Extracts of the book 'What I Learned Losing a Million Dollars' by Jim Paul and Brendan Moynihan

Extracted from What I Learned Losing a Million Dollars by Jim Paul and Brendan Moynihan. The book examines the mental processes, behavioural characteristics and emotions of people who lose money in the markets.

The first part of the book is more about how the protagonist Jim Paul lost a million dollars. What I have summarised below are the lessons that he learnt in the process, which form the second part of the book. Make no mistake, the entire book is a superb read.

Foreword by Jack Schwager

The truth is that trading, both successful and unsuccessful, is more about psychology than tactics. As Jim Paul ultimately learns through a very expensive lesson taught by the market, successful trading is not about discovering a great strategy for making money but rather a matter of learning how to lose.
Studying losses, losing, and how not to lose was far more important than studying how to make money.

Part One: Reminiscences of a Trader

Experience is the worst teacher. It gives the test before giving the lesson. —UNKNOWN
Peter F Drucker has said: success always obsoletes the behaviour that achieved it.
Personalising successes set people up for disastrous failure. They begin to treat success as a personal reflection rather than the result of capitalising on a good opportunity, being at the right place at the right time, or even being just plain lucky. People begin to think their mere involvement in the undertaking guarantees success. Apparently, this is a common phenomenon. Listen to An Wang, founder of Wang Laboratories: “I find it somewhat surprising that so many talented people derail themselves one way or another during their lives … all too often a meteoric rise triggers a precipitous fall. People fail for the most part because they shoot themselves in the foot. If you go for a long time without shooting yourself in the foot, other people start calling you a genius.” 2 Listen to Herb Kelleher, CEO of Southwest Airlines: “I think the easiest way to lose success is to become convinced that you are successful.” 3 This “becoming convinced” is the process of personalising achievements or successes. Learning to recognize and prevent that process is what this book is all about.
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.

Chapter 1 - From Hunger

As far as I could see, it wasn't what you did for a living that was important in life; it was how much you got paid for doing it.
It wasn't what you did, it was how much you made.

Chapter 2 - To the Real World

Misery loves company
I was beginning to think of myself as a little different and some how a little better than other people.
I never thought about hat I was going to do; it wasn't what you did for a living, it was how much you got paid for it.
That taught me that there are people for places, places for people. You can do some things and you can’t do other things. Don’t get all upset about the things you can’t do. If you can’t do something, pay someone else who can and don’t worry about it.
There is a right way and a wrong way of answering questions, depending upon whether you want to be a stockbroker or a priest.

Chapter 3 - Wood that I would trade

Sometimes, knowing the right people and being at the right place at the right time can make all the difference in the world.
The successes in my life had given me a false sense of omniscience and infallibility. The vast majority of the successes in my life were because I got lucky, not because I was particularly smart or better or different.
There’s nothing worse than two people who have on the same position talking to each other about the position.
One of the oldest rules of trading is: If a market is hit with very bullish news and instead of going up, the market goes down, get out if you’re long. An unexpected and opposite reaction means there is something seriously wrong with the position. Two consecutive limit down days following the release of a supposedly bullish government report does not indicate a strong market. Faced with that situation, what did these two bold and committed traders do? Get out or confidently hold onto their position and opinion? That’s right! We decided the market was wrong, and we were not going to let them get us out of this great position.

Chapter 4 - Spectacular Speculator

Chapter 5 - The Quest

Obviously, there is no secret way to make money because the pros have done it using very different and often contradictory approaches. Learning how not to lose money is more important than learning how to make money.

Part Two: Lessons Learned

Good judgment is usually the result of experience, and experience is frequently the result of bad judgment. —ROBERT LOVETT

What started as a search for the secret to making money had turned into a search for the secret of how not to lose money. Why is it is so important to learn how not to lose? Because when people lose money in the markets, they usually look for a new approach to make money. Obviously, the previous method was defective; it’s never the investor’s or trader’s fault. Given the myriad of how-to methods, you could spend a lifetime trying, and failing, to make money with each one because you don’t know how not to lose. On the other hand, if you learn why people lose and thereby control losses, profits will follow.
Trying to avoid taking losses altogether is the loser’s curse. But the losses you are trying to avoid are the ones for which you hadn’t made allowances, the ones that sneak up on you and the ones that ultimately put you out of business.
Losing money in the markets is the result of either: (1) some fault in the analysis or (2) some fault in its application. As the pros have demonstrated, there is no single sure-fire analytical way to make money in the markets. Therefore, studying the various analytical methods in search of the “best one” is a waste of time. Instead, what should be studied are the factors involved in applying, or failing to apply, any analytical method. Even when equipped with accurate analysis, correct forecasts, and profitable recommendations, people still manage to lose money. Why can’t people match the profitable performance records of the market advisory services they subscribe to? They can’t because of psychological factors that prevent them from applying the analysis and following the recommendations.
And then there’s that oldie but goldie: “Don’t trade on hope or fear or make emotional decisions.” Sounds simple enough, but as you will see later in the book, emotions in general, and hope and fear specifically, create a unique paradox for the market participant.
But I don’t have to be a psychologist to know that losses caused by psychological factors presuppose your ego’s involvement in the market position in the first place, which means you have personalised the market.

