Wednesday, February 12, 2014

Top Trading Mistakes People Make in the Market

By Dr Van Tharp Trading Education Institute and Workshops

My goal for 2014 is to write a book about beliefs and trading because everything boils down to beliefs (and of course, that statement is also a belief). Knowing that, I was very intrigued when I saw a Forbes website piece on the top mistakes even supposedly savvy investors make. What’s interesting about these types of articles is their general vagueness: no one ever clearly defines a mistake or states any of their assumptions when they describe mistakes.

I decided to go through the Forbes list of top 10 mistakes and discuss some of the underlying beliefs for each and then share my own list for the top 10 mistakes.

The Forbes List

In this list, I will repeat each mistake from the article with a short explanation. Then I’ll restate the mistake in a more useful form. The revised form will still be their definition of a mistake, but just in a format that most people may find more meaningful.

1) Forgetting value. The assumption here is that value investing is one of the most important types of investing and then if forgotten, of course, it becomes a significant event. However, you could probably say other versions with different assumptions such as “forgetting what the market is doing” or “not paying attention to reward versus risk.” I actually think those beliefs are more important. So perhaps a better version of this mistake would be — Forgetting some core value that drives your trading.

2) Getting too big for your britches. This is an interesting mistake because it is actually a metaphor. The author seems to mean not knowing how to handle an account that has grown too fast. I don’t really think this is a mistake at all because if you had been thinking in terms of R-multiples and percentage risk because sudden changes in your account size should not matter. Let me rephrase this mistake as — Not risking a constant percentage in each trade (which helps you meet your objectives).

3) Putting too many eggs in one basket. Again, this is an interesting metaphor to describe an investing mistake but when the author explains the meaning (putting too much money into one stock), the metaphor doesn’t fit really well anymore. I would certainly agree that an improper position sizing strategy (or lack of one) is a huge mistake. So rephrasing this becomes — Risking too much and not understanding the implications of position sizing strategies.

4) Thinking you are special. So what does this mean? Well according to the author of the piece, this occurs when someone thinks that the common judgmental heuristics that people have in their decision making doesn’t apply to them. But wouldn’t a better way to say this be? — Not understanding that you are the most important factor in your trading.

5) Chasing yield. Here’s another rather unspecific statement. You could easily create a great investment strategy based upon yield, however, if you realized the assumptions you were making and were able to test it. So my rephrasing of this one would be - Understand your strategy (system) and how it works in different market types.

6) Letting the tax tail wag the dog. Oh, the power of language and the desire of author to be colorful. I’ve known people whose investment strategy was totally controlled by the capital loss limitation. So their rule might sound like, “Don’t lose more than $3,000." And then other people might not sell a huge position that’s gone up 20 fold because they wanted to avoid the capital gains tax implications. So this one boils down to — Not having sound objectives and being influenced by such things as taxes.

7) Changing horses midstream. What does that mean? Well, according to the author it really means that your emotions caused you to change your plans. So wouldn’t the mistake be - Emotional decision making?

8) Buying all at once. The author tried to explain this by saying that if you are going to buy 1,500 shares, just buy 500 shares at first and see how it does. To me this suggests that the author doesn’t really understand entry methods, good objectives, and effective position sizing strategies. So how about rephrasing it as —Not understanding entries and the correct amount to risk for your trade.

9) Not minding the market. The author really seems to mean that buying and holding positions without paying attention to what is happening in the economy and market is a mistake. So my version of this mistake is simply — Buy and hold.

10) Trading the news instead of the stock. So this one probably reflects the author’s bias that investors need to understand the fundamentals of a stock or perhaps the technicals. Of the mistakes in the article, however, this one is probably the vaguest of all. I’ll rephrase this mistake as — Not trading your strategy under the conditions in which it works.

So do I agree with any of the mistakes on the list? Based upon how the author phrased the mistakes, the answer is no. Based upon how I rephrased the mistakes, however, I would agree all are mistakes but that only 4, 5, 7, and 10 are on my list of top ten mistakes that traders make.

But now, based upon my many years as a trading coach, let’s look at my version of the top ten mistakes.

Van’s Top Ten Mistakes that Investors/Traders Make

First let me define a mistake. A mistake occurs when you don’t follow your written rules. This of course assumes you have written rules and leads us to the first and biggest mistake that most traders make:

1) The biggest mistake of all is — Not having any written rules because then everything you do is a mistake.

2) Not understanding that trading is 100% beliefs and psychology. This belief makes you the most important factor in your trading and it is similar to my revision of mistake four on the Forbes list.

3) Not understanding that trading is a business. Additionally, trading takes as much training to perform well as does any professional field. So the mistake I see often is people treating trading as if it were a hobby. Approaching trading as a business means 1) clearing out your psychological issues; 2) developing a handbook to guide your trading; 3) developing at least three strategies that cover at least three major market types; and 4) improving your trading efficiency so that it is at least 95% (no more than one mistake per 20 trades). It’s not an accident that these are the steps and goals for people in my Super Trader program.

4) Not having sound objectives. Objectives require that you know yourself and what you want. Defining your objectives is at least 50% of the process of developing a system that fits you.

5) Not understanding market types. There are at least six different market types: up, sideways, and down under quiet or volatile conditions. It’s very easy to design a Holy Grail system to fit any single market type but it’s insane to assume that one system will work well in all market types. This mistake is pretty similar to the way I have rephrased the Forbes article mistakes 5 and 10.

6) Not monitoring your mistakes and not understanding their impact. You need to monitor your efficiency so that you make less than 1 mistake in 20 trades to maintain 95% efficiency or better. While this mistake sounds a little like number one, it more specifically applies to following your written rules. Repeating the same mistake over and over again is a great definition of self-sabotage. So you must be aware of when you are doing this and do whatever you can to make sure that you are minimizing the impact of mistakes.

7) Not being aware. You are generally controlled by your thoughts and emotions. There are many ways to prevent this, but they all require you to be aware of when it happens. Being controlled by your thoughts and emotions and then being aware of it only after the fact (or perhaps never) is a huge mistake. This is similar to mistake #7 on the Forbes list.

8) Not understanding that it is through your position sizing strategies that you meet your objectives. You should be spending most of your time strategizing about how to use position sizing strategies to meet your objectives, which assumes that you have objectives. Many people make this mistake and it can have a huge impact. And it’s probably my version of mistake three on the Forbes list.

9) Needing to be right instead of understanding the impact of reward to risk. A trading system that generates 7 straight -1R losses followed by a +10R win illustrates one of my core teachings. You have only been right 12.5% of the time, but you have suddenly have a net +3R. And if you were risking 1% per trade, you are now up 3%.

10) Not understanding that trading is a statistical process with probabilities and distributions. If you understand this then you can measure your likelihood of success in the future and develop plans that will help you meet your objectives. That’s what I call sound trading.

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