Biases and Bad Behaviour Around Money

I can across an interesting article “The Psychology of Money” by Morgan Housel.  The author examines twenty ‘flaws, biases and causes of bad behaviour….when people deal with money’.

My take on the aspects applying to trading.

• The fallacy of ‘Earned Success and Deserved Failure’: a tendency to underestimate the role of luck and risk; and a failure to recognise that they are different sides of the same coin.

The main reason why newbies fail. They fail to appreciate that trading is a probability game. As such, there are time you can do everything right and still lose money; and there are time when you can everything wrong and make money.

I decided to sell my legal practice and trade full-time when I experienced a super run of wins. Starting with one Tael contract, I made enough money to buy my wife a fur coat in six weeks! I failed to appreciate I had encountered ‘flow’ – that lucky time when a trader can do no wrong.

Experienced traders recognise the state – they press their trades while ‘flow’is on with one cocked for its end.

Newbies think they have a natural skill that will make them millionaires in a short time. So when ‘flow reverses’, they lose all they made and more. That’s what happened to me.

• . A tendency to adjust to current circumstances in a way that makes forecasting your future desires and actions difficult, resulting in the inability to capture long-term compounding rewards that come from current decisions.

I interpret that statement as ‘cutting your winners short and letting your losers run’.

This tendency comes as a direct result of seeing profits turn to losses – that’s when we remember: “never let a profit turn into a loss”.

The solution to the two statements is to define ‘profit’. And, you can do that only when you have some stats from your trading. The key formula is your positive expectancy:

(Average Dollar Win x Win Rate) – (Average Dollar Loss x Loss Rate).

You don’t have a profit until you have attained the dollar win that will enable you to generate a positive result given your win rate. Until that happens, the ‘positive dollar’ experienced is just noise.

Until you reach that return, you are still in the initial trade management phase: in this phase, I manage risk by having:

1. A hard stop (i.e. a stop order in the market); and
2. A soft stop – conditions that will say to me: “Ray, your wrong. Exit now!”

More Monday.