Last Updated on October 16, 2021 by Oddmund Groette
Many traders focus a lot on the psychological aspect of trading. That is, of course, important but not as important as having a statistical trading edge and the correct position sizing.
Is focusing on psychology overrated in trading? What is more important – a statistical trading edge or a mental trading edge? In this article, we discuss what we consider the most important aspects of trading: to have a positive statistical edge, proper position sizing, and only then focus on the behavioral aspect.
Is Focusing On Psychology Overrated In Trading?
We believe so. Even though we have written at length about the importance of psychology and understanding yourself, it’s inferior to a couple of other issues in trading.
In order of importance, we believe the three most important things in trading are these:
- Make sure all your strategies have a positive statistical trading edge.
- Make sure your position sizing is reasonable compared to your account size and the strategies you are trading. You need to avoid ruin.
- Make sure you can follow the rules in numbers 1 and 2. This is where psychology and a mental edge kicks in.
Let us briefly explain these three aspects of trading:
What is a statistical trading edge?
First, we need to define what a statistical trading edge is:
It’s a mathematical expectation of your trading strategy or your overall portfolio trading strategies. Let’s assume you have the following strategy:
- The win ratio is 65% and the average winner is 1.1%
- 35% is losers or break-even trades and the average losing trade is -1.15%
These numbers let you easily calculate the expected gain per trade:
(0.65*1.1%) – (0.35*1.15%) = 0.3125%
This means your expected gain per trade is 0.3125%. This is not much, of course, but the point in trading is to turn over your capital frequently with the least amount of drawdowns.
Unfortunately, a positive statistical trading edge is no guarantee for success:
Why position sizing matters in trading
In a previous article, we wrote about the win ratio in trading and why it’s important: a low win ratio increases the risk of ruin and it also influences how well you execute your strategies (behavioral mistakes – see below).
Even if your portfolio of trading strategies has a positive expectancy, you might lose money or even face ruin. A string of consecutive losses can happen even with the best strategies! The win ratio is one of the main determinants: a low win ratio requires a lower position size because of the increased risk of many consecutive losers.
Thus, you need to make sure you have proper position sizing for each strategy compared to your overall account size. This is not easy and requires both time and experience. One way to do this, for example, is to take the average loss in each strategy and adjust the position size accordingly.
Even more important: you need to take into account that the biggest drawdown is yet to come. A backtest is just a snapshot of the past and a new crisis is just around the corner.
We have a general rule in trading that we have repeated over and over in many articles: to avoid behavioral mistakes, ruin, and devastating losses, always trade smaller than you’d like. You might kick yourself for not trading bigger when you are doing well, but you need to think long-term and not adjust position sizing up and down. You might end up going around in circles.
But having a positive statistical trading edge, correct position sizing, and risk management might be to avail if you can’t execute:
The importance of psychology in trading
You can have the best statistical edges in the world, but they might be useless if you can’t follow the rules. Any backtest of strategies or portfolios might indicate you are sitting on a gold mine, but you have to ask yourself the following:
How big a drawdown can you digest before you abandon the strategy (or trading completely)?
- How to overcome trading biases (tips, tricks, and hacks)
- The most common trading biases (how to deal with them)
Putting it all together
At the end of the day, you’ll get nowhere if you don’t have a positive statistical trading edge. Thus, the most important thing in trading is having a statistical edge.
You should spend at least 80% of your time on backtesting, simulating, and generating trading ideas. Practically all trading strategies are temporary and you should expect them to fade away with time, just like we wrote in our 26 trading lessons. This means you need to expect many of the positive trading edges to be loss-making when you start trading live. This can be reduced by a proper out-of-sample backtesting, but this technique is not bullet-proof, of course.
If you have a portfolio of statistical trading edges, properly backtested out of sample, you need to spend some time simulating the performance of the portfolio of strategies. We would say you need to spend around 10% of your time on this.
Last, you need to understand your weaknesses and strengths. How much pain can you suffer? How much drawdown can you tolerate before you abandon? Our experience is that most traders tolerate only small drawdowns. Any portfolio simulations of drawdowns higher than 20%, increase the likelihood of abandonment and detrimental tinkering of the strategy.
How do you find trading edges in the markets?
You might wonder how you can find trading edges. This is not easy and requires a lot of work. We recommend reading an article we wrote a long time ago:
Alternatively, you can look at our free trading strategies or you can subscribe to our monthly Trading Edges:
Conclusion and summary:
Many of those who fail in trading often blame it (erroneously) on the behavioral/psychological aspect. Unfortunately, we believe that many of these don’t have strategies that have a positive statistical trading edge in the first place.
The main task in trading is to make sure you have positive expectancies in your strategies, avoid ruin, and lastly that you can execute your strategies. This should be your order of priority.
- 26 trading lessons I have learned after 20 years as full-time trader (learning how to trade)
- Why build a portfolio of quantified strategies (including two strategies)
- Is this the Holy Grail of trading? (The secret of Holy Grail trading strategies)
- What does correlation mean in trading? (Trading strategies and correlations)
- Why use seasonalities in trading (Seasonal examples and strategies)
Disclaimer: We are not financial advisors. Please do your own due diligence and investment research or consult a financial professional. All articles are our opinions – they are not suggestions to buy or sell any securities.