There are a couple of things you need to succeed in the stock market: Acquiring skill i.e. learning a strategy, gaining experience in applying the strategy, and training your mindset/psychology to follow through consistently.
The latter part of the mindset – the psychology, the emotional discipline, the correct attitude & expectations – is the foundation that your palace of success will be built on, and a weak foundation will sooner or later lead to the palace collapsing. A speculator without the correct trading psychology, no matter how good his technical skill, will always perform far below his potential, and most blow up sooner or later.
Most people have something aking to a strategy, but almost no one follows through with it when push comes to shove. This follow-through, sticking with your rules when the rubber hits the road, is true mastery, and the true challenge of the market.
Everything hinges on psychology
Alex Honnold is a free-solo climber – mounting large walls and natural monuments without safety ropes. He once stated “There is no adrenaline rush. If I get an adrenaline rush, it means that something has gone horribly wrong.” Although free-solo’ing up a rock wall hundreds of meters is akin to driving Formula One cars without a safety belt or buying stocks without a stop-loss, the basic wisdom of that statement as well applies to speculation.
Calmness, focused application of principles and rules, calculated and pre-meditated action, patience & deliberate inactivity, deep-diving into analysis when the exchanges are closed, and informed decision-making are the norm.
Forget about the typical image in the movies of the stressed trader shouting around the floor with telephones in both hands, or frantically buying and selling in front of 20 flashing screens. Even when physical trading floors – the ‘pits’ – were still in operation, this was an exaggerated picture, and it is even more so in the digital age. Be it a global macro investor holding positions for a year or longer, a stock speculator, or a index futures day-traders doing more than a 100 trades a day – the successful ones will have learned the hard way not act impulsively, hectically, or let fear/greed/stress take over. When that happens, they get out of sync with the market, and losses ensue.
That is because human nature, including emotions and instincts, has evolved for hundreds of millions of years to instinctively respond in a certain way to certain triggers and scenarios. On top of that, we have been reinforced with certain mentalities and mindsets since early childhood.
On the one hand, this is unfortunate, because most emotional impulses, instinctive responses and every-day behaviors are fundamentally incompatible with a successful trajectory in stock speculation.
You can have learned best strategy in the world in front of you – but if you did not hone your psychological toolset, it will be as good as useless.
One the other hand, there is something positive here – since we are aware of these shortcomings, and emotional responses, impulses and behaviors are programmable to a certain degree, we can learn how to avoid the most common pitfalls and re-condition our own thinking, instincts and impulses over time with the correct way – the ‘Pro’ way.
Differences between Pros and amateurs
Taking technical skill, knowledge of how the stock market works, and experience out of the picture – what makes the difference between amateur and Pro individual speculators, whether they wield $100 or $10,000,000 in their trading accounts?
As we discussed in the very first guide, long-term profitability in the markets comes from having a sound & profitable strategy, and its consistent application. When Jack Schwager interviewed the top traders in the world in his book series “Market Wizards”, be it stock or commodity traders, long-term holders or day-traders, technical, fundamental, mixed, or intuitive approaches to trading, he found that factually there were only two main characteristics that all of them had in common – 1) a consistently applied sound strategy that suited their own character, and 2) a no-defect policy to risk management.
We have already touched on a part of risk management before, namely loss cutting, and of course there are more parts to it that we will learn later.
Not having a strategy at all, or a system based on limited research, is akin to reading an “Introduction to Law” book over the weekend and then trying to defend yourself in a murder court case against seasoned attorneys before a judge pressed for time. But ironically, this is the equivalent of what many people do in the stock market. As Richard Wyckoff comments, it is astounding to see how men, shrewd, careful and successful in their own business, come to Wall Street and throw all caution to the winds.
I will list a number of behaviors and attitudes below that describe how amateurs and those recording consistent losses in the stock market. Of course, the list is not exhaustive. You will see that they all either flow