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The Challenge of Taming the Financial Markets

The secrets to amassing real wealth over time as an investor or trader are not elusive. They are well known, and you can find them in time honored expressions and adages, many of which are displayed at the top of our web site. So why do the majority of market participants fail over the long-term? Because, as a character in a famous science fiction movie once observed, there is a difference between knowing the path and walking it. It is so hard to tame the financial markets because human nature will often lead you down the wrong path as emotions such as hope and fear continually attempt to cloud your judgment. The secrets to success may be known, but you will do your very best to forget them, especially when you need them the most. Mastering the markets, therefore, is very much an exercise in self-mastery, and those very few investors and traders who are able to adhere to the time-honored, proven strategies, even when their instincts are telling them to do otherwise, are the ones who succeed.

Let’s consider an example. There is an old trading adage that says “let your winners run and cut your losers short,” meaning investments or trades that show a profit should be given plenty of time to develop, while losing trades should be closed as quickly as possible for as small a loss as possible. When you consider this advice rationally, it makes sense. If a trade moves in the direction that you expected, the market is suggesting that your rationale for opening the position has merit, so you should have patience and let the move continue until the price action indicates otherwise. On the other hand, if a trade moves against you after it is opened, the market is indicating that your reasoning, your timing, or both, are flawed and you should close the position immediately and reevaluate. When it comes to executing this principle, however, human emotion steps in and makes it very difficult. If a trade shows a quick profit after you open the position, fear makes you worry that the gain will vanish unless you lock it in right away. So the tendency is to close profitable trades much too early. Conversely, when a trade shows an early loss, you feel the urge to give it time to recover, and as the loss grows, you want to give it even more time and become even more emotionally invested in the position. Additionally, when a trade goes wrong, closing the position for a loss can feel like admitting defeat psychologically, like admitting that you were wrong. Of course, there are always multiple possible scenarios, so you can be right and still have the market move against you, just as you can be wrong in a decision and ultimately be rewarded. Sometimes the market is right and sometimes it's wrong, but it never loses an argument, so engaging in one with it will always prove futile.

So how do we train ourselves to make the right choices even as our instincts tell us to make the wrong ones? As they observe in many addiction recovery programs, the first step is admitting that you have a problem. We are all human, so we all have this obstacle to overcome as financial market participants. Once you learn to recognize when human nature is attempting to lead you down the wrong path, you can take steps to prevent it from doing so. One of the most effective ways to succeed in this endeavor over time is to keep a log of everything that you do. Every time you open an investment or trading position, write it down. Include a detailed description of the trade, describing your rationale for opening the position at this time. Really justify taking the action, make a compelling argument. If you cannot, you probably shouldn’t be entering the trade to begin with ("when in doubt, stay out"). Further, note the steps that you have taken to manage risk. Where is your stop loss level, and why did you select it? Finally, and most important, evaluate the trade after it is complete, especially if it resulted in a loss. This is the key to improving your performance over time. In general, successful trades have very little to teach you, precisely because what you did worked. It is when you fail that you learn the most. Carefully consider what went wrong when a trade loses money. Was your rationale for opening the position sound? Was your timing simply off? Did some sort of unexpected market event cause the trade to move against you? Your goal should always be to identify the reason for the failure. If you are unable to do so, that suggests a lack of understanding on your part and should motivate you to rectify the situation by filling in the identified gap in your knowledge base. Whenever you are surprised or shocked by what the markets do, that doesn't mean that market behavior is completely unpredictable and unknowable. It means that your understanding of market behavior is lacking, so you should always take those opportunities to try and figure out what you are missing.

The point of this discussion is yet another cliche: never stop learning. The moment you convince yourself that you have the markets all figured out is the moment you set yourself up for failure. Challenge yourself to grow and learn every day. Learn from your mistakes. Learn when the markets throw you a curve ball that you never saw coming. If you do, you will find that you make fewer and fewer mistakes over time, and the markets will be able to catch you off guard less and less. Maintaining a detailed investment and trading log will assist you in this pursuit by keeping you humble and focused on self-improvement as a market participant.

Disclosure: No positions