Friday, February 27, 2015

Best Practices in Trading: The Power of Elimination

When I first tried my hand at developing quantitative models of markets, I was impressed by the predictive power I could gain by adding more predictors to my equations.  Of course, that worked just fine on an in-sample basis, but completely fell apart when applied out-of-sample and especially in real time.  Why?  Because the complicated equations were custom fit to the historical data and thus not well suited to adapt to new data.  That overfitting created a false sense of security.  The equations with fewer, but powerful predictors were almost always the most robust--most able to provide predictive value going forward.  They were simple in their sophistication.

Today's best practice comes from a long time mentor of traders, Charles Kirk.  He follows markets daily via The Kirk Report and conducts mentorship programs for groups of subscribers.  Charles describes his best practice as "elimination", and his insight fits well with my early quant experience:

"Over 20 years I studied about every possible thing you can imagine about trading and investing.  I accumulated so much knowledge, but eventually realized that the path toward greater profits and success was figuring out what to eliminate so I could focus on the things that really helped me when I was trading at my very best.  All of us go through a period where we add more factors in our strategy.  More things to watch, more indicators to use, more screens to run, more backtesting research to review, more people to listen to, and so on.  The problem with doing that is that once you've been doing it for a while, the complexity itself becomes a huge distraction.  Much of trading well is figuring out what things truly add value and which are actionable and then having the courage to eliminate everything else.  There is a lot of noise and unhelpful factors out there that may be very interesting, but in reality are not helpful and often can present yet another obstacle for you to overcome.

Once you understand the steps you must take and information you need that leads you most often to successful trades, the next step is to eliminate everything you can that isn't absolutely necessary.  In addition, once you have a strategy that works, as a rule you never add anything else into it unless you can at the same time take something away.  That rule will prevent you from making things far more complicated than they need to be and allow you to focus on what truly matters.  The best practice of all, in my view, is one of elimination."

Charles offers a great piece of insight when he points out that it takes courage to eliminate the nonessentials.  In other words, you have to have confidence in the few, essential components of your success to lean on those exclusively.  Too often, when we seek the crutches of things to add to our strategies, it's because we lack confidence in those strategies.  Stripping down our performance to bare essentials forces us to commit--and then to put our money on that commitment.  

The same wisdom holds true for how we present ourselves in public.  If we are comfortable with who we are, we can present ourselves as we are--simply and straightforwardly.  If we are not comfortable with who we are, we will add layers to our social presentation to try to appeal to anyone and everyone.  We might adopt clothing or attitudes that aren't truly ours, or we may try to adapt our presentation to the social setting of the moment.  In each case, adding layers of complexity is a confession of low self-confidence and low self-acceptance.

When we trade who we are, we reinforce who we are; we don't undercut it.  And, as Kirk wisely observes, that's a great reinforcer of confidence.

Further Reading:  When Traders Lose Confidence