Continuing the series on Seven Lessons I’ve Learned, we will explore Lesson 3: A process and methodology of your own are what make you a long-term winner. As we have seen in the past two lessons, trading well is mostly a product of making good risk/reward decisions in the face of stress. The markets can do what they’re going to do but you stay calm and focused on making the right decision. The key question is: how do we do that? How do we go about making the best decisions possible?

One of the most basic challenges that we face is the structure of our brain. According to mainstream neuroscience, our brain is made up of three parts: the reptilian, limbic and the neocortex. The first is an evolutionary holdover, controlling our automatic body functions and basic instincts, such as the famous “fight or flight” reaction. It is almost completely beyond our conscious control. The limbic brain is our basic interface with the experiential world, responsible for sensing, feelings and emotions. The neocortex is responsible for abstract and rational thought. The neocortex is extraordinary—it is really what separates us from animals. Possessing the pattern recognition abilities and processing power of all but the most powerful supercomputers, it processes language and abstract thought. While the multi-part structure is a marvel, as traders and investors we could do without the emotions and randomness of the other parts of our brain. We would prefer to be making decisions with our neocortex—the logical, rational part of our brains– because the other parts of our brain can lead us astray

We want to find a way of doing things that aids us in avoiding our own cognitive pitfalls: biases, heuristics, inconsistency. As I documented in the post on Lesson 1, brain researchers have shown that we act subconsciously according to all kinds of quirks without even realizing it. We want to take whatever measures we can to avoid these traps. Similarly, we want to avoid information overload by setting up filters so that we get only the information we need to make good decisions. The way to do that is to insist on a methodology.

The first is to make sure that you have an idea of how it is that you make decisions—and that you can describe what you do and how you do it.  Write down for yourself a few lines about your overall approach. It should cover the markets that you look at, your overall strategy or approach, and then a few words about your typical entries and exists from positions. This is just to organize your thinking. It would look as follows:

“I am an intraday trader on the US stock market. I am looking for stocks that are in play and will be volatile, because of news or earnings. I try to buy strength and sell weakness, and make numerous small trades to test the waters before I put on a larger position”.

OR

“I am a global macro investor who invests in multi-month trends. I do a deep dive macroeconomic analysis of what’s happening all over the world and forms medium-term views. Then I scan global markets for where there are significant mispricings relative to my outlook and put on positions. I close the positions when the mispricings disappear or when my initial view is proven wrong.”

These are quick and simple write-ups but they go a long way to crystallizing your thought process. Basically, your little write-up should describe your strategy—and provide a reference point for every trade that you do. If you describe yourself as a medium term global macro investor, then you’ll know that you’re off track if you find yourself putting on a futures trade and saying “I’ll just hold this for a couple days and see what happens”. You should know better than that. Actually, with time you should develop an active aversion to any position that’s not in keeping with your stated methodology.

That’s the goal. How do you make sure that you stay on track with this? The first is to get the inputs right for your decision-making. One of the biggest environmental hazards we face is information overload, as we are literally deluged information with all the time. In the Information Age, we need to filter information. To make sure we can execute our methodology to the best of our abilities, we should monitor only information that’s relevant for our methodology—and actively ignore everything else! If we pay too much attention to the wrong things, then it can start to tempt us into making dumb decisions based on factors that are not relevant. For instance, if you are a long-term value investor and hear a famous fund manager on CNBC who is short a stock, then that could color your impression of the stock. But rather than acting on his idea, you would prefer to do your own work. You would base it on your criteria for what constitutes long-term value, free of any outside influence. Turn the TV off. Stay focused on what matters and only on what matters.

Next, we have to understand more about how our brains make decisions. Our brain has limited resources that it can devote to hard thinking. Our rational, decision-making brain can tire from making too many decisions. In his landmark book Willpower, Roy Baumeister describes how we have limited willpower during the day and we can wear it out by making decisions of great complexity or just too many decisions. The result is “ego depletion”—when the cognitive parts of our brain just run out of gas. You’ll recognize this phenomenon if you’ve ever studied too much all at once or had a killer day at work and your brain just feels fried. The key takeaway is that we are “cognitive misers”—we need to hoard our valuable decision-making resources and use them wisely, otherwise we could use them up. In a trading context, that means reducing the number of decisions that we take, or reducing their complexity, or both. That way, we can get more mileage out of our limited cognition- and make better trading decisions more consistently.

One of the ways to do this is to distill your methodology down to a checklist—a series of yes/no questions. Dr. Atul Gawande’s seminal work, The Checklist Manifesto, is a brilliant overview of how checklists help us make better decisions in a variety of fields. His embrace of checklists grew out of medical research on how to prevent line infections, which are low-level infections that can occur when IV lines are inserted during surgery. The simple and elegant solution was to introduce a pre-operation checklist that reminded doctors of the various safeguards and steps that they needed to take before moving on to the actual operation. While it seems pretty straightforward, it actually proved to be hugely effective, reducing the incidence of line infections to zero in some cases.