Chapter 6 - The Psychological Dynamics of Loss

I can’t get out here; I’m losing too much. —LOSER’S FAMOUS LAST WORDS
Losses caused by psychological factors presuppose your ego’s involvement in the market position in the first place. It means that you have personalised the market. Knowing what causes something is the first step in preventing it from going into effect.
I can’t get out here; I’m losing too much. - Loser’s famous last words.
A fruit seller knows that two out of one hundred apples will rot. Losses don’t bother him, unexpected losses do. Acknowledging that losses are a part of the business is one thing. Taking and accepting those losses is something else entirely.
In the markets, most of us have difficulty actively taking losses. The reason is that all losses are treated as a failure. The word loss has negative connotations. Most of us regard the words loss, wrong, bad and failure as the same. As a result, the word ‘loss’ isn’t associated with anything nice in our vocabulary. We also regard win, right, good and successful as the same. As a result, when we lose money in markets we think we must have been wrong. When you lose a game, you weren’t wrong, you got defeated.
Losses are categorised as (1) internal (self-control, esteem, love, your mind) or (2) external (bet, game, contest, money)
Internal losses are subjective and external losses are objective. A loss is objective when it is the same for me, you and anyone else. The loss is subjective when it differs from one person to another - when it is entirely a personal experience.
If a team loses a game, it is an objective loss. A spectator may choose to personalise this external loss if he or she were to equate their self-esteem with the success or failure of the team. In other words, one could internalise an external loss.
Market losses are external, objective losses. It’s only when you internalise the loss that it becomes subjective. Needless to say, internalising an external loss involves ego. It causes one to view it negatively - as a failure, something that is bad or wrong. Psychology deals with the ego. As a result, if one can eliminate the ego from the decision-making process, the losses caused by psychological factors can be controlled. The trick is to prevent market losses from becoming internal losses, to understand how this happens and avoid those processes.
To do this one has to understand the difference between facts and opinions. Facts can never be right or wrong, they simply are. Opinions are personal assessments of the facts. They are right or wrong depending upon whether they correspond with the facts. As a result, opinions can be right or wrong, facts cannot. It follows that the words, right and wrong, win and lose, are inappropriate for markets. The reason is that participating in the markets is not about being right or wrong or about winning and losing; it is about making decisions.
Decision making is a process of concluding careful consideration, it is a judgment, a choice between alternatives when all facts are not yet known and cannot yet be known because they depend on events that may or may not unfold in the future. Decision making is not a choice between right and wrong. The quality of the decisions will decide whether or not market positions turn out to be favourable or unfavourable. How sentences are worded, we tend to confuse losing with being wrong. As a result, one tends to take what had been a decision about money (external) and internalise it by equating it with pride and reputation. This is how one’s ego gets involved with your position in the market. One begins to take the market personally. Hence, the loss becomes subjective when in fact, it is objective. It moves from being a monetary loss to a personal loss.
It may seem a bit strange comparing the loss of life to a loss in the market. Ordinarily, you wouldn’t think of a loss in the market as a life-or-death situation (although living through a million-and-a-half-dollar loss can sure make you think about the alternative). However, the stages people go through when experiencing a loss in the market are strikingly similar to the stages people go through when facing death. When my father was dying, a friend of mine gave me a book about people with terminal illnesses titled On Death and Dying, by Elisabeth Kübler-Ross. During interviews with 200 terminally ill patients, the author identified five stages terminally ill patients go through once they find out about their illness. One can see the same stages in most people facing personally tragic news, such as the death of a spouse or a child. I also think people experiencing any type of internal loss go through these stages. For the purposes of this book let’s refer to them as the Five Stages of Internal Loss.
Once a person has internalised a market position, he doesn’t know how it is going to end. He then goes through these five stages. The five stages of Internal loss. (1) Denial - if you don’t sit down and calculate how much you are losing in a position, but while winning you know how much you are winning, then you’re denying the loss. (2) Anger - This follows the first stage. Anger is directed in all directions and projected onto the environment. (3) Bargaining - all you want to do is to get back even and that’s it. (4) Depression - sadness, distancing from loved ones, change in sleeping habits and being constantly tired. (5) Acceptance - resigning oneself to the inevitable. Hope is a constant across all five stages.
While going through the five stages above, many a time, one goes back and forth multiple times before finally reaching the acceptance stage. Acceptance may be reached either on ones own or due to market forces. With each rally, one tends to vacillate and shift stages.
Even for profitable positions traders tend to go through these five stages. For e.g.., if a position is profitable, but not as profitable as it once was, we tend to get married to the price at which it was most profitable.
Matches and games are discrete events. they have a predefined ending. However, markets are a continuous process. As a result, internalising an external loss is a lot easier to do when it pertains to the market. Since markets are a continuous process, it triggers the five stages of internal loss. As a result, the loss becomes internalised, personalised and subjective. Take the racecourse as an example. When you bet on a horse, the race doesn’t stop midway and allow you to revise your bet. It is a discrete event. Markets on the other hand are continuous and they allow one to revise bets and shift horses midway multiple times.

