway of looking at it is that you need the 90 to get the 10. To best understandthis, let’s use a baseball analogy (why not, everyone else does). Think ofthe situation faced by a .300 hitter in baseball, who, even though he knowshe’s going to be unsuccessful 70% of the time cannot simply decline to stepup to the plate on the 7 out of 10 occasions where (statistically speaking)he isn’t likely to get a hit. Truth is, the 7 outs he makes in 10 at-bats are anecessary  condition of  his  .300  batting  average,  and  he  can  no  moreexpect to be more successful by limiting his at-bats than you can expect tobe  successful  in  your  trading  by  reducing  your  number  of  transactions.True, just as the batter may know that he does better against certain teamsand  pitchers  and  in  certain  parks  than  others,  so  will  you  as  a  portfoliomanager have some insights into the conditions that are most conducive tomaximum profitability—across individual names, market cycles, and otherfactors. However, in both cases, the individual in question cannot expectto gain any benefit through a lack of participation.
Therefore, the principal lesson you should derive from 90/10 may wellbe that the lower 90% of your transactions, which are likely to sum up tozero  P/L,  are  a  critical  component  of  your  success.  If  properly  analyzed,these  trades  can  provide  insights  into  the  controllable  elements  of  yourportfolio management activities that can be enormously valuable to yourbottom line. However, if you fight against this tide, you are likely to fall intoa  large  group  of  market  participants  who  have  very  useful  skill  sets  butwho inevitably become their own worst enemies.
Once I observed the 90/10 pattern, it made sense to examine what wastaking place at the other end of the performance spectrum. Specifically, Iwanted  to  know  whether  there  was  some  sort  of  concentration  of  largelosses that had material impacts on overall portfolio performance. In sta-tistical terms, if the answer was yes, it would imply that most individualtransactions-level return patterns demonstrated kurtosis, or a larger thanexpected  number  of  observations  at  each  end  of  the  distribution.  If  theanswer was no, then we would characterize these data sets, from a statis-tical perspective, as being skewed to the positive. This would be a positive,if unlikely, outcome (at least for most accounts), indicating a real edge onthe high-magnitude trades in their portfolios. 
I  must  admit  that  I  spent  less  time  on  this  subject  than  I  did  on  theanalysis  of  the  high-profitability  transactions.  Don’t  ask  me  why;  I  don’trightly know myself. Perhaps I was just tired of looking at losing trades. Werisk  managers  do  get  tired  of  wallowing  in  losses,  you  know,  or  did  youthink we had an infinite appetite for this sort of thing? Anyway, the answerthat I came up with is that there is a similar, if less dramatic, concentrationof drawdowns in a handful of losing trades. Call it 80/20, or even 70/30, and
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calculate  this  statistic  by  adding  up  your  biggest  losers  until  the  dollarvalue meets that of your largest drawdown. Then calculate the percentageof trades this represents. The number is surprisingly small. 
What does all of this mean? Well, for one thing, it’s pretty plain that agood deal of your time as a portfolio manager is likely to be spent spinningyour  wheels,  setting  the  stage,  so  to  speak,  for  the  outcomes  associatedwith that small subset of your trades that is actually driving your perform-ance. Okay, fair enough, but let’s take a look at how to apply the informa-tion productively across various elements of the portfolio decision-makingprocess:
• Position Selection. This one’s pretty intuitive, right? If one is awarethat 10% or less of one’s trades are generating all of one’s profitability(and  perhaps  all  of  one’s  drawdown),  one  ought  to  take  this  intoaccount in one’s position selection, no? But most people make the mis-take  of  focusing  on  the  nominally  bad  news  that  90%  of  their  tradesdon’t work as planned, ignoring the (factually) good news that all theyneed,  in  order  to  be  successful,  is  to  have  1  out  of  every  10  trades(perhaps fewer) reach their targets at “fully invested” risk levels. As acase in point, let’s go back to the ol’ ballpark. Just as it’s impossible forthe allstar batter to know in advance which at-bats are going to producea hit for him, so it will be impossible for a trader to know in advancewhich  trades  are  going  to  work  for  big  returns  and  which  are  not.  Areally great player, say Ted Williams, goes out there thinking, “Hey, thisis easy; I can fail 6 or 7 out of 10 times and still be a hero to an entiregeneration.”  A  little  bit  of  this  mindset  with  respect  to  your  tradingprobably wouldn’t hurt much at all. Just as Ted never grabbed his woodwithout  expecting  to  get  a  hit,  so  should  you  only  put  on  positionsexpected to make money (unless, perhaps, they are specifically desig-nated  as  hedges).  However,  given  that  most  of  these  trades  won’tcontribute  appreciably  to  your  bottom  line,  you  should  orient  yourposition selection toward putting you in the best situation to capitalizemaximally  on  the  “impactful”  10%,  while  ensuring  that  those  that  fallinto the 90% category are not ones that will cause enormous damage.
