Imagine that you\u2019re on top of the world\u2026You have achieved brilliant career success on the trading floor of Chicago; you sit on the important governing body of your industry; you\u2019ve got a wonderful family; and plenty of toys to enjoy in your spare time.<\/p>\n
And then, in what seems like a blink of an eye, you lose it all. You lose one million dollars, your career and all of the trappings of success.<\/p>\n
Poof.<\/p>\n
All gone.<\/p>\n
How would you react if you were that guy?<\/p>\n
Well, there was such a guy. In his book \u201cWhat I Learned Losing A Million Dollars\u201d, Jim Paul shares his own personal story. He experienced all of the highs and lows. He was a remarkably successful lumber broker who had achieved it all. He had his own business, made lots of money, and even had a seat on the Governing Council of the Exchange. He lived the good life and had a wonderful family to boot.<\/p>\n
I only found out about the book from Amazon.com\u2019s recommendations system\u2014I had never heard it mentioned it before by anyone. Indeed, the book is a bit old so it may not seem particularly relevant. Don\u2019t let that deter you. The book is a treasure trove of insight!<\/p>\n
By talking through his market experiences and ups and downs, hopefully we can learn the same lessons. As he puts it in the book\u2014\u201cWhen I was a kid, my father told me there are two kinds of people in the world: smart people and wise people. Smart people learn from their mistakes and wise people learn from somebody else\u2019s mistakes\u201d. Let us endeavor to be wise in our trading and to learn from other people\u2019s mistakes.<\/p>\n
First of all, about his success. Paul readily admits that a couple of things drove him to the heights of success in the business. The first is luck\u2014he had a couple of \u201cright time, right place\u201d experiences that helped him on the way to achieving better things. The second is a keen understanding of what the \u201cgame\u201d is that he needs to play, and then figuring out a way to win at it. For instance, in school and in the military, he managed to perform well by figuring out the name of the game and doing it. Since childhood when he was making good money as a golf caddy, he has been motivated by the desire to make money \u2013 both for the sake of financial security and also to have nice things. Together, these two traits propelled him to rarified heights in the business world.<\/p>\n
Paul\u2019s spectacular blowup came because he put on a soybean spread trade, thinking that this would be the huge winner that made him, his friends and his clients millions. The funny thing is\u2014it started out as a winner. The initial position was successful and Paul, always searching for a big financial score, was practically counting his profits. However, the position quickly reversed and Paul was too stubborn about cutting it. After that point, he was unable to get out doing to the market being locked at limit, so he kept bleeding until he lost everything\u2014his business, his net worth, his exchange membership and his position on the Exchange Board. In summary, he took too much risk and lost all of his material wealth, to the point where he contemplated suicide for the insurance money.<\/p>\n
After his loss, he realizes that he never was a proper risk-taker, a real trader. He was trading the markets but without ever having learned how to take risk<\/b>. His position sizes were enormous and he wasn\u2019t fully aware of the risks that he was taking. As a result, he would get into positions that could have potentially disastrous outcomes. If you\u2019re taking huge risk and you don\u2019t know what you\u2019re doing, then you\u2019re almost guaranteed to blow yourself up.<\/b><\/p>\n
In the trade that wiped him out, he had risked almost everything on a huge amount of margin.<\/b> While it would have made him an immense amount of money if it had worked out, he also left himself wide open the possibility of blowing up. This is more akin to gambling than prudent risk-taking. Once he realized that he was basically gambling, then Paul could start to approach risk-taking properly and learn it from the ground up.<\/p>\n
Lesson 1<\/span><\/b>: Only take prudent amounts of risk and with the right preparation. \u201cSwinging for the fences\u201d is more likely to leave you six feet under<\/b>.<\/p>\n As part of his journey into learning more about trading and investing, he goes on an exploration of various famous traders and what they have to say. Their advice couldn\u2019t have been more different\u2014some, like Warren Buffett are proponents of buy and hold, while others are notorious traders; some are pure technicians while others have never looked at a chart in their lives. Some preach diversification, while others adhere to the doctrine \u201cPut all of your eggs in one basket and watch the basket\u201d. Paul is downright confused by all of the conflicting advices and methodologies.<\/p>\n The fact remains that there are a host of strategies and tactics to make money in the markets<\/b>. Many famous investors have styles that starkly differ from one another. There are computer scientists who build fabulous automated trading systems; there are deep value stock pickers who buy and hold; there are macro investors who invest in macroeconomic trends all across the world. They all have a style that suits their personality and unique strengths and they stick to it. There is no magic bullet for anyone learning this, as the trader will have to learn a style that fits their own individual personality.<\/p>\n More importantly, Paul then stumbles across a rule common to all great investors\u2014cutting losses. <\/b>This stands out precisely because everyone repeats and underlines it as the most important thing. As Warren Buffet famously put it in his two rules to investing, \u201c1. Never lose money. 2. Never Forget Rule Number #1\u201d. Thus, while they can\u2019t agree on much, all great investors can agree that it\u2019s important to limit losses and be disciplined in your risk management. This was Paul\u2019s breakthrough\u2014when he discovered that \u201cLearning how not to lose money<\/i> is more important than learning how to make money<\/i>\u201d. This hits the nail on the head!<\/b><\/p>\n In our journey to make money in the markets, we want to stay in the game. We can only do that if we keep our losses small and if we never blow up. This approach is the way to long-term success. If we can just think in these terms on every trade– about watching our back as opposed to dreaming of the Rolls Royce with the profits from our trade\u2014then we\u2019ll avoid taking the kind of reckless and excessive risk that can lead to career-ending losses, like the one that Paul suffered. You need to take risk to make money in the markets\u2014but you definitely don\u2019t need to take *excessive* amounts of risk<\/b>.