Psychology – A Common Theme

Of all the emails we receive, a common theme emerges:

“It is hard to stick with the same strategy during drawdowns, due to the fact that the market always seems to be tanking whenever I decide to trade again.” – Andy N.

“My biggest challenge is sticking to a strategy when it is not performing to my expectations. I can fall into the trap of chopping and changing.” – Steve A.

“My #1 challenge in the markets is not getting too low emotionally after a losing trade and maintaining the courage to take the next trade after experiencing loss.” – Nick A.

“My number 1 challenge, trading through the drawdowns.” – David B.

I’m not going to delve into any psycho-babble about this topic, however, here are some exercises to explore to get you over the hump:

(1) Reality Check

Firstly, I think it important that expectations are aligned with reality, and I’m not talking about the self-appointed experts on Twitter and trading forums who seemingly never have a losing trade.

Plenty of people have travelled this path before you. Investigate how their journey unfolded, from the world’s best like Buffett, Dalio, Tepper, Paulson, Cohen, Tudor-Jones, Crabel, Harding and down the line. Read the stories of top traders from Market Wizards, scour the performance data of top trading funds, read white papers such as Vanguard’s “The Bumpy Road To Outperformance“. The key takeaway from all these is that being a good short term loser is an absolute requirement to becoming a long term winner. Nobody likes to lose. But consider that every field of endeavor, form elite sport, to great science discovery, to successful entrepreneurial businesses, all overcome some kind of drawdown at some stage.

(2) Personality Match

Another consideration could be that the strategy is not aligned to your personality, you have unrealistic expectations or that you know the strategy is based on faulty planning or design. In fact, Jack Schwager, after interviewing enough “Market Wizards” to write numerous books, concluded that the most important characteristic of all good traders was that they had found a system or methodology that was right for them.

If you don’t have a high conviction in your strategy or processes then short term noise will generate anxiety and easily knock you off track. You will doubt, balk, tinker and switch direction often. Alternately, when a strategy is right for you it feels and comes naturally. There is no conflict or anxiety. Order placement and trade management flow without second thought.

Ideally to get to this state entails you building a plan around your personality traits. When using someone else’s plan, you need to research and practice it extensively. Cut the position size or trade in a simulation mode, then follow the strategy religiously for a decent length of time. This will tell you whether or not the strategy suits you and whether it’s worth following.

(3) Turn It Down

All too often amateurs try to avoid loss and drawdown altogether. They look for ‘comfort’ strategies, specifically those that have a high winning percentage of trades, have a low drawdown and minimal losing periods. Whilst this is an admirable goal, the key point is that professionals do not attempt to avoid loss and drawdown. Instead they manage it. There are a variety of ways to do this, including adding non-correlated strategies, or adjusting risk.

Lets assume you have $100,000 to invest and the chosen strategy has a possible drawdown of 30%, which is above your own tolerance of 20%. Rather than ‘avoid’ the drawdown by tinkering the strategy, what you should do is allocate $70,000 and trade it as designed. Put the other $30,000 in cash. If/when the strategy designed drawdown occurs your exposure will only be 20% of the total portfolio value (70,000*0.3), which is within your tolerance.

To build wealth one doesn’t need a strategy that is 90% accurate and generates positive returns every day, every month and every year. Simple strategies with modest returns applied over the longer term is how the great traders and investors operate.

If you haven’t already done so, I strongly recommend watching this 60-minute presentation on the quantitative vs qualitative traits of trading.