Chapter 7 - The Psychological Fallacies of Risk

Most people who think they are investing are speculating. And most people who think they are speculating are gambling. —UNKNOWN
Gambling creates risk. Investing or speculation assumes and manages the risk that already exists.
Created risk is a risk that is not a natural byproduct of the activity itself. Inherent risk is coincident with the activity itself.
Whether or not one is engaging in created or inherent risk is determined not by the activity itself but by the characteristics the person exhibits while engaging in the activity. The five kinds of activities are investing, trading, speculating, betting and gambling.
Investing is parting with capital with the expectation of safety of principal and a return on the capital in the form of dividends etc. It is essentially long-term.
Trading is essentially defined as market-making. The idea is to keep the net position as close to zero as possible. Jobbing and trying to extract the bid and ask spread.
Speculating is buying for resale rather than for use or income. Capital appreciation is the sole expectation in terms of returns that the speculator expects. Speculation is derived from the Latin word specere, which means to see. In other words, speculating means to visualise and perceive.
Betting is an agreement between two parties wherein the party that is proved wrong about the outcome of an uncertain event will forfeit a stipulated sum. As a result, a bet is about being right or wrong.
Gambling is a derivative of betting. Gambling is a form of entertainment and is regarded as a vice. Gambling is an activity that is engaged in because of the action and excitement of participation.
As I have said above, whether a person is investing, trading, speculating, betting or gambling is determined by the behaviour of the person and not by the nature of the activity. The difference between betting and gambling, would for instance be determined by whether he or she wants the satisfaction of being right in his or her prediction or the entertainment of participating.
Gambling deals with the unknown and is based on pure chance. Money is the only ticket, hence, winning and losing are relatively unimportant. It is the excitement that is important. The professional gambler is different. He aims to make money. He is disciplined and systematic. His frequency is limited to infrequent but highly favourable opportunities. His behaviour is controlled and is the result of a studied approach to his chosen game. He gambles when the element of skill is sufficient to result in an advantage to him as compared to the other players. The professional gambler knows that he is dealing with an uncertain outcome. He then seeks to profit from his ability to anticipate the future or to see the future or in other words to speculate. Professional gamblers are speculators because of the characteristics they exhibit when risking money. They are not seeking entertainment, they are trying to make money. You find speculators in casinos and you also find gamblers in the stock market. Whether they are speculating or gambling will be decided by their behaviour, irrespective of what they think or say that they are doing. In other words, market activity can be either an end or a means to an end. For the entertainment guys, it is an end. For those who wish to earn money, it is a means to an end.
Most people don’t know whether they are speculating or gambling. When you couple this with the fact that they cannot distinguish between the two types of loss producing events (continuous or discrete), it means he or she is waiting for disaster to happen. Betting and gambling are suitable for discrete events, not for continuous processes like the stock market. Once we introduce the behavioural characteristics of betting or gambling to continuous process events we are leaving ourselves open to enormous losses. Because of the continuous nature of the stock market, if you wager and wait, you can lose a lot of money. In discrete events, the process will end and the loss will stop, not the case in the stock market.
While speculating or engaging in professional gambling, what we can do is as follows. Since markets are random we cannot estimate the probability of the occurrence or non-occurrence of an event. What we can do is to determine the amount of our exposure as compared to the probability that the market will behave by our premise.
Risk, Exposure, and Probability - The definition of risk is to expose to the chance or possibility of loss. Most people erroneously try to assign a numerical value to that chance, which simply confuses risk with probability. In the markets we are talking about unique, non-repeatable events, so we can’t assign a frequency probability probability to their occurrence. In statistical terminology, such events are categorized under case probability, not class probability. This means the probability of market events is not open to any kind of numerical evaluation. All you can actually determine is the amount of your exposure as opposed to the probability that the market will or will not go to a certain price. Therefore, all you can do is manage your exposure and losses, not predict profits.
Money Odds vs. Probability Odds - Perhaps the most common fallacy to which market participants are susceptible is money odds vs. probability odds. Many market participants express the probability of success in terms of a risk-reward ratio. For example, if I bought my famous takeover stock (which you will hear about in the next chapter) at twenty-six dollars and placed a sell stop below the market at twenty-three dollars with an upside objective of thirty-six dollars, my risk-reward ratio would be three to ten. Risk three dollars to make ten dollars. It is clear that I don’t understand probability. Couching my rationalizations in arithmetic terms does not automatically lend credibility to my position. The three-to-ten ratio has nothing to do with the probability that the stock can or will get to thirty-six dollars. All the ratio does is compare the dollar amount of what I think I might lose to the dollar amount of what I think I might make. But it doesn’t say anything about the probability of either event occurring.
Some Dollars Are Bigger Than Others - Why did the dollars seem so big at the blackjack table? Because I was accustomed to dealing with price ticks in the market, not tokens with $25 or $100 printed on them. Ordinarily, the use of chips is a psychological gimmick to minimise the importance of money, and it works on most people. But I was used to handling hundreds of thousands of dollars of market transactions on the simple shout of my voice, which made it seem like money wasn’t actually involved. When I had to physically take two twenty-five-dollar chips and throw them on the blackjack table, it felt like real money.
The money wasn’t important because we hadn’t worked for it. Those hundred-dollar bills were not nearly as big as the ones I had to work for in the pit.
Profit Motive or Prophet Motive - I couldn’t believe it. Here was Joe Siegel, easily trading more lumber futures than anyone else on the floor, and he didn’t even know the difference between green and kiln-dried lumber in the cash market. I wasn’t sure if he was kidding me or not. But looking back, I can only now see how it was possible for him to be such a successful trader without knowing that green lumber isn’t actually painted green. He was a trader, and he relied on short-term information like order flow and price action to make his decisions because his time frame was short-term. He didn’t let longer-term information more suited for investor types interfere with his trading. He knew the difference between traders and investors.In other words, we can only manage exposure and losses, we cannot predict profits.
In the market one has to decide if one is trying to be right or trying to make money. In other words, are you motivated by the prophet motive or the profit motive? To answer that you have to figure out what kind of participant you are, investor, trader, better, speculator or gambler. that, in turn, will be determined by your behaviour and not by your activity.

