This book writes about how Jim Paul got into Wall Street, rapidly became very successful, and then lost more than a million dollars in a soybean-oil spread trade. In the process to learn from this mistake, he realized that there are lots of different, and contradictory ways to make money, but all the successful investors/traders practiced strict risk management to control their losses. From this experience, he came to the conclusion of the need to develop and adhere to a proper plan, especially on the need to determine the exit criteria before a trade is even entered.
Overall its a pretty short book and a quick read. The first run of the book appears to be from 1994, but this edition that I am reading is from 2013. For those who already understand the need for, and adhere to trading plans, you probably do not need to read this book. For those just starting to trade/invest, it would be a good read to get a perspective of what goes on when your position goes against you, if you are led by your emotions without a proper trading plan.
One interesting bit I learnt was this idea that a continuous process is more prone to personalization compared to discrete events with a defined end point. I guess a continuous process gives you an ‘out’ to say to that you have not yet been defeated, which allows your losses to snowball.
Learning How Not to Lose Money Is More Important Than Learning How to Make Money
- There are as many (contradictory) ways to make money in the markets as there are people in the markets, but there are relatively few ways to lose money.
- There will be lots of losses, just as there are losses in any business. The losses you are trying to avoid are the ones for which you hadn’t made allowances, the ones that sneak up on you and the ones that ultimately put you out of business.
- Losing money in the market is the result of either
- Some fault in the analysis; or
- Some fault in its application
- There is no single sure-fire analytical way to make money in the markets. Therefore, studying the various analytical methods in search of the “best one” is a waste of time. Instead, what should be studied are the factors involved in applying, or failing to apply, any analytical method.
How People Lose
- They personalize market losses.
- It is easy to equate losing money in the market with being wrong. In doing so, you take what had been a decision about money (external) and make it a matter of reputation and pride internal). This is how your ego gets involved in the position.
- You begin to take the market personally, which takes the loss from being objective to being subjective. It’s as if profits and losses were a reflection of their intelligence or self-worth.
- External losses are objective facts, while internal losses are subjective and defined in terms of the individual experiencing it.
- Market losses are external, objective losses. It’s only when you internalize and personalize the loss that it becomes subjective.
- Once a market position is personalized and it starts to show a loss, it is uncertain when or how it is going to end, leading a person to go through the five stages of internal loss while the loss gets larger.
- Denial – Seeking second opinions and only listening to the ones that conform with your own denial
- Anger – Getting angry at the market or others
- Bargaining – Bargaining to get out of the position if only it can go back to breakeven
- Depression – Distancing yourself, losing interest in all things, unable to focus
- Acceptance – Finally accepting and getting out of the position or getting forced out by margin calls
Develop and Follow a Plan
- You must have a means to remove yourself from “subjectively experiencing” the market while making decisions. You must have a means to “objectively perceive” the market while making decisions and to maintain that objectivity once you’re in the market. That’s exactly what a plan does.
- People fail to apply their particular method when they do not have a pre-established plan to control losses.
- If you haven’t thought things out ahead of time, you are either gambling or betting. Both of these involve your ego, which means you have personalized the market and your emotions are in control. With your emotions in control, you are part of a psychological crowd.
Elements of a Plan
- Decide what type of participant you’re going to be
- Investor or speculator?
- What markets to participate in? Needs to be consistent with the characteristics and time horizon of the type of participant you choose to be.
- Select a method of analysis
- Don’t jump back and forth among several methods in search of supporting evidence to justify holding onto a market position.
- Develop rules
- Define hard-and-fast rules on what constitutes an opportunity for you, what are the entry and exit points.
- Establish controls
- Define the exit criteria that will take you out of the market either at a profit or loss, e.g. price order, time stop, condition stop.
- Before you get into the market, you have to decide where (price) or when (time) or why (new information) you will no longer want the position.
- Your exit criteria creates a discrete event, ending the position and preventing the continuous process from going on and on.
Playing in the Market Is a Continuous Processes That Is Prone to Personalization
- A discrete event is an activity with a defined ending point, such as a baseball game or a roulette roll. Losses from such events are more natural to be treated as external losses because after the event, the result is definitive and cannot be argued with.
- A continuous process is an activity that has no clearly defined ending point, such as trading.
- With a market loss, there is no certainty of how or when the position will end, which makes it a continuous process. You can continue to make decisions and not be forced to acknowledge the loss (until you blow up). Losses from continuous processes are much more prone to become internalized.
Difference Between Investing/Speculating vs. Betting/Gambling
- Investing – Getting an adequate return in the form of dividends, interest, or rent, while expecting safety in principal
- Trading – Making a market, trying to stay net flat and makes money by extracting the bid-ask spread
- Speculating – Buying for resale rather than for use or income, expecting capital appreciation
- Betting – Trying to be right
- Gambling – Trying to get excitement
Common Psychological Fallacies on Risk and Probability
- Tendency to overvalue wagers involving a low probability of a high gain and to undervalue wagers involving a relatively high probability of low gain.
- Tendency to interpret the probability of successive independent events as additive rather than multiplicative.
- Belief that after a run of successes, a failure is mathematically inevitable, and vice versa (aka Monte Carlo fallacy).
- Perception that a favorable event has higher probability over an unfavorable event even though their mathematical probability is the same.
- Tendency to overestimate the frequency of occurrence of infrequent events and to underestimate that of comparatively frequent ones after observing a series of randomly generated events.
- Confuse the occurrence of “unusual” events with the occurrence of low-probability events (e.g. getting 13 spades is just as probable as getting any other hand).