Mind, Money, Method - Which One is More Important?

I was looking at my blog this morning and noticed the label cloud at the sidebar. It was no surprise that the 3M (Mind, Money, Method) are ones of the popular labels read. What surprised me is that the cloud size of Method is bigger that Mind and Money.

One certain thing is that the label Method is the most popular label in the blog, but does it necessary the most important aspects of the 3M?

People may have different opinions about this. Though all three aspects are important and I have written so many articles about 3M in this blog, one aspect should be prioritized among others.

To me, the Money aspect is the easiest to take care (though the accumulating money part is not easy at all). Understand the theory of positing sizing, and follow the concept with discipline. Mind is the hardest really, while for new traders Method is the most exciting.

I used to spend hours in a day just to find all sort of combination of technical analysis to find the Holy Grails. I tried to find the best Method, spending most of my energy and time to Method, ignoring Mind and Money. However, as I learn from Mr Market along the way, I have done it the wrong way. The 80/20 rules apply here.

MIND comes first. METHOD last.

What is your sequence?

More on Greed and Fear

I have just finish reading my first book of 2014 (29 more to go)! - The 7 Secrets of Extraordinary Investors

One of the essential lessons I get from the book is the emphasis (almost in all investing books I read) on the need to control the two emotions in trading - Greed and Fear. The book went on to quote some examples which I find very inspiring and worth sharing in this post.

CC Image courtesy of Daddy Hardhead on Flickr

"Greed causes investors to put too much money into one investment, to overstay a winning investment or to use leverage to enhance the returns of a sure thing."

"Greed makes us believe that the investment of the moment is a buy at any price because the future is so certain and the price has been going up like crazy."

"Greed leads investors to do wild, reckless things that can often lead to permanent losses of capital, which are BRUTALLY difficult to recover from."

Be fearful when others are greedy, and be greedy when others are fearful - Warren Buffet

"Fear overlooks returns because of the current perceived risks in the market or economy."

"Fear makes us forget the moments of maximum uncertainty are often when the risk is lowest because so much bad news is priced into the investment."

"Fear makes us believe at any price because everything has been going down and the future is so uncertain."

So, the question is - are you in control of your greed and fear?

Trading Psychology Is Important!

From my early days in trading stocks, I am a strong believer that the three important components of stock trading are the 3M - Mind, Money, Method.

Understanding money management is not that difficult if you understand the concept of position sizing and act on it. To come up with a solid method (or some say Holy Grail) is rather difficult and more time consuming. But the most difficult is actually to understand (and act upon it) the trading psychology - MIND.

CC Image courtesy of lisainglasses on Flickr

Let's first introduce trading psychology and why it is very important to every trader. Let me quote Brett Steenbarger that wrote neatly and precisely many articles on trading psychology. The relevance of psychology for trading is based upon two important realities:

#1. Trading is a performance activity, much like athletics or performing arts. Psychological variables influence both the acquisition of skills in any performance field and the application of those skills. While there is much more to performance than mindset alone--talents, skills, and interests must align--the wrong mindset can greatly hamper performance. 

#2. The human mind does not process information efficiently or effectively under conditions of risk and uncertainty. To simply "trade what you see" is a recipe for falling prey to a variety of cognitive and emotional biases. The trader's psychological development is crucial to learning how to properly gauge risk and reward when performance pressures mount.

These points are relatively true in most things what we do - as far as trading is concerned. In trading, the four main emotions - fear, greed, hope, despair - are our enemies, if we do not control them properly (of course a little bit of fear and greed is good). Hence understanding the NEEDS of trading psychology is a good start for all traders - novice or experienced.

When trading psychology is not properly handled, we see many examples of disaster in trading: making impulsive decisions, allowing fear to overtake opportunity, over-trading, allowing losing trades to run and capping winners, and the like. If you can make those mistakes - and learn from them - long before you put the lion's share of your capital at risk, you will have an opportunity to grow into the trader you're capable of becoming.