Chapter 8 - The Psychological Crowd

Man is extremely uncomfortable with uncertainty. To deal with his discomfort, man tends to create a false sense of security by substituting certainty for uncertainty. It becomes the herd instinct. - Benner W. Godspeed, the Tao Jones Averages.
Recall from basic economics that markets exist to satisfy the wants and needs of consumers. This means people make purchases for only one of two reasons: to feel better (satisfying a want) or to solve a problem (satisfying a need). Trying to do the former in the financial markets is dangerous. If you are in the markets to achieve a certain emotional state or create self-esteem, then you have some psychological disorders and need to see a therapist.
Greed and fear are popularly referred to when talking about emotions and stock market investing. However, emotions are neither good nor bad. They simply are. Emotions cannot be avoided, but emotionalism (decision making based on emotions) is bad and should be controlled and avoided. Emotions are very strong feelings arising subjectively rather than through any conscious mental effort.
The fundamental characteristic of a crowd is that it is exclusively guided by unconscious motives. If you don’t have conscious control of your emotions, then your emotions have control of you.
All of us know that we are not supposed to follow the crowd and to be contrarian. However, we don’t know what a crowd is, much less recognise it and then decide whether we are a part of it.
The popular definition of a crowd is when there is a mania and everyone is gripped by it. The crowd has been studied and described in terms of historical events rather than as a mental process that can happen to individuals. In this way, the crowd is described as some kind of an anonymous ‘they’ who get caught up in frenzies.
As part of our study on crowd behaviour we also look for endorsements at market tops and capitulation at the bottom. In reality, we cannot always be positioned against the crowd. In reality, both you and the crowd will have to be aligned at least some of the time. Only then can your idea become profitable with the force of the crowd.
The views of the crowd expressed above are of no use to us. The above is useful only when such patterns begin to repeat themselves in the market, not otherwise. These patterns do not reveal anything about the decision-making process of the individual. We need to be warned when we are becoming part of a crowd in our thinking.
From a psychological point of view, when the sentiments and ideas of all the people in the gathering take the same direction and their conscious personality disappears, then the gathering has become a psychological crowd. In other words, a psychological crowd does not require a gathering of people. An isolated individual who displays the characteristics of crowd behaviour (unconscious thinking etc) is for all intents and purposes, a member of the crowd.
The basic difference between individual and crowd behaviour is that individuals act after deliberation and analysis. The crowd acts on feelings, emotion and impulse - never by reasoning, in any case.
Three main characteristics describe the mental state of an individual forming part of a crowd. (1) A sentiment of invincible power - the improbable doesn’t exist for the crowd or its members. The sentiment is defined as a complex combination of feelings and opinions as a basis for judgement. Crowd behaviour is anonymous and the responsibility that keeps individuals in control vanishes when they are a part of the crowd. (2) Contagion - It is like being hypnotised or mesmerised. (3) Suggestibility - the individual displaying crowd characteristics is highly suggestible since he is no longer conscious of his acts. This results in impetuosity. In this stage, the individual is in the hands of the price changes occurring on the screen and the suggestions of whoever got him into the trade in the first place.
Once individuals have formed the crowd mentality, it puts them into a sort of collective mindset that makes them act in a manner that is different from their mindset in isolation.
A person exhibiting crowd characteristics exhibits & commits acts contrary to his most obvious interests. It also results in individuals holding on to erroneous assumptions, despite mounting evidence to the contrary.
In other words, individuals do tend to make a crowded trade. This is done unknowingly. The characteristics displayed when entering the trade determine whether or not it is a crowded trade. The quantity of individuals entering the trade is not material. If a person is displaying the characteristics of the crowd he is part of the psychological crowd.
There are two types of crowd trades. One is when we are attempting a recovery trade. This is before the trade has been made. In this state we are in an attentive state ready to make money, once the suggestion has been made, a process of contagion takes over and the trade is made.
The second type describes an individual becoming a part of the crowd after the trade has been executed. In this type, the stages are; affirmation, repetition, prestige and contagion. These stages apply to whether we are in a winning trade or a losing trade. In either case, an individual becomes hypnotised and is out of control.
Emotions are neither good nor bad, they just are. Greed and fear are cited as the dominant emotions. In reality, Hope and fear are the ones we need to control in the practical sense. Greed is an extrapolation of hope. According to Jesse Livermore, we should hope when we should fear and fear when we should hope. For e.g.., we should hope that our profits will become bigger, rather than fear that our profits will turn around. In the case of losses, we should fear that our losses will become bigger, rather than hope that losses will turn around. In other words, hope and fear are two sides of the same coin. More often than not, one is likely to experience both hope and fear simultaneously.
When the herd instinct combines with hope and fear in a market environment, we get panics and manias. Mania is defined as an inordinately intense enthusiasm or hope for something; a craze, a fad or behaviour that enjoys popularity and pertains to the common people or people at large. Panic is defined as a sudden overpowering terror often affecting many people at once. Since an isolated individual can be classified as a crowd, the same individual is susceptible to solitary panic and mania. As a result, the market doesn’t have to be frothy or to fall for individuals to behave as part of the psychological crowd. It can happen in a flat or a sideways market as well. The fact that a person is exhibiting impulsiveness, irritability, incapacity to reason, exaggeration of sentiments and absence of critical judgement, he is part of the psychological crowd and is exhibiting all of the above characteristics along with hope and fear.
In a solitary panic, crowd behaviour combines with an individual’s fear of losing money or fear of missing an opportunity to profit and becomes the primary reason for acting or failing to act. In a solitary mania, crowd behaviour combines with an individual’s intense hope for profit or hope that a losing position will turn around and becomes the primary reason for acting or failing to act. You have to guard against the above to avoid emotionalism.
The day after my $248,000 Thursday in August of 1983, Broderick and I were sitting on the dock at his lake house. He turned to me and said, “What’s the only thing that can keep this market from really going?” I thought a minute and said, “Well … if it rains that’ll change things.” That night we were watching the news, and the weather report called for rain over the weekend. Broderick looked at me and said, “Well? That’s it, right?” I said, “Well … no … it ain’t … it may not be enough rain … and it’s not really getting Indiana …” It only took me about half an hour to decide that the rain didn’t matter. There wasn’t enough rain in the right places, and the market had already shrugged off that little bit of rain by closing higher that day. Broderick got out of the market on Monday—because it had rained. And I had told him that if it rained the trade was over. So he got out and he made money. But me? No! I had to stick and stay and tell myself it hadn’t rained enough. I was not going to be tricked out of one of the best trades of the decade by “a little rain.” I had my own solitary mania going on. To repeat the leitmotiv of the book thus far: people lose (really lose, not just have occasional losing trades) because of psychological factors, not analytical ones (chapter 5). They personalise the market and their positions (chapters 1 through 4), internalising what should be external losses (chapter 6), confusing the different types of risk activities (chapter 7), and making crowd trades (chapter 8). Is there a single factor common to all of these errors, and can we determine a way to address that factor in order to avoid the errors?

