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#Quora: What’s the biggest mistake that stock market investors make?

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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.082115-Tradingsecrets-01

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:

  1. 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)
  2. 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

The view from the short-side: how we process emotions and the market signature of the 5 stages of grief Kubler-Ross by Laurent Bernut on Alpha Secure

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.

The psychology of stop loss: how You can be 100% right despite 60% failed trades by Laurent Bernut on Alpha Secure

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?

The game of two halves: an elegant two-step process designed to cut losers, run winners, while maintaining conviction

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In every hospital around the world, there is an unwritten rule: surgeons should not operate on their own children. There is no such thing as professional detachment when it comes to your own child. In the investment realm however, market participants are consistently asked to defend their convictions, but also expected to be surgical about their losers. How can someone maintain enough attachment to weather rough times, but stay detached enough to surgically cut when necessary ?

“Cut your losers, run your winners” is the key to survival in the markets, but no-one tells You how to pick the lock. This is especially difficult if You are a fundamentalist (fundamental analyst/manager/investor/trader). First, there is no price mechanism like a stop loss to tell You it’s time to move on. Second, You don’t want to be perceived as lacking conviction. Third, investors want You to manage risk. No wonder 80% of managers find it difficult to outperform every year.
This is the second article in a series of four about exits and affective neurosciences. Our central premise is that the quality of exits will determine the quality of performance. The purpose of this exercise is to help fundamentalists cut their losers, run their winners, while keeping conviction. It is based on the assumption that they are refractory to the idea of a stop loss policy. It is a simple yet powerful method that is guaranteed to mechanically lift performance.
You do not need to be right 51% in order to make money
One of the classic myth is that “You will make money as long as You are right 51% of the time”. Wrong. You will make money only if You have a trading edge:
                     Trading edge = Average Win% * Win% – |Average Loss%| * Loss %
Let’s take an easy example: if average profit is twice as big as average loss, what would be the break-even hit ratio ?
          0  = 2 * X – 1 *(1-X)
          X     = 1/3
with X = Win% and Loss% = 1- Win%
In a system with a 2/1 profit/loss ratio, you only need to be right 1/3 of the time. In other words, stock pickers who identify 3-5 baggers only need to keep losers small to make formidable gains
In reality, the visual representation of a stock picker’s P&L distribution looks very much like the chart below: a few princes make up for a lot of frogs. . Being right 51% of the time through the entire bull/bear cycle is the unicorn of stock picking. Every strategy experiences a drawdown at some point. Stock pickers make money as long as they stay disciplined and keep their losses small.
 Gain Expectancy - Classic Trend Following
 In order to move to the distribution shown below,  one of two things need to happen:
  1. Either reduce the number of frogs: easier said than done, particularly when strategies stop working at some point through the cycle
  2. or, their impact is reduced: reducing drag will mechanically improve profitability
 Gain Expectancy - Alpha Secure
Predicting tomorrow’s winners is much harder than dealing with today’s losses. The game outlined below is an elegant way to deal with losers. Not only does it mechanically improve the trading edge, it also salvages ego and rewires neural pathways from outcome to process orientation.
The game of 2 halves
The objective is to halve the weight of losers once they detract more than half average contribution. Proceeds are then re-allocated to either fresh ideas or winners. This is a simple two-step process:
  1. Divide all positions between contributors and detractors, calculate average contribution: first half
  2. Reduce weight by half (1/2) for all detractors below -1/2*Average contribution: second half
Example:
Average contribution: +0.5%          Babylon Ltd weight: 4%  Unrealised P&L: -0.4%     Realised P&L: 0%
After weight reduction                      Babylon Ltd weight: 2%   Unrealised P&L: -0.2%     Realised P&L: -0.2%
Now two things will happen: either Babylon Ltd will perish, or it will rise
  1. If Babylon meets a tragically eponymous fate : it would have to drop another -15%, just to reach minus average contribution, or -0.5%. At this point, it will be either it is a screaming Buy or a dog. Either way, it will be an easier decision to make
  2. If Babylon rises: then unrealised profits will compensate for realised losses. One rule of thumb in order to maintain a positive trading edge, do not add to the position until it crosses previous entry price
The additional 2% freed-up can be re-allocated either to winners or fresh ideas. Adding to winners cements conviction. Adding fresh ideas brings fresh blood to the portfolio. Either way, it is more of a good thing.
Special mention for managers who use an equal weight position sizing: Equal weight position has many drawbacks, but it has one benefit in this case. Instead of using contribution (weight * return), a simple distribution of return is sufficient.
The game of two halves has three deep benefits
  1. Trading edge mechanically improves: this is a simple elegant formulation of the first mantra: “cuts your losers and ride your winners”
  2. Good stewardship: managers are often torn between defending their convictions and dealing with problems. If they cut too frequently, they are perceived as lacking conviction, which negatively impacts investors confidence. By selling a portion of the position, they show peers and investors that they both maintain their conviction and deal with problems
  3. Process versus outcome neural pathways re-wiring: funds reach capacity not when they are too big in size, but when inertia sets in. Dealing with losers forces managers into action. This accomplishes three things:
    1. Managers become dispassionate with their problem children: since dealing with them improves stewardship, the stigma of taking a loss disappears. The game is simple enough to be executed even in the darkest
    2. Increased fluidity: since proceeds are re-invested, managers have a direct incentive to look for fresh ideas, or to their existing ones
    3. Process versus outcome mindset: believing that being right about a stock is a matter of profitability is an outcome process. When ideas are profitable, ego gets validation. When (not if) they are unprofitable, ego feels under attack. This invariably leads to defensive, unprofitable and often destructive behaviors. Dealing with losers in an orderly fashion changes focus from outcome to process. Being right is no longer about the outcome but about doing the right thing.
Conclusion
The game of two halves is a key to unlock the “Cut losers and ride winners” fortress. It is an elegant solution to the oldest problem in fundamental investment. It reconciles the demand for conviction with the need for action. The privilege of its (mathematical) simplicity is that it imposes itself even in the darkest times.
More importantly, it changes the definition of being right. It is not a binary outcome on the profitability of individual ideas., It is the observance of a process that will lead to higher aggregate profitability. In the Jungian archetypes, it no longer triggers the orphan (amygdala in the limbic brain, responsible for fight, fight or freeze), but activates the ruler (pre-frontal cortex or thinking brain). In short, the game of two halves reduces stress and improves profitability.