Obviously, doctors are very smart and capable people, so why did a simple checklist make such a dramatic difference? Why do fields as disparate as aviation and construction make extensive use of checklists? And what can we learn from it?

Let’s take a look at what an investment checklist would look like. Here, I am referring to some of the lessons in my post “Does Your Hedge Fund Have An Investment Process?”. William J. O’Neill’s book How to Make Money in Stocks is a great presentation of an investment process, where he goes through the seven steps of his CANSLIM process. The letters stand for:

C—Current quarterly earnings. Companies should have high growth in earnings per share this quarter.

A—Annual earnings. Earnings growth should be similarly strong, at least 25% per year.

N—New Products or Services, New Management, New Highs. You want a company that develops new products and services; its stock price should be hitting new highs.

S—Supply and Demand. A product or service that is in demand by the public, which will drive earnings growth.

L—Leadership. The stock should be the leader in its industry group in terms of earnings and stock price performance.

I—Institutional Support. There should be large institutional buyers which are supporting the stock.

M—Market direction. Only buy winning stocks in an uptrending market.

 

With this list in mind, you could take any old stock and just run it through each individual step to see if it qualified for investment. Alternatively, you could run quantitative screens on the entire market to find stocks that meet the criteria listed, such as 25% earnings growth or stocks hitting new 52 week highs. It could be difficult to know what to do with a random stock that you read about in the newspaper, but a checklist like this gives you exactly what you need: an approach. You can filter out stuff that doesn’t matter. For instance, this strategy is not particularly fussed with a company’s balance sheet, so you can safely skip over it. By contrast, a long-term value investor would be particularly sensitive to the balance sheet. You can concentrate on what does matter, step by step. And using this approach, you also know when to get out of a position—when it stops meeting any of the criteria listed or when it hits your pre-defined stop loss. By linking entry and exit criteria, you stay consistent and disciplined in your approach to the markets.

Nevertheless, a checklist can seem like an overly simplistic approach. Yes, airline pilots and construction specialists use it, but why would investment professionals need one? I can identify three reasons:

1. It reduces complex tasks into a series of yes/no decisions

There is a lot of wisdom in the old proverb, “What’s the best way to eat an elephant? One bite at a time”. Similarly, the best way to approach making a trading decision is to go step by step. The genius of a checklist is that you write down a series of steps that you will consider in potentially making a trade, starting from the most basic of steps. You go down the list and see if it matches your criteria or not. Step 1—yes or no? Step 2 – yes or no? And so on and so forth.

The beauty of this is that you are preserving a lot of precious cognitive resources. A series of simple, straightforward decisions is simple to go through and doesn’t tax you at all. You’re not reinventing the wheel or solving complex differential equations—you’re making a series of simple determinations. The end result of a bunch of simple decisions will be a complex one, but without draining too much of your cognitive resources. You will find investing less taxing while at the same time being able to do more.

 

2. It serves as a useful reminder and game plan, so that we consider all the angles that we need to

You want to be consistent in your approach—always considering the same factors and arriving at decisions in a similar way. Just like a surgeon who always prepares for operations the same way, you want to run through the same routine before you get into or out of a position. A checklist helps you to remember, just in case you leave something out. After all, the markets can get quite stressful or you can have a lot of going on, but seeing every item on your checklist will make sure that you pay it some attention. It prevents you from overlooking things and makes sure that you consider the right points and in the correct order.

In fact, the order is just as important as the items on the list. In medicine, you would want to swab the skin before an injection, and not the other way around—otherwise the swabbing is useless. Similarly, you want to go from most important to least important in your game plan, to make sure that you are going in the right order. If you are a top-down investor, you look at general market conditions before digging down into individual securities. In that case, the first items on your checklist would be seeing if economic conditions are favorable and expansionary; if central bank policy is supportive; and only then would you decide which sector to invest in to take advantage of that. To be a top-down investor, you have to proceed in that order. If you started looking at sectors first, then you would be doing things the wrong way around and your returns would end up suffering. You would also be departing from your strengths, which are supposed to be more about top-down.

 

3. By nearly automating routine decisions, it lets our decision making prowess and specialization shine forth

One misconception is that a checklist will straitjacket us into a narrow, formulaic execution of a methodology. This could not be further from the truth. Rather, the checklist is designed to compensate for the fact that we are cognitive misers. It’s designed to provide an easy backstop in case we skip over something. It gives us a series of relatively simple decisions, so that we don’t tax our limited resources. It’s designed to make us think in the right order using the correct steps, so that we follow through on our game plan. And because we have plenty of cognitive reserves left, then we will have a greater ability to tackle genuine judgment calls and the really difficult dilemmas.

For instance, if you invest in growth stocks, then you could be looking for stocks that meet several criteria: new products, high-growth sectors, and producing annual revenue and earnings growth of 20%. At first glance, these are all relatively straightforward. Each step exists on its own as part of a straightforward path. But you can stop and do a deeper dive along the way if you need to. As an example, reported earnings growth could be 20%– but you investigate and find that it’s all from coming from one-off charges, then you realize that the stock is one you should pass on investing in.

