Investment Psychology Explained

by Martin J Pring

  Rule 5. Don't Overtrade

  This topic was covered in Chapter 2, so there is no need to repeat the detailed explanation except to say that overtrading leads to a loss of perspective and considerable transaction costs.

  Rule 6. After a Successful and Profitable Campaign, Take a Trading Vacation

  Many traders find that accumulating profits is relatively easy; the difficult part is keeping them. I am confident if most traders were to show you a graph of their performance, it would look like the oscillator in Figure 8-1, that is, a series of giant sine waves running up and then falling down, because they failed to recognize when their luck and trading skills had peaked. In short, they did not know when to walk away from the table.

  No person, however talented, can maintain a super trading performance forever. People operate in cycles in virtually every endeavor. Take baseball players-even the best have their off days, off weeks, and even off seasons. The same is true for traders. Therefore, make sure that you take a break after a successful campaign, returning to the markets six or eight weeks later. Your outlook is likely to be less overconfident, and you will also be able to take a more objective view of the markets.

  Rule 7. Take a Periodic Mental Inventory to See How You Are Doing

  Quite often we get so engrossed in our trading and investing that we lose sight of where we are going. It therefore makes sense to reflect occasionally on where we are headed and to make sure that we are doing the right thing. As part of this process, you might want to ask yourself some questions on the lines of the following. Am I able to afford the risks I am taking? Am I speculating or investing intelligently or am I gambling? Am I following the right system? Am I trying to buck the prevailing trend? Am I too close to the market? Am I overtrading?

  There are many more questions you could ask, including the other rules cited in this chapter. This simple little exercise will help to draw your attention to any mistakes you might be making or rules that are being broken. In addition, it will serve to reinforce those rules in your mind so that they have a better chance of eventually becoming good habits.

  Rule 8. Constantly Analyze Your Mistakes

  When we are successful, we tend to think that this process arises from hard work or good judgment. Rarely do we attribute it to chance or the luck of being in the right place at the right time. On the other hand, when things go against us, we often blame our setbacks on bad luck or some convenient scapegoat. Of course, we should be questioning our own judgment first because that is the most likely source of any mistakes that may have been made. It is only when we have made a mistake that we can begin to take responsibility for our own actions and learn from those mistakes. You can read books on the psychology of markets ad infinitum, but only when you have gone through the pain of losing money and attributing it to a mistake are you likely take remedial action so it doesn't happen again.

  This process of self-critique has to be a continuous one. After a brief time, chances are that you will be lulled back into a false sense of security as profits begin to roll in once again. In this type of situation, most people will again fall back into their old ways. It will therefore take more losses to reignite the self-examination process. Either the lesson will eventually sink in or your account will be so depleted that you will no longer be trading.

  The greatest benefit of analyzing your transgressions therefore arises because failure is often the best teacher; it brings you back to the reality that if you had faithfully followed the rules, you would not be in your current predicament. What more natural course than to follow them next time around? Most mistakes arise because of emotional deficiencies-the fear of being wrong or of feeling a fool at having to having to face your broker or some other person with the loss. This is also true of professional money managers who not only have to deal with the vagaries of the market and with their own emotions but those of the client as well. This latter battle-the fear of losing the client-can often be the most devastating of all.

  The first step is to face up to such fears, recognize that they are a destructive force, and take some steps to rectify them.

  Rule 9. Don't Jump the Gun

  In any investing or trading situation, there is always the temptation to put on a position before the particular discipline or methodology that we are using has given the all clear. Enthusiasm replaces prudence. This is a poor practice because it means that we are not, in actual fact, following the discipline but have decided that we know better. Rarely does this type of policy pay off. After all, why go to the trouble of researching a methodology or approach and setting up the rules if we are not prepared to follow them? When tempted to do so, you may debate with yourself that this is an exceptional situation and that it justifies taking immediate action. The problem is that these "exceptional" situations will keep occurring until they become an everyday experience. In effect, the discipline will have been totally abandoned.

  Rule 10. Don't Try to Call Every Market Turn

  In our natural desire to be market perfectionists, it is quite understandable that we should feel the need to call every market turn. Unfortunately, that task is quite unobtainable. If we find ourselves trying to guess every twist and turn in the price action, not only will it lead to frustration, but we will totally lose any sense of perspective.

  Money Management

  Rule 11. Never Enter into a Position without First Establishing a Risk Reward

  It is not possible to set out a specific mathematical ratio of expected profits to maximum acceptable losses in all cases. The decision should be taken with regard to the proportion of capital being risked in a particular trade or investment. Another factor would relate to the character makeup of the person concerned. Risk-averse individuals should not go into a high-reward highrisk venture and vice versa. Risk is always relative. What is a financially life-threatening risk for one person may be beer money for another. Generally speaking, you should use a good dose of common sense, making sure that the ratio is normally at least 3-1.