What  is  required,  above  all  else,  is  a  deep  understanding  of  theprospective risk/reward characteristics of each trade you are contem-plating. Awareness of the 90/10 rule provides you with an opportunityto focus on those trades that, if they work, will produce material profits,while  if  they  don’t,  they  won’t  cripple  you  from  a  capital-preservationperspective. What is more, it is very easy to evaluate your perform-ance in this regard, once again by keeping track of your objective andstop  levels  and  comparing  them  to  your  trading  attribution  results.You should feel pretty good about any position that, even if it didn’t
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produce the hoped-for profits, didn’t create a big negative revenue out-come. Simply tell yourself that it fit well within the pattern of what isprescribed by the 90/10 rule.
• Trading  Frequency. Another  superficially  logical  but  (in  my  view)incorrect reaction to the 90/10 rule is a desire to decrease trading fre-quency. In fact, this is the exact opposite of what I would recommend.Remember, your only goal here is maximizing risk-adjusted profitabil-ity; and as long the trades that aren’t producing big gains for you areon balance approaching a break-even proposition, my advice would beto participate as much as you can in the markets. Active trading offersa number of important benefits, offering you insights that are unavail-able through observation alone.
First, these insights include a better sense of the price sensitivity,liquidity, and other execution characteristics of the names you are trad-ing—factors that can only increase in importance as you evaluate themacross different market conditions, position sizes, counterparties, andso on. For example, by executing frequent transactions in a given stockacross a long temporal interval, you stand to derive keen understand-ings of how it will trade around key information dates, such as earningsreleases. Over time, you will begin to understand who owns the stockand why, how they manage their position, and what constitutes a mate-rial change in their viewpoints. Digging deeper, you will begin to noticehow  the  trading  in  one  name  interrelates  to  activity  in  the  stocks  ofcompetitors  and  other  companies  that  operate  closely  within  a  givenpart of the economy. All of this information offers a critical edge overthe average market participant who typically evaluates only a subset ofthis data when making portfolio decisions, and it can only be masteredin my view through the actual trading process.
Second, active trading elevates your status in the marketplace. Tothe brokerage community, you become an important source of commis-sion flows. To other market participants, you become a critical outlet forinformation, insight, and market liquidity. As a result, you will find yourinformation flow improving dramatically with your level of trading activ-ity.  People  will  pick  up  the  phone  when  you  call  or  return  your  callsmore quickly if they are otherwise engaged. Remember, you are lookingfor  a  few  big  scores  a  year;  and  just  as  is  the  case  with  the  baseballplayer who needs the at-bats to produce the results he seeks (or the bas-ketball player who needs the touches), you cannot possibly maximizeyour returns to trading unless you get in there and mix it up a bit.
Third,  the  more  actively  you  trade,  the  more  you  achieve  a  con-nection with the markets that cannot be gained by other means, andthe better position you will be in to manage your destiny on each indi-vidual transaction. You will learn that no position is priced too high to
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buy or too low to sell—particularly on the liquidation side of a trans-action. And by being an active trader, you will rise above a conditionthat I would term, for lack of a better alternative, “position paralysis.”This typically occurs when you have developed a very strong markethypothesis that, for one reason or another, has not played out in themarketplace in the manner you expected. Oftentimes, you still like theplay  and  will  be  reluctant  to  liquidate  your  position  because,  invari-ably, it will seem that your liquidation is the very catalyst the positionneeds in order to move in the direction you originally expected.
