Lesson #1 : Good trading is about good decision-making

Last week, I wrote up seven lessons that I’ve learned about investing and trading over the past few years. That was an overview of some of the more interesting and surprising things that I’d come across in my journey in the markets. As a continuation of this series, I’m going to do a deeper dive on each of the seven lessons, giving a sneak preview of the content in my upcoming book, Peak Performance Trading and Investing.

When we are investing or trading, we are making decisions about what and when to buy and sell. How we arrive at those decisions is up to us, but we are essentially just processing information and thinking about it until we reach a conclusion. Unlike with sports, there is almost no physical component to the markets. We’re not running or jumping or lifting, so there’s little to do with our overall athletic ability. It’s really just about how well we make decisions. Furthermore, profits come as a result of the decisions that we make, not the other way around, suggesting that we should put our emphasis on our decision making. There’s a reason that one of my first blog posts was entitled “Why Trading Well Has Little to do With Money”.

This may sound easy, almost seductively easy. After all, we as humans make hundreds, if not thousands of decisions every day. The structure of making a decision is actually straightforward. We gather up the relevant informational inputs, evaluate them and compare them against certain criteria, and then we decide what to do. For instance, an intraday trader who uses charts to make decisions would look at a stock’s chart over several different timeframes; compare the stock’s price movement to his criteria for what constitutes a breakdown or breakout of critical levels; and then make a decision accordingly. If it looks like a breakout, he buys the stock; if it doesn’t look like a breakout, then he doesn’t do anything. Taking a different tack, Warren Buffet looks for a mid-teens return or better, a strong economic “moat and a comfortable margin of safety.  In both cases, their rules are simple, right?

Problems arise in our decision-making because we are human beings. Our decisions and decision-making processes are inherently susceptible to numerous pitfalls. The most obvious one is emotion. We have all experienced the effects of greed and fear—they are formidable enemies and can lead us to make boneheaded trading mistakes. We’ve all cut losing positions at the exact low in a panic, and we’ve all put on position sizes that were far too big, because we were in a hurry to make a lot of money. When we start focusing on money, we can become very emotional due to the enormous emotional weight of money. We can panic or get overexuberant if we have large P&L swings. If you contemplate terms like “poverty” or “financial freedom”, then you’ll realize that these are sensitive and emotional topics and that emotions can influence us to make poor trading decisions, ones that we wouldn’t have taken in a normal state of mind.

While we recognize that emotions can cause us to make bad decisions, we can’t just get rid of them. We are human beings, not robots. Emotions are an integral part of the human brain and human experience. No matter how we try, we can never turn them off. We’ll have to accept that we’re stuck with emotions and take a different approach. We should have as our goal to make the best decisions possible in spite of our emotions. We know that emotions can derail us and we want to invest and trade in such a way that we are making the best decision possible without being hostage to our emotions.

Biases and heuristics can be an equally perilous trap for trading, and unlike emotions, we don’t even know that they’re causing us trouble. I would encourage everyone to read Thinking Fast and Slow by Nobel Prize winner Daniel Kahneman. It’s a veritable encyclopedia of our various cognitive quirks and how dramatically they impact our decisions. One notable example is the endowment effect, where we value things differently once we own them—for instance, we may be prepared to no more than $50 for a bottle of wine but we would not sell it, even for $500, because the ownership of the bottle gives us a new reference point for bargaining. Selling the bottle would the feeling of loss. Obviously, cognitive biases like these could substantially hurt our trading if we are not careful.

These biases are so deeply ingrained because of the structure of our brains. Kahneman highlights two different systems in our brain: System 1 is the automatic part, generating thoughts and most feelings instantaneously and without effort. It is what we would commonly call the subconscious part of brain. System 2 is the more reasoned, deliberate decision maker, which requires focus and deliberation. It is the conscious part. These two parts could easily be in conflict, with System 1 often trumping our slow-paced but thorough, logical System 2. This effect is so powerful that Kahneman sums it up, “We are every influenced by completely automatic things that we no control over, and we don’t know we’re doing it”. Ideally, we want to make the most logical trading decisions possible. That means working around or minimizing the role of our various cognitive biases.