Is Stock Picking Overrated ?

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Summary

  • If 80% of managers underperform their benchmark, we probably focus on the wrong thing. How about focusing on gain expectancy instead of stock picking ?
  • Signal module: how often we win (hit ratio) is not a function of what we enter (stock picking) but how we exit.
  • Money is made in the money management module: how much we win is a function of how much we bet (position sizing).
  • Psychology module: Great traders are not smarter, they have smarter trading habits

The finance industry is built on the cult of the stock picker. We have been conditioned to believe that entering the right stocks is the recipe to beat the markets. Year after year, we spare no effort, expenses, technology and time just to find that golden nugget. We never stop and ask ourselves whether it works in the first place. SPIVA gives an unapologetic report on active versus index investing. Every year, about 80% of managers underperform the market by a few percentage points, the equivalent of fees plus transaction costs of one time turnover. There are probably two reasons for this.

Firstly, Charles Ellis explained in his book “winning the losers game” that markets are dominated by institutional investors. The index is therefore the average of highly educated, intelligent, hard working and ferociously competitive people. So, outperforming the index comes down to beating a very high average.

Secondly, if , year after year, we try the same old “better sameness” just a little bit harder and expect different results, only to be humbled each time, we may have been focusing on the wrong thing in the first place. The answer may lie in an equation so simple it is often overlooked: Gain Expectancy.

But first, please understand that our objective is not to throw stones at active management from our modest glass house. We are committed to helping market participants build smarter trading habits. We provide simple yet powerful tools to nudge performance: resources, research, links, Excel files.

