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The Psychology Challenge of Active Investment Part 2

November 10, 2010
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If you are investing according to a consistent method then all trades are potentially “good” trades. Don’t fret about which one is the best of the “good” trades or which one will be a loss trade. Just do the trade according to the rules of the methodology! The rules are your edge in the market with loss trades built into the edge.

Successful active investment is about making profits, not about being right.

It doesn’t matter which trade delivers you a profit. Active investment using technical analysis is about finding high probability trends. This is why it must become easy to exit trades according to the rules whether they are in profit or in loss at the time. Don’t hold onto a trade because you want to make more profit or less loss in that particular trade. It doesn’t matter; the next trade may deliver more profit. Detach yourself from your prejudices about past profitable or loss trades. You do not know what will happen next nor do you need to know to be successful in the markets.

Follow your exit signals without any expectation of what might happen after you exit. Don’t hold on to sell at the original entry price when facing a small loss after an exit signal occurs. There is a very good chance that the entry price will not be achieved again for a long time, maybe years, if ever.

A good example is Telstra, a “Blue-chip” stock on the ASX which has remained in drawdown from its high of $9.20 for more than 11½ years as at November 2010. “Sound” companies with Australian household names such as Bab Cock & Brown, MFS, HIH Insurance, One-Tel, Bond and Quintex went into liquidation where their stock prices went to zero let alone regaining their old highs!! There are countless examples of such stocks around the world.

In the sub-prime bear market of 2007 / 2008 many “blue chip” stocks lost 50% – 90% of their value in a matter of a few months, some even in a few weeks. No, they don’t all come back! Nobody knows what is going to happen in the future.

Exit the trade

Ignoring exit signals merely puts you under undue psychological stress because you enter a zone where there is NO signal to bring you to action. You must have known that the price would go higher! The net result is that you take no action and hold onto a losing trade, hoping that one day you will get your money back and avoid the pain that comes with closing out a loss trade.

This mentality will cause large loss trades to occur, the ones that wipe out all your profits for the year, or longer. Always ensure that your active investment capital is in high probability trades. Note there is no such thing as a guaranteed profit trade, just a high probability one.

Take responsibility

Take responsibility for your actions and results. If you do not there will always be someone or something else, i.e. not you, causing you not to perform. This mindset allows you to continue repeating your mistakes………..because it is not you making the mistakes! This means that you will never need to address anything to improve your performance because it will always be beyond your control.

Learn to take responsibility for your actions so you can address any shortcomings and move on to grow and improve.

To complete this journal posting I will use a scenario used by Dr Van K. Tharp to illustrate a case in point on actively investing with a Trading Methodology. This material can be found in Jack D. Schwager’s book, “Market Wizards”. If you are trading with a methodology (entry and exit criteria, portfolio, risk and money management) then you can choose one of the following two ways of trading.

Thought pattern one:

  • See the Trading Methodology signal.
  • Recognise that it is a valid signal according to the rules.
  • Tell yourself what might go wrong if you take the signal.
  • Feel bad about it.
  • Do not do the trade.

Or you could follow this second thought pattern:

  • See the Trading Methodology signal.
  • Recognise that it is a valid signal according to the rules.
  • Feel good about it.
  • Do the trade.

Or put another way: confidence is thinking about what you want to happen and lack of confidence is thinking about what you do not want to happen. Whilst your confidence will not affect the outcome of the opportunity, it will affect whether you partake in the opportunity or not.

If I could leave you with this statement,“The cost to you for your fear will be the loss of profits which will be far greater than the losses you fear”.

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Comments

  • Keith Warrington says:

    should have had this advice years ago would have saved me a fortune

  • Max Sweetman says:

    Hi Gary

    You may remember me from the Gold Coast.

    I am fully retired now and travelling OZ in a 5th wheeler and travelling overseas, loving life.

    enjoy your comments and business channel

    Regards

    Max Sweetman

  • Gary Stone says:

    Max,

    I certainly do. You were managing a complex at the time and had live telex share prices coming thru on your computer (or just the TV?).

    Good to hear from you. Keep well and keep loving life.

