Well, we are now some three weeks into the lastest mentor program and it is interesting to see the shift in the thinking of some of the participants. I have to admit it is always intriguing to see the ideas that new traders seem to have picked up along the way and often how tenaciously they cling to them. This observation has prompted me to revisti some thoughts I jotted down awhile ago on the delineation between the successful and the unsuccessful.

Is failure inevitable in traders?

The answer to this is unfortunately yes, the majority of people who attempt to trade will fail and fail dismally. They will fail not because they lack a powerful enough computer or they don’t have cable TV or their broker is an idiot or because the new sine wave corrected low fat twin overhead cam moving average doesn’t work properly. They will fail because of the people they are, traders have been failing in their droves ever since there have been markets. Markets have seduced the best and the brightest none are immune. Even Isaac Newton one of probably the five smartest humans to have ever lived was caught by the speculative fervour surrounding the South Sea Bubble.

Don’t be too depressed by this to a degree it is not your fault you have been hard wired to fail. I am not talking about such babble as your mother didn’t hug you enough or you were dropped on your head when young I am referring to the way evolution has hard wired your brain to respond under certain circumstances. It is this hardwiring that prompts most traders to engage in behaviour that guarantees their failure. The types of behaviour that guarantee failure can be examined in the context of responses to various situations a trader might find themselves in.

Loss aversion except when threatened.

Life for your average cavemen must have been inordinately harsh, each day survival was at the forefront of all activities. As such it was paramount to avoid any form of loss, when you are living a desperate hand to mouth existence to lose a little may mean you lose your life.

It may seem that this sort of background would naturally predispose us to be adverse to loss. However consider this in a wider context, this would naturally predispose early man to not being a big risk taker. If you had just enough to get by why take unnecessary risks, risks that may spell disaster for not only you but also your extended family or tribe. If you came across an unexpected bounty such as a tree in fruit or an abandoned carcass the natural response would be to grab whatever could be carried and then run for shelter.
Consider the old phrase of you will never go broke taking a profit. This phrase has its roots in the actions of our early ancestors. They were risk averse for most of their existence, if they saw a profit in terms of an unexpected bounty they would grab what they could an run. This is precisely the behaviour of most traders, if they have a small profit they are inclined to grab it and run. One of the most time honoured maxims in trading is to let your profits run. Most traders are completely incapable of doing this the reason they are incapable of doing this is that they have been programmed to behave that way.

When you make a small gain in trading hundreds of thousands of years of primate evolution come into play forcing you to take tiny profits and exit the market.

However in doing this you have guaranteed your own destruction.
The counterpoint to this inability to let your profits runs is to cut your losses. Just as evolution has made it impossible to let profits run it has also made it impossible to cut losses. The answer to this lies in the way our ancestors survived. Imagine that you are a loss averse cavemen each day you struggle to survive hoarding whatever food comes your way through good luck or good management. Sometimes through the course of their lives our ancestors would have experienced a threat by a predator a natural disaster or a competing tribe. It is safe to assume that in these moments of great stress our ancestors became risk seeking doing anything to save themselves from disaster.

In averaging down this is precisely what the cave man as trader is doing they are becoming risk seeking when they should be risk averse. Traditionally as a stock a novice is holding drops away from the price it was purchased at the novice consoles themselves with the thought that their stock is a good stock and that good stocks get better. As such when faced with a loss the loss is compounded by buying more, risk is actively being sought out at a time of threat.

This inability to take losses and let profits run has been termed the disposition effect and it is a well known phenomena among behavioural economists.

The professional trader understands that when a position moves in the wrong direction then they should become risk averse and exit the position. The novice trader hamstrung by primitive behaviour becomes risk seeking and buys more of the stock and completely abandones any pretext of sane money management. Conversely, when faced with a bounty in the form of a position moving in their favour the professional becomes risk seeking and engages in pyramiding. They add to their already profitable position by buying more. The novice exhibiting all the behaviours of our ancestors exits the position early and feels better about letting their profit escape by repeating the time honoured losers mantra of I left something on the table for somebody else.

Confidence before realism.

Confidence would have been a key survival strategy in stone age times, those who survived undoubtedly believed they would survive. Confidence would have had an emboldening effect on the individual. Such a factor would not seem at first to be a limiting factor in trading since confidence is a feature of not only top traders but also anyone who is successful.

However this excessive self- confidence leads to an overestimation of ones ability to perform certain tasks. Everyone believes they are an above average driver but simple statistics tell us that this cannot be true. This overconfidence permeates the trading arena as well, the interesting thing about over confidence is that it is not gender specific but it does have a distinct gender drift. Terrance Odean an Associate Professor in behavioural finance at the University of California Graduate School of Management in analyzing over 35,000 brokerage accounts found that males traded 45% more than women. This active trading actually reduced the performance of the males by 2.65% per year whereas in the females it reduced trading returns by 1.72% per year.