Breet mentions in one of his articles that the best therapy for improving trading psychology is to get into the therapy yourself. To go to stock markets with poor psychological aspect in your trading skills is very expensive. Psychological development needs to precede trading development: resolving those issues is the best way to approach markets with a clear and open mind.

When you have improved your trading psychology, you will notice that you will recognize when others are making the mistakes you used to make. You will see markets acting on fear and greed and you'll be able to take the other side of those reactive trades. You'll observe when market sentiment is tilted one way and price can no longer sustain its trend.

"Developing yourself psychologically doesn't mean that you'll be free of emotion. It means that you will become increasingly competent at using your feelings as useful trading information."

Avoid Recency Bias in Stock Trading

First start with definition.

In general, recency bias is the tendency of traders to focus only at the most recent events in his/her trading results while ignoring or disregarding the older, equally important trading results. If this bias is not well-recognized by traders, this will affect traders negatively in decision making.

Recency Bias - Focus on recent event and disregard the bigger picture.

Curtis Faith, in his bestselling book (and my favorite too), Way of the Turtle, mentions:

"A trade that was made yesterday weighs more heavily than do trades from last week or last year. Two months of losing trades can count as much as or more than the six months of winning  trades that happened previously. Thus, the outcome of a series of recent trades will cause most traders to doubt their method and decision-making process."

 Examples of recency bias..

#1. A mechanical trader, who uses technical analysis and candlestick patterns, places a lot of weight on newly formed candles or exponential moving average (which give more weight on recent results), making him lose track of the long-term trends.

#2. A fundamentalist puts too much meaning to recent economic events and fails to take into account the larger macroeconomic background.

#3. Another example related to psychological aspect. Say there are trader A and B, having each 10 trades so far. Trader A is on 3-trade winning streak, with overall record 4 wins and 6 losses. Trader B on the other hand, is on 3-trade losing streak, with record 7 wins and 3 losses. Trader A has 0% return, while trader B is 10% up year-to-date. If both traders are trapped in recency bias, trader A could end up ignoring possible warning signs and enter a trade hastily while trader B could become frustrated, abandon his risk management rules, and start overtrading. Both situations are clearly undesirable.

Solutions..

#1. Keep track of all trades and trade history. This is obviously helpful so that you can always know where you stand and not trapped in recency bias. You do not have to be Excel expert to start making a simple spreadsheet to keep track your performance in the stock market.

#2. Stick to your written plan and system.

#3. Write down mistakes you did. Not following your system is a mistake - write it down. Forgetting to put a stop loss is a mistake - write it down. Pulling out of the market while still profiting is a mistake - write it down. Buying a stock out of excitement (because you are on winning streak) is a mistake - write it down.

The Psychology of Trading (2) - Dare to be Dull

The point I want to convey here is stock investing or trading does not have to be sexy and excited. Even some market experts are saying that exciting investments are more often than not are a bad deal. When you seek entertainment or excitement in your stock trading is liable to lead you to poor result.

According to William Bernstein, in his book The Four Pillars of Investing, one of the most deadly investment traits is the need for excitement.

"One of the most consistent findings in behavioral finance is that people gravitate towards low-probability/high-pay-off bets. For example, it is well known among professional horse race bettors that is much easier to make money on favorites than on long shots. The reason is that the amateurs tend to prefer long shots, making the odds for the remaining favorites more advantageous than they should be."

I, personally, trapped once in this situation. When the market is hyped, and the stock I had been watching, was showing a good uptrend sign, even though my system gave no buy signal. I got excited! I bought it and I sold it a few weeks later at loss. I should have understood that I should not trade for excitement.

CC Image courtesy of ota_photos on Flickr

Key takeaway:

#1. The most exciting assets tend to have the lowest long term returns, and the dullest ones tend to have the highest. If you find yourself stimulated in any way by your portfolio performance, then you are probably doing something very wrong.

#2. The exciting investments are highly likely the ones that attracts a lot of public attention and hence will be over-owned. This means this drives up the price, lowering you potential future returns.

