Friday, January 25, 2008

A Cardinal Virtue of Trading

The novelist/philosopher Ayn Rand considered the willingness to face and deal with reality to be among the cardinal human virtues. While other animals can survive through their ability to forage or hunt prey, the human animal can survive only through reason and the use of the mind. To blank out reality--or fake it--is to betray what makes us unique; it is a moral failing and not just a psychological one.

I've interviewed and worked with some very experienced and successful traders at investment banks, hedge funds, and proprietary trading firms. One common ingredient in their success is their willingness to acknowledge when they're wrong. If a trade goes against them and hits their stop point, they get out. They don't fudge reality, they don't turn the trade into a longer-term position, and they certainly don't add to the loser in hopes of making the money back.

These very successful traders are often quite confident, but they accept losing. They can face drawdowns, cut their risk, and keep themselves from blowing up. There's no head in the sand, no excuses, no revenge trading. For them, losing is a normal event, not a threat.

In a recent interview for a Reuters story, I emphasized that the SocGen trader who nearly brought his firm down with $7 billion in losses merely enacted on a larger (and illegal) scale what we see among traders during volatile times. The failure to acknowledge a loss leads to efforts to make up for the loss and eventually to a blow up. How often do we see the same kinds of blowups when people fail to face other kinds of problems, with their health, their marriages, or their careers?

It all boils down to acknowledgment of reality vs. denial.

There aren't many occupations that require participants to face loss every single day. That requires a kind of steadfast integrity: a rare ability to see consistently see things as they are, rather than as we'd like them to be. It sounds paradoxical, but normalizing failure and accepting loss are the prerequisites for achieving success and gain in the markets.


The Dual Road to Trading Success


NoGreedNoFear said...

"There aren't many occupations that require participants to face loss every single day."

That is so true. As an engineer turned trader, that's something I have a lot of problems with. A loss at the end of the day is like a failure to me. I have to constantly "convince" myself losing is part of the game. It's not easy but it is necessary if I want to improve as a trader and keep a healthy state of mind.

RobinhoodTrader said...

Many traders who succeed spend a good portion of time learning about honing their risk level. This is often a slow process involving many trades gone "bad", or swings in volatility that they simply learn to avoid. Poorly managed risk (excessive bets and lack of discipline) leads to excess volatility, which leads to loss of control, which leads to emotion. And we all know that emotion has no place in consistent trading success. In fact, I will actually question my risk level even when a winning trade seems to go too far too quickly. I will ask myself - would I be able to tolerate this move if it went the other way? If not, I've made too large a commitment. This often occurs when I trade a new equity or instrument.

Unfortunately, many traders do not survive this learning process.

garyasdf said...

On an unrelated note, although you've probably heard about this, there's an interesting article in the current issue of Popular Science titled "The Science of Wealth: How psychology can make you rich"

procol said...

Many traders, myself included , hate to lose.

So I design my trading to win a vast majority of the time, probably at some net cost to overall profitablilty.

That said, hating to 'lose' is akin to saying you'd never buy a stock if it ever down ticked. Not too many on that list. Or any.

The best traders in the world lose, some often. They down tick. But their trend is up, which is the most you can expect or ask for,

#2 said...

A very interesting post. I think it’s a shame that the “keeping it real” qualities that you refer to are hard to find in the writings of professional traders who blog or publish regularly. The last few weeks have been very difficult for many market participants yet it is difficult to find anybody who openly admits to losing money or making mistakes. This is a shame as it gives the impression to less experienced traders that the pros always make money. This is of course not true.

Imagine a world in which professional traders did not blank out or fake reality. Some of their blogs might look – somewhat refreshingly – like this:

- Much of what I’ve written over the last six months about the resilience of the stock market to more difficult economic times has proved to be wrong. Quite simply my analysis has been found to be wanting.

- Over the last month my account has taken quite a big hit. I empathize with my readers and recognize that many of you will have lost money you cannot afford to lose. These are difficult times. We have lost money too.

- I’ve been in these markets for 20 years and I still find the current conditions frightening and difficult. I admit that at times I too lose my discipline. As you know, one of my strategies is to look to buy stocks which I consider to be significantly unvalued. On Thursday, for example, when AAA, which I have long thought offered good value, opened down 25% I did not pull the trigger to buy. I admit it folks I was scared that the market knew something I didn’t. I did not have the courage of my convictions even though I had done my homework.

- Many of the indicators I have been recommending to readers have not done an adequate job in signposting market movements. We must constantly review and evaluate the indicators we use and if they are found not to work replace them with better ones. For example, the Fed Model, which we’ve written so much about, has proved to be as much use as a chocolate fireguard in protecting short and medium term market players from danger. We have also recommended monitoring the work of the XYZ as they have an excellent record on predicting recessions. In retrospect, I realize that reading anything into such a small sample is statistically unreliable and if I’m honest my dog saw this economic downturn coming before XYZ did.


ELTICI Executive Search said...

Hi, Garyasdf,

What is the link to the article?

"The Science of Wealth: How psychology can make you rich"


T. said...

I received this piece from someone and did not know where to post it exactly. If you haven’t read this already, I think you'd find the "action bias" of interest, and it is most opportune in turbulent times.

"In a 2005 study, "Action Bias Among Elite Soccer Goalkeepers: The Case of Penalty Kicks," five Israeli professors found that while "the utility-maximizing behavior for goalkeepers is to stay in the goal's center during the kick, in 93.7% of the kicks the goalkeepers chose to jump to their right or left."

In other words, in a high-stress situation, the most efficient decision -- inactivity -- was taken but 6% of the time. The researchers hypothesized that the reason for the discrepancy was "action bias":

According to the norm theory, people have stronger feelings associated with outcomes when they come from abnormal causes. Consequently, because the norm is that goalkeepers jump to one of the sides, the disutility associated with missing a ball might be greater following a non-common behavior (staying in the center) than following normal behavior (jumping to the side)."

Brett Steenbarger, Ph.D. said...

Thanks for the excellent comments on the post and also for the interesting links. Bryan, I think your point about intellectual honesty among financial commentators is *so* on the money; great comment. I also like the study you posted, T., re: the action bias of soccer players. Many times traders are looking to go long or short, but the best move is to not trade and let the market show its hand!


ELTICI Executive Search said...

If anyone has the link to the article mentioned by Garyasdf:
"The Science of Wealth: How psychology can make you rich"
please let me know. I am keen to read it.
Thanks in advance.