Following on from last weeks blog post, I have continued to dissect the statements made by Mr Kerr Nelson in the Australian Financial review article, “Wizards of the game”. I hope you enjoy my commentary.
“Loss aversion is an irrational approach sadly evident in the stockmarket. Many investors keep hanging on to losing stocks in the hope that some day, somehow, they will bounce back. Such is the distaste for loss that it causes a mental freeze that renders people incapable of sound judgement.”[GS] As discussed last week, the ability to accept when we are wrong, cut out of the trade and move onto the next opportunity is what successful traders and investors do on a continual basis. They have learnt that holding onto losing positions is costly both financially and psychologically. They have mastered the ability to accept that they are wrong, and that this trade is only one of many hundreds of trades they will execute over the course of their trading. They have no emotional or financial attachment to the result of any one trade. By cutting the losing trades early and quickly, they also avoid the potential for one large losing trade which can have a significant impact on their financial position and well being.
A mechanical system that is based on price action will provide an unambiguous signal to cut out of a position that is falling.
“Overconfidence is a particularly dangerous trait in the field of investment. It leads to overestimation of ones knowledge and underestimation of risk. In the 1990s, many investors enjoyed exceptional paper profits in technology stocks and attributed their success to their ability. I’d say, underestimate your knowledge and overestimate your risk.”[GS] We must always accept that the market is right. It is bigger and stronger than any one individual. Being humble when we win and equally as humble when we lose is an important attribute to develop. Too many people get carried away during rampaging bull markets. They become euphoric and place too much capital into positions at the end of the run thereby setting themselves up to give more back to the market than they should have. Also, their euphoria blinds them to the possibility of a bear market and, as they enter a riskless state of mind, they continue to place full positions into the falling market believing that it will continue to rise. Only when the pain of losing becomes too great do they snap out of the state of euphoria or overconfidence.
“We think the biggest fault for investors is to overemphasise a current event – if you were in Queensland today, you’d pay a lot for insurance against natural disasters.
In the stockmarket, the nearby event is the commodities boom, which will blind you to emerging issues – inflation, for example. In our view, inflation is more interesting than the run up in commodity prices; it depends on how you want to look at the world.
One day you can like a stock and it can change in price and you like it less – not because the price has gone down but because it has gone up”.[GS] Mr Neilson is referring here to recency bias where recent events, particularly big events, magnify our view of the world with a particular bias. We then over-react to events that immediately follow the big event, in both a positive and a negative sense, depending on whether the big event was a positive one or a negative one.
It is extremely important to remain neutral about the market and the effects of recent and current events and not knee-jerk react to noise or personal prejudices. This is achieved by adhering to a strict plan for entering and exiting all trades based on objective and unambiguous analysis of price action.
This is the mechanical approach. It provides clear entry and exit signals without the need to make judgement calls based on emotional reactions to price moves. Again this comes down to a disciplined approach that removes the emotion from trading and investing in the stock market.