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The world does not need yet another market commentator. Our tools are designed to help investors along their investment journey
- Signals: trend reversal signals (Bull/Bear) on equity indices, Forex and government bonds
- Trading systems: simple steps from concept, back tests to auto-trade
- Money management: bet sizing algorithms, money/risk management tools
- Psychology: research and practical tools on habit formation
- Topics: discussions on the industry, trends
#Quora: What’s the biggest mistake that stock market investors make?
My answer to What’s the biggest mistake that stock market investors make?
Answer by Laurent Bernut:
Short answer: Absence of exit plan. The only soldiers who go to combat w/o an exit plan are Kamikaze. They don’t need one because they expect to die. Unfortunately so do a lot of market participants.
The apparent simplicity of the answer hides sophisticated concepts that can be broken down in two part: statistical and psychological trading edge
I Statistical trading edge
A Stock picking is overrated
Most market participants believe that stock picking is the alpha and omega of alpha generation. Stock picking is merely everything that precedes entry. It excludes bet size and exit. Unfortunately, stock picking has little influence on the statistical trading edge
Trading edge = Gain Expectancy = Win% *AVG Win% – Loss% *AVg Loss%
1 Stop Loss is the most important variable in a trading system
Stop Loss has direct impact on 3 out of 4 components: Win%, Loss% (1-Win%) and Avg Loss%. Furthermore it has impact on trading frequency: the tighter the stop loss the higher the frequency and vice versa for Buy and Hope
Oops, this just proved that exit is the most important factor.
Please read further about the psychology of stop loss, even if you do not agree
2 Don’t call the race before the finish line
As can be seen, entry has some influence on Win% and Loss%, but nearly not as much as exit. The only time the amount of money that has been made/lost is known with irrefutable certainty is after exit, when open risk is closed
The corollary is that poor entry can be salvaged, poor exit can’t. If You do not have a proper exit plan, You will fail to appreciate the exit plan the market has in store for you
3 Money is made in the money management module
Secondly, Stock picking excludes bet sizing. Bet sizing is the most important determinant of performance
Here is an interesting story to prove this point. When I was at Fidelity, I was running my algo across all managers’ portfolios. My unbridled ambition was to help them trade better 0.05% at a time (multiply this 0.05% by 20 and you are in the rarefied atmosphere of outperformers).
It soon dawned upon my thickness that the same stocks were featured in in my esteemed colleagues’ portfolios. Nothing surprising there, everyone has access to the same research and there is healthy cross pollination. What was surprising was that despite low dispersion of holdings, there was high disparity of performance and volatility: despite owning the same stocks, some people were making a killing, while others were getting killed.
Conclusion: the difference that made the difference is not stock picking, it is bet sizing
4 Blow-ups and feed free-loaders
Watch your winners, but watch your losers more closely. Interesting story: i once had the opportunity to analyse multiple portfolios over many years across many managers on a trade by trade basis. The most important findings were:
- Winners look big to the extent that winners are kept small: If You exclude the worst three detractors, everyone would have outperformed the benchmark every year: 100% outperformance 100% of the time (before costs)
- Free loaders are performance killers: winners and losers are visible, so they get dealt with. The problem is to identify positions that are neither one nor the others, free loaders. They do not contribute enough to compensate for blow-ups and do not lose enough to be visible. They mobilise resources that should be deployed on productive assets. The psychological consequences is called capacity: you are at capacity when inertia sets in, when you do not want to take a trade because you think you are too big
The two issues that cause managers to underperform are directly related to Absence of EXIT policy
II Mental edge: 90% of trading is mental, the other half is good math
Optimism peaks before entry. After that, emotions kick in. The ultimate proof of this is divorce statistics…
1 Pre-mortem
Few market participants give bet sizing the importance it deserves. It is often either conviction (feel good) based or equal weight. Once they are in a position, things change. Or, more accurately, their perception change: they have either too much or too little of a stock.
The concept of pre-mortem is finally finding its way in decision making: Nobel prixe winner Daniel Kahneman, Dan Gilbert (positive psychology Penn U), Hal Hershfield (future self). The idea is to visualise the worst possible outcome and plan accordingly.
If for every trade You are about to take, you visualise a stop loss, something interesting will happen: you will size positions smaller. That is a natural reaction.
In other words, the most important question about fund management is: could i live with earning a little less than i could or could i afford to lose a lot more than i should ?