These  things  happen  much  less  frequently  to  active  traders  thanthey do to the buy-and-hold crowd. This is because active traders oper-ate with a mindset that reinforces the notion that both the liquidationand the reestablishment of a position is just a trade away. They mighthave the opportunity to put the trade on and to liquidate it (or at leastto trade around it) a half dozen times before their catalyst monetizesitself. In the meantime, while they have generated transactions costs,they  have  gathered  potentially  important  information  with  each  newtrade. Even if they happen to be out of the position when it starts tomove in a favorable direction, they are in a position to change this in aheartbeat. While they may not capture every major move that they mayhave anticipated in its entirety, in most instances the good ones cap-ture the fat part of the pricing action. 
By trading actively in a disciplined manner, you stand to increasethe size of the 10% pool that will determine your trading destiny overany period you choose to examine. The size of individual gains in thesenames may be smaller than those associated with a buy-and-hold strat-egy, but, by definition, you’ll have a lot more of them; and I believe thaton the whole you’ll be substantially better off.
I think I’ll close this section by invoking the image of Teddy Ball-game  one  last  time.  I  know  that  we  should  probably  let  him  rest  inpeace, but that does not seem to be what the Almighty has in store forhim. On September 28, 1941, the last day of the baseball season andmonths  before  Pearl  Harbor  compelled  Teddy  to  leave  the  diamondand strap himself into fighter planes for the next three odd years, theBoston Red Sox, 17 games behind the Yankees (who else?), played adoubleheader  in  Philadelphia’s  Shibe  Park  against  the  last-placeAthletics.  Ted  Williams  started  the  day  batting  .3995—the  statisticalequivalent of a .400 season, a feat that had not been achieved in over adecade and has not been accomplished since. A whole lot of folks (hisagent no doubt among them) encouraged him to sit out these mean-ingless games, so as to ensure his place in the .400 club. But Teddy washaving none of it. He played both ends of the twin bill, went 6 for 8,including a homer that gave him the American League championship,
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and finished the year at .406. I reckon Teddy understood better thananyone the point I’m trying to get across: Every good swing you canget is probably worth taking.
TELEPHONE TAG
It’s  often  easy  to  be  right  conceptually  and  wrong  on  timing.  I  once  wasacquainted with a situation in which a European Telecom analyst, of Teutonicdemeanor  and  self-assurance,  was  making  a  presentation  to  an  active  traderabout  why  he  should  short  Nokia  (or  Nuk-ya,  as  he  liked  to  pronounce  it).Specifically, he showed with mathematical precision and cogency of argumentwhy Nokia would have to sell 1.3 handsets for every man, woman, and childalive on earth in order to justify their prevailing valuation. 
The trader in question looked at the analyst and said, “This is a very com-pelling  argument.  Unfortunately,  Nokia  may  double  before  the  investmentworld catches on to the validity of what you are saying.” As it turns out, theywere  both  right:  Nokia  did  double  from  that  point,  but  then  it  proceeded  tocrash along with the rest of the global technology sector. Eventually, when thestock came careening back to earthbound levels, the analyst won kudos fromhis peers for his clearheaded evaluation.
Rumor has it the trader made money buying the stock till it hit its peak and
shorting it all the way down.
Risk Control. Awareness of the 90/10 rule offers portfolio managers apartial  road  map  for  risk  control  that  represents  a  significant  advantagerelative  to  models  that  don’t  contemplate  profitability  concentration.  Tofully understand this, consider the rule’s following key components:
• Approximately  10%  of  your  trades  are  going  to  account  for  100%  of
your profits.
• The  other  90%  of  your  trades  are  likely  to  be,  best-case,  revenue
neutral.
• The  best  traders  won’t  have  corresponding  high-magnitude  losses  tooffset  the  gains  in  the  top  10%  category;  those  who  do  are  likely  tohave significant volatility problems in their accounts.
• There are no reliable methods (that I know of) to anticipate in advance
which trades will fall into the 10% category.
Given these realities, the ideal risk control program becomes one thatpreserves capital for maximum effectiveness when the top-tier opportuni-ties  do  present  themselves  while  at  the  same  time  doing  everything
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possible to guard against the big transactions-level losses that can operatelike poison on your return stream. In turn, this means pretty much doingeverything in your power to ensure minimal slippage on the 90% of yourtrades that will not fall into the category of big winners. 