A checklist works because of how it is set up: a series of little decisions that help us to realize an overall goal. By putting the basic decisions on rails, it gives us the mental bandwidth to tackle the things that matter. We don’t have to reinvent the wheel every time we look at a potential trade, nor do we have to worry about forgetting things or doing them in an inappropriate order. But we will be able to dive deeper where it counts

Moreover, a checklist functions as a guide to our own best practice: how we choose to do things in the best possible case. This allows us to integrate things that we learn over time, or even to learn from the mistakes that others have made. Monhnish Pabrai, a prominent advocate and user of investment checklists, has several dozen items on his list, including many that he borrowed from seeing the mistakes that others made in their own investments. As a result, he reported that his win rate went up after he began using checklists.

Just as important as having a methodology and checklist is having one that you can call your own. Jack Schwager summarized his research that started with the book Market Wizards by saying, “Each trader had found a methodology that worked for him and remained true to that approach. It is significant that discipline was the word most frequently mentioned”.  I think that the key in this statement is “worked for him”, because a methodology not only has to be profitable overall, it has to fit your personality and strengths. Otherwise, you will find it difficult to stick to and as a result produce subpar returns. Sticking to a process and staying disciplined are difficult enough as it—you want it to be something that you are interested in doing!

What do I mean by playing to your strengths? Ideally, it would draw on your existing talents or experiences in some way. If you are a trained accountant, then you know how to look at and analyze a company’s financials—so you should utilize that skill to invest in the securities of companies. If you are an economist, then you should design a strategy that draws upon your expertise—most likely, it will be research-based and targeting longer time frames. If you are a winning poker player, then you are used to making risk/reward calculations at light speed—you should use that skill and look to trade on shorter timeframes.

A lot of problems for beginners occur because they try to use a system that is not well-suited for them. For instance, I started out trading foreign exchange and interest rate products. Despite being surrounded by great colleagues and tremendous resources, I was a failure—an experience that I wrote about in the post “What I Learned From the Best Trader At Citibank”. However, I switched to be an equities investor, which suited my personality much better. Equities demanded more whole-brain thinking and the returns were more open-ended, meaning that winners would be much bigger. Moreover, in emerging markets I could draw on my interests in politics, history, and languages, which I wasn’t using before. I ended up thriving in the new markets and with a different strategy.

The trading and investing strategies of these three people will end up looking quite different, as if they have nothing in common. On the surface, they don’t. But all traders and investors have certain things in common. One of those we have already seen—they have a well-defined process that they can stick to.  But what are the others? What are the commonalities that unite them?

Over the years, I’ve compiled a list of these, which I call the Basic Truths of Trading. These are some characteristics that are shared by every successful trader and methodology, whether they’re investors or traders. Some of these are obvious, like the importance of cutting losses and letting winners ride.  Other are less obvious, like the necessity of a position sizing framework.

Here’s the overall list. I go into each point in more detail in my book, but for now I’ve included several thoughts to mull over.

1. Well-defined objectives. Are you trying to beat a certain return hurdle, like inflation or an index? Are you trying to generate 5% or 50% returns per year? Or are you just trying to have a comfortable retirement? You need a solid understanding of your objectives in order to craft the right methodology and approach.
2. An understanding of the markets that you will be operating in. Stick to what you know. Narrow your focus so as to make the most of your efforts. If you’re just starting out, then choose one—and only one—market in which to specialize. Learn as much as you can until you become an expert.
3. A clearly defined methodology for getting into and out of positions. This includes which indicators, news items, fundamental data points you look at and when you take action. Put it in a convenient checklist format that breaks it down into numerous steps you or anyone else could follow.
4. This methodology must utilize your strengths and skills and suit your personality. A cerebral, research-driven economist should not become an intraday scalper. An adrenaline-fueled athlete should not be a long-term trend follower. Do what you’re good at!

 

5. This methodology has a positive statistical expectancy— the gains from winners more than outweigh the losses on losing trades. Use your own statistics and the formula for statistical expectancy as a rough guide as to whether or not you have positive statistical expectancy. We discussed some of this in a previous lesson dealing with “Trading Is Decision Making”.
6. A well-stated risk management policy for when you get out of losing positions and how you manage risk overall. If you don’t stop losers, then they will grow out of control and wreck your performance. Risk management means cutting losers and also being vigilant to make sure that you’re not taking too much risk in the first place.
7. A framework for sizing positions. This is related to risk management—obviously, you don’t want to take a position that’s over a certain size, ever. But you may also want to size positions according to certain specific criteria, such as your conviction in the position or volatility in the market. Or they could all be the same size. Nonetheless, your methodology has to be able to address it and come up with a well-reasoned answer.

 

This list of Basic Truths should give you a way of critiquing your own methodology, to make sure that you’re getting the most out of your system. If you are trying to ignore or to fight these truths, then you are doing yourself a great disservice. Try to make your methodology fit with these, and you will have the basic building blocks in place for success.

 

No relevant positions

 

By Bruce Bower | E-mail: Bruce [at] howoftrading.com

Blog: www.howoftrading.com | Twitter: @HowOfTrading