Part Three - Tying it All Together

Chapter 9 - Rules, Tools, and Fools

A fool must now and then be right by chance - William Cowper.
The final irony of this story is that the bean-oil market turned shortly after I blew out in November 1983. If I had been able to stay in the market a little longer, by May 1984 my 540 spreads would have been worth $3,200,000. In hindsight, however, I don’t think it would have made any difference. Sooner or later I was going to lose all of my money, and the later it was, the more I was going to lose. If I had ridden through that valley of death and come out the other side with $3,200,000, somewhere along the line, in some other trade, I would have ended up losing $6,000,000 instead of $1,600,000. It just would have postponed the inevitable loss and made it bigger. Is it possible that I might have done some smart things like pay off the house or lock some money away? Maybe. But I still believe that eventually the disaster was going to happen.
In life one succeeds by following the rules. However, one also succeeds by breaking the rules. If one gets into the habit of succeeding by breaking the rules, one is riding one’s luck and that is something that cannot continue forever. If one succeeds by breaking the rules, one tends to get into an impression that rules are for everybody else and that one can break them and yet succeed. If one keeps breaking the rules and succeeding, one fine day a big loss using the same methodology can wipe you out. The reason is that you assume you are better than other people and can afford to break the rules and yet succeed. As a result, your ego inflates and you refuse to recognise the reality of a loss when you see it coming. You assume that even if the market is against you it will come back and rescue you.
There is a common factor that triggers the mental processes, behavioural characteristics and emotions of a net loser: the uncertainty of the future. In a certain world, we wouldn’t have to choose or act. Certainty would replace probability.
James Grant has said: “Because the future is always unfathomable, there are always buyers and sellers in every market. If the socialists are right and the future could be accurately divined, markets would disband because nobody would ever take the losing side of a trade”
The herd instinct and crowd behaviour arise out of our desire to replace uncertainty with certainty, if the future were certain we wouldn’t succumb to emotionalism - there would be no hope and fear syndrome. However, we need to deal with an uncertain future.
While dealing with the uncertainty of the future you have three choices: engineering, gambling or speculating. The engineer operates in a world of certainty. The gambler is playing for enjoyment, for the adrenaline rush - he isn’t playing to win. The speculator doesn’t have the advantage of the engineer but he knows more than the gambler.
Speculation is the application of intellectual examination and systemic analysis to the problem of the uncertain future. Successful investing is the result of successful speculation. Successful traders always have an if / then equation - it is these equations that dictate the subsequent buy and sell decisions.
Speculation is forethought - the successful speculator puts thought before action and uses reasoning before taking a decision. Reasoning about what to buy or sell, when to buy or sell and whether to buy or sell. In other words, the speculator develops several scenarios of future events and then tries to determine what his actions will be under each scenario. He thinks before he acts. This sequence is called a plan - effectively speculating and planning are the same thing.
Therefore, speculating and planning are the same thing. A plan allows you to speculate with a long time horizon (as an investor), a short time horizon (as a trader), or on a spread relationship (as a basis trader or hedger). Since you can’t really be an engineer in the market (unless you’re a “rocket scientist” on Wall Street) and since we’ve already discussed the dangers of gambling in the markets, then speculating, and therefore having a plan, is the only way to deal with the uncertainty of the future in the markets.
A plan, the noun, is a detailed scheme, program, or method worked out beforehand for the accomplishment of an objective. To plan, the verb, means to think before acting, not to think and act simultaneously nor to act before thinking. Without a plan, you fall into one of two categories: a bettor, if your main concern in being right, or a gambler, if your main concern is entertainment. If you express an opinion on what the market will do, you’ve gotten yourself personally involved with the market. You start to regard what the market does as a personal reflection. You feel vindicated if price moves in the direction you predicted and wrong if it doesn’t. Moreover, when the market moves against you, you feel obligated to say something to justify your opinion, or, worse, you feel obligated to do something like show the courage of your conviction by adding to a losing position. Participating to be right is betting, and betting for excitement is gambling. In order to be speculating, by definition you must have a plan.
You can’t be an Engineer in the market since gambling is dangerous and purposeless. Hence, speculating - having a plan is the only way of dealing with an uncertain future.
Participating in the markets is about decision making. You must decide the conditions under which you will enter the market before making a plan to implement the decision.
The decision making process would involve: (a) deciding what type of participant you’re going to be (investor or speculator)(which market -stocks, bonds or currencies), (b) selecting a method of analysis, (c) developing rules, (d) establish controls and (e) formulate a plan.
The plan that you develop must be consistent with the time horizon and the type of participant you chose to be. Why? Changing your time horizon in the middle of trade changes the type of participant you are and is almost as dangerous as betting or gambling in the market. For e.g.., Ninety per cent of the time an investment is a trade that didn’t work. People start with the idea of making money in a short period, but when they start losing money they lengthen their time horizon and suddenly the trade becomes an investment. We always lengthen our time horizon to rationalise hanging on to losing positions.
Most of the time when one buys a stock and the price starts falling we think of two things: (a) either I have been stupid and made a mistake or (b) the market is wrong. No prizes for guessing what most of us pick - (b) of course. Effectively, we fight the market, hold on to losing positions and convert trades into investments.
When stock players pay for their stock in full they are very prone to extending their original time horizon. Why? The reason is that they are never forced to leave the market when the position starts to lose money. Hence, it is very easy in the stock market to let a loss get out of control by simply lengthening your time horizon. The stock investor can stay in the position forever, and F&O participants will be forced out of the market. Hence, it is very important to decide what kind of a participant one is going to be while investing in the stock market.
