What Does A Winning Methodology Look Like?

sspencerBruce Bower, Trader Development, Trading Lesson, Trading Theory1 Comment

**This is the first in a series of posts from Bruce Bower related to “Peak Performance” the topic of his new book that SMB U will be releasing April 20th**

**SMB will be hosting a free webinar on April 13th in which Bruce will discuss in depth the concept of “Peak Performance” and how it can be applied by all successful traders and investors. **

By Bruce Bower

I would guess that everyone who gets into the markets seriously wants to be a success. And not just a success on the first trade, but to become a true success. The next Warren Buffett. The next George Soros. The next Bill Gross.

What do all of them have in common? They are prime examples of sustained success over many decades. They have been made gobs of money for their investors and themselves. And they are all known for possessing their own unique winning methodology.

In order to be successful in investing or trading, we need a process. A methodology. Whatever you call it, you need some way to order your thoughts and actions, and to keep you on track. As I emphasized in one of my first blog posts, good trading is about making good risk/reward decisions. As Bella puts it, our job is to make One Good Trade followed by another. If you have established in advance your criteria for good decisions then you have a benchmark that you can compare against. A methodology is your game plan, your own rules for yourself.

Moreover, your process needs to be your own. As Jack Schwager put it in Hedge Fund Market Wizards, “traders must find a methodology that fits their own beliefs and talents”. It will have to utilize your strengths and avoid your weaknesses. If you are a trained accountant and digging into company balance sheets for fun, then you would be an excellent investor in corporate bonds or stocks. If you find research boring, then you should stick to something else. If you are a successful athlete and able to think quickly on your feet, then intraday trading may suit you well. Warren Buffet and Peter Lynch are skilled company analysts and they chose to invest in individual companies; George Soros and Bill Gross are skilled macroeconomic analysts and invest accordingly. To each, their own.

We know that you need a methodology and that it should be your own. Each methodology should be our own and customized to suit our very own personalities. What interests us is not just what a methodology looks like but a winning one. One component is how a methodology is structured or conceptualized. Another element is what rules or principles you are following. Some things just simply work regardless of the methodology. There are several good rules that apply to anyone. One would be, “Cut losers and let winners ride”. Another would be “Never put yourself in a position where you can blow up”, i.e. where you could suffer a permanent loss of capital.

In terms of how a methodology should work, we have to remember a core fact about our being human: our brains are complicated. We have amazing cognitive and reasoning capabilities, but we also have instinctual and emotional parts to our brain. We wish that we could make decisions and take action based purely on reason and logic, but that is not the case. Rather, our decisions are the result of a veritable soup of reason, emotions, and other factors that we don’t even yet understand. The effect is that we make sub-optimal decisions riddled with biases and other cognitive pitfalls. As Daniel Kahneman documented in his book Thinking Fast and Slow, there are numerous mistakes to watch out for — and even a Nobel Prize winner who has studied this for 40 years is still susceptible.

In this respect, we can learn from other fields where people have to make split-second decisions in spite of pressure or outside influence. In his book The Checklist Manifesto, Dr. Atul Gawande talk about a program designed to reduce the instance of line infections in patients. These infections are minor and almost entirely preventable, but in the context of surgery or intensive care, they can dramatically raise patient mortality. The remarkably effective solution was a simple checklist which would be run through before a surgery.

A checklist is a wonderful idea because it takes a complex decision or action and boils it down to a simple series of essential steps. These are not necessarily the only steps—but they are the critical ones. Just like with airline pilots doing a pre-flight checklist, you cover all of the important things. You don’t have to struggle to remember what the right steps are or the correct order. Instead, you just go and get the results you want.

This should be an inspiration for traders and investors everywhere. First of all, by defining our methodology like a checklist, we are able to lay out the most important steps in a process. We know, for our own sake, what actions, judgments and decisions we have to make. Like a team with a plan for the big game, we know what the plan is and can return it all the time. We can also avoid the basic errors that come when we skip over steps or forget things. We can reach well under stress.

Moreover, if our investment process is not defined as a checklist, then we open ourselves up to all kinds of risks. As we have seen, our brains are subject to various irrational cognitive shortcuts and biases, all of which can derail us from making the best decision with our trading and investing. If we have a plan formulated as a logical series of decisions and actions, then this very discipline should regulate our decision-making, avoiding any room for diversions into cognitive traps.

In my book, I dive deeper into checklists. I talk more about where they come from and how to structure an investment or trading checklist. If we can use a checklist to make slightly better and most consistent decisions, then the cumulative effects can be impressive.

*No relevant positions

One Comment on “What Does A Winning Methodology Look Like?”

  1. Great article..some very valid points. I would add the following
    I think it is important to remember that trading can be stressful activity that generates a wide range of emotional responses. When we are subject to these responses our decision making is often impacted in a detrimental manner. This is supported by a range of research where our ability to perform complex tasks can be severely compromised in high stress scenarios. In many respects our ability to perform under these conditions can be improved through a process of progressive desensitization and gradual exposure to this stress(e.g. role playing worst case scenarios through paper trading). What is also important however is to acknowledge that the process of trading should be as simple as possible, and as systematic as possible in order to effectively implemented under stressful conditions. I personally have no idea how people trade in a discretionary manner as this opens you up to far greater opportunity to make the wrong decision. I would also imagine that this would expose you to even greater doubt and therefore even greater amounts of anxiety? Once again two psychological states that are not generally consistent with enjoyment or profitable outcomes. The other important aspect is evaluation of your performance. How do you quantify and measure something that is discretionary? How do you possibly identify trading errors when the decision making is essentially random?

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