6 
6 BECOMING A COMPETENT INVESTOR IS A TOUGH TASK. IN THIS CHAPTER, we will focus on some of the lessons that hold for any investor trying to achieve more than mere competence and actually “beat the market”—or in more technical terms, earn abnormal returns. Generating abnormal returns is, by definition, difficult, and it stands to reason that becoming an accomplished investor or trader is an even tougher task. (Throughout the chapter we will use the terms trader and investor interchangeably to represent attempts to generate abnormal returns, the only distinction being one of time frame.)
Active investing is the attempt, for lack of a better term, to beat the market. Active investing comes in many forms. At one extreme, it represents what professional traders, who rely on what they earn from the market for their livelihood, do on a daily basis. At the other end of the scale, it represents what individual investors are attempting when they buy a stock or two. Since there are few excuses left to hold a broadly diversified portfolio, deviations from these benchmarks necessarily represent a form of active management.
Barry Ritholtz took a look at the odds that an athlete, high school or college, is able to advance on to becoming a pro athlete. He found that only a very small fraction of these athletes go on to the highest levels. Ritholtz compares the odds of becoming a pro athlete with those of becoming a professional trader: “Are the odds identical? Not precisely—there are many more people scratching out a decent living as semi-pro traders than there are semi-pro ball players earning enough to feed their families. And if you find you have a specific talent for it, and are willing to put in the long hours of work required, trading can be incredibly rewarding.”1
It is easy to see why becoming a professional athlete or trader is so attractive and draws a steady stream of willing candidates. We just need to recognize that beating the market on whatever scale, professional trader or individual investor, is a tough task indeed.
Most traders fail. That should not be an altogether surprising statement. Most small businesses, most prominently restaurants, fail. A trader takes inputs like capital, labor, knowledge, and skill and tries to generate profits. Trading in that regard is just another form of small business.
Mike Bellafiore, author of a popular book on proprietary trading called One Good Trade, looked at this very topic of the failure rate of proprietary traders: “Numbers abound about what the failure rate is. Some say 95 percent. Others claim 80. We had a college student fly across the country to visit us who was writing his college thesis on this very subject. He came in at 90 percent. At a big bank the whisper number is 55 percent.”2 If you look across trading and investing disciplines, a 90% failure rate is a reasonable number to work with.
Bellafiore notes the many ways a trader can fail, including not having enough training, not putting in the effort, or simply not being good enough. In that respect, a trading business is like all others that fail. Businesses usually fail for any number of reasons, including bad luck. There are ways to try and mitigate the chances of failure and the costs that come with that failure, but these are not panaceas.
Managing the financial and psychological challenges of trading is hard enough. Traders don’t trade in a vacuum. In the end, they are trading against other traders, some of whom are quite literally rocket scientists. Increasingly these days, sophisticated computer programs are on the other side of a trade. The financial industry is filled with smart people, armed with sophisticated technologies, looking to do what every other active trader is attempting to do: beat the market.
So before putting hard-earned money into the market, aspiring traders need to think about whether they have what it takes to be successful. It is not enough to want to be a successful trader. Everybody who sets out wants to be a good trader. We cannot say in advance which 10% of traders are going to make it through the market gauntlet and find profits on the other side. We can say that the other 90% are going to experience some real costs in their attempt to become accomplished traders.
An issue largely overlooked in the trading literature is the concept of opportunity cost. The time and effort spent in trying to become an accomplished trader, by definition, come at the expense of other activities. The biggest cost to the 90% or so of traders who fail is not necessarily the financial costs, but rather the time lost to other opportunities. Money can be made in a number ways, trading only being one of them. However, time is not something any of us can get back. For this reason and this reason alone, aspiring traders need to recognize that the costs involved in failure are not always in dollars and cents.
Taken as a given that most traders fail, what constitutes success? The financial industry is awash with fund managers and newsletter providers quoting statistics that show them outperforming the market by wide margins. We know already that most professional investors underperform the market, so we should already be skeptical about these claims. The fact of the matter is that there is a speed limit on anyone’s ability to outperform the market consistently over time.
One example of this is portfolio manager Bill Miller. He became arguably the most celebrated mutual fund manager in America by guiding the Legg Mason Capital Management Value Trust to a 15-year streak of S&P outperformance. That is no mean feat. However, subsequent to this streak, Miller’s fund has underperformed the S&P 500 in 4 out of the past 5 calendar years (2006–2010).3 The point is not to denigrate his efforts, but rather to show that becoming good and staying good is a challenge for even the most celebrated investors.
