With markets as crazy as they have been recently, its important to be introspective. I believe that market psychology and behavioral finance are critical aspects for both traders and investors. I personally spend a lot of my time, thinking about my ideology, philosophy and how I can translate that into actionable and tradeable investment ideas.

As someone who manages their own money, this iterative process gets refined on an ongoing basis to build what becomes my ‘formula’ for how I invest. Now, its not to say it’s the right formula for everyone, but it’s the formula that makes the most sense to me. Furthermore, it is not static. Life is not static. As my own circumstances change, so does the ‘what’ I want to achieve from my investments. My own risk tolerance and risk appetite will change as life changes and I must be willing to adapt to the same.

Now, no one worth their salt in markets will tell you that they haven’t lost money and/or made mistakes along the way. That’s part of ‘paying the school fees’. I have had my fair share of lapses in judgement and loss of discipline as a result of ‘greed or fear’.

Part of the investment and trading discipline entails learning to recognize one’s weaknesses and to actively work on reigning them in to ensure that investment or trading decisions are made in a rational and unemotional manner. Sometimes, even the best system is susceptible to poor execution.

Losing it

Let me give you a real-life example. Last year, I carved out a small portion of my portfolio for a trading strategy that I had developed and back tested and refined and I decided that it was time to put it to the test in real life. As it was only a portion of my money, it was the perfect way to incubate a new strategy.

The strategy was great and resulted in all the right metrics. My win/loss ratio was around 70%/30%. My drawdowns were way less than my profits. Even with the churn factor, the strategy made reliable gains in both up and down markets. I also took to consulting some friends along the way to hear their thoughts and use their learnings to further refine my execution. It was a win!

Now for the lesson. The strategy was orientated around taking consistent position sizes (either long or short) and using a rules based technical and quant model to ruthlessly take profit and also to cauterize losses, quickly. This is how I preserved my gains and intuitively, why the win/loss ratio worked in my favor. Then I let it go… the discipline that is, and the results were nasty.

It creeps up on you. When winning, you get greedy. I scaled to a position size that I should not have been comfortable with. The asymmetry of emotional reactions to wins vs. losses are skewed to being more negative on the losses than the wins. As such, you don’t feel the risk of an outsized position going up. But when it turns, it hurts…a lot.

I made meticulous notes as I went along. This is why I was able to reflect, much later, on what went wrong, how and why. What amazes me when poring over these manuscript notes (yes, I am a little old school) is that the flags were all there. The mistakes I made, in hindsight, were predictable and repetitive. On the plus side, I have taken these learnings and worked on them for months. No, I am not immune to the same mistakes again but I now know what to look out for and how to correct.

My learnings:

It highlighted very specifically the type of behavior I should have avoided. I will provide a precis of my learnings from both my investing and trading (I know they are different) below. Most are applicable to both approaches to the market:

  • Define your trade or position size. I looked at the average size of drawdowns through the cycle and worked this back to how much pain I could feel without losing sleep. Even in an investment portfolio, diversify well and remember to watch your concentration risk.
  • When you have a winning formula, don’t get greedy. This was my primary mistake. All strategies will have rough days. If you’re greedy, you ignore point 1 above and when the tide turns, the losses will wipe out the gains and then some if your sizing is wrong.
  • When you hit a rough patch, do not let FEAR define you. When the greed from point 2 costs you too much, FEAR will hold you back from following the formula you spent so long refining. As such, your gains, as you claw back, are smaller than the outsized losses you took because of 2.
  • Overtrading. Sometimes, it is best to sit on your hands. Whatever your method and process, sometimes, things are not ready. If you are staring at your screens all day, the urge to DO SOMETHING is powerful. Don’t! Wait for the set up to be right even if that means missing a few opportunities along the way.
  • Be patient! When baking a cake, don’t open the oven, when braaing (barbeque for my non-SA readers) don’t turn the meat unnecessarily. Wait. When trading or investing, know your parameters, your definition of value and know your entry and exit levels and why you are making an investment or trade. If you are long and believe your thesis, wait for the results. If you are waiting for an entry price, don’t jump ahead and erode your margin of safety. This erodes returns and increases risk.
  • Sometimes, the markets get scrappy. Don’t get sucked in if you don’t have a good feeling and are not confident in the set up. Step away, Clear your head and re-assess based on the information at hand.
  • Liquidity is key. Related to the point above as well as position sizing, always know what you are getting into. Do not get sucked into names you don’t understand and always consider your exit strategy BEFORE you get into a position.
  • Lastly, trade and invest with a clear head. Being all cerebral about your process and method is one thing. But life happens. When your head is not in the game, step away again. Sometimes its not when markets get scrappy, its when life gets scrappy. I hedge myself against this by outsourcing a portion of my investments for the times when I am not able to give it my full attention and focus.

Investing and trading are a marathon and require lifelong commitment and refinement. In an era of investment fads and social media pumping ideas out there, its easy to get sucked in. If you trade or invest as a hobby, that’s fine, you’re probably doing it with money you can afford to lose, but when you’re considering longer term goals and/or considering it as a means to true wealth creation and preservation, get serious.

Do your homework. Due diligence, discipline and a strong process are all a prerequisite to investing success. Maybe its unfashionable but remember that when the tide goes out, you see who’s been swimming naked. In times like these, many people feel like heroes and many people have made serious money…nothing wrong with that. But if what you are looking for is consistency and sustainability, remember it’s a marathon and not a sprint.

I continue to learn and this is what Moe-Knows continues to be about…learning together. If reminds me of an African proverb:

If you want to go fast, go alone. If you want to go far, go together.

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