Again, the only way to grasp this is to mentally think about exit first
2 Kubler Ross: market participants grieve their way to selling
I am a professional short seller. On the short side, you make money by selling along people who liquidate their long position. You lose money by selling short crowded shorts…
There are many psychological charts about euphoria to despondency. They are all nice, adorable and lovely, but they are written from people whose perspective is to go Long. They do not understand the psychology of selling. There is one model that grasp the emotions we go through; the psychology of grief popularised by Elizabeth Kubler-Ross
Market participants grieve their way into liquidating losers and are too complacent when leaving winners.
3 The psychology of stop loss
Even if You do not agree with what you have read so far, You must read the post below.
All diets w/o exception have failed: statistics show that we are all getting fat year after year. Diets address the wrong problem. They talk about what we eat, not about how we relate to what we eat. Diets are a psychological issue, not a physiological one.
Stop Losses are exactly the same. They are an identity issue, not a statistical one. The ego associates being profitable with being right. So, losing money is an attack on the ego. We rationalise, change our beliefs (Festinger and ognitive dissonace, Gazzanikas and split brain theory) rather than kick out losers.
Read this post to learn how to reframe your beliefs and execute stop losses like you brush your teeth.
Conclusion:
Making money in the market is about having an edge. There are two types of edge: statistical and mental. The only ways to tilt your trading edge is to start with the end in mind: think about how you are going to exit before you enter
What’s the biggest mistake that stock market investors make?
@Quora: What is the point of hedging a portfolio instead of closing losing positions?
My answer to What is the point of hedging a portfolio instead of closing losing positions?
Answer by Laurent Bernut:
It seems like You are experiencing pain right now. This is clouding your judgment. So, let&s do a step-by-step approach’ 1. Emotional relief, 2. Boundaries, 3. Recovery 4. New rules
1. Emotional and Financial capitals: forgiveness and dissociation
You can recover from financial losses over time, as long as You recover from emotional losses. So, We need to get out of your emotional pain first.
The power of forgiveness
Forgive yourself for losing money. Make peace with yourself. You made a bad a decision. It is alright. In Jungian archetypes, this is called re-parenting the orphan. You soothe yourself as if You were soothing your child who got hurt. This is no new age fell good stuff: i am a professional short seller, not a cat lady.
There is solid academic research that links forgiveness and learning ability. Bottom line, if You beat yourself up, You create trauma and are statistically more prone to relapse. The Village People masculine approach to taking losses like a man may result in storing memories in the hippocampus (trauma, pain), rather than the pre-frontal cortex learning centre.
Dissociation
“No problem can be solved at the level it was created“, Albert Einstein, patent clerk
This is a cool jedi trick. Put yourself in the shoes of someone You respect for her investing/trading skills. Really feel being that person. How would she react ? Would she be calm, composed ? Would she have slow or fast breathing ? Try to emulate this person both physically and mentally.
While You do that, exhale twice as long as You inhale, and widen your vision from tunnel to peripheral, look up a bit.
When You have impersonated this person, ask yourself how would this person solve the problem ? Take a pen a paper and write it down. Do not commit to memory. The chemical reconstruct we call memories are highly fickle and inaccurate.
This is a powerful exercise that frees up some mental bandwidth. Stress triggers the fight flight syndrome. This hijacks the prefrontal cortex and hijacks the thinking brain. This exercise frees up mental bandwidth. Practice often and You will be the iceman on the trading desk
2. Set boundaries
“Hope is a mistake”
“Hope is a mistake“, Mad Max, Aussie philosopher
If You ask this question, it is probably because You thought this “soft patch” would go away and You would be back on happy street in no time. You ignored the signals and You got caught in a storm with a t-shirt, didn’t You ?
Stock repair strategies as we use in options world never really do the job properly and they cost a lost of mental capital. Bad idea. Same applies to your situation.
You were probably optimistic and failed to think about stop loss. You probably don’t believe in them and may buy into the “buy and hope” fairy tale. Well, the best car in the world would not even sell 1 unit if it did not have good brakes.
At this stage, You will have to decide a NUMBER of the loss You can afford to sustain. Not maximum pain, just how much can You afford to lose so that You can recover within 6 months ? Repeat the exercise and stretch the time horizon, 1 year, 2 years 3 years, 5 years etc. Stop when You come to the same number at various intervals. Focus on the recovery period.
This neat jedi trick invokes the “future self” and reframing: it focuses on recovery as opposed to pain.
Write that number down and commit now to liquidating everything if your losses reach that point. No negotiation, no investment committee, just out
The way to make it more acceptable is to tell yourself being right means following a process, being profitable is an outcome, not a process thought.