#3. Stick to your trading plan. Eliminate emotion as much as you can. Follow your trading plan and rules religiously.

The Psychology of Trading (1)

Relating 80/20 Rule and 3M (Mind, Money, Method) in Your Trading

I have just finished reading The 4-Hour Workweek, a bestseller book by Tim Ferris. One of his many interesting theories that struck me was the use of the 80/20 rule. This rule, also known as Pareto's Law  is applied in business studies, sales, economy and many other endeavors. Today, I am going to illustrate how the 80-20 rule can help optimize your trading and boost your trading profits.

Pareto's Law can be summarized as follow: 80% of the outputs result fro 20% of the inputs. To put it in different ways, Tim Ferris gives more examples in his book:

1. 80% of the consequences flow from 20% of the causes.
2. 80% of the results come from 20% of the effort and time.
3. 80% of the company profits come from 20% of the products and customers.
4. 80% of all stock market gains are realized by 20% of the investors and 20% of an individual portfolio.

One important thing to note is that the ratio is often skewed even more severely such as 90/10, 95/5, 99/1 are also common, bu the minimum ratio to seek is 80/20.

How this Law is related to trading?

Trading in general consists of the 3M - Mind, Money, Method. Mind is basically how you manage your emotions and understand the psychology of trading. Money is the position sizing system so that you can manage the risk and survive in the trading business. Method is the strategy to buy and sell stocks. 

For most traders out there, there is one thing that matters the most: the trading system. Trading system research and developing new strategies for trading are their main focus, but mostly this is about looking for that holy grail of trading systems. Their argument is that while I do like to apply money management and discipline/psychology, about 80% of what I do is test new trading systems and look for new methods. That leaves 20% for money management and trading psychology & discipline.

The truth is, to make profits in trading, one does not need to have the most accurate system in the world. What is needed is really a good system executed with discipline and using proper money management methods. I strongly believe that trading psychology + money management are the 20% which is responsible for 80% of trading success.

So, to relate the 80/20 rule, I would like to summarize this way..

1. Instead of researching and keep updating/changing your Method (I am not saying it is not important), spend more time in understanding the trading psychology and position sizing.
2. As 80% of your profits are coming from your top 20% trades, focus on the market movement and make sure you do not miss the boat when the market is uptrending.

Happy trading and happy holiday!

Stock Trading is Just Like Doing Maths

If you recall your school days, your math teacher often asked you to do math exercise. It was easy to find the answer - flip the book to the last page and you can find the answer. However, by knowing the answer is not enough really. And probably you will not earn full marks for that. In math, workings are required and you need to understand fully to show it in your exam/homework.

Stock trading is just like math!

Most of us know the final answers! But again, knowing the answer is not enough, we need to know the "workings" and the steps to the right answers..

Just think for a while, what are your "steps" (read - system) you have to get your answers (read - profit/wealth)?

Who are Your Shoe Shine Boys?

The story goes like this..

In 1928 in New York City, John D. Rockefeller was having his shoes shined. The shoe shine boy, presumably not knowing who Rockefeller was, started giving him stock tips and financial news of the day. Rockefeller took his shoe shine boy’s advice but not in the way you would expect. He decided that if a shoe shine boy was giving stock tips.. It was time to get out of the market. He did! And it’s the reason his family was able to stave off the Depression, and continued to be one of the richest in our history.

Honestly, I do not give a damn if the story is true or not. But this story really give us a piece of important lesson!

Who is your equivalent shoe shine boy? Is he the taxi driver? Is he your colleague who has shown sudden interest in stocks like never before? The first tip is about increasing your street smarts by surveying the sentiments of the people around you. When many people are optimistic about investing in stocks, it is probably time to get out.

 "Honesty is a very expensive gift, don't expect it from cheap people"

Stick to your trading plan, and be disciplined. Keep it simple.