<\/p>\n Taking risk means putting on a position only when the risk-to-reward ratio is skewed heavily in your favor. And if you do lose money on the trade, then you want that loss to be completely manageable so that it doesn\u2019t disrupt your trading plans. And under no circumstances do you want to take so much risk that you can lose everything\u2014no matter how good mouth-watering the trade seems. In markets, a good defense is essential. <\/b><\/p>\n Moreover, if we can be sure that we\u2019ll stay in the game, then that gives us time and scope to find a methodology that works and enables us to make money consistently<\/b>. When starting out, we can usually go and \u201cborrow\u201d a methodology or approach that may suit our personality. For instance, a successful athlete might like intraday trading stock index futures as it plays to his strengths, whereas an economist would feel more comfortable making long-term, research-driven bets on interest rates and currencies. That\u2019s how to start out and with time and continued deliberate practice, they can refine their approach and work on other aspects of their trading. Without proper loss-cutting, they could easily be out of the game.<\/p>\n I completely agree with this. In my experience, I have seen many traders \u201cshoot the lights out\u201d, i.e. have one or two big years and then fade away or blow up quickly. But I have never seen anyone who has stuck around for the long haul without proper risk controls. As the saying goes, \u201cThere are old traders and bold traders, but never old, bold traders\u201d. <\/b><\/p>\n The lesson that I have learned is something that would have seemed completely counter intuitive to me when I first started out\u2014that the way to make big money in the markets is to take a controlled amounts of smart risk and to be fanatical about cutting losses. There is no place for \u201cswinging for the fences\u201d or trying to double your money in a short period of time. As Jim Paul, myself, and numerous other traders have discovered, losing real money is a painful and humbling experience. I hope you become wise from our losing money and the lessons that we have to share<\/a>.<\/p>\n Lesson 2<\/span>: Learn how not to lose, as it\u2019s the path to winning.<\/b><\/p>\n It\u2019s one thing to know that we need to control our losses. It\u2019s another thing to actually do it. Paul writes about the various psychological forces and biases that can interfere with or sabotage our decision-making, hurting our ability to make detached decisions<\/b>.<\/p>\n As Paul correctly observes, this is unavoidable. As human beings, we are emotional beings and thus we will always be subject to some kind of emotional influences on our decisions. These can stem from childhood programming, from our own ego, or a million other places. The key question is how to make good trading decisions that aren\u2019t overly influenced by our own ego.<\/p>\n For students of decision-making, this is not new. Many popular works and authors, such as Daniel Kakhneman<\/a> and Richard Thaler, emphasize precisely this fact, as it can be so interesting to explore! Of course we have emotions and other biases that emphasize our decision-making, but what we can learn from them? What can we do differently so as to minimize their negative role and benefit from any positive forces?<\/p>\n In this respect, I have to admit Paul\u2019s book falls down a bit<\/b>. When exploring some of the major psychological issues, they undertake only a cursory explanation of what they are and how they can influence a trader\u2019s decisions. For instance, the desire to be right and not to be wrong are powerful influences on traders, especially ones who are beginning\u2014this usually causes them to sit in a losing trade, rather than closing it and admitting that they are wrong. \u00a0They would prefer to protect their ego rather than their P&L. Another one is \u201cplaying with the house\u2019s money\u201d\u2014when you have a profit, whether realized or unrealized, you feel entitled to take more risk because you have yet to internalize that it\u2019s your money. While the author touches on these points, I feel that he could have undertaken a more thorough exploration of them.<\/p>\n As traders, we have to realize that we have emotions and that they can influence our decision-making<\/b>. There are two schools of thought on how to deal with this: 1. Change ourselves into robots who don\u2019t have emotions 2. Change our decision-making process to make it as robust as possible, thereby side-stepping a lot of the potentially deleterious impact. Often, we choose number two, simply because it\u2019s much easier for most personality types. Some of the most common ways to do that: setting automatic stop losses; using some kind of checklist to evaluate investments, so that we can\u2019t get seduced by bad ideas; reviewing our work to see if we have gone off-track.<\/p>\n In that respect, the author\u2019s advice on how to sidestep emotions is super solid<\/b>. First, select a type of market analysis that works for you\u2014for instance, being a fundamental investor, a technical analysis-based trader, etc. Next, set rules to describe what an opportunity looks like. As he puts it, \u201cYour homework determines what parameters or conditions define an opportunity and your rules are the \u2018if\u2026then\u2019 statements that implement your analysis. This means entry and exit points are derived after you have done your analysis\u201d. Then you put controls onto you trades and portfolio. This is setting stop losses and also the criteria for when you will exit a position at a profit. By setting these in advance, you take away the possibility of making a difficult, emotional decision at some point in the future. Instead, you make the difficult decision when it\u2019s easy.<\/b><\/p>\n While the advice is rather spare, it contains many pearls of wisdom. By setting out in advance clear rules and processes for making decisions, you can avoid the possibility of panic or ego influencing your investment decisions at the exact moment when you don\u2019t want them to. You can make your trading decisions when you are at your detached best, rather than gripped by fear, greed or hope.<\/p>\n Lesson 3<\/span>: Set up ways to make detached trading decisions, so as to minimize the influence of emotions\u00a0 \u00a0\u00a0<\/b><\/p>\n