Trading from the trenches
Friday, 11 October 2019
By Ryan Dinse
- Life is uncertain. Deal with it…
- Running your trading ‘shop’
- Look out for this…
Ryan Dinse here, covering for your usual editor Bernd.
Today, I’m going to explain why you make the investment decisions you do.
The real answer might surprise you…
But, as I’ve found in my trading career, understanding it is the key to making money consistently.
It’s that important…
For a long time it was something no one really understood. Well, at least no one in the hallowed halls of academia.
The boffins at prestigious places like the Chicago School of Economics — home to notable luminaries like Milton Friedman, Eugene Fama and Friedrich Hayek — were still labouring under the assumption that people were rational.
But marketers and advertisers already knew differently. They understood that people’s actions weren’t always rational.
After all, why do so many people still smoke around the world when it’s proven to cause cancer?
It wasn’t until the 1970s, when two little-known Israeli psychologists got together, that the academic world finally caught up to what the Mad Men in advertising had already grasped.
The unconventional duo began to unravel why we really make the decisions we do. Investing or otherwise.
Understand this and you’ll be halfway to understanding why you make (and lose) money in the markets.
Let me explain more after the markets…
Overnight, the Dow Jones Industrial Average closed up 150.66 points, or 0.57%.
The S&P 500 closed up 18.73 points, or 0.64%.
In Europe the Euro Stoxx 50 index closed up 31.85 points, or 0.92%. Meanwhile, the FTSE 100 gained 0.28% and Germany’s DAX closed up 69.94 points, or 0.58%.
In Asian markets Japan’s Nikkei 225 is up 209.27 points, or 0.97%. China’s CSI 300 is up 0.096%.
In Australia, the S&P/ASX 200 is up 48.10 points, or 0.73%.
West Texas Intermediate crude oil is US$53.76 per barrel. Brent crude is US$59.32 per barrel.
Turning to gold, the yellow metal is trading for US$1,498.25 (AU$2,210.46) per troy ounce. Silver is US$17.62 (AU$26.00) per troy ounce.
One bitcoin is worth US$8,566.35
The Aussie dollar is worth 67.78 US cents.
Life is uncertain. Deal with it…
‘In tank warfare, the speed at which one can decide on a target and act on that decision makes the difference between life and death.’
Daniel Kahneman had been in the Israeli Defence Force and knew a thing or two about risk.
As a child, he’d survived Nazi-occupied France with his family, at one point hiding in a chicken coop as Nazi troops scoured the land.
In 1968, Kahneman met fellow psychologist and economist Amos Tversky at the Hebrew University in Jerusalem. It was to mark the start of a fiery relationship between the two thinkers, who were in many ways opposites.
But this relationship led to a few key insights that changed the understanding how humans think.
Especially when it comes to managing risk and uncertainty.
You can probably see where this is going…
Because dealing with risk and uncertainty is an investor’s lot in life. It’s what you have to deal with every single day.
And it’s why Kahneman and Tversky’s findings turned out to be so important for stock traders.
One of the key insights for traders was that loss aversion was a bigger driving force than profits for most.
The simple example they gave from their findings was that most people preferred to take $50 with certainty than taking a 50/50 bet on making $100 or $0.
However, interestingly, the same people, when confronted with a 100% chance of losing $50 or a 50/50 chance of losing $0 or $100, most preferred the second option.
According to Kahneman and Tversky, losses and gains are valued differently. Users make decisions based on perceived gains instead of perceived losses.
This was a key insight.
Because when aiming to avoid losses, we become risk seeking and take the gamble over a sure loss, in the hope of losing nothing.
Running your trading ‘shop’
Now, for traders, losses are a part of everyday life.
I liken the business of being a stock trader to being a shopkeeper in some ways.
If you open a shop, you’ve a lease to pay and bills to cover. These are the costs of being in business and can’t be avoided. The key is to make sure whatever you’re selling is worth the expense.
Similarly, in trading, making losses is inevitable. They’re the cost of being in business — the trading business — and you can’t avoid them.
Though, it’s the trap most people fall into. They try to avoid losses as much as possible and therefore make bad decisions, unable to accept the necessity of the cost.
The key, like with any business, is to make sure the profit equation adds up. That is, your income is more than your expenses.
The difference is that the only customer you’ve got to look after in trading is yourself.
To manage your own psychology, deal with your weaknesses and have the strength to follow a system no matter what your base emotions might be saying.
For years, this was the battle I had with trading small-cap stocks.
And it’s how I developed a system which looked to lock in three possible results.
- Small losses
- Small gains
- Big gains
The one outcome I needed to avoid was big losses.
Kahneman and Tversky would have understood the merits of this system.
It protected my psychology from the worst ravages of uncertainty. And while the small gains and small losses would even out and ‘pay the bills’, the big gains were the money makers that made my trading business profitable.
This is the key elements to any trading system. It’s not all about the profit making equation. It’s also managing your own psychology, too.
For example, the famous trader Nassim Taleb had a trading system where he would buy low priced ‘out of the money’ options.
These were bets on very unlikely events.
For years he’d make losses as his colleagues — those taking the other side of the trade — would make money off him every week and laugh at him.
Then one day in 1987, when the market crashed 22.61%, he made enough money to retire altogether!
Those unlikely events he was betting on weren’t as unlikely as the market thought.
My point is, this is a great system. But it’s not one I — nor many people — would have the head to trade. You’d need the confidence (some might say arrogance) of a person like Taleb to trade this type of system.
Even though it turned out to be super profitable!
Look out for this…
Next week, I’m going to share with you more on my system of trading small-cap stocks.
It’s a system which I think can let you invest in this exciting, yet risky side of the market a lot more comfortably than how you might already be investing here.
And importantly, it can also be super profitable, too. Some of my open trades right now are up 52%, 92% and one a whopping 420%, all in just a few months.
If you’ve ever thought about setting up your own ‘trading shop’, then I want to help you get started.
That’s why I’ll be sending out three videos you can access for FREE starting on Monday. Look out for those in your inbox.
Editor, Billion Dollar Breakout Trader