Let’s look at this question another way. Warren Buffett is generally assumed to be the best investor of his or any subsequent generation. A look at his performance over a 46-year period at Berkshire Hathaway can serve as a practical limit on just how much an individual could expect to outperform the market. From 1965 to 2010, Buffett was able to compound the per-share book value of Berkshire at a 20.2% rate. This far exceeded the 9.4% for the S&P 500, and in 8 of the 46 periods, Berkshire underperformed the index.4 In so doing, Buffett has become one of the wealthiest men in the world.
It is likely not a coincidence that Buffett’s performance is in line with what could be described as the theoretical limits on performance. Wesley R. Gray performed a thought experiment that put to the test just how rapidly individuals could compound their returns using the history of the U.S. stock market since 1926. Gray found that “earning 20%+ returns over very long horizons is for all intent and purposes virtually impossible (assuming the market experience of the past ~90 years is representative of the future).”5 Gray’s numbers show that if an investor had more rapid performance, that person would eventually end up owning the entire stock market.
Gray acknowledges the case of Buffett as an outlier and as a practical example of the limits facing investors. That is not to say that someone like a Bill Miller could not go on for an extended period of time beating the market. But it seems that for most investors these periods of exceptional outperformance eventually end.
The point of this discussion is not to discourage investors from trying to beat the market. This discussion should serve as a warning that much of the talk you hear from investment managers and research providers should be taken with a grain of salt. Outperforming the market by large amounts over extended periods of time is virtually impossible. Still, these numbers are not likely to discourage the most intrepid investors from trying to beat the market. So a look at some lessons can help provide some further insight into what it takes to be a great investor.
Somewhere along the way, we all learn the harsh lesson that life isn’t fair. For some this lesson comes earlier than for others. If life isn’t fair, we shouldn’t expect trading to be fair either. Anyone who has traded for even a short period of time will be involved in a situation or two that highlights the fact that the financial markets are not fair, and never were fair.
We have already demonstrated the long odds against becoming an accomplished trader or investor. No investors, however, can become great, let alone good or mediocre, without fully taking responsibility for their own trading. Great investors recognize that once they make an investment decision, the results are largely out of their control. They can have a plan about when to sell, but the market will ultimately dictate how that investment works out over time. Great investors recognize that they are going to end up taking losses even if their original thesis was airtight. Losses are simply part of the game.
Less accomplished, or immature, investors take these losses personally. They act as if the market somehow knew they were holding a particular position. The market does not know what you hold in your portfolio and, more important, does not care. You are the only one who really cares about your investment results.
Taking losses is difficult. It means that we have to admit to ourselves that we were wrong about a trade. It is ultimately easier to try and find someone else to blame for your losses than to own them. There is never a shortage of culprits out there. Investors used to blame the shadowy “market makers” for their losses; today high-frequency trading is the latest in a long line of market villains. The best investors do more than simply “own” their losses; they look at their losses in a constructive fashion. Research shows that the only way to learn from losses is to acknowledge them and not simply ignore them or explain them away.6 Losses effectively become the tuition paid for a more complete market education.
Another thing individual investors also have a tendency to do is to rely on the crutch that if only they had the information or trading systems that the big institutional investors have, then they would be successful. The largest institutions pay large amounts of money to get news, data, and information as quickly as possible. Some firms are going so far as to move their servers as close as possible to the exchanges to minimize the time it takes for their trades to hit the market.7
There has always been an arms race to get an information edge on the rest of the market. In any race, there are going to be leaders and laggards. While the Internet has done a good job of leveling the playing field for individuals, there will always be haves and have-nots. Whining about what advantages the so-called big boys have is a waste of time. More so, it probably reflects the fact that you really are not ready to trade on your own. As Adam Warner writes, “There’s not an even playing field out there. Learn to live within it or don’t trade/invest, unfortunately it’s that simple.”8
Some strategies are better off left to the institutions. Short-term trading has largely become the province of the trading algorithms. The days of the SOES bandits are long gone.9 Other complex strategies as well are likely off-limits to individual investors. Strategies that involve trading bonds like distressed debt or capital structure arbitrage are the province of institutional investors. Strategies that involve shorting individual stocks are also tough for individuals because the big institutions get first crack at available inventory. There is no doubt that institutions have very real advantages when it comes to the mechanics of trading and investing.