Men traditionally rate their level of confidence as being higher than that of women in what are perceived to be more masculine tasks. Men report trading as being a masculine task that they should excel at hence they display a greater degree of overconfidence than women.

The most striking thing about Odean’s work is that active trading significantly lowered returns from a given pool of funds. This again is a reflection of overconfidence most traders believe that they must be in the market constantly and that their level of skill allows them to engage the market all the time.

This overconfidence also reflects itself in an interesting side effect. Traders believe that they are some how capable of influencing the market. This may seem like a ludicrous suggestion but consider this. Have you ever watched people filling out lottery tickets by hand. The question is why do people fill out a ticket in a game that is determined purely by chance by hand. The answer curiously enough is that they believe that by doing so they influence they outcome of the event. This may sound irrational but the majority of traders are irrational.

Gossip.

Trading is essentially an information management exercise it requires traders to sift through vast reams of data to seek out trading opportunities. The most efficient way to undertake this exercise is to engage an objective trading protocol that simply looks for movement in indices or stocks based upon whatever criteria are of interest. Unfortunately most traders sabotage their chances of success by having a random set of inputs into their trade selection. The most insidious of which is the tip or the rumour.

The internet has brought with it a vast increase in the resources available to the trader. There is now simply no limit to the amount of information that can be brought to the desktop PC. But this revolution in communication has brought with it a hidden downside, the ability to either propagate rumor and misinformation on a grand scale.

The perception of having inside information is one of the most dangerous traps novices can fall into. About the only time I would agree with Warren Buffet is that with a million dollars and enough inside information you can go broke.

Novices are attracted to what they perceive to be a tip or inside information for evolutionary reasons. Early primate societies undoubtedly had rapidly shifting power structures. Those who survived were those who understood these shifts in power and swiftly adjusted to them and multiplied. Since there was no evening news to inform individuals of these changes the only way they could be communicated was by very informal mechanism one of which evolved into what we call gossip.

Humans love to feel as if they are in the loop or they have the inside running.
The internet has enabled the spreading of gossip at an extraordinary rate, this has largely been facilitated by the evolution of the internet chat room or forum. A benign interpretation of these facilities is that they are the 21st century equivalent of the town hall social or perhaps a specialized club where ideas and information are exchanged.

Much is made of the view that chat rooms are really an extension of the old share club idea. But as Terrence Odean has shown so wonderfully in his paper “Too many cooks spoil the profits: the performance of investment clubs”, Financial Analyst Journal January/Februaury 2000. Share clubs conspire to lower the trading performance of the individual trader.

A more pragmatic view of the chat room is that they are the equivalent of a gossip magazine whereby the gullible are lead by the ignorant. And that they promote a variation on the group think so essential for the formation of a crowd or mob. The unregulated chat room is the hot house for misinformation and the rumor.

In the past the ability to understand shifts in power structures was of undoubted benefit. Unfortunately it has left us with an evolutionary hang off that makes us vulnerable.
A simple strategy for dealing with the insidious impact of gossip is to simply ignore it.

Emotion before reason.

All situations we encounter are filtered by our emotions first they are then subject to logical interpretation. Powerful instincts were a valuable survival strategy cognitive processing was a luxury that could not be afforded in times of stress. The same condition affects traders who react without thinking about or analyzing a given situation. This type of response often compounds the responses I have talked about earlier particularly the impact of gossip.

Poor traders simply do not take time to analyze the situations they find themselves in. They react then they think.

There was no mention of more sex or bungee jumps. A palliative nurse who has counselled the dying in their last days has revealed the most common regrets we have at the end of our lives. And among the top, from men in particular, is ‘I wish I hadn’t worked so hard’.

More from the Guardian

The typical evolution of a trader goes something like this. You have read a few magazines  perhaps bought a few shares you may even have seen Wall Street on video. You go to bed Sunday night, wake up Monday morning and decide that you are a stock market trader.

Not too implausible you think, after all you have probably been able to master a few skills in your life, why not trading. Well consider a variation on a theme, imagine that you have seen a few episodes of ER perhaps you have even been to the doctor once or twice. On the basis of this background you decide that you are more than adequately qualified to be a trauma surgeon. Sound silly, it is no sillier than deciding to trade the stock market without actually having any background as a trader.

You may consider yourself a trader on the basis that you have made a little bit of money in the current market. But consider carefully the following questions, which are arranged in order of importance and see if you can answer them.

1. What is your position-sizing algorithm, is it loss based or volatility based.
2. What is your exit trigger, more commonly known as stop losses.
3. What is your entry system.

New traders face a variety of hurdles as they embark upon their trading career, what I will do in this article is touch upon a few of these problems and hopefully offer a few pointers that will assist traders.

A lack of skill.

One of the key problems that new traders face is that they confuse their skill with the luck of having entered the market during an extraordinarily powerful bull market. Most new traders are incapable of acknowledging that they know very little about the markets. Reconsider the first few questions I posed, these are some of the most basic of questions that all professional traders simply take for granted. If you cannot answer these questions then you should acknowledge that you do not know anything about the basics of trading.

