All Your Emotions Belong to You
Trading psychology is something most people don’t think about when dealing with their retirement investments. However when trading for yourself, your emotions will have an unavoidable impact on your outcome. Every price in the market is the sum of all our hopes, fear, pride and greed (1). Even if a system is completely automated, it was still built by emotional human beings who apply their biases to their art, whether they realize it or not.
Intuition and Biases
Many professional traders seek to improve their ability to deal with their emotions much in the same way professional athletes do before a major event or even as part of their regular routine. The possibility of money, power or success can easily corrupt your thinking and force you to make the wrong decisions at exactly the wrong time. Your intuition and biases can lead you down the wrong path if they are not aligned with reality.
The typical beginner will usually be worried more about when to enter a trade than anything else. They think little of risk management, or even bother to plan when to sell. Because of this, when a trade begins to turn against them, they hold with the hope of coming back to even or their former profit level. Worse off, they may average down, in effect doubling down on a loser. This is in effect a great way to achieve uncontrolled, negative skew.
It seems the initial entry point into an investment may be of least importance. Don’t get me wrong, well-timed entries could help your returns, but factors such as how much of each stock to buy and when to sell will always be more significant in the long run. A trading plan considers all aspects of managing a systematic portfolio, removing all emotional biases and intuition and solely relying on the impartial execution of its steps, especially when it comes time to sell. This is very difficult for some people to achieve because when dealing with large amounts of money, you tend to break your rules or make new ones along the way, solely for the purpose of justifying how you feel at the moment.
Finally you need survivability. If you are seeking absolute returns using a reactive approach, you will always get in a little late as you wait for the trend to confirm and you will always sell late waiting for the trend to break down. Initial buys may go through an initial dip, or you may have profitable stock that spends a few weeks consolidating in a base (when price typically becomes range-bound after reaching a certain level). These motions in price will inevitably cause drawdowns in your portfolio that can last weeks, months or even years. Being able to sit through these periods is probably the most difficult aspect about trading. The value in this is that every drawdown comes to an end, and anecdotally, it always occurs when you are at your emotionally lowest, when you think it just can’t get any worse. In fact, investors who buy into trendfollowing hedge funds usually buy them during a drawdown because they know the mechanical reality of the system will likely bring it out into profit again, eventually.
Mechanically removing your emotions from your strategy is a big reason why systems trading is becoming so popular. Trading outside market hours also helps avoid the mania of the open market. I use only end-of-day data and place my orders at the market open for that very reason. It also makes backtesting simulations much more easier and cheaper. This allows me to work a regular job, and not worry about the daily fluctuations, while being able to sleep at night comfortably as well. It’s really important your trading style be compatible with your lifestyle.
When I started my first trendfollowing strategy, I immediately went into a 6-month drawdown before coming up to even. Luckily, I expected this as returns in trendfollowing are large yet sparse compared to the many, smaller losses. Therefore it is very likely when you enter such a strategy, you will enter in a drawdown. The ability to understand what your strategy will go through beforehand is probably the best way to deal emotionally with your trading. If you backtest, you can even measure how likely a drawdown is, how deep they are on average and what the worst-case was, all using historical data. As long as your portfolio’s drawdown is within these statistical measures, you know the system is working as planned. If you don’t backtest, look at the returns of traders similar to your style and think real hard if that kind of roller coaster is for you! What matters is that you quell the uncertainty and doubt that pollutes your decisions by planning ahead for all possibilities.
Finally, simply taking care of yourself and your life is the way to making sure you maintain your objectives. Having too many skeletons in the closet, being dishonest with yourself, being lazy or just letting your daily stresses build up will impede your ability to think clearly and rationally. We all need to simplify our lives in this increasingly sedentary, medicated, and noisy world. But even more critical, we need to remind ourselves to do nothing sometimes and just think about now. Stop the rumination, stop the wild thought tangents, the imaginary arguments with your adversaries and just concentrate on now. This is something I’m working on now, and it’s really not easy as I’m a serial day-dreamer and tend to put off taking care of myself. It’s pretty well-known that mindfulness is used by a lot of successful people to clear their mind and focus on their goals. People who are mindful are even known to be less likely to be obese, less likely to engage in substance abuse, less debt; all the usual vices tend to disappear. Mindfulness has probably been the coolest discovery in my trek through stock trading. I hope I master it one day!
What I like about the psychology aspect of trading is that it is really universally-applicable in anything you do. I know it’s helped my life for the better and will only continue to do so.
This post doesn’t even cover a sliver of what there is to talk about. Here are some books I recommend that have helped me:
Trade Mindfully – Gary Dayton: This book taught me about our biases, how our mind works and how trying to fix our mind with our mind is a really terrible idea. The mindfulness techniques in this book are worth the price alone. You don’t even need to trade to benefit from this book, honestly.
Trade your Way to Financial Freedom – Van Tharp: This book taught me about risk management and also how it ties into our emotions. What blew me away is how they showed a system with random entries but good risk management actually manages to make money, showing how low on the totem pole entries really are, no matter how counterintuitive it seems.
Market Wizards Series – Jack Schwager: Any of the books in this series are awesome because you really delve into the psychology and strategies of the some of the best investors on any market.
Trend Following – Michael Covel: The book that probably pushed me towards this type of trading the most. What’s great is that most people expect a how-to book and then are flabbergasted when it just concentrates on the historical trendfollowing data, psychology and mindset needed… almost on purpose to make a point on how the actual trading is not key itself.