In the previous two articles I outlined what I believe are the major problems and obstacles that stand in the way of success for the typical retail trader or investor. In this article I offer my solution.
The key issues which throw up formidable barriers to long term profitability are inherent in the nature of the markets themselves. In order to achieve success you will need to acquire three things-
- A statistical advantage or Edge.
- An appropriate Risk and Money management plan.
- The mental discipline, intelligence and psychological skills to develop, maintain and follow both your edge and money management plans. I call these mental qualities a Trader’s Mind.
An edge is normally the key element of a trading strategy. Identifying an edge and developing a workable strategy is an art that comes from experience. It is blending together a number of different elements in a balanced and complementary way. Edge and strategy development is beyond the scope of this current article, but is a subject that I hope to deal with in detail in the not too distant future.
The Basics of an Edge
If we look at what an edge is in its most basic form, it is the ability to ‘read’ the market and predict, using whatever means you have at your disposal, whether the price will go up or down over a specified period of time. It would be nice if we could also predict to some extent how much the price will move, but just getting the direction right is a pretty good start.
There are many who say that markets cannot be predicted and it is not uncommon to hear reputable people actively rejecting any suggestion that they use prediction. Their typical claim is that it is only necessary to respond to what is actually happening in the market at any given time.
This makes no sense to me. We have to estimate what we believe is going to happen and this is called ‘prediction’ whether we care to acknowledge it or not.
Developing our skills requires lots of practice, and doing this in live markets with real money can be an expensive and potentially devastating proposition. A common and accepted practise is to use a demonstration account with virtual money. Another option, which I believe has significant potential but is currently under-utilised, is the use of games and simulations.
Astronauts, aircraft pilots and military combatants routinely use simulations and games to develop skills, which would be difficult or risky to obtain through other means. Well-designed simulations and games dramatically increase both the quantity and quality of experiences and often reduce the time it takes to develop specific skills.
I have experimented with this approach over the last few years, mostly in a class room environment, and the results have generally been positive and encouraging.
In the previous article entitled ‘Learning’ I talked about feedback. Trading and investing is a process of continuous learning about the ever changing conditions of the market.
We need to constantly update our knowledge, never taking things for granted and watching carefully for change. Since raw results from individual transactions will confuse rather than inform, we need to keep accurate records from which we can derive meaningful averages.
Most people find it impossible to accurately recall the significant number of transactions needed to calculate meaningful results. If do you attempt to do so, you will inevitably succumb to a cognitive bias known as recency bias; ie you will give more weight to recent results, whether they be good or bad, than to earlier ones. This will skew the results of the already weak feedback signals that you are trying to extract from the raw data of your experiences.
I manually record the information about each of my trades in a daily trading journal. At the weekend, when the markets are closed, I transfer this information into my database. A database can be as simple as an Excel spread sheet. We need our data in an electronic form to easily analyse it whenever we wish to do so.
Most people find looking at columns of numbers meaningless and boring; we do need to process our collected data to extract whatever intelligence we can from it. To do this we need basic statistical skills and software tools like Excel, or better.
You do not need a Ph.D. in mathematics for this task. If you don’t already have the necessary skills they are freely and readily available from numerous online resources. I recommend the Khan academy as a good starting point.
I have no doubt that there are a few individuals who manage to perform all this analytical work intuitively, without resort to record keeping or mathematics. The human brain is capable of amazing feats, particularly where pattern recognition is involved. Untrained or badly trained intuition, however, is a ripe field for self-delusion, and in my opinion, the majority are likely to do much better using a structured analytical approach.
Risk and Money Management
Until you have a reasonable edge, risk management is very simple. Just keep your position sizes as small as possible even when transaction costs are completely killing any chance of making a profit or if possible use a demo account with virtual money.
Once you have a quantifiable edge, your money/risk management plan needs to take into account the size and characteristics of that edge, together with your own personal level of risk tolerance. This will vary significantly from person to person.
Going beyond your risk tolerance at any time is a recipe for disaster. Doing so will inevitably trigger subconscious impulses; these are likely to have a negative impact on the quality of your decisions.
The mathematics of risk and money management for the typical retail trader or investor is usually pretty simple. In my experience, the calculations involved seldom present a problem. Sticking to a simple plan, however, often does.
Watching your portfolio disappear before your eyes because you have failed to stick to your plan will provide a sobering and powerful learning experience. Again I mention the potential of games and simulations to dramatically demonstrate these important principles.
Here is a simple rule of thumb that can be useful for determining your personal level of risk tolerance –
“Your risk is right when you sleep at night”
Last, but not least, we come to the important area of psychological development that I call a Trader’s Mind. I have already dealt with this subject in recent articles so I will not dwell upon it here other than to say again that I am looking very closely at the use of well-designed games and simulations to help people develop these skills.
While this is by no means a new idea, to the best of my knowledge it is not something that is receiving a great deal of interest or attention at the moment. It is however a significant part of my own research efforts and I look forward to sharing and discussing the results of any progress in this fascinating area with anyone who is interested.