  Rule 12. Cut Losses, Let Profits Run

  This is probably the most widely known rule of all. It is also one of the most important. We enter any trade with the objective of making a profit, so when the position goes against us, it is natural to feel some kind of emotional pain. Many of us choose to ignore the loss, rationalizing that the market will come back. Sometimes we can justify the decline because the market came down "on low volume," or "it might have declined, but the action was good so I will hold on." Another favorite comes from rationalizing the reason for the decline. "That was a bad piece of news, but it was amazing how the market only came down 50%; it's obviously very strong technically." Occasionally, we wait for an event to take place as justification for making a decision. I remember getting very badly burned in the in the spring of 1980. The commodity markets were under pressure because Jimmy Carter had told people to stop using their credit cards. A moralebuilding announcement was expected any day, but in the meantime commodity prices kept on slipping and the announcement kept on being delayed. In the end, I sold out, but waiting for the announcement cost my account dearly. I should have considered the market's action in relation to my game plan when deciding whether to liquidate. Instead I allowed my losses to compound.

  It's amazing how we can play games with our emotions by justifying almost anything. This is because we want prices to go higher (or lower if we are short), but we either forget or chose to ignore that the market is going to move in the direction that it wants to, not the way we desire. The market is totally objective, it is the participants who are emotional. We may wish for a rally but that has no bearing on the situation except that our wishes are bound to cloud our judgment.

  We need to remember that if the market has gone down when we expected it to go up, it is a warning that the original analysis is flawed. If this is so, then there is no rational reason for still being in the position. We should cut our losses and liquidate.

  This does not mean that every time we enter a positi
on and see it go against us, we should sell. A good trader will establish a potential reward and acceptable risk before putting on a position. Part of this acceptance of risk involves the possibility and even probability that the market will decline before it advances. It would certainly be extremely optimistic for us to expect every trade to become profitable immediately we put it on. No, the rule about cutting losses really refers to the point at which these acceptable risks are exceeded, for it is only then that the market is telling us that our original analysis is probably at fault. Even after these predetermined benchmarks have been exceeded and you have been stopped out, there is still room for the element of doubt to creep back. Even though the market has now given its decision, some of us do not like to accept that our hopes and expectations will no longer be realized. In such circumstances, the temptation is to break away from this self-imposed discipline and get back into the market. This is often done at a higher level than the level at which the liquidation took place. Rising prices, remember, build confidence. However, my experience has been that if a carefully chosen stop point has been executed, it rarely pays to get back in. More times than not, it would have been more profitable to have taken the opposite side, but very few people possess the mental agility to do so.

  Cutting losses is a fundamentally important money management technique, because it helps to protect capital and therefore enables us to fight another day.

  Letting profits run really involves the same principle as cutting losses. When the market exceeds your downside cutoff point, it is a warning that you have made a mistake. On the other hand, as long as the general trend moves in your favor, the market is giving you a vote of confidence, so you should stay with the position and let your profits run. There is a famous saying that "the trend is your friend." In effect, this is another way of telling us to let our profits run. Trends, once in force have a habit of perpetuating but no one on earth can forecast their magnitude or duration, despite what you may read in newsletters and the media. As long as your analysis or methodology indicates that the trend continues to move in your favor, you have few grounds for selling unless it is to lock in some partial profits. Markets spend enough time waffling back and forth in confusing, frustrating, and unprofitable trading ranges to allow the trader the luxury of prematurely getting out of a good trending market.

  The problem is that when many people have a profit, they want to take it there and then. The rationale is based on the theory that it is better to cash in now, otherwise the profit will get away. It is certainly true that you can never go broke taking a profit. Unfortunately, every trader and investor cannot avoid losing positions. A net profit situation can only be achieved if the profitable trades outweigh the negative ones, and usually a few highly profitable ones carry most traders. Taking profits too early therefore limits this potential.

  It is interesting how most people are risk averse when it comes to taking profits and risk seeking when it comes to losses. They prefer a smaller but sure gain and are unwilling to take a wise gamble for a large gain. On the other hand, they are more willing to risk their capital for a large uncertain loss than for a certain small one.

  Rule 13. Place Numerous Small Bets on Low-Risk Ideas

  Since a high proportion of trades unavoidably will be unprofitable, it is a wise policy to make bets small so that a significant amount of capital is not risked on any one transaction. As a general rule, it is not advisable to risk more than 5% of your available capital on any one trade. This goes against the natural tendencies of many of us. In our quest for a large and quick profits, it seems much easier and more logical to put all our money on one horse.