The next step is to select a method of analysis that you are going to use. In case you don’t have a method, you will jump back and forth among several methods in search of supporting evidence to justify holding on to a market position. Since there are so many ways to analyse the market, you will inevitably find some method of analysis to justify your stance. This is true for both profitable and unprofitable positions. You will keep a profitable position longer than originally intended and you will rationalise holding on to a losing position far beyond what you are originally willing to lose. Your method of analysis is crucial. Your analysis does not tell you what to do or when to do it.
To translate your analysis into something more than mere commentary, you need to define what constitutes an opportunity. That’s what the rules do. Rules have to be hard and fast. Tools like charts and fundamental analysis have inbuilt flexibility in the way they are used. Fools have neither rules nor tools. The rules must define opportunities, determine how and when you will act. To do this one has to do one’s homework and define parameters. Your homework defines parameters, your rules are the if-then statements that implement your homework. As a result, entry and exit points are defined. If the criteria are not met, you don’t act, as simple as that. One has to remember that participating in markets is about making decisions. Drucker says: “There is no perfect decision. One always has to pay a price which means passing up an opportunity.”
The next step - establishing controls is about the exit criteria that will take you out of the markets at a profit or a loss. These may take the form of a price order, a time stop or a condition stop. Your exit criteria will create a discrete event ending the position and preventing the continuous process from going on and on. According to Drucker, ‘controls follow strategy’. What he means is that exit criteria should be consistent with the strategy - they should not be selected after the strategy is implemented. You must pick the loss side first. Remember that you can only calculate your exposure and manage your losses, you can not calculate the probability of a trade being profitable. Hence, you can manage your losses, not predict profits.
The last step - formulate a plan. The plan has to be a detailed one. Everyone knows the recipes of how to prepare a cake or any food item. The blend - the measurements and mixing instructions are critical. It matters less what the plan is. What matters is what the plan does. Regardless of methodologies used, before you decide to trade, you have to first decide where (price) or when (time) or why (new information) you will no longer want the position. All plans will have an entry, stop loss and price target. However, for a plan to be successful, one must first define the stop loss, then the entry and then the target - necessarily in this order. Defining the stop loss is THE criteria before deciding whether and where to enter the market. As Drucker says: “The first step in planning is to ask of any activity, any product, any process or market, ‘if we were not committed to it today, would we go into it?’ If the answer is no, one says, how can we get out - fast”. While trading in the market you don’t have to be committed to the market at all, hence you ask the last question before entering the market. Your entry point must be a function of the exit point. Once you specify what price and under what circumstances you would no longer want the position, and specify how much money you are willing to lose, then and only then, can you start thinking about where to enter the market? In this way, one will miss many profitable trades. But missed trades cost zero.
At all times one must remember that we are trying to manage possible scenarios and losses, not predict the future and profits. Trying to predict the future means that you’re betting, which in turn means you’re going to get caught up in trying to be right. Scenario planning does not, of course, tell us the future; only fortune-tellers can do that. And we already know trying to predict means you’re betting, which gets you all caught up in trying to be right. The objective of the scenario approach is not to decide which scenario is right…. There is no ‘right’ answer.
Our preoccupation with wanting to be right or wanting to be perceived as being right, explains our tendency to focus on why the market is doing what it is doing instead of what the market is doing. We end up constantly asking why is the market up or down. When someone asks, “Why is the market up?” does he really want to know why? No. If he is long he wants to hear the reason so he can reinforce his view that he is right, feel even better about it, and pat himself on the back. If he isn’t long, he’s probably short and wants to know why the market thinks the market is up, so that he can argue with it and convince himself that he is right and the market is wrong. He wants to say, “Oh, that’s the reason? Well, that’s the stupidest reason I ever heard.” He wants to justify his position of being the “wrong” way in the market by asking “why” so he can say, “That’s a stupid reason.” Let me tell you some good news and some bad news about “why” and the markets. The good news is, if you’re long and the market is going up and you don’t have a clue as to why, you get to keep all the money. Every cent. They don’t charge you a single penny if you were “only lucky.” The bad news is, if the market is going up and you’re short and you know exactly why it’s up, you don’t get any money back. Now how important is it to know why? Knowing why doesn’t get you any brownie points with the market. Nor do you get any partial credit like you did in school for knowing why you got a math question wrong. And this is true for all business, not just the markets.
The reason we want to know the reason is to use it to justify our position. How important is it to know the why? Knowing why doesn’t get you any brownie points with the market. What’s the point if you know the why and you still don’t make any money? You can be right and lose money, what is more important? There are two kinds of rewards in the world, recognition and money - is it a prophet motive or profit motive. In markets, don’t concern yourself about being right, instead, follow the plan and watch the money. Preoccupation with being right means you’re betting, which personalises the market and is the root of losses due to psychological factors.
The uncertainty of the future when facing a market loss triggers the Five Stages of Internal Loss. Have you ever said to yourself, “No way! Is the market really down that far?” That’s denial. Have you ever gotten mad at the market? Called it a name? Gotten angry at friends or family because of a position? That’s anger. Ever begged the market or God to get you back to breakeven so you could get out? That’s bargaining. Has a market loss ever changed your sleep or diet patterns? That’s depression. Ever have a firm liquidate one of your positions? That’s acceptance.
Since the end is in acceptance, the prudent course of action is to short circuit the five stages by going straight to the acceptance stage. Always remember that markets are continuous processes. Unless you create some event defining parameters, you are in jeopardy of gambling or betting in an environment completely unsuitable for such activities. If you don’t have some means of stopping the continuous process, nothing is locked in, profit or loss. In this way, one is open to being pushed around by fluctuating prices, random news events and other peoples opinions. As a result, one has to convert the continuous nature of the market to a discrete event. That is what a plan does.