Enter Gain expectancy

Gain expectancy is just another fancy word for average profit. All strategies without exception boil down to this formula:

Gain Expectancy = Win rate% * Avg Win% – Loss rate% * |Avg Loss%|

Using this equation, we will examine what we believe to be the four components of any strategy in increasing order of importance: entry, exit, money management and psychology.

Entry Accounts for 5% of performance

Jesse-Owens-007

Finance is the only sport that hands out medals before the race

Finance is the only competitive sport where we expect medals to be handed out before the race. Market participants focus their energy on picking the right securities, but stock picking is the process that leads to entry. When we focus on stock picking, we just care about getting the best stocks to the starting blocks and assume they will do well thereafter. We overlook critical questions such as 1) what if they do not perform as expected, 2) how big we should be and more importantly 3) will we have the fortitude to stomach the ride ?

Stock picking is not irrelevant, it is overrated. There is no doubt that picking the right stocks increases our chance of success. The treasure hunt of stock picking is the most exciting aspect of the job. Ironically, entry is also the part that has the lowest impact on performance. Looking back at the gain expectancy formula, entry is just an ingredient of the win rate%, not the happy meal. After all, even the best ingredients will not necessarily turn into a succulent meal if there is no recipe. When everyone else is fixated on entry, paying a little more attention to other components may give us a critical edge.

In the coming articles, we will examine different types of entry techniques, common pitfalls and remedies. Everybody likes to buy on weakness and sell short on strength. But sometimes weakness is a symptom of a bigger problem and vice-versa on the short side, strength turns into bullishness.

Exit Accounts For 20% of Performance

jesse-owens

It’s not what we pick but how we exit that determines the hir ratio

We all have been shaken out of a position and then watched it rally without participating. The hit ratio is not determined by what we enter, but how we leave. Exit is a binary event: a trade is either profitable or not. The only time when win rate% can be calculated with absolute certainty is after positions are closed. Anytime before that is just paper profit. The quality of our exits determines the shape of our P&L distribution.

Before I embraced the sophistication of simplicity, I used to believe that a certain combination of factors would generate optimal performance. I was looking for a holy grail of some sort. The first epiphany came after a Monte Carlo optimization. One of the combinations made money 19 years out of 20, despite a win rate of 34%. Meanwhile, the highest win rate (67%) lost money 17 out of 20 years. The lesson was clear: “making money in the markets is not about trying to be right. It is about accepting one is wrong and move on”. There is one class of individuals to whom it should come easy: married men.

Would You drive a car without brakes ? Then, would You trust a strategy without a stop loss ? Market participants are often refractory to the idea of a stop loss. It is however the second most important component in any strategy. It has direct impact on 3 out of 4 variables of the gain expectancy: win rate%, loss rate%, Avg loss%. In addition, it has a direct impact on trading frequency and bet sizing. Profits look big only to the extent that losses are kept small.

Entry and exit constitute the signal module. They only determine the win rate. A trading system is like a car. The signal module is the engine. The money management is the transmission and psychology is the driver.

In the coming articles, we will examine the various types of exits and their influence on the P&L distribution.

Money management accounts for 25% of performance

Different Weight simulations SPX - Excel 2015-03-10

Same strategy, different bet sizing algorithms generate different outcomes

Money is made in the money management module. There is rampant confusion in our industry that associates alpha generation capability with high win rate. LTCM used to boast a win rate above 70%. Yet, their demise nearly took down the modern financial system. By contrast, William Eckhardt, the father of the Turtle Traders, claims a modest win rate of 35%. He has however achieved a remarkable annualized performance of 18% over a 36 year career. It is not how often we win but how much we make that ultimately determines our performance.

In a previous job, I used to run my algorithm across various portfolios. The objective was to help other managers better trade their positions 5bps at a time. Compound this over a year and this is the difference between 2nd quartile and top decile performance. The same stocks kept on reappearing in top ten bets. Managers exchange ideas and have access to the same research. There was a low dispersion of holdings, but there was a high disparity of performance. So, the difference that made the difference was obviously not stock picking: everybody owned the same stocks. The primary determinant of performance was bet sizing.