3. Recovery: two certainties in life: death and short squeezes
“There are unknown unknowns”, Great War Criminal
There is no way to tell how long a bear market will last. Forget about the talking heads, They did not see the bear coming, so they probably won’t see it go either
One rule of thumb about hedging: it gets expensive during sell off, so be patient. Wait for a squeeze to hedge. They come once a month. Politicians feel compelled to flap their mouth at regular intervals during bear markets… So, don’t worry, someone is coming.
When short squeeze comes do this:
- Reduce your exposure: reduce size of positions that stress You the most. Reduce until You can sleep if You are not mathematically inclined. You have to do it, it is part of hedging
- The smart way to reduce risk is to sell call against your holdings: You collect premium and reduce exposure
- Do not trade VIX options to hedge: this is for losers, amateurs and TV talking heads
- Long put spread: skew changes marginally during squeezes. So, this is time to put on put spreads. Put spreads are volatility structures that will make money if the markets fall between a ceiling and a floor. Risk is capped and so is profit potential. It is not very risky
- Don’t waste time looking for the golden fleece of safe asset class that does well in bear markets: The only asset class that fits this profile is cash.
- Avoid short selling yourself, delegate: short selling requires a level of skills that takes time and practice to mature. You should delegate this to a professional short selling manager.
- Be careful with selling index futures: Shorting S&P futures while being Long small caps it not a hedge. You are implicitly Long small caps and short large caps. Large caps fare better in bear markets, small caps get crushed. So, this feeling of being hedged is illusory at best
4. New rules
“The best time to repair the rof is when the sun is shining“, JFK, Great XXth mystery
Hedging is like swimming lessons, It is a bad idea to think about taking swimming lessons when You are drowning.
The market is a joint venture between Murphy and Marcelus Wallace. Murphy makes sure that if something goes wrong it will. Then, Marcellus gets medieval on your a@#.
Bottom line: be prepared. Decide your hedging strategy before you put on a trade.
The best advice about position sizing I can ever give is: size your position not thinking how much you could make, but expecting them to fail and how much You can afford to lose.
What is better in the end, earning a little less than You could, or losing a lot more than You should ?
Good luck, and practice the first two mental exercises. May the force be with You
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What is the point of hedging a portfolio instead of closing losing positions?
@Quora: Do simpler trading strategies make the psychological aspects of trading more manageable thus making them better for rigid implementation …
My answer to Do simpler trading strategies make the psychological aspects of trading more manageable thus making th…
Answer by Laurent Bernut:
Excellent question. Complexity is a form of laziness. 1) The privilege of simplicity is that it imposes itself, even to those who do not understand its sophistication 2) Simplicity is the exact opposite of easy.
Complexity is fragile
I have met many people trading complex strategies. I have had the privilege of meeting many people with long track record. I have yet to meet trading complex strategies with a long track record.
Complexity gives an illusion of control. It is also highly specialised. So, it tends to fall out of sync. then, traders start drifting and tweaking and add one more widget instead of subtracting.
As the Great Chinese philosopher Bruce Lee used to say: ultimately, perfection runs into simplification.
Complexity is a form of laziness:
People who settle for complex solutions have not worked hard enough to simplify them. It is easy to throw another oscillator in the mix. It is simplistic to optimise for a moving average. Below is my screen, no indicator, no oscillator, nothing, just the purity of the price:
In fact, the opposite of simple is not complex. The opposite of simple is easy.
The privilege of simplicity is that it imposes itself, even to those who do not understand its sophistication. We can understand it. It intuitively imposes itself.
Simple is not rigid, it is fluid
You will know that You are on the right track when You start subtracting instead of adding to your strategy.
I started off with 9 exit conditions. Now, I have 2: trend reversal and stop loss.
I started off with 3 distinct strategies. Now, i have 1 unified strategy. It knows when to suspend trading, reduce risk. Hint: the answer is not in the Buy/Sell signal but in position sizing and rejection of small orders…
But behind this simplicity there is immense relentless kaizen. It took me years to see what was in front of me. We do not see things as they are. We see them as we are.
Simple is a way of life.
The false comfort of complexity
People are intimidated by complexity. If it is simple, they believe that anyone could do it, therefore it cannot work. Picasso once drew a picture on a napkin to a restaurant owner and then asked for an astronomic sum. He then told it took him 30 years to draw those simple lines.
People often mistake simplistic and simple. I often ear that what i do is superficial. Perfect, “let’s step into the math then” and 5 minutes down the road, they have an angelic blank stare and conclude it is too complicated.
Simple rules
- Stop Loss: 2nd most important variable
- Position sizing: money is made in the money management
- Exits: You have to get off the bus at some point
- Entries: vastly overrated
- Above all: clarity of purpose, of formalisation. Be specific, very specific