    Regards
    Gary

  • Craig says:

    My thought process:

    snip

  • NEIL HULME says:

    Gary,
    Extremely pertinent article on a situation that occurs time and time again.i cant help but feel (and hope)that taking all signals without emotion or thought of “what if” becomes easier and easier as the number of trades mount up over time.Meaning that 5 trades out of 20 = 25%,whereas 5 trades out of 200 trades = irrelevance.

    Regards

    Neil

  • Jeff Walters says:

    Started trading live on Jan 27 2010 and went in to large drawdown for most of year. Made heaps of mistakes but I promised myself to do a year no matter what (in my plan). At worst was $13K down on my $90K investment. I think I’m finally doing things right as I’m now in profit!. My biggest issue was trying to get a little more on my sells and buying a little cheaper. Worked sometimes – but not always. Now I just trade (unless the new buy stock jumps more than 5% – in my plan). I think I’m starting to finally come around Gary – this journal entry is very relevant to me. I re-read your earlier material and see it differently than when I first read it.

  • Gary Stone says:

    Jeff,

    Thank you for this insight. The fact is that the majority of investors either new to trading or new to a specific methodology will go into drawdown in the their first few months.

    This can be caused by the methodology not being aligned to the market for a period of time, as happened in your case. However, mostly psychology trading issues that manifest themselves as trading mistakes either cause all the drawdown or compound the drawdown caused by methodology mis-alignment.

    When the methodology does align with the market, as SPA3 has done since 9 July 2010, it can massively outperform the market and more than make up for the drawdown during the period of mis-alignment. However, if the trader hasn’t resolved some the psychological issues discussed in the post above and many other posts, they simply will not execute and ‘do the trade’. Which means they will not come out of drawdown.

    They then blame the market, the methodology, their job, their spouse, their software etc etc. They need to take responsibility.

    I can remember having a conversation with a customer way back in September 2001 when their SPA3 portfolio, as did mine and all our customers, fell by around 18% in a week as a result of the 9-11 World Trade Centre tragedy in New York. It was SPA3’s fault that their portfolio had dropped.

    Sure, we were all feeling emotional pain and shock horror from the event and from what had happened to our portfolios but cool heads and objectivity are called for in such times. We can’t control or change events but we can control how we react to events and what we do in response to them.

    My response at the time to the customer was that the market will tell us what to do, either stay out by not providing new entry signals or re-engage by providing new entry signals. This particular customer stopped using SPA3 at that point and probably stopped investing altogether for some time. The emotional pain was too much. This meant that their portfolio would remain in drawdown at that level; forever, if they never started investing again. It took SPA3 just 4 months to rise out of drawdown and make a new equity peak. That was at $130,000, now it has cracked the $500,000 mark, while the market is up just 40% over the same period.

    My point is that we will never know in advance when a methodology will be aligned or mis-aligned to the market. During times of mis-alignment our portfolio will go into drawdown, during times of alignment our portfolios will rise and eventually come out of drawdown and make a new equity peak.

    Psychologically, the challenge is to keep executing according to the rules through all types of markets, trusting that the researched edge will deliver over a large sample of trades. In reality, many human beings have difficulty remaining consistent and objective during times of drawdown.

    How much profit one makes in the market with a methodology that has a proven edge is directly proportional to how much emotional pain one can endure during times of drawdown.

    In Rocky Balboa terminology, “when the going gets tough the tough keep going”.

    Sure, any methodology can be improved which SWS is constantly working on (as not a single system will always be aligned to the market in all types of markets) – we keep our customers up to date on developments with new research.

    In conclusion, recently we had a customer who ceased using SPA3 during these wide ranging sideways markets that that dominated the ASX during 2010. The customer had discovered that SPA3 was roaring ahead and had made a new all-time equity high in our publicly traded portfolio. It was our fault that we had not communicated that SPA3 was now smashing the market! Now the customer had suffered emotional pain at two levels, the pain caused by the drawdown during the wide ranging sideways market which proved difficult to handle (the methodology was blamed for that) and then the emotional pain of missing out on the very strong rise that ensued (we were blamed for that).

    I write this long response and provide real life examples in the hope of us all learning from other people’s experiences, especially after a drawdown period followed by a run-up period. After all anybody can learn from their own experiences (or can they?) but it takes a wise person to learn from others’ experiences.

    Jeff, hopefully you will have helped others take another small step forward in transitioning their perspective on their ongoing active investment journey.

    Best Regards
    Gary

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