The more you treat the markets like a game, the less likely you are to have losses due to psychological factors. The reason is that games have rules and defined ending points. As a result, one doesn’t confuse speculating with betting or gambling. It also prevents you from betting or gambling on a continuous process. Thinking before acting is the definition of speculation. Mixing up the order of the process (acting before thinking) is betting or gambling. Trying to be right (betting) about an event that never ends means that you will never be completely right. Trying to get excitement from an event (gambling) that never ends means that you will get more excitement than you bargained for.
Having a plan requires thinking. Only an individual can think, a crowd cannot. Having a plan ensures that you are not part of the crowd. Following your plan imposes discipline over your emotions. Discipline means not doing what your emotions would have you do. If you don’t have the discipline to follow your plan, your emotions have taken control and you’re part of the crowd. If you don’t have control of your decisions via a plan, then your decision making will be based on emotions. You become a part of the psychological crowd. As they say: “Weak is he who allows his actions to be controlled by his emotions, and strong is he who forces his actions to control his emotions.”
The three-part psychological trap discussed in chapters 6, 7 and 8 above, does not have to occur in the order that is described. The errors can occur in any sequence and form a vicious circle. They then feed on each other.
For the roulette player the last moment of objectivity is just before he places his bet and the wheel starts spinning, after which he can’t do anything to lose more money than he wagered. For the market participant, the last moment of objectivity is the moment before he enters the market, after which he can still do plenty to lose more money. Hence, one must determine the exit criteria during the pre-trade when your thinking is clear and not muddled. The decision of how much you are willing to lose must be made before entering the market, not after.
The point is that thought-based decisions are deductive and emotion-based decisions are inductive. Inductive puts acting before thinking - establishing a market position and then doing the work, selectively emphasising the supporting evidence and ignoring the non-supporting evidence. Deductive thinking, on the other hand, is consistent with ‘thinking before acting’, doing all the homework and then arriving at a conclusion of whether or buy, what to buy and when.
Another way of looking at it is: are you bullish because you are long are you because you are bullish? If you’re bullish because you are long, your decision was inductive and you will look for reasons, other peoples opinions or anything to keep you in your position - anything to keep you from looking stupid or admitting you are wrong.
Invariably, you find what you are looking for to justify staying in a losing position, and the losses will mount. In his book Teaching Thinking, internationally renowned education expert Edward de Bono says, “A person will use his thinking to keep himself right. This is especially true with more able pupils whose ego has been built up over the years on the basis that they are brighter than other pupils. Thinking is no longer used as an exploration of the subject area but as an ego support device.”17 That sounds exactly like me. My ego had been built up over the years because events seemed to indicate I was a little better than other people. Using thinking in this manner is similar to the inductive decision making mentioned above: it starts with a conclusion and then looks for evidence to support it. De Bono’s comments describe how people use their thinking when they personalise their market positions. When people personalise a string of successes (or profits) and an unfolding failure (or loss) develops, having come to believe they are infallible, they use all their intelligence as an ego-support device to prove that they are right, rather than as a means to determine an appropriate course of action. When people personalise losses, they use their thinking to protect themselves, thereby rationalising holding onto the position and distorting facts to support their view that they are “right,” not “wrong.”
Participating in the markets is not about egos and being right or wrong. It is about making money, taking decisions and implementing a plan. The minute it starts getting exciting, you’re gambling.
If someone asks you what you think about the market, avoid personalising the market by answering something along the lines of: “According to the method of analysis I use and the rules I use to implement the analysis, if the market does thus and such, I’ll do this. If the market does such and thus, I’ll do the other.” This response expresses your deductive thinking in the form of an objective plan rather than inductive thinking in the form of a subjective opinion. The response is also consistent with viewing the market objectively instead of subjectively, which would lead to personalising your successes and profits as well as your failures and losses. Answering in the manner just described is not an attempt to absolve you of responsibility for your decisions. On the contrary, taking responsibility and taking something personally are two different things. It is possible to accept responsibility for the ultimate outcome of a decision without internalising the intervening upswings and downdrafts and postponing the final outcome to the constantly postponed future, hoping the loss will turn around so you can be right.
Your choice of words has a powerful impact on how you regard the market. It reveals which of the five types of participants you fit into. If you say ‘I’m right or wrong’ you have implicated your ego and you are a bettor. Taking success or failure personally means that your ego is involved and you are in jeopardy of incurring losses due to psychological factors. As a result, a small loss can become a big loss and then a disaster. Are you trying to protect your ego or restrict your losses?
Therefore, your self-image should not be a function of what you have accomplished but how you have gone about doing it. Therefore, judge yourself by the degree to which you objectively defined the parameters/conditions that would constitute an opportunity and how well you adhered to them. In other words, pat yourself on the back or kick yourself in the backside depending on whether you develop a plan from a method of analysis, implement the plan via rules, and then follow the rules.
Participating in the markets without a plan is like ordering from a menu that has no prices and then letting the waiter fill out and sign the charge slip. It’s like playing roulette without knowing in advance how much you have bet and only after the wheel has stopped letting the croupier tell you how much you have lost. If you wouldn’t do that in a restaurant or a casino, why should you do it in the markets?
The last step would be to put pen to paper - write the plan in black and white. As a result, you objectify, depersonalise and externalise your thinking. You can then hold yourself accountable.

