Thursday, October 09, 2008

The Need To Be Right Versus The Need To Make Money

Over the last few days, I've had the opportunity to talk with everyday investors as well as my usual contacts with prop traders and portfolio managers. One of the distinguishing themes in these talks has been stubbornness versus flexibility: the willingness and ability to maneuver and adapt to changing market conditions versus the need to stick with positions and be proven correct.

Among the traders, the ones who have done well in the recent market decline are those who have been selective in their risk exposure, riding short-term market moves, limiting overnight headline risk, and shifting positions tactically to adjust to volatile conditions. They have focused on making money--and limiting loss of capital. They've been quick to recognize when they're wrong, at times getting stopped out once, twice, three times before finally riding the anticipated market move.

The traders who have performed most poorly are those that have been stubborn. They have had strong views of markets and have stuck with those views, even in the face of markets that have moved against them. Convinced that markets are overdue for reversal, they have faced large losses as weakness has led to further weakness. They have been more concerned about being right than making money; they've been reluctant to be stopped out, instead waiting for markets to validate their opinions.

Interestingly, I'm seeing the same dynamics among individual investors. Some have made proactive adjustments to their portfolios to reduce risk, including reducing exposure to vulnerable investments (financial stocks, preferred shares, high yield bonds); some are also revising their views of the financial future, looking for themes and sectors that will benefit in a changed economic environment (firms that generate cash and are less reliant on borrowing; firms that appeal to consumer value rather than luxury; safe yields among beaten down bonds). Other investors are frozen, immersed in hope that "things will come back". They remind me of the dot-com investors who, stunned by losses of 50% in their holdings, insisted that a bottom was at hand. Sadly, many of these shares declined by more than 75% before we saw a durable market bottom--and many of those companies never survived the decline.

This is one of the paradoxes of trading and investing: you need distinct views to put your money at risk, and you need to persist with these views in order to ride winners. At the same time, you can't become married to these views; you need to quickly revise and even abandon your outlooks in order to limit losses. We can trade and invest for ego needs, and we can trade and invest to make money: over the long haul, we can't do both. It takes a strong ego to formulate and act upon one's ideas; an even stronger one to step back from those ideas in the face of non-confirmation.


Four Qualities of Successful Traders

Ten Lessons From Traders


Space said...

I wonder what someone like Jim Rogers would have to say about this - he has been short financials for a number of years now if I'm not mistaken. This has obviously worked out well for him - he had the conviction part - but not the flexibility, adding more to his positions as they initially went against him. For some investors this would be a disastrous strategy, but for Mr. Rogers who has the research skills and capital to back up his convictions this is the only way to trade. Like 'the trend is your friend' this paradox is simply another trading myth - different individuals, and different strategies use different guidelines to achieve success. Thanks for another thought provoking post.


Nightowl said...

Trading the emini I went out off the market as volatility exploded. Not of fright or being especially prudent but because of the change of characteristics of the market. It suddenly didn't feel at home anymore so now I study the course, adjusting to it which for me is no ten minutes-job. But anyway, I'm not losing money.

Greetz, Roberto from Amsterdam

Stan's Trading Journal said...

Hi Dr. Brett this is a wonderful article. I faced this same problem for countless times as I did not get stopped out of a trade thinking that my view is right (the need to be right = ego) and suffered huge losses. I could have stopped out of the trade once or twice or even thrice till the opportunity arise again. I know what I should be doing but keep making the same mistake due to my ill discipline. Really hope if you could add a post on how to improve trading discipline. Thanks for your great post.


Mark Wolfinger said...

Dr. Brett,

Right on!


Thre ae always examples of people who go against the tide and win. Lottery winners, for example.

But most people don't have Jim Roger's money and should not be adding to losing positions.


Daniel Ivandjiiski said...

Interesting article. We have gotten to a point where few people invest in the traditional buy and hold sense of the word. Most traders are beholden to their investors on a monthly basis which is why everyone gets on the same bandwagon hoping to be ahead of the other guy on the way out. This way at least the slowest 25% exiting are burned as opposed to 100% if you dont have the backing of the crowd. Needless to say this is a sad state of affairs, with volatility and MTM taking front and center. As long as the VIX is over 20 i dont see this changing.

Daniel Ivandjiiski

procol said...

Rogers is also a huge commodity and China bull, How do you know he didn't lose more there then he made supposedly short financials.

Ritholtz said...

I just mentioned the same thing today