However, do not be too harsh on your self, most professional market advisors cannot answer these questions either. If there are any true secrets of trading they are to be found in these three questions. If you are to succeed as a trader it is essential that you be able to answer these questions and to understand their role in your trading system.

A lack of a trading system.

My own anecdotal observations would suggest that the vast majority of traders simply have no concept of what a trading system is. Your trading system encapsulates your approach to the market, it defines everything from your objectives as a trader to which markets and which time frames you will trade. Your trading system is in essence your business plan.

It is imperative that as a trader you have a rules based approach to the market. It is important to have rules to guide you as you trade for two reasons. Firstly there are no rules for trading imposed upon you the market has no rules for how you should trade. Any rules you generate are your own as such they have to suit your objectives as a trader and you personal approach to the market.

Secondly having rules removes the emotion from trading. Many traders have the wrong idea about trading, they assume that it is some testosterone driven environment where there is a lot of yelling and screaming each day is a confrontation that needs to be won. Nothing could be further from the truth. Trading is a calm, disciplined profession, the moment your emotions creep into trading you are lost. Certainly the popular image of trading is one of a very boisterous environment, generally dominated by males. This image is a false one but unfortunately it infects the psyche of a trader and leads them towards failure. It also acts a barrier to women who want to enter trading as a career. Such a development is unfortunate because the available evidence suggests that women are better traders than men.

Traders must have a trading system, if you have no system you will fail.

Information management.

Much of a trader’s day is spent managing information. In trading there is no shortage of information. It is possible to track the opening and closing of all major world markets courtesy of cable television. The internet has brought the dealing desk into the home with vast information resources available via the pc. It is possible to subscribe to magazines from all around the world, you can even get the Wall Street Journal on line as it is delivered to homes in New York.  You can even get research from broking houses although the available evidence suggests that you would be more profitable doing the opposite to what your broker recommends.

There is a problem with all this information. It is largely irrelevant to the professional trader. None of it is provided by people who actually trade for a living (this includes stockbrokers who are commission sales people). New traders are unfortunately prone to trying to find as many sources of information as possible. As a consequence of this they suffer from two conditions the first goes under the traders euphemism of the paralysis of analysis. Too much information causes the trader to literally seize up and be paralysed into inactivity.

The second problem with information overload is more insidious and probably more important. Humans have some unique idiosyncrasies when it comes to processing information. The first is related to our confidence in our decision- making ability. Let’s assume that we are trading NCP and we receive a single piece of information and we are asked to rate how confident we feel about any outcome based upon the limited information we have received. We can for the purpose of the exercise assign an arbitrary weighting to our confidence. Lets say that with one piece of information we are 10% confident. If we get another piece of information our confidence ma go to 20%. This is reasonable we have doubled the information we have received so our confidence level doubles. However, if we get three sources of information our confidence level instead of going to 30% will suddenly rocket to 90%. Traders become disproportionately more confident with a slight increase in information.

An additional traders quirk applies to how we process more and more information. The more information we get the more we focus on the superfluous and the irrelevant. What has been found is that traders become less accurate the more information they receive.

Whilst it is psychologically comforting to feel that your opinions are validated by the opinions of others there is overwhelming evidence that you will not get rich listening to the advice of others.

The new trader needs to manage the information they are receiving to ensure that they are receiving information that is only pertinent to them and is not tainted by the opinions of others. Traders need raw information not recommendations.

Within this management of information the technical trader needs to be addressed. Technical analysts may initially assume that because they use purely price to dictate their actions then they would be immune from the problems of information management faced by other traders.

Unfortunately for the technician this is not true. You will remember that the least important question that I posed in my introduction was what is your entry trigger. Entry triggers comprise probably about 10% of trading. Most technicians ignore this and scour the globe looking for the one perfect indicator, many buy software packages containing what is called the ultimate indicator. The most popular question I am asked at seminars is what is the magic number for my moving average. Yet when subjected to rigorous testing technical indicators are shown to under perform random probability in the validity of the trading signals they provide. There simply is no perfect set of indicators, your indicators should simply act to get you into the position and that is all, and that is the least important part of trading.

Risk.

I have saved the most important till last. Typically when a trader enters the market for the first time they start thinking about how much money they will make. The reality is that a new trader may never make any money because reward is a phantom that may never exist. The only constant in markets is risk. Despite the current vogue in stock market advertising there is no such thing as a risk less trade. Markets only operate because of the risk reward equation. No risk no reward.

Risk can never be eliminated only managed. Professionals have always known this and it is reflected in the approach they take which is not to make money but to minimize the amount they can possibly lose. This is why the first two questions I posed relate to position sizing and exit triggers. These two techniques ensure a trader’s survival when a trade goes wrong. As such they are the most important questions in trading.