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IT'S NOT ROCKET SCIENCE |
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Janice Dorn, M.D., Ph.D.
I have had enough and I can no longer remain silent. Here is a small sample of my present beliefs. Remember that my beliefs (as yours likely ought to be) are fungible and subject to change at any time: We have been in a recession since approximately October 2007, and are now nipping at the heels of entering a full blown Bear market. Those who are holding and hoping long, (praying to be “all in” when the markets decide to stop going down) are getting absolutely decimated. The markets can be timed—not exactly—but pretty well. The coming rally is likely to be quite vigorous, thus confounding bulls and bears alike. When we get anywhere near the October 2007 highs people will again begin to believe that "We are never going down again." History may not repeat, but it often rhymes. Cash is a position. If you don’t know what you are doing, then stay out. When in any doubt , get out. You don’t have to trade every day or every week for that matter (Some the best long -only fund managers I know have been in cash since last fall). Those short since last fall are getting a little too euphoric. There is no holy grail, and no magical indicator or combination of indicators. Anyone who sells you his or her trading system is making money selling his or her system to you… period. If that system is so fabulous, why isn’t that person off on a desert island somewhere basking in the sun and drinking whatevers? If anything is moving up from left to right on the chart, buy pullbacks to support. If anything is moving down from left to right on the chart, sell rallies into resistance. The secret of making money in the markets is to not give back hard-earned gains. It is about preservation of capital, i.e., return of your money, rather than return on your money. In a Bear market the one who loses the least money wins. One rule/one model systems do and will break down. Patterns that once worked consistently will stop working. The majority of people who tell you “I have never seen anything like this before” are losing. SELL is a great four letter word. If you are not watching the currency and bond markets, you do not understand the game you are playing. OK!! I think that’s enough beliefs for now, and we are moving on to the rocket science thing. This is about handling losing positions and getting your trading brain out of the cave once and for all. Get Your Trading Brain Out Of The Cave. If you do not have a plan for handling losing positions, you don’t have a plan. The majority of the writing on what is now called Behavioral Neurofinance relates quite beautifully to this to this concept. Call it what you want—Prospect Theory, Disposition Effect or Overconfidence---it basically means the same thing. Traders hold on to losing positions because they have not learned the fine behavioral skill of accumulating regret. Just like the cavemen, traders and investors will do everything possible to avoid regret and to accumulate pride. People refuse to sell losers because they don’t want to deal with the regret associated with selling. This would mean, perhaps, that –because they made a mistake—they are bad people, bad traders, worthless and will never amount to anything. What people do not “get” is that losing is winning. Trading is the only occupation in life where losing is winning. Taking losses preserves capital and allows a person to stay in the game. Holding losers and hoping to get out breakeven draw down on all aspects of human capital—financial, mental, emotional, physical and spiritual. Cutting losses quickly and without fear of reprisal (mostly from oneself) is the best thing you can do for your portfolio. If the position turns around and goes your way, you can always get back in because you have preserved your capital and lived to play another day. So- what is your plan? What is your formula for cutting losses? There are four easy questions to ask yourself in this regard: (1) Why are you
getting in? Once you answer these questions and adhere to your plan, you remove from the equation the most dangerous of all market enemies---you and your emotional rat brain. It is emotions that convince you, deceive you, trick you and lie to you about why you are staying in the trade. Additionally, you will do other things in an attempt to appease the “thinking” part of your brain. You will look for "confirmation” that you are in the right position, that you are correct and the market is wrong. This "confirmation bias", if pursued is likely to lead to every manner of physical and emotional illness imaginable. Not adhering to your stop is the worst thing you can do for yourself. You do not adhere to your stop because you want to accumulate pride (convince yourself that you are right) and avoid regret (don’t want to admit that you are human and made a mistake). I am not done here, so please bear (pun intended) with me a bit longer. Underlying this caveman brain behavior is something called overconfidence. Most traders and investors—including professional traders and fund managers—are overconfident. Work in the behavioral finance literature has shown that traders hold losing trades longer than winning trades AND that the average position size for losing trades is larger than for winning trades. Think about it. Do you see anything in your own trading that resembles this? I certainly have and that is how I got a Ph.D. in futures losses in 1996. All you need do is turn on any of the financial radio or television channels to hear this. Do you think anyone is going to tell you that he or she has “no clue” about what is going on? I think not. If they did, I would expect that their days on the media are numbered. Oh yes—in retrospect—when their feet are to the fire, they will say something that slightly resembles humility. Why? Because they have nowhere to hide and have to admit they made a mistake. Listen carefully to all the talking heads and the way that they say they were wrong. Listen to what they don’t say.
Traders that are
unsuccessful
expose
themselves to
increasing risk
in order to
generate
income. This
practice, if
continued over
time, will do one
of two things to
your portfolio:
The takeaway
from this is
simple: The
least successful
traders are the
least
disciplined in
terms of their
ability to
adhere to stops
and cut losses
quickly. The
most successful
traders do the
opposite: they
hold losses for
the shortest
period of time.
Until Next
Time,
Janice Dorn,
M.D., Ph.D.
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What
is the solution
to the
non-rocket
science
situation? Get
to know your own
disposition
effect/prospect
theory
continuum/overconfidence
situation. In
other
words—-Trader