Conclusion

It’s not wise to violate the rules until you know how to observe them - T.S.Eliot
What you have to understand as a Speculator, entrepreneur, or manager is that there is a fine line between perseverance because you think the IDEA is a good one and perseverance because YOU think the idea is a good one. The former is objective. The latter is subjective and often follows personalising previous successes. In the first case, you arrived at the decision deductively after examining the evidence. The decision is supported by the facts, and you have a pragmatic exit discipline—a defined set of circumstances that will cause you to determine the idea is no longer a good one, because the evidence no longer supports the original decision. In the second case, the decision is made first; with no exit strategy, you inductively seek evidence that will support the decision. In the former, your thinking is used to explore possibilities and you arrive at a conclusion by default; in the latter, your thinking is used to defend a previously expressed opinion and to protect your ego, which is attached to that opinion.
If you didn’t understand the distinction about perseverance mentioned above, you might think all you had to do to be a successful entrepreneur was believe in your idea and take on the risk of carrying it out. After all, that’s what entrepreneurs do, right? They take risks. Some of them take seemingly huge risks, so huge that entrepreneurs are often compared to daredevils. But are they actually seeking risks?
Doing the wrong thing in the markets and still being rewarded means you will repeat behaviour that may or may not have been responsible for the profitable trade. If you don’t know what is making the profitable trades, you won’t know what to repeat to repeat the profits.
What about ‘making the wrong move at the right time?’ This is the same as deviating from your plan based on a hunch, feeling or intuition.
If you deviate from your plan as you inevitably will, it is important to remember: Speculation is the only endeavour in which what feels good is the right thing to do. We know we shouldn’t drink and smoke. We do these things that are not good for us and we know they are not, yet we do them because they feel good. In the markets it is different - you’re supposed to do what feels good. If you deviate from your plan and the market starts going against you, will you be saying that you are having fun? Obviously no. You then know what to do, get out, don’t look for supporting evidence. Get out of positions that make you feel bad and stick with positions that make you feel good. The minute it doesn’t feel good, stop doing it.
In the end there are a million ways to make money and only a limited number of ways to lose money. Concentrate on how you may lose money.
We participate in markets to satisfy a need (solve a problem) or satisfy a want (make them feel good). Managing risk solves a problem and should never be engaged in to feel good, smart or to be right. You must focus on the loss side first and always.

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