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In my Money and Markets column each week I tell a story, or give a prediction about the future. Hopefully it makes for interesting reading. And maybe some of it is even helpful and plays out in the real world to make you some money.
But forecasting is a mug’s game when it comes to making money in the market. The reality is you don’t have to forecast to make money, but you do need to control your risk.
Traits we all exhibit at times are what swiftly separates us from our money — traits of an “acute successful randomness fool,” as defined by Nassim Taleb, author of the excellent book, Fooled by Randomness.
Today, I’d like to examine these common traits. Because if you can identify and recognize the traits of fool, and apply some simple principles, you’ll have your own built-in risk management system in place.
Keep in mind, though, that even some of the best traders in the world are prone to these mistakes, as we see so often in the blow up of funds and firms. So if it can happen to the pros, it can happen to you.
After each of the traits of market fools I provide an example that perhaps you can all relate to, and a reality bite to show the proper perspective and simple ways to avoid these mistakes.
Trait #1 — An overestimation of the accuracy of their beliefs in some measure, either economic or statistical
Example: The U.S. dollar MUST fall because the current U.S. account deficit is rising. Reality: No it doesn’t have to fall. If money pours into the United States from international investors for whatever reason (stocks, high yield deposits, real property, etc.) the dollar will rise regardless of what the current account deficit does. Develop reasons, but don’t be dogmatic.
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| “The market can remain irrational longer than you can remain solvent.” — John Maynard Keynes |
Trait #2 — A tendency to get married to positions
Example: The dollar sold off even though the jobs report said employment is strong. I’m right, the market is wrong. Reality: It’s always about price action. There is much going on in the market, and a lot we will never know about. Price action tells us that our reasons may be wrong, no matter how much evidence we gather. Listen to the market. It’s your only master.
Trait #3 — The tendency to change their story
Example: You are a short-term trader and the market just moved against you on a key daily report. You rationalize that it’s okay, because “I’m in this trade for the long haul, and sooner or later I will be right.” Reality: If you develop reasons and time frames, stick with them. If the market gives you information that says your view is wrong, get out! You can always re-enter. Getting out will at least give you an opportunity to more objectively evaluate new information.
Trait #4 — No precise game plan ahead of time as to what to do in the event of losses
Example: You enter the trade thinking you’re going to make big money — all you think about is your reward. Reality: You should always think of your risk before you enter a position — that’s what professional traders and speculators do. You must consider your risk beforehand because if you wait until you have already taken a position, you tend to lose your objectivity.
Trait #5 — Absence of critical thinking expressed in absence of a “stop loss”
Example: You liked owning the euro when it was at $1.40 against the dollar, you will love it at $1.35 — the average down mentality. Reality: This goes to point number 4 above; set your risk parameters ahead of time by establishing a stop-loss level to exit a trade and stick with it — don’t rationalize. The euro at $1.35 may indeed prove to be a bargain. But it may also be the start of a major decline that can significantly damage your capital or wipe you out if you are trading with high leverage.
Trait #6 — Denial
Example: Well, I really got hosed on that trade — it was bad luck. Reality: There is usually a very good reason why you lose money. Take the time to try to understand it. You learn more by objectively analyzing your investment mistakes than you do by studying your winners.
The bottom line of all this is that you can never keep from being fooled by the market. But you can control your risk. And if you can control your risk and stay in the game to fight another day, your chances of winning will increase dramatically.
Best wishes,
Jack,
{ 9 comments }
That was helpful! thanks….
Good advice.
Well done, Jack. A lesson learned from this essay could be “A fool and his money are soon parted.”
Here’s some facts.
89% of traders lose all their account and possibly more in the first year of trading futures
7% break even
4% WIN THE 89% !!!!!!!!!!!
Or…say u want to day trade for a living and U start with $100k
In the first year U have 100% ROE = $100,000 profit.
U have to pay tax ,eat,provide for hols, your future etc
At the end of the year U have an account = $130,000 for eg
NEXT YEAR…Costs are same, maybe even worse with a one off expense.
So you have $60,000 in your account but you have a losing year of $10,000.
TRY AND MAKE A LIVING ON $50,000…you have to make at least 140% just to get your expenses
DONT FOOL YOURSELF. HAVE A PLAN AND TRADE THE PLAN.
AND ALWAYS ALWAYS HAVE A STOP IN THE MARKET
SW from OZ
All you amateur traders are fools, and your adviser lives up to his name. “it’s always about price action”…and “…much going on in the markets…and a lot you will never know…”(no kidding); “even some of the best…and if it can happen to the pros it can happen to you” (really?). The point is that the markets are made and driven by priviledged information and fraud, and are insufficiently regulated. Until this changes, do not trade, or even “invest” (except in your own personally owned business, property or education”.
To: Hanrod…………..thank you for the truth. In a time when we all should be looking after one another everyone is wanting to sell the information which will save us when we have little resources available and as you point out such information is almost useless. The wolves are running wild.
It is always good to be reminded of these tendencies and caveats even though Mr. Taleb wasn’t first to recognize them. In general I agree with Hanrod above. However since trading is the business I’ve chosen it seems I feel there are ways to combat the fraud, manipulation, or lying, cheating, and stealing by the market manipulators. Even though we all have made some of these mistakes, Not making them, is essential for success. To emphasize the point of price action, a fellow who sold his trading system for 10 mln to a bank said, “Price is all that matters”. People try to use all sorts of measures to get a grasp on which way they think the market may go. Price can rise or fall on either light or heavy volume. If anyone watched the Crude Oil market from 2003 to 2008 the witnessed manipulators driving it up beyond any previous measure of supply and demand, war premium, and inflation based on the price of gold. Bubbles are the name of the manipulators game. Don’t get caught on the wrong side. So the moral of the story here is:
Pay attention to what a market IS doing rather than what you think it should do.
Thanks again Jack!
I am a naive investor. My thought process
a) Petrol is at $60
b) I want 25% profit.
c) I will come out when oil reaches $75
I make my money and come out. I will wait for some other opportunity. Or re-enter with a different strategy and different time frame. Am i am wrong.
To clarify: Following the rule to pay attention to what the market IS doing doesn’t stop once you enter. If your pretermined Loss exit is spotted in a reasonable place where you can think of it as a Risk Management deduction rather than “a Loss”. It is much easier to get back in if that market should reverse once again to the upside. …and you still think there is a significant upside available (what you and/or others think the market should do; something to be very skeptical of; never forget who owns the media; or at times Everyone or Anyone can be wrong. This is why pro after pro states Risk Management IS the single most important aspect of trading). You will end up proving this to yourself one way or another.