  It is also important to make sure that any trade or investment that you do make is a carefully thought out low-risk idea. The estimated potential reward should always be much greater (at least 3-1) than the maximum acceptable risk.

  Rule 14. Look Down, Not Up

  Most people enter a trade by calculating its probable upside and building that assumption into their expectations. As a result, they are setting themselves up for a disappointment. The question to ask when putting on a position is "What is the worst that can happen?" By looking down, not up, you are addressing what should be your number one objective: preserving your capital. If you erode your capital base, then you will have nothing left with which to grow. Almost all traders lose as many times as they win. The successful ones make more on the winning trades but more importantly lose less on the bad ones. By looking down, they are, in effect, assessing where they should cut their losses ahead of time. If this potential margin of error proves to be too great, they walk away from the trade.

  I can remember many instances when I was extremely optimistic about the prospects for a trade. I knew in my mind that the market would tell me I was wrong, but the chart point would be considerably below my entry point. My expectations would be so positive that I would fool myself into believing that the market would "never go down that far because the trend was bullish." Invariably it would, and so I would pay a heavy price for not taking the worst possible scenario seriously. A series of painful experiences have taught me that it is better to look down first and look up later.

  If you know that about half the trades that you put on are going to go against you, then it makes sense to try to make those mistakes as inexpensive as possible.

  Rule 15. Never Trade or Invest More Than You Can Reasonably Afford to Lose

  Any time that you risk capital that you cannot reasonably afford to lose, you are placing yourself at the mercy of the market. Your stress level will be very high, and you will lose all objectivity. Decisions will be emotional because you will be focused on monetary gains and the painful psychological consequences of a loss and will not be based on the facts as they really are.

  Rule 16. Don't Fight the Trend

  There is a well-known saying that a rising tide lifts all boats. In a market sense, it is as well to be trading in the direction of the market since a rising market, in effect, lifts all long positions. Going short in a bull market therefore entails considerable risk; for by definition unless you are agile enough to take profits at the appropriate time, a loss is certain.

  The opposite is true in a bear market where rallies are often unpredictable and treacherous. If you study the results of most trading systems, you will see that the negative results inevitably come from positions that are put on in the opposite direction to the main trend. Obviously, you do not always have a firm opinion about the direction of the primary trend, but when you do, it is much more sensible not to trade against it.

  Rule 17. Wherever Possible, Trade Liquid Markets

  In general, you should always trade liquid markets, that is, where the difference between the bid and ask prices are usually narrow. Trading in illiquid or "thin" markets means that in addition to broker commissions, you are also paying some form of cost because of these wide spreads. You may think that this can be overcome through patiently waiting to buy at a specific price, as opposed to placing a market order. Nevertheless, when you decide to sell, you are more likely to be doing so under pressure, so the wide spread will make the cost of an immediate execution work against you. Illiquid markets can be ascertained by the amount of average daily volume transacted. Normally, anything less than 2,000 contracts per day is considered illiquid. It is also important to remember that in the futures markets, deferred contracts (i.e., those due for settlement some time into the future), can also be extremely illiquid even with such widely traded items such as Stock Index Futures or gold. It is therefore usually a better idea to trade in the nearby futures since the commission costs of "rolling over" into the next available contract on expiration is normally less than the cost of dealing with the wider spread.

  Liquid markets imply a wide variety of participants with differing opinions, so there is usually someone with an opposite opinion to your own who is willing to take the other side of the trade. Illiquid markets can be very profitable if you happen to be on the right side, but if y
ou are caught on the wrong side when some unexpected bad news materializes, the results can be devastating. This is especially true in the futures markets that are subject to daily price limit moves. Most of the time, markets trade within the limits, but it is amazing how they seem to exceed those limits when you personally have a position. When we talk of "liquid" markets, we mean that it is relatively easy to get in and out of a position most of the time. This does not imply that so-called liquid markets are always liquid. There are times when even the most liquid of all, such as the S&P Composite, bonds or gold move at such a frantic pace that it can be impossible to obtain an execution at anywhere close to the expected price. This situation often develops after the release of a government report. If the market has factored in, say a bullish number, but the report is bearish, then for a few moments there may be no liquidity whatsoever as the market adjusts to this new reality.

  These situations seem to arise when most participants are positioned on the same side and the market has factored in seem very favorable expectations. When the bad news comes out, there is virtually no one to take the other side and yet seemingly everyone wants to get out at the same time. Only when the price has made a rapid and, for the majority, painful adjustment, does liquidity return to the marketplace. It therefore makes sense for those who have a short-term horizon to avoid potential situations of this nature, for you really have no control over the outcome. You are literally gambling on the content of a government report that will probably be revised anyway.