Tuesday, December 26, 2006

Three Pervasive Myths of Trading Psychology

My work as a trading psychologist has provided me with a fascinating window on the factors that separate successful from unsuccessful traders across a variety of settings, from proprietary firms to investment banks to hedge funds. Having met and worked personally with well over 100 professional traders in the past few years, the main conclusion I’ve come to is that most of the generalizations about trading success are simply not true. In this article, I thought I’d summarize three of the more pervasive myths about trading success out there and offer my own, different perspectives.

Myth #1: Emotions are at the root of trading problems. Yes, emotions can interfere with concentration and performance, but that doesn’t mean that they are a primary cause. Indeed, emotional distress is as often the result of poor trading as the cause. When traders fail to manage risk properly, trading size that is too large for their accounts, they invite outsized emotional responses to their swings in P/L. Similarly, when traders trade untested patterns that possess no objective edge in the marketplace, they are going to lose money over time and experience an understandable degree of emotional frustration. I know many successful traders who are fiercely competitive and highly emotional. I also know many successful traders who are highly analytical and not at all emotional. Trading is a performance field, no less than athletics or the performing arts. Success is a function of talents (inborn abilities) and skills (acquired competencies). No amount of emotional self-control can turn a person into a successful musician, football player, or trader. Once individuals possess the requisite talents and skills for success, however, then psychological factors become important. Psychology dictates how consistent you are with the skills and talents you have; it cannot replace those skills and talents.

Myth #2: Anyone, with dedicated effort, can get to the point of trading for a living. That is nonsense. How many people make their living from acting or musical performance? What proportion of people playing sports can actually make their livelihood from athletics? Many people play chess or poker, but how many can sustain a living from it? Quite simply, to make a living from any performance activity means that you are consistently good at what you do. Not everyone has the talent, skill, or drive to be that successful—in any field. Across the many traders I’ve met in various settings, from home-based, independent traders to professional ones in firms, the best predictors of trading success have been the size of the trader’s account and the resources available to the trader. If a person were to make 30% per year on their accounts year after year, they would be among the world’s most successful money managers. Most money managers of mutual funds, hedge funds, and pension funds cannot sustain such performance. If, however, a trader begins with $60,000 of capital, he or she may not be content with $18,000 of profit. This leads the trader to accept huge leverage and court a risk of ruin when an inevitable string of losing trades occurs. Indeed, such excess leverage is a main cause of emotional distress in trading. Take a look at how the Turtles made their money: they learned a trading method, learned to be consistent with that method, and were given enough money by Richard Dennis that they could trade multiple markets with enough size to scale into positions in each. Even with those resources, not all of the Turtle students could succeed. Talent, skill, and opportunity are the ingredients of success, and these are relatively normally distributed in the trading population, just as they are relatively normally distributed in the population at large.

Myth #3: The main cause of trading failure is a loss of discipline. This is a myth perpetuated by “trading coach” and “guru” types that: a) don’t trade themselves and b) have a vested interest in your belief that their services are all that stand between you and success. The main cause of trading failure is a lack of an objective edge in the marketplace, trading random patterns that have never been tested out for success. We would never consider buying a car simply by looking at it. We’d want to research it, test-drive it, and peer under the hood. Amazingly, however, many traders will risk far more money trading patterns that they never research or test-drive. Many times, the reason they stray from those methods is that, intuitively, they realize that those methods are not working. In any performance field, we find a hard-and-fast truth: the great performers spend more time practicing their performances than actually performing. That is just as true for the Broadway actress as for the Olympic athlete. Many traders, however, think that on-the-job training will be enough. Unfortunately, their accounts often don’t survive their learning curves. A well-placed executive within a trading firm confided to me last year that the average time it takes the average trader to blow through their entire account is seven months. That is why brokerage firms are always on the hunt for new customers. It’s not that these traders are all deficient in discipline: they simply haven’t engaged in sufficient practice to figure out the right markets and trading styles for them and to hone their skills. In every other performance field, you can find relatively easy levels of competition: you can join a community theater, play rounds of golf at the par-3 course, or set the challenge level on your chess computer. There is no easy level of competition in trading, however. When you place a trade on a major exchange, you are up against the pros from day one. No wonder it is so difficult to succeed! Discipline is necessary for trading success, but there is much more to success than discipline. It takes concerted practice and the cultivation of skills at reading and acting upon market patterns.

In an ideal world, I wouldn’t have to challenge these myths. You’d be able to obtain very realistic messages about trading success from brokerage firms, vendors, trading gurus, books, and magazines. The reality, however, is that most of these commercial entities have a vested interest in perpetuating a dream that is, in reality, a cruel fantasy: that, without real, sustained effort, anyone can make it big as a trader.

Does that make me a Scrooge during this holiday season, saying “Bah, humbug!” to the aspirations of thousands of traders? I think not. The reason I wrote my most recent book, Enhancing Trader Performance, was to show that there is a common process beneath the development of elite performance in any field. That process involves several components:

Finding a Niche – Identifying a performance field that takes maximum advantage of your skills, talents, and interests;

Deliberative Practice – Rehearsing skills in increasingly realistic settings to prepare for the challenges of actual performance;

Constant Feedback – Intensive review of performance to identify strengths and weaknesses, so that you can capitalize on the former and address the latter.

The successful traders I’ve known have found a market (or set of markets) and a trading style that capitalizes on their abilities. They have been relentless in working on their skills, using videotaping to review markets and performance and using simulators to rehearse under different market conditions. To sustain such effort requires a love of the markets themselves, something not all traders have. Some traders love the action, some love the dream of making money, some love the opportunity to work for themselves—but many don’t love the work itself: the effort of mastering patterns in demand and supply.

Success is possible in trading as it is in any performance field. If anyone tells you, however, that the path to trading success is different than it is for the surgeon or Olympian, you know that you’re hearing a myth. If you choose the path of the elite performer, trading can be wonderfully challenging and rewarding. If trading is not your ideal path for self-development, however, you are far better off finding your passion elsewhere and managing your money prudently. The goal is to develop the best within you, whether that is as a trader or as something else. Your life deserves nothing less.