Understanding Fear, Hope, Greed and Despair in Stock Trading

From one of my favorite trading books, Way of the Turtle by Curtis Faith, I learnt about 4 most common emotions that traders experience during trading days. The key point here is to understand these emotions so that you will not be trapped in this trading psychology. I myself experience these emotions while trading, and in my early trading days, not having understand and knowing how to deal with it, I lost many trades.

The 4 emotions are well-written in the title of this post, but with some examples, here they are..

#1. Fear - I can’t take another loss; I’ll sit this one out.

#2. Hope - I sure hope this goes up right after I buy it. 

#3. Greed - I’m making so much money, I’m going to double my position.

#4. Despair - This trading system doesn’t work; I keep losing money.

"How many times have you felt these emotions while trading?"

So how do you avoid being trapped and finally losing your hard-earn money because of these emotions? My simple answer is to stay DISCIPLINED to stick to your trading rules and plan. Before trading stocks, you should spend some time crafting your business plan (trading system), read books on fundamental and technical analysis, create rules to enter and exit the market (keep testing your system).

Come up with a good system (good here means the system will give you positive return in the long run if you religiously following it) and be disciplined.

Some examples:

You see a stock that's cheap enough and your friends keep telling you how this stock will go up in a few days. You want to buy it because you HOPE it will go up. Instead, go to your system and ask yourself questions if the stock is worth buying. Does it satisfy your entry rules? Is your capital big enough to allow you to buy the minimum lot of the stocks? Have you done research on the stock personally (you are responsible on your own trades anyway)?

You are in the market having bought stock A which has gone down passing your cut-loss limit of 10%. Deep in your heart you know you should get out, because you write it in you system that you have to get out when it drops by 10% from your buying price (why 10%? you need to figure out what percentage works best for you). However, unknown voice in your brains says,"Hey, it will bounce back up tomorrow! Do not worry!". Again, this is HOPE! Once in a while the stock will go up, but dare not to predict market! You better get out before you lose more money.

"When HOPE is what's left, get out of the market"

Personal Responsibility in Stock Trading

To have the right mind for stock trading, to me, is very important. In my previous post on Trading Psychology, I discuss about the facts that you need to fully understand about stock trading.

Apart from that, there is another part of trading psychology that is equally essential: Personal Responsibility.

One of my trading rules is that YOU are responsible to every trade you make. YOU are the most important factor in your trades. Even though you have a superb METHOD, YOU are the one applying it. YOU are also the one exercising your positing sizing (MONEY).

So start telling your self this:

" YOU are RESPONSIBLE to every trade you make. No Regret." 

When you accept that you are responsible to all you trades, you can fix your mistakes and problems that causes you loss money in trading. No more excuses like "My system sucks" or "The loss is because of the market", etc. When you come up with this excuses, you do not fix the problem and you will repeat the problem in the future.

When you start accepting the mistakes are caused by you, you will try harder to look at the problem and solve it.

Think about it.

Stock Trading Rules

Rules are made to be followed. I am a systematic person and I love creating system. In my trading days, I stand by my trading plan at all times. It is not easy initially, but I believe I am getting used to this. If you recall my post on my business plan for my stock trading, one of the important aspects is to have your beliefs and rules to follow. I created a checklist which is online on my Evernote - so that I can check on it occasionally. My room wall is too decorated with my trading rules :)

How do I define my trading rules? I read many books on real and successful traders and started to jot down their traits, quotes and advice. If you find these advice make sense, go ahead and adopt them in your trading rules. To categorize it in a systematic way, I split my rules into three main classes: MIND, METHOD and MONEY!

Take note of my rules below. Some are very conservative and sometimes causes me to be extra cautious in making decision to trade. Adopt what your think make sense to you. If they are not, ignore them.