On the other hand, individual investors have some real advantages over institutions. For example, most institutions need to be acutely aware of their portfolio benchmarks. That is why many institutions require their managers to remain “fully invested” at all times. As an individual trader your performance benchmark is what best suits your style and risk tolerance. The performance of the S&P 500, for example, should be but a data point to an individual trader. Individual traders can happily go into cash knowing that they are preserving capital, or keeping their powder dry, for better opportunities down the road. Charles Kirk suggests that this is really the only way traders should go on vacation—in cash and with no positions to monitor.10
In many ways, size can be a real disadvantage for institutional investors. Many institutions cannot buy meaningful positions in small-cap stocks because they would move the stock price disproportionately getting in and out of the stock. An individual can usually get in and out of most stocks within seconds with relatively little price impact. Other strategies like those that involve options are often off-limits for institutions. But individuals can undertake options strategies at their own discretion. Maybe most important, individuals don’t have clients breathing down their necks with unrealistic performance demands. As an individual investor, you are, for better or worse, your own client, and your only concern should be trying to attain your goals with the least amount of risk possible.
The bottom line is that in some very real ways individual investors have distinct advantages over institutional investors. If your strategy relies on perfect executions or institutional-grade information systems, then you are playing a game that you are likely to lose over time. Any advantage you think you have is likely unsustainable. Individuals, if they are going to actively invest, need to play an altogether different game than the institutions play.
As a society, we don’t let minors do a lot of things, including trading stocks, because we recognize they are not fully responsible for their actions.11 With the ability to trade on our own comes an equal amount of responsibility. Responsible traders recognize that they need to have an overall trading plan, not unlike a business plan, to guide their daily trading.
One of the problems novice traders have is that they don’t treat their trading with the same rigor and seriousness that they do any other sort of business endeavor. However, trading is just like any other business in that it has revenues, overhead, variable costs, etc. Trying to trade off the cuff without a plan or a means of measuring your performance is a recipe for disappointment.
Many traders balk at the idea of formulating a trading plan because they feel it might stifle their creativity or ability to react to rapidly changing market conditions. As well, in the wider world of startups, the detailed business plan seems to have gone into disfavor. In the world of trading, it never really seemed to catch fire. However, traders are well served to think about how they plan to go about generating profits. A trading plan that lays out what instruments they will trade, when they will trade them, and what methodology they will use to enter and exit trades is essential. Maybe even more important is a strategy to limit losses both on individual trades and in an overall portfolio. And as important as an overall trading plan might be, a trade-by-trade plan might be even more important.
Some traders find it useful to have a checklist they consult on an ongoing basis when they trade to ensure they are not missing anything along the way. As Atul Gawande, author of The Checklist Manifesto, writes: “In aviation, everyone wants to land safely. In the money business, everyone looks for an edge. If someone is doing well, people pounce like starved hyenas to find out how. Almost every idea for making even slightly more money—investing in internet companies, buying tranches of sliced-up mortgages—gets sucked up by the giant maw almost instantly. Every idea, that is, except one: checklists.”12 Checklists don’t dictate what a trader does; rather they ensure that what a trader is supposed to do in a trade gets done.
The hallmark of a well-designed trading system may be the actuality that a checklist can be created. The more experienced and successful the trader, the simpler his or her trading system becomes over time. Many traders begin their education reading books on trading and come away with a jumble of ideas and techniques. Some of those ideas will resonate with a novice trader, while others will not. The challenge is that until those ideas are put into action, new traders really can’t know what will work for them. Experienced traders have spent a lifetime whittling down ideas into a plan that works for them—and maybe nobody else.
As we have seen, the world of trading is an always unforgiving and sometimes paradoxical place. There are unfortunately few shortcuts to learning how to trade. The best way to learn is simply by doing. It is said that the worst thing that a new trader can experience is early success. This is because the important lessons of trading come from managing risk and minimizing losses, not from gaining profits. Trading losses represent the tuition the market is going to charge anyone trying to become a competent trader. Some novice traders think that engaging in paper trading is a way to avoid paying that market tuition.
Paper trading is an attempt to track what trades you would have made if you had the capital to trade. There are some real benefits to paper trading for beginning traders. These include being able to work through the mechanics of trading and the ability to try novel strategies absent financial risk. Another approach some traders use is to back-test their strategies. Back testing involves setting up a set of trading rules that one can use to look back at historical data to see how the rules would have performed over time. Both these approaches can accelerate one’s learning without putting money at risk.
Paper trading and back testing are all well and good, but eventually traders need to put their money at risk. Don’t be fooled into thinking that fantasy-trading contests like the CNBC Million Dollar Portfolio Challenge can simulate the real thing. The CNBC contest promises “No Risk. All Reward. Grand Prize $1 Million.”13 Unfortunately real live trading requires a completely different approach. The very best traders are laser-focused on risk and let the rewards take care of themselves.