The best means of accomplishing this is to actively manage every posi-tion with an eye toward protecting your downside. Forget about the factthat any given trade may be that big winner that you are forever seeking.Focus on your commitment to liquidate every position that is going againstyou  at  predetermined  levels  of  loss.  Such  a  strategy  may  deny  you  theopportunity to capture the entire price move that you have anticipated inyour selection process; but the savings, in terms of minimizing the magni-tude and incidence of big losers, will far outweigh this opportunity cost.You should continually review the reasons you are in each position with apredisposition  to  liquidate  any  position  where  conditions  have  changedmaterially. A very simple but underused methodology is to ask yourself ona frequent and routine basis whether you would put the same position onat  current  prices  at  the  time  of  the  review.  Every  position  that  you  can’tanswer in the affirmative should be a strong candidate for liquidation.
Although  there  are  multiple  schools  of  thought  on  this  concept,  youshould  adhere  to  your  liquidation  points  on  the  upside  with  roughly  thesame  discipline  you  adhere  to  on  the  downside.  If  a  position  has  hit  thedesired target, it may very well have additional room for continued pricemovement  in  a  favorable  direction.  However,  it  may  also  reverse  itself.Remember,  there  are  others  in  the  market  who  are  thinking  the  samethoughts  that  you  are.  If  they  bail  out  of  a  winner  once  it  has  hit  whatappears to be a new equilibrium price level, you may be left holding the bag(or holding Herman). Again, one way of doing this is to review the posi-tions  that  have  hit  your  targets  and  to  ask  yourself  whether  you  wouldreestablish the position at the new price level. If the answer is no, it’s timeto  take  your  profits.  In  any  event,  you  will  never  lose  money  by  scalingback your position by a fixed percentage (say, by half) as it hits your pricetarget. The bankable P/L you gain in the process should be of enormouscomfort to you, particularly in difficult market conditions where there islittle momentum-based follow-through. You may kick yourself for not rid-ing  the  position  for  all  it  was  worth;  but  you’ll  take  much  more  psychicpain for those instances when your script played out exactly as you antic-ipated but you failed to take profits and the market subsequently reverseditself. If you adhere to this model, you will gain the confidence that per-haps your entire methodology is scalable across many individual transac-tions. However, if you repeatedly are on the right side of the market but failto make money because you didn’t liquidate in time, it’s hard to envisionhow  you  will  ever  gain  the  momentum  in  your  account  necessary  toachieve maximum success.
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This all being said, there is a whole school of investing, called momen-tum  trading, that  calls  for  portfolio  managers  to  increase  their  positionsizes  as  the  market  moves  in  their  favor.  Over  the  years,  this  has  led  tospectacular successes for many portfolio managers, but I suspect that theyare significantly outnumbered by the incidence of spectacular failures. 
In the best of all worlds, momentum investing has been shown to workonly under certain market conditions, and under a very specific and com-plex methodology. My advice is that unless you understand these programsin  great  detail,  you  are  much  better  off  taking  profits  when  they  presentthemselves.
One final aspect of your risk control program of which you should bemindful is market  liquidity. You can easily find yourself trading in posi-tions  that  will  require  care  in  the  liquidation  process  and  for  which  thedamage associated with unwinding your position under conditions of mar-ket duress will cost you more than you would expect them to before thefact. Due to technical factors in the marketplace, multiple market partici-pants often set their specified liquidation points at similar pricing levels.When  markets  move  adversely  toward  these  common  points  of  action,there can be a liquidation momentum that can cause prices to move muchfarther  against  you  than  is  justified  by  the  prevailing  fundamental  infor-mation on which market participants are acting.
This  problem  occurs  whether  you  trade  on  the  long  side  or  on  theshort  side  of  the  market.  Many  rallies  are  caused  at  least  in  part  bysqueezes  on  those  with  short  positions,  by  participants  that  have  keeninsight into the difficulties that short sellers face in maintaining their posi-tions when markets are going up, and many sell-offs are the result of savvytraders  seeking  to  force  liquidations  at  below-market  levels.  Finally,  it  isimportant to be aware that the use of so-called stop-loss orders may nothelp you much to control these exposures because these types of ordersmerely  instruct  your  broker  to  liquidate  your  position  at  any  price  if  themarket touches a given threshold. Often, investors who think they are pro-tected by stop-