MIND
[ ]When in doubt, get out. Only trade when you feel confident about your trading strategies.
[ ]Never get into the market because you are anxious from waiting, and never get out of the market just because you have lost your patience.
[ ]Never change your position in the market without a good reason. If you execute a trade, base it on a fundamental reason or technical rule.  And then do not get out without a definite indication of a change in trend
[ ]Do not guess where the top and bottom of the market is, but let the market prove its top and bottom
[ ]Perception is not reality. Only trade on "quality" advice.
[ ]Use self-discipline as your guide when the market goes against your position. Take your loss and wait for another opportunity.
[ ]Avoid taking small profits and big losses
[ ]Ignore the minor price fluctuations and place positions with the basic trend of the market. Remember, the odds are on your side when you trade with the trend rather than try to pick trend reversal points.
[ ]Guessing key reversal points can be risky. Therefore, let the market tell you when it is over by a patterned reverse in direction.
[ ]Always remain true to your trading plan, and follow the trading style that works best for you.
[ ]Put your trust in the markets, and do not be afraid when they reach historic highs or lows
[ ]Never let greed or fear take control over your winning positions

METHOD
[ ]Use stop-loss orders and always protect a trade when you use a stop-loss order by using reasonable price limits
[ ]Never over-trade and adhere to your risk management rules.
[ ]Remember, "the trend is your friend," and never buy and sell if you are not sure of the trend according to the fundamentals and technicals.
[ ]Trade "at the market" whenever possible and try to avoid using orders with a fixed buying and selling price (except a stop-loss)
[ ]Never buy just because the price of the stock is "low", or sell just because the price is "high."
[ ]Never Average Down.
[ ]Never make a mistake without asking yourself why. Learn from your trading mistakes. If possible, keep a log of your trades - why you made them, what happened and why, etc
[ ]Remember, the key to any plan is how well it performs over time

MONEY
[ ]Only trade with genuine risk capital, and be aware of the risk of losing.
[ ]Do not treat all markets the same. Learn to adjust the size of your positions and the frequency of your trades for different markets.

One tips I find it useful is to run through all the list when you are about to buy or sell. If any of the rules is broken, simply do not trade.

The Psychology of Trading (1)

"Making ONE winning trade is easy, being a consistent winner is hard"

Emotion plays a big part in every traders' heart. With a wrong mindset, this game of trading can make one loses a  lot of money. Psychology of trading is one of the most important aspect in stock trading. Some experts refer this to one of the M in the famous 3M (Mind, Money, Method). Yes, I am talking about MIND. We need to have a good mindset before we are going to buy stocks in stock market.

In this article I am going to share the powerful quotes from Mark Douglas, the writer of a really good book, Trading in the Zone. When I read the book last year, my attention was caught by the "Five Fundamental Truths" of Trading Psychology. Read this carefully and decide if this makes sense to you. I fully absorb the ideas of these principles and this helps me to be a better trader.

1. Anything can happen - Simple translation: we have no control over the market. Accept this. So when the market is against you and you losses money, understand that you cannot blame the market. I repeat: we have no control over the market.
2. You don't need to know what's going to happen next in order to make money - I used to see people predicting whether tomorrow the market will be green or red. This is rubbish! The fact is, we cannot predict anything. Sure we can analyse and guess, but we have to realize that we cannot predict the market, so do not waste your time giving prediction or believe in people prediction. Focus on your edge, ignore any attempt to predict.
3. Wins and losses are random - This is about math lesson: probability and normal distribution. Understand that one day you win, the next day you can lose. What is important is you win in the LONG run. The sequence of winning and losing doesn't matter, what matters is you are winning over time.
4. Your EDGE is nothing more that a higher probability of one thing happening over another - The edge is defined as the system and strategies you used in buying stocks and selling stocks. The definition is very broad and you have to find out your own edge. And by testing it for a long period of time, your edge must have a positive return in the long run (that is you are winning in long haul). Remember this: Your edge is no guarantee of a winning trade, just of winning over time.
5. Every moment in the market is unique - Just because a similar trade/pattern won last time doesn't really mean that it will win this time. Treat every trade as unique occurrence you will see the truth of the trade without relating it to the what happened last time.