There is simply no substitute for putting your own money on the line. Anyone who has had even the smallest bet down on a game, like the Super Bowl, recognizes the very different psychological and physiological effects the prospect of winning and losing can generate. For most traders, it isn’t the analytical side of trading that trips them up; it is the psychological side. Novice traders can read books and blogs all day long, but learning by doing, even with small amounts of capital, is the only way to become a better trader.
The evidence indicates that in a very real way more trading equals more learning. Seru, Shumway, and Stoffman show that traders learn two important lessons from their trading experience.14 The first lesson is that, for some traders, more trading leads to better results. The second lesson is that, for other traders, their trading skills are just not that good. It may make sense for people to trade even if they think they are not particularly skilled. Linnainmaa shows how traders “trade to learn” even if they are not confident about the outcomes.15 Traders can only demonstrate their skills through trading. As with other things in life, there appears to be no substitute for experience.
The challenges of trading are many; the rewards are limited to a skilled (and lucky) few. Most investors would be well served by acquiring the skills to become competent, or even just mediocre, investors. Other investors are going to feel compelled to try their hand at trading despite the odds being against them. For them, learning by doing will be the only way to truly figure out whether they are suited for trading. Unfortunately most of these aspiring traders will have exhausted their capital before they had a chance to evolve into successful traders.
The science of evolution is, at its core, pretty simple. Those individuals and species that are able to adapt, evolve, and pass on their DNA or genetic information to the next generation survive; those that don’t end up extinct. If they are lucky, like the dinosaurs, they become the object of fascination of preteen boys. Trading is in a certain respect like evolution. Those traders that are able to generate profits and minimize losses are able to survive and live to trade another day; those that don’t will end up leaving the playing field or becoming extinct.
This section isn’t about all the various strategies that investors and traders successfully use to beat the markets. It is beyond the scope of this book to properly introduce and explain these in any detail. What this section is about is losing. This is because to a large degree winning trades take care of themselves. What traders need to learn is how to lose effectively. In so doing, they can survive to trade another day.
A trader can’t live on winning trades if the gains on those trades are offset by larger losses on losing trades. In trading, there is a concept called expectancy. It measures a trader’s profitability by comparing the probability of a winning trade multiplied by the average win against the probability of a losing trade multiplied by the average loss. Expectancy therefore measures the expected profit from a typical trade. If positive, a trader should, on average, profit from trading and vice versa. Said more simply by Michael Martin, “Gains only look like gains only to the extent that you keep your losses small.”16
In this framework, the percentage of time you are right is only part of the overall profit equation. In practice, traders can be right less than 50% of the time and still be profitable if they manage their trades well. However, if trading expectancy is negative, then a trader is on the path to failure. Traders need to recognize that a large percentage, maybe even more than 50% of their trades, are going to fail. Traders can sometimes get hung up on the idea that they need to profit from most if not all of their trades. The fact of the matter is that being right is only one part of what it takes to succeed in trading. Novice traders and the industry that sells trading systems want to believe that their win percentage matters a great deal. All that really matters for traders is making profits and generating those profits with a reasonable amount of risk.
Behavioral finance has found that investors have a seemingly irrational desire to sell winners quickly and hold on to losing trades indefinitely. The disposition effect seems to affect novice traders in particular. The desire to be right, or in the case of losses “get even,” affects their better judgment. Research seems to indicate that changing our minds comes with a high psychological cost, even when the subsequent decision turns out to be correct.17 In our minds, we want to be right all the time, but trading is one discipline in which being right is both impossible and overrated. Traders need to ask themselves whether they want to be right or whether they want to make money.
A focus on being right demonstrates a fundamental misunderstanding of trading. Being right may be a necessary component of trader profitability, but it is not sufficient. Proper money management techniques are required to turn trading decisions into trading profits. While it is sometimes difficult to take, being wrong—and accepting it—is a big part of being a trader. Don’t let the need to be right prevent you from becoming a better trader.
The second great insight gained from using a framework built on expectancy is the importance for traders to cut short or minimize their loss per trade. Trading is in a certain respect less about being right or wrong and more about knowing when you are right or wrong and acting accordingly. It is far more important to take a loss on a losing trade and get to trade another day than it is to stubbornly try and turn a losing trade into a winning trade.