Looking back at the gain expectancy formula, bet sizing is the component that tells how much we make. It helps us achieve our investment objectives. It is also the most important component for market participants engaged in short selling activities.

In the coming articles, we will look at various position size algorithms, risk management tools so as to help You extract more alpha out of your ideas. We will look at specific techniques designed to help You clarify your objectives and achieve your goals.

Psychology Accounts For 50% of Performance

“If You don’t know who You are, this [markets] is an expensive place to find out”, Adam Smith

Habits

Great traders are not smarter, they have smarter trading habits

Unfortunately, bull markets have never boosted anybody’s IQ. We simply get overconfident during winning streaks and start gambling away. Then, during the ensuing losing streaks, we get depressed and take too little risk. In any case, we tend to abandon our discipline. Even systematic traders tend to tweak their models during losing streaks.

We have been conditioned to believe that willpower is the key to success. Unfortunately, willpower is a muscle that tires quickly, particularly under stress. For example, we all know that the key to performance is to cut losers and ride winners. So, we promise ourselves that we will reevaluate positions once stories change. Unfortunately, no plan has ever survived its collision with reality. If we leave this process to our willpower, it invariably turns into an internal debate, where our inner saboteur often convinces us to keep losers in the portfolio.  Inertia creeps in and the next thing we know, our portfolio has turned into a toxic waste junkyard. The problem is: every time we say “Yes” to a loser, we say “No” to a potential winner.

Market psychology is comprised of two parts. It is the ability to execute a trading plan through winning and losing streaks alike. It is also the inner game of investing: the inner alignment from deep subconscious beliefs to daily unconscious routines. “Watch your thoughts, they become words. Watch your words, they become actions. Watch your actions, they become habits. Watch your habits, they become character. Watch your character, for it becomes your destiny”, Mohandas Gandhi

There is a simple, but not easy, solution to change our psychological make-up. According to a 2002 research paper by Wendy Wood, we spend between 45% and 60% of waking time in habitual mode.  Interestingly enough, the study was conducted on young undergraduates, a segment of the population where habits are still highly malleable. Imagine how habitual our behavior can be after 10 years on the job. We probably learned for the first 2 years and then pushed the repeat button ever since.

Great traders are not smarter, they have smarter trading habits. They have developed and practiced profitable behaviors that have turned into trading rituals. The beauty of habits is that they bypass conscious decision process. They become effortless and emotionless over time. Under stress, we ditch elaborate plans and fall back to our habits. This is why installing smarter habits is critical: success is a habit and unfortunately, so is failure.

Fortunately, executing stop losses can be as emotionally intense as brushing teeth. This is a gradual process that starts, not with ruthlessly cutting losers, but with keeping a portion in the portfolio…  It starts small but the compounded effects are immense. The difference between sending a golf ball off course or close to the hole is one millimeter when hitting the ball. If smarter trading habits resulted in a gain as small as 0.02% per trade, the compounded effect over 100 trades would put us in the rare company of market gurus.

At ASC, We are committed to help You build healthier trading habits. In the coming articles, we will provide You with research from the fields of finance and medical sciences, resources exercises, links that will help You change your habits.

Conclusion

“We are what we repeatedly do. Excellence, then, is not an act, but a habit.”, Aristotle

If we want different results, then doing something different is probably a good start. Stock picking is not irrelevant, it is overrated. All it takes to nudge gain expectancy (i-e performance) is to redirect a small portion of our focus to the other components of the success formula.

Great traders are not smarter, they have smarter trading habits. We are committed to helping market participants form healthier trading habits. We will provide You with resources, links, exercises and an App on the Bloomberg portal.

Preview of the next article

  • In the next article, we will introduce a powerful visual representation of gain expectancy
  • Using this tool, we will reclassify strategies across all asset classes in two types
  • We will provide You with suitable risk measures risk for either type of strategy
  • We will introduce a new risk measure: Common Sense Ratio
  • We will provide You with a simple technique that dramatically improve your win rate %