Transcript:

'Successful Trading' - Episode 2: Reasons for a Trading Plan

Presented by Jeff Bryant, HomeTrader.

Hello - and welcome to this, the second in our series on successful Trading.

In the last episode, we spent some time on the differences between Investing and Trading - and if you haven't seen it yet, 
Check out the archives so you can catch up on the ground we’ve already covered.

In this episode, we're going to look more deeply into the reasons WHY we need a robust Trading Strategy.

Prominent financial author, Jack Schwager, in his ‘Market Wizard’ books concluded that the one thing the Super Traders he’d interviewed all had in common was a trading plan… method… strategy… system… call it what you like - when they stuck to it they were OK; when they didn’t – things started going wrong, usually resulting in various financial ‘nasties’.

OK – changing tack slightly - imagine you have a bat and a ball. Together they cost $1.10 and the bat costs a dollar more  than the ball. How much does the ball cost? Most of you will be thinking ten cents. Some of you might even be thinking I’m trying to trick you ... not this time.

Here’s the answer: together they cost a $1.10. The bat costs a dollar more than the ball - so the ball costs 5 cents!

I asked you to make a decision – about the cost of the ball. This takes us right into the world of human decision-making and the field of Trading Psychology. As humans, we make decisions at 2 levels. Firstly, there’s the intuitive, subjective level; ‘System 1’, as it’s called. It’s quicker, easier - & gives us our first impressions. System 2 is the more rational, reasoned, rules-driven approach. It’s slower, more considered.

For most people, to answer the question I posed earlier, you’d need to reach for pen and paper. But you probably already had 10 cents pretty firmly entrenched in your mind. At this point, let me introduce to you to Daniel Kahneman. After many years of research with his now-late colleague Tversky, Kahneman was awarded the 2002 Nobel Prize in Economics in the field we now know as ‘Behavioural Finance’.

We pause for a moment to remind ourselves that the Nobel prize is not tossed around lightly. Whatever is discovered has to be both substantial AND substantiable – it needs to be proven. So with that in mind, let’s see what they found.

In an environment of uncertainty, such as the stock market, people tend to make system 1-type judgements rather than the more rational, system 2 decisions. The research went on to show that these system 1 type judgements are often biased, or worse – just plain WRONG! In our ‘normal’ live, we have the skill sets and the experience to make good decisions. In the stock market however, left to our own devices, the same cannot be said. The reason is that we don’t know HOW to get to the system 2 level of decision making. It is too easy for our emotions to sneak in & affect the way we think.

Trading is said to be a counter-intuitive activity. What you think or feel might the right thing to do, is too often not. Let me give you some examples of what I am talking about. When presented with a loss, most people will hold on ‘hoping’ that the stock recovers. Too often it doesn’t.

When presented with a profit, most people will sell early, in fear of seeing any of that profit go back to the market. There’s nothing worse than doing this, only to see the stock take off and generate bigger profits. Simply put – they lift the average of their losses, & reduce the average of their winners.

But that doesn’t make sense, I hear you thinking. And you’re right – it doesn’t. But here’s the kicker: This behaviour is SO common, it’s been given a name:  The Disposition Effect. This is HOW the vast majority of people tend to think and act in this environment.

What causes this apparent meltdown of basic commonsense? It not just one thing. Firstly, humans actively seek to avoid regret - they can’t bear to think that they might sell their HIH shares and then see them immediately turn round and head north again. The Easiest way to avoid this regret – don’t sell! And so – we hang on to our losers!

Secondly – we seek those things that cause us to feel pride – such as winning trades. So when we see a small profit, we take the money and run. This action is a combination of pride and also fear – fear of price falling. We KNOW price goes up AND down, and yet, irrationally, we fear the latter. So – out we go. We promise ourselves we can always get back in later – and yet we don’t. We take solace in that old, dare I say, hackneyed cliché, “You can’t go broke taking a profit”. I won’t argue that one here, but WILL make the point that so doing, - can seriously impede your performance as a trader. The reason being – you will be reducing the average of your wins.

The trader wants smaller losses, and bigger wins – that is, to be on the right side of this equation. The trader also realises that they need help to get there. That’s where the trading plan comes in. You need to get around or overcome your emotions. And a robust, well-constructed Trading Plan lets you do that.

OK - in this session, we've talked about WHY you need a (sound) trading strategy. Over the next few Episodes, we'll be looking in more detail at the specific elements associated with a successful strategy.

As always, for those of you who wish to find information more quickly, don’t hesitate to visit our web site at hometrader.com.au, and book in to one of our free Information seminars.