It would seem like the easiest solution is to slow down every decision and to enlist as much of the logical brain as possible, so that System 1 can’t get us off track. The thing is that we have limited bandwidth for decision making. The researcher Keith Stanovich calls humans “cognitive misers”, as we have a finite amount of concentrated focus that we can utilize to make decisions during the day. Once we’ve used it up, then the quality of our decisions drops dramatically. Ergo, we can only draw on System 2 so much before it tires out. The antidote is to save our precious cognitive resources for the most important decisions, or to make ordinary decisions less taxing.

We reframe trading as decision-making as a way to get around these two pitfalls. We choose this focus because it gets our focus on to the most important thing—making the right decision—and also because it distracts us from the pitfalls. If we reconceptualize trading as making good decisions, then we will put a lot of the effort into doing precisely this. That could mean setting up or utilizing tools that enrich our decision making while making it easier. It could also mean automating many processes so to as converse our valuable cognitive bandwidth.

Focusing in decision-making does us one other favor: It takes away our focus from making money, thereby dialing down the emotional intensity. Of course, making money is the desired outcome for putting our capital to work. But the emotions that come with the focus on money can actually hinder our efforts to make money. We need to shift our focus to making good decisions to trick our minds a bit, so that we are taking some of the emotion out. Money will come as a result of making good decisions.

What do we mean when we say making good decisions? The first thing is to understand that we are making decisions about what to buy or sell. Because we are fallible and because there’s an element of randomness in markets, we will never be right 100% of the time. We always have to consider the possibility of losing and prepare in advance. There is necessarily a balance between risk and reward and we have to be thinking about that tradeoff. We may lose money on one single position; but if we properly balance risk and reward, then the probabilities will work in our favor.

We can enlist the language of statistical expectation and probability to describe an attractive risk/reward opportunity. The formulaic description is as follows:

Statistical Expectation = (Winning % x Profit Per Winner) – (Losing % x Loss Per Loser)

If we estimate that a position has a 50/50 chance of being a winner, then the profit per winner just needs to be a bit higher than the loss per loser for you to make money long term. As your profit per winner grows relative to your loss per loser, then your required win rate goes down. If you make $6 on every winner and lose $1 on every loser, then you can be right only 25% of the time and still make a fortune. If a position has a positive statistical expectation, then the risk/reward makes sense—and putting it on is a good decision.

It helps to make a distinction between looking at the outcome of a trade versus how it was put on. We can either make money or lose money on a position—that is the outcome. It was a winner or it was a loser. But in and of itself, that doesn’t tell us about the quality of the decision. We could bet it all on black at the roulette table and win, and even though it was a winning bet, it was not a smart bet. Instead of winning and losing trades, we should divide them up into good and bad trades. A good trade is one that was well thought-out, disciplined, consistent with your methodology and having positive statistical expectation; a bad trade is the opposite. While any one trade could end up being a loser or a winner, that is not the case over a long timeframe. In reality, a long series of good trades will make money, as the positive statistical expectation will assert itself over a large sample size.

What’s more, you can only control the decision-making in this process. As Michael Mauboussin writes in his paper on luck versus skill, “Where there is luck, focus on the process”—meaning that where there is randomness, stay focused on what you can control. This is the other reasons why we need to focus on making proper trading decisions—to do what we can control and not to worry about the rest.  To a large extent, that is what we do in the markets. We do our homework, put on our positions and then manage the uncertainty.

There are certain things that we can do to help ourselves make better decisions. The first is to enlist some kind of process or methodology to structure our investment decision making. This also helps to filter out data points that don’t matter, saving you from information overload. We will explore this in a lot more detail in a later post on process. The second is to keep using a probability-oriented framework for thinking about risk. This is applicable no matter what methodology you are employing. It helps getting into positions when you judge risk versus reward, but there are extension of the concept. In my book we explore the Kelly Formula and other statistical ways of measuring risk and their implications for investors and traders. The third is to automate certain decisions or to lower their difficulty, to make it easier for you to do them. One example would be a simple investment checklist, like the ones that aircraft pilots use. It’s simple, short and easy to follow—but you are much less likely to forget one step or to jump into an impulsive position.  Through using tools like checklists and stringent self-imposed rules in our own trading, we can reduce the compounded difficulty of our trading decisions. That in turn makes us more likely to make good decisions regularly, thereby getting better results.

I know that “trading is about decision making” can sound quite dry, but I hope that this post illustrates the various ways that this mindset can help you. By staying focused on making the best risk/reward decisions possible, you should minimize the Siren’s call of emotional and impulsive trades. Hopefully your P&L will vindicate this new perspective.

No relevant positions

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

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