Last Updated on November 30, 2020 by Oddmund Groette
Always inverse, says the famous investor Charlie Munger, Warren Buffet’s friend and business partner. What is inverse thinking? This is when we turn a problem on its head or look at it backward. If a newspaper headline claims one-third of the population is against passing new legislation, it also states two-thirds approve it. You might develop a strategy that performs well on paper, but instead of trying to approve the strategy, you might want to kill it. If you can’t find any reasons why it shouldn’t work, then perhaps you are onto something.
Similarly, by looking at failed traders, you can find out what not to do. This article lists eleven reasons why sloppy traders don’t make it. By making sure you don’t follow what they do, you might stand a better chance.
What is inverse thinking?
Inversion involves thinking and focusing on the opposite of what you want. If you want to be a successful trader, learn what it takes to be unsuccessful (and avoid that). Mr. Munger claims he has been very successful in life by studying how to avoid mistakes and remove errors. After all, if you avoid managing failure there are not many options left.
Presumably, The Stoics used much the same logic and thinking to overcome fear and negative experiences. Done correctly, inversion is a very powerful tool that can be used in all aspects of daily life. Just think about it: life is a journey where mistakes are done on a daily basis. By inversion, you can spot and track potential pitfalls before you do them. At your job, you can simply be successful just by showing up on time every day, even though you’re not particularly smart.
We at Quantified Strategies are not particularly smart either. But we have managed to become moderately successful traders and investors for over two decades simply by making sure we:
- Survive another day.
- Removing markets and strategies we know are difficult to trade.
- Avoid investments we don’t fully understand.
- Make sure we don’t do the same mistakes over again.
- By not trying to be smart and advanced.
- By focusing on simple strategies in markets where we can get an edge.
Summed up, most of the energy is spent on avoiding strategies, markets, and behavior that are difficult to master. For example, we are not involved in penny stocks or forex.
Backasting and premortems
Annie Duke offers a different, but somewhat similar approach in her book Thinking In Bets called backcasting and premortem. This book was praised by Mr. Munger, and you find some fascinating quotes from the book on RationalThinking.net.
Backcasting starts with a positive end result and you imagine how you ended up there. For example, you look at yourself as a successful trader ten years in the future and you write down reasons and plans on how you ended up successful.
Likewise, you can imagine a negative result in ten years’ time. Annie Duke calls this premortems. Forensic crime dramas are full of postmortems where a medical examiner determines the cause of death (after it has happened). A premortem is an equally bad investigation (as you end up unsuccessful), but before it happens. How did you end up as an unsuccessful trader? Duke argues we are generally biased to overestimate the probability of good things happening. We imagine ourselves as successful traders, even though almost all fail. Being positive is in general a good trait, but being realistic and rational are not bad either.
By imagining obstacles to reach your goal, you are better prepared to avoid and circumvent those obstacles. Dreaming about achieving a goal won’t help. You need to behave in correct ways that make your goal realistic.
Few ways to win, many ways to lose
There are so many ways to lose, but so few ways to win. Perhaps the best way to achieve victory is to master all the rules of disaster and then concentrate on avoiding them.
– Victor Niederhoffer
This quote from The Education of A Speculator is a brilliant one. It captures the essence of inversion. In order to not become a failed trader, focus on the pitfalls. However, it didn’t help Niederhoffer from going belly-up with his hedge fund.
So how do you fail as a trader? Below we give you 11 reasons how to become an unsuccessful trader:
Reason 1: Make sure you do it for the money – not passion
Trading is scalable, ie. you can make big money fast. Unfortunately, this is the lure of many aspiring traders, but it’s like getting the wrong end of the stick. If you have no passion, you will ultimately fail. You need detachment from money. Make sure you love your job.
Reason 2: Make sure you don’t understand the ecology of the markets
Are you the predator or the prey? Make sure you are the prey, and you will fail.
Most traders fail. How many fail? Who knows, but the number is most likely above 90%, and traders “making a killing” are probably below 1%. Unfortunately, it makes perfect sense.
Because the markets are intensively competitive, and in the short-term, it’s more or less like a zero-sum-game. Think about a poker table: all players can’t win. Any poker player wins by raking in chips from the other players. It’s no different short-term in any market, even in stocks. By making sure you are the prey, you are guaranteed to lose money. Make sure you understand the market and its players. Who are the competitors? Who are the predators? What is your edge?
Compare this to long-term investing: the US stock market has risen about 6-7% in real terms since WW2. Why? Because it’s not a zero-sum game. Companies produce value via increased profits, and the Fed keeps on printing more USD. You have two tailwinds to help you build wealth. As such, simply by being patient and having a diversified portfolio, you can build wealth with high probability. Unfortunately, this is not very exciting and takes a lot of time. Most people don’t want to delay gratification:
Reason 3: Delay gratification – think short-term
There are a zillion research papers showing the importance of delaying gratification, in any field. Pension is one of them. Saving for retirement is next to impossible for many because the joy of spending today is immediate. Saving means the pleasure is way distant decades ahead.
I guess you have read about the Marshmallow experiment? An American psychologist tested the ability of four-year-old children to delay gratification. Just like children are bad at delaying gratification, traders don’t want to take their time to learn trading skills. Trading is a profession like no other, and it takes years to learn. By being impatient and unable to delay gratification, you risk the temptation of instant success instead of working relentlessly and consistently to get the good long-term returns you want.