Tim Harford, in his book Adapt, talks about the importance of trial and error and explains how it is that great success often stems from failure.18 Organizations that set up their operations to take advantage of trial and error ensure that no single experiment will wipe them out. In a trading framework, each trade needs to be of a size that won’t torpedo your portfolio. On the face of it, this is a simple proposition for traders with a measure of discipline. Simply don’t risk too much on any single trade. It is a cliché to say that you need to cut your losses short and let your winners run, but it is absolutely true. The mathematics of expectancy requires that the losses on losing trades be on average smaller than the profits on winning trades. However, the problem often doesn’t lie in any single trade but rather in a series of trades.
The concept of drawdowns comes into play here. A drawdown is the percentage loss a security or portfolio experiences from peak to trough. Some traders devise rules based on portfolio drawdowns to prevent them from letting individual trades cascade into devastating results for an overall portfolio. Trades can often go wrong all at the same time because of a particular methodology a trader is using. So a focus on the overall portfolio is needed even if proper risk management techniques are used on each individual trade.
This stems from the mathematics of performance. If a portfolio declines 10%, it needs to return 11.1% to get back to the breakeven point. Similarly if a portfolio declines 50%, it needs to return 100% to get back to the breakeven. Large losses make it difficult for a trader to recover in any meaningful way. Some traders at this point simply quit. Others try to trade more vigorously to get out of the hole. On balance, this rarely works.
To minimize trading losses, traders need to have a system in place to recognize when a trade has gone bad. In the classic trading book Market Wizards by Jack D. Schwager, the idea of risk control is front and center. It was one of the common themes that great traders mentioned in their interviews. Schwager writes, “Rigid risk control is one of the key elements in the trading strategy of virtually all those interviewed.”19 Every trading plan should have risk control as an integral part of the trade management process. In fact, before any trade is entered, a trader should note what conditions will mark a trade as incorrect. Some traders use very simple rules to judge a bad trade, including rules such as any stock that declines 10% is a sell. Other traders use more sophisticated rules based on chart patterns, fundamental events, and even time. Despite the diversity in methods, the important point is that this recognition needs to be made before the trade is ever put on.
This is important because once a trade is under way, it changes the way you think about it. Once a trade is on, you are rooting for it to succeed. In a real sense, your ego is now wrapped up in its success. Losses, i.e., failure, now can affect how you react to the trade. Traders who confuse losses with being right or wrong are at risk of letting losing trades grow until they are of the size to ruin a portfolio. Some traders implement their plans for controlling risk with stop-loss orders. That is, stop losses are put in place when a trade is entered with a broker, and they become active if a stock reaches a certain price level (or loss). Stop-loss orders are more controversial than they seem on the face of things. Some traders swear by them; some are reluctant to leave their trade exits in the hands of the market. Both methods require discipline; the latter obviously requires even more discipline.
Nobody comes to the financial markets knowing how to trade. Novice traders can educate themselves in part on what they read in books and in blogs. Research and paper trading can be helpful as well. In the end, though, traders trade. There is no substitute for putting money on the line. It goes without saying that traders should only risk those funds that they can stand to lose. Some of the traders that went on to become legends often lost their entire initial stakes before going on to success. The lessons the market teaches us are going to be the most valuable lessons we learn. The best traders view their losses as tuition in the pursuit of a more thorough education in trading.
The fact is that every successful trader is a lifetime student for two very important reasons. The first is that markets change, especially in the area of technology. A trader from a couple of decades ago transported to today would be shocked at what even the most basic trading systems now have. Second, traders don’t stand still either. Traders, it is hoped, embrace a lifetime of learning. This changes how we approach the markets. As traders age, what they want and can obtain from the markets changes as well.
Evolution happens in the natural world on a scale we cannot see happen. In the financial markets, the process of evolution occurs on a much faster time scale. The only thing traders can do is to first survive and second adapt. Survival is the most basic requirement of traders and something we have emphasized throughout this book. Adaptation to changing markets is also a necessity, but traders should also recognize that what they want (and need) from the markets is changing all the time as well.
Most traders fail. The 90% of traders who fail will not only lose money but also experience the opportunity cost of time spent in the pursuit of trading success.
Outperforming the market by large amounts over large periods of time is difficult. Don’t get fooled by those who claim otherwise.
Trading isn’t fair. The best traders take full responsibility for their trades and treat their losses as tuition paid for a more complete market education.
Every trader needs a trading plan. A checklist helps traders stay on track.
Expectancy is an important framework for traders to understand. For traders, expectancy highlights the fact that being right is overrated and that there is a need to keep losses small.
Markets are always changing, just as are the individuals who trade them. To thrive, traders need first to survive so that they can adapt to shifting market conditions.