Evaluating and improving trader psychology has become a cottage industry in recent years. Numerous books have been written, several by this author, about the subject. While important, excessive focus on the psychology of trading may take up more of trader’s time than necessary.
True, early in the career of all traders, trading success is very much a function of psychological factors, as is technical expertise or market information. Efforts to overcome problems of discipline have ranged from the implementation of totally mechanical methods to trading by committee.
But amid all of this, trader psychology has remained a hot topic.
The growth of courses, seminars, audio and videotapes, one-on-one tutoring, mentoring, modeling, trading coaches and neuro-linguistic programming has become an industry unto itself. Traders are told that success is achieved through discipline. A lack of discipline will give rise to a plethora of evils, not the least of which is losing money. For those who trade by the seat of their pants that may still be true, but for those using a system, as long as they strictly follow its rules, poor performance should cause them to reevaluate the system, not send them to Dr. Phil. Even the most disciplined trader will fail to make money with a bad system. The good news is technology allows traders to systematize and develop valid trading methodologies.
TIMES CHANGE
There was a time when the psychological make up of the trader was thought to be the cornerstone of success. In fact, The Investor’s Quotient (John Wiley & Sons, 1987), written by this author, sought to explain, in behavioral and psychological terms, the fragile psychology of the trader in an effort to help traders overcome emotional and behavioral impediments to their success. That effort was sincere, and through the years literally hundreds of letters and phone calls have been placed in appreciation of that book. In 1993 it was updated and it continues to sell. There are many ideas regarding trader psychology in that book, and others written by this author since, that were quite excellent. But, unfortunately, they are no longer as relevant. Computers have changed things. Yes, a focus on trader psychology was correct, but it was a path that was 2,000 miles long. Today we can take an alternate path that is 10 times shorter. Trader psychology is far less important than many believe. Some will praise that statement; others will curse it.
OCCAM’S RAZOR
Occam’s Razor, also called the law of parsimony, states that if a simple explanation of a topic will suffice then don’t use a complicated one.
Many roads lead to Rome, or in this case profits. We live in an age of introspection. We seek to know the why of things. In the new age of self awareness we want to understand our motives, conflicts, behaviors, issues, relationships and spirituality.
I was invited to speak at a yoga center in Kansas City; the topic was “spirituality and money.” The group was incredibly diverse — some were recognized from previous trading seminars.
My speech began: “Ladies and gentlemen, I have discovered my personal relationship with the markets and spirituality. When I lose money trading, I become spiritual. When I make money trading, I become spiritual.”
After a brief pause, the group broke into laughter.
This was when I realized that in all of my trading and efforts at self-understanding, I had made things far too difficult, complicated and detailed. It was time to simplify. What often looks like progress only complicates matters.
Yes, there is a lot to be said for self-understanding and self-awareness. Yes, there is a lot to be said in favor of trader discipline and effective trading behaviors. But we have a choice. We can make it simple or we can make it difficult. We can follow the law of parsimony or we can wallow in details. Which path you take depends on whether you understand the underlying cause of dysfunctional trader behavior.
WHAT CAUSES LOSSES?
To gain some insight into trader behavior we need to understand what causes traders to lose. We can answer this question in simple terms or we can hide behind the false assumption that it requires a deep answer. Let’s listen to Occam. The simple answer is best.
What causes the vast majority of trading losses is a poor trading system or a poor understanding of the markets. It’s that simple and that complicated.
Does this mean that trader behavior has nothing to do with profits and losses? Of course not. Clearly, the primary cause of losses is a faulty trading system or method. Traders lose money because they have bad trading systems. A bad system undermines confidence. Lack of confidence causes lack of discipline. Lack of discipline further undermines the already bad trading system in use.
Yes, it’s basic. Yes, it’s obvious. But, it is true.
More important, even though traders insist they understand the concept of an effective system with objective rules, few really do. If they did, why would they have spent millions of dollars in aggregate on trader discipline training when, in fact, the most simple, most effective and most obvious answer was right there in front of them all along.
POINT BY POINT
Clearly this line of thinking completely regresses to a much more basic or elementary understanding of the markets. We have come full circle. Once, this author thought the answer to profitable trading was an even split between trader psychology and trading system. Now it’s clear the system is far more important than the trader.
Consider the following:
• A profitable trading system or method with objective and precise rules improves trader confidence.
• Trader confidence promotes and facilitates discipline.
• Discipline facilitates consistent application of trading rules.
• Implementation of trading rules enhances system performance.
• Profitable system performance enhances trader confidence.
• Enhanced trader confidence leads to more discipline.
• More discipline leads to more profits.
THE EXCEPTIONS
Yes, there is still a place for trader psychology — the opposite was never at issue — but in some circles there has been far too much emphasis placed on psychology rather than on the system development. It is profitable trades not karma, that improves discipline. These guidelines are suggested:
• Focus energies on finding or developing a profitable trading system. Avoid over optimization or systems with less than 60% accuracy.
• Make certain the trading system is objective. If interpretation is called for, make sure to have precise rules for each possible scenario.
• Test the trading system on out-of-sample data.
• Make sure performance testing makes allowances for slippage.
• If performance is acceptable commit a sufficient amount of capital as dictated by the out-of-sample testing.
• If the trading system is profitable, the trader will avoid the psychological blunders that afflict poor traders.
• If the trading system is making money on paper but losing money in real trading then something is wrong with the logistics of applying the system. Many losing traders overlook the logistics of trading. Poor execution or can lead to losses as quickly, or quicker, than poor system logic.
• If a lack of performance is due to errors of discipline despite a solid system and logistics, then and only then is the trader a candidate for assistance.
• In seeking solutions to poor performing systems, begin with the simplest solutions first. Don’t use a cannon to kill a mosquito. Many problems are resolved through organization, the addition of a trading partner to help with order placement and/or the rectification of your trading procedures.
DON’T MISS THE OBVIOUS
Psychology and discipline can make the difference between success and failure, all things being equal. But your trading system should be the first thing to look at if your results are bad. Many will consider this approach simple and obvious. It is simple but it’s also powerful. Traders have been led to astray by an over emphasis on psychology. The concept is simple: System trumps psyche.
Jake Bernstein is a long-time trader, market analyst and educator in the Chicago area.