Reason 4: Do a lot of trading – overtrade
Overtrading is one of the worst traits you can have as a trader.
What are the reasons for overtrading? Here are some:
- After a good day, you would like to “test something new” on the spot.
- Lack of patience.
- Free commissions.
- Lots of software, info, indicators, bells and whistles.
The opportunities for becoming a losing trader has never been better: free commissions and lots of info is a recipe for overtrading. Free commissions make you blind to the real costs (slippage) and an abundance of information makes you overconfident in your analysis. You become complacent. As Nassim Taleb says: If you want to bankrupt a fool, give him lots of information.
Mr. Taleb is a guy worth listening to.
Reason 5: Don’t bother keeping detailed trading records
Why would you need to track your trades? It takes time and it’s not much to learn from recording the trades. Besides, it’s boring.
Trading records are important. Why? Because humans form beliefs and believe in all sorts of things we have not researched ourselves. If you read something in the paper or talk to someone you trust, your default is to believe what you hear and see. Trading records debunk a lot of those beliefs. By quantifying you learn and adapt.
Good decisions compound. Even small decisions today, which might hardly be noticeable, can make a huge difference 10-20 years ahead. Improving decision quality is what trading is all about. A ship one-degree off course is not noticeable over short distances, but when crossing the Pacific Ocean you end up way off your destination.
Reason 6: No structure and rules – no quantifying
Why do quantified analysis and make automatic trading systems when you can do discretionary trades? You are uncomfortable with trading rules and discipline. You are driven by emotions, and volatile markets compound your lack of discipline.
Trading is all about making decisions based on an uncertain future. Trading decisions have financial consequences, thus it’s paramount to spend some time on how to develop structure and systems in your daily life as a trader. You come a long way by quantifying your strategies, for example by using a testing platform:
Reason 7: You are not rational and agnostic – can’t learn
Trading is a perpetual state of learning. You can only learn by being rational and open to change your opinion – being agnostic. The self-serving bias is in-built in all humans. We take credit for good outcomes and blame others for bad outcomes. This way you make sure you don’t learn from experience and your decisions. A good result is not necessarily because you made a wise decision! Likewise, a bad outcome is not necessarily a result of a poor decision.
Annie Duke writes in Thinking In Bets that in multiple-vehicle auto accidents 91% of the drivers blamed someone else for the accident. Don’t be one of those. All decisions are yours, and there is no luck or bad luck in the markets (long-term).
Reason 8: Lack of understanding of your risk tolerance
Why investigate your risk tolerance? No trader thinks about this before they start. Unfortunately, most learn the hard way. Once bitten twice shy. Trading is about doing things right and without emotional gut feelings. Your tolerance for both risk, losses, and workload must be understood when you both trade and develop strategies.
Behave like a surgeon: No surgeon enters the operation theater thinking about all the money he makes (some of them make a lot).
Reason 9: No understanding of probabilities – no quantified strategies
You might argue trading is about winning, not about losing. You never go broke by taking profits! Both are somewhat true, but trading is more complex than that. You need to understand probabilities and the law of big numbers. By not quantifying your strategies and ideas you are fumbling in the dark.
Sadly, innumeracy is prevalent among traders. Not knowing the basics of probability, statistics, chance, luck, and randomness is a weak point among many traders. But what can you expect when many people leave ten years of schooling without understanding percentages?
Some days ago we published an article about how you can find trading edges. The whole point of trading is to look for quantitative edges where the market shows some irregularities.
Reason 10: Survival is ignored
Let’s face it, many are attracted to trading because it offers the opportunity to get rich quickly. Unfortunately, it also offers the opportunity to get rid of your money. But trading is about surviving – protecting your capital and make sure you can return to the battlefield the next day. If you allocate 15-25% of your capital on each trade, you are very unlikely to survive. A few losers make sure you are unable to recover.
Losses need to grow geometrically to recoup. A 25% loss needs a 33% return to return to break-even. If you lose 50%, you need to make 100% to recover. Very few traders are able to recover after losses.
A 15-20% return on capital (unleveraged) is something hardly anyone can manage or sustain over many years. Only systematic and rational traders can accomplish that, or perhaps very lucky ones (never underestimate the role of chance and luck).
Reason 11: Turning simplicity into disasters
Presumably, Robert Prechter once said that most traders take a good system and destroy it by trying to make it into a perfect system. There is a lot of truth in this. The hunt for the holy grail makes you tinker with your quantified systems. In reality, this often leads to curve fitting by adding more filters and criteria to make it fit the past. This makes a backtest very good but rarely predict the future.
A simple system with few criteria is more likely to be a robust system that can stand the test of time.
All in all: what differentiates a good trader from a bad one?
Most traders fail because that’s the rule of the game. All can’t win in the markets, someone has to provide energy and food for the fit and adaptable predators further up the food chain. And it certainly not helps by being ignorant to probabilities, the law of big numbers, survival, plan and rules, keeping records, and having no detachment to money.
Let’s sum up this short article with these words:
Be agnostic, adaptive, open, truthful to yourself, and a student for life. Try to quantify your strategies as much as you possibly can. This should compound both knowledge and wealth.