Imagine that you’re on top of the world…You have achieved brilliant career success on the trading floor of Chicago; you sit on the important governing body of your industry; you’ve got a wonderful family; and plenty of toys to enjoy in your spare time.

And then, in what seems like a blink of an eye, you lose it all. You lose one million dollars, your career and all of the trappings of success.

Poof.

All gone.

How would you react if you were that guy?

Well, there was such a guy. In his book “What I Learned Losing A Million Dollars”, Jim Paul shares his own personal story. He experienced all of the highs and lows. He was a remarkably successful lumber broker who had achieved it all. He had his own business, made lots of money, and even had a seat on the Governing Council of the Exchange. He lived the good life and had a wonderful family to boot.

I only found out about the book from Amazon.com’s recommendations system—I had never heard it mentioned it before by anyone. Indeed, the book is a bit old so it may not seem particularly relevant. Don’t let that deter you. The book is a treasure trove of insight!

By talking through his market experiences and ups and downs, hopefully we can learn the same lessons. As he puts it in the book—“When I was a kid, my father told me there are two kinds of people in the world: smart people and wise people. Smart people learn from their mistakes and wise people learn from somebody else’s mistakes”. Let us endeavor to be wise in our trading and to learn from other people’s mistakes.

First of all, about his success. Paul readily admits that a couple of things drove him to the heights of success in the business. The first is luck—he had a couple of “right time, right place” experiences that helped him on the way to achieving better things. The second is a keen understanding of what the “game” is that he needs to play, and then figuring out a way to win at it. For instance, in school and in the military, he managed to perform well by figuring out the name of the game and doing it. Since childhood when he was making good money as a golf caddy, he has been motivated by the desire to make money – both for the sake of financial security and also to have nice things. Together, these two traits propelled him to rarified heights in the business world.

Paul’s spectacular blowup came because he put on a soybean spread trade, thinking that this would be the huge winner that made him, his friends and his clients millions. The funny thing is—it started out as a winner. The initial position was successful and Paul, always searching for a big financial score, was practically counting his profits. However, the position quickly reversed and Paul was too stubborn about cutting it. After that point, he was unable to get out doing to the market being locked at limit, so he kept bleeding until he lost everything—his business, his net worth, his exchange membership and his position on the Exchange Board. In summary, he took too much risk and lost all of his material wealth, to the point where he contemplated suicide for the insurance money.

After his loss, he realizes that he never was a proper risk-taker, a real trader. He was trading the markets but without ever having learned how to take risk. His position sizes were enormous and he wasn’t fully aware of the risks that he was taking. As a result, he would get into positions that could have potentially disastrous outcomes. If you’re taking huge risk and you don’t know what you’re doing, then you’re almost guaranteed to blow yourself up.

In the trade that wiped him out, he had risked almost everything on a huge amount of margin. While it would have made him an immense amount of money if it had worked out, he also left himself wide open the possibility of blowing up. This is more akin to gambling than prudent risk-taking. Once he realized that he was basically gambling, then Paul could start to approach risk-taking properly and learn it from the ground up.

Lesson 1: Only take prudent amounts of risk and with the right preparation. “Swinging for the fences” is more likely to leave you six feet under.

As part of his journey into learning more about trading and investing, he goes on an exploration of various famous traders and what they have to say. Their advice couldn’t have been more different—some, like Warren Buffett are proponents of buy and hold, while others are notorious traders; some are pure technicians while others have never looked at a chart in their lives. Some preach diversification, while others adhere to the doctrine “Put all of your eggs in one basket and watch the basket”. Paul is downright confused by all of the conflicting advices and methodologies.

The fact remains that there are a host of strategies and tactics to make money in the markets. Many famous investors have styles that starkly differ from one another. There are computer scientists who build fabulous automated trading systems; there are deep value stock pickers who buy and hold; there are macro investors who invest in macroeconomic trends all across the world. They all have a style that suits their personality and unique strengths and they stick to it. There is no magic bullet for anyone learning this, as the trader will have to learn a style that fits their own individual personality.

More importantly, Paul then stumbles across a rule common to all great investors—cutting losses. This stands out precisely because everyone repeats and underlines it as the most important thing. As Warren Buffet famously put it in his two rules to investing, “1. Never lose money. 2. Never Forget Rule Number #1”. Thus, while they can’t agree on much, all great investors can agree that it’s important to limit losses and be disciplined in your risk management. This was Paul’s breakthrough—when he discovered that “Learning how not to lose money is more important than learning how to make money”. This hits the nail on the head!

In our journey to make money in the markets, we want to stay in the game. We can only do that if we keep our losses small and if we never blow up. This approach is the way to long-term success. If we can just think in these terms on every trade– about watching our back as opposed to dreaming of the Rolls Royce with the profits from our trade—then we’ll avoid taking the kind of reckless and excessive risk that can lead to career-ending losses, like the one that Paul suffered. You need to take risk to make money in the markets—but you definitely don’t need to take *excessive* amounts of risk.

Taking risk means putting on a position only when the risk-to-reward ratio is skewed heavily in your favor. And if you do lose money on the trade, then you want that loss to be completely manageable so that it doesn’t disrupt your trading plans. And under no circumstances do you want to take so much risk that you can lose everything—no matter how good mouth-watering the trade seems. In markets, a good defense is essential.

Moreover, if we can be sure that we’ll stay in the game, then that gives us time and scope to find a methodology that works and enables us to make money consistently. When starting out, we can usually go and “borrow” a methodology or approach that may suit our personality. For instance, a successful athlete might like intraday trading stock index futures as it plays to his strengths, whereas an economist would feel more comfortable making long-term, research-driven bets on interest rates and currencies. That’s how to start out and with time and continued deliberate practice, they can refine their approach and work on other aspects of their trading. Without proper loss-cutting, they could easily be out of the game.

I completely agree with this. In my experience, I have seen many traders “shoot the lights out”, i.e. have one or two big years and then fade away or blow up quickly. But I have never seen anyone who has stuck around for the long haul without proper risk controls. As the saying goes, “There are old traders and bold traders, but never old, bold traders”.

The lesson that I have learned is something that would have seemed completely counter intuitive to me when I first started out—that the way to make big money in the markets is to take a controlled amounts of smart risk and to be fanatical about cutting losses. There is no place for “swinging for the fences” or trying to double your money in a short period of time. As Jim Paul, myself, and numerous other traders have discovered, losing real money is a painful and humbling experience. I hope you become wise from our losing money and the lessons that we have to share.

Lesson 2: Learn how not to lose, as it’s the path to winning.

It’s one thing to know that we need to control our losses. It’s another thing to actually do it. Paul writes about the various psychological forces and biases that can interfere with or sabotage our decision-making, hurting our ability to make detached decisions.

As Paul correctly observes, this is unavoidable. As human beings, we are emotional beings and thus we will always be subject to some kind of emotional influences on our decisions. These can stem from childhood programming, from our own ego, or a million other places. The key question is how to make good trading decisions that aren’t overly influenced by our own ego.

For students of decision-making, this is not new. Many popular works and authors, such as Daniel Kakhneman and Richard Thaler, emphasize precisely this fact, as it can be so interesting to explore! Of course we have emotions and other biases that emphasize our decision-making, but what we can learn from them? What can we do differently so as to minimize their negative role and benefit from any positive forces?

In this respect, I have to admit Paul’s book falls down a bit. When exploring some of the major psychological issues, they undertake only a cursory explanation of what they are and how they can influence a trader’s decisions. For instance, the desire to be right and not to be wrong are powerful influences on traders, especially ones who are beginning—this usually causes them to sit in a losing trade, rather than closing it and admitting that they are wrong.  They would prefer to protect their ego rather than their P&L. Another one is “playing with the house’s money”—when you have a profit, whether realized or unrealized, you feel entitled to take more risk because you have yet to internalize that it’s your money. While the author touches on these points, I feel that he could have undertaken a more thorough exploration of them.

As traders, we have to realize that we have emotions and that they can influence our decision-making. There are two schools of thought on how to deal with this: 1. Change ourselves into robots who don’t have emotions 2. Change our decision-making process to make it as robust as possible, thereby side-stepping a lot of the potentially deleterious impact. Often, we choose number two, simply because it’s much easier for most personality types. Some of the most common ways to do that: setting automatic stop losses; using some kind of checklist to evaluate investments, so that we can’t get seduced by bad ideas; reviewing our work to see if we have gone off-track.

In that respect, the author’s advice on how to sidestep emotions is super solid. First, select a type of market analysis that works for you—for instance, being a fundamental investor, a technical analysis-based trader, etc. Next, set rules to describe what an opportunity looks like. As he puts it, “Your homework determines what parameters or conditions define an opportunity and your rules are the ‘if…then’ statements that implement your analysis. This means entry and exit points are derived after you have done your analysis”. Then you put controls onto you trades and portfolio. This is setting stop losses and also the criteria for when you will exit a position at a profit. By setting these in advance, you take away the possibility of making a difficult, emotional decision at some point in the future. Instead, you make the difficult decision when it’s easy.

While the advice is rather spare, it contains many pearls of wisdom. By setting out in advance clear rules and processes for making decisions, you can avoid the possibility of panic or ego influencing your investment decisions at the exact moment when you don’t want them to. You can make your trading decisions when you are at your detached best, rather than gripped by fear, greed or hope.

Lesson 3: Set up ways to make detached trading decisions, so as to minimize the influence of emotions    

There are lots of good trading books out there, with plenty of good advice. I even authored a guide on how to figure which ones are useful. What really speaks to me about “What I Learned…” is the very personal nature of the book. We follow Paul through various successes all the way until he takes his disastrous fall in the markets and loses everything. Even better, he’s able to let us in on what he did wrong while pulling no punches. He acknowledges that he had no real idea how to trade and even credits a lot of success in markets and in life to luck.

It takes an extremely introspective and wise person to look at himself so objectively. When reviewing his failures, he’s able to arrive at some useful insights and share them from the perspective of someone who’s trying to be helpful. This combination gives his suggestions and advice even more weight and credibility. The purpose of this article is just to pull out general lessons from his experience.

As Paul notes, a wise person learns from other people. Hopefully you and I don’t have to lose a million dollars to learn three of the big lessons from his loss.

By Bruce Bower | E-mail: Bruce [at] howoftrading.com

Blog: www.howoftrading.com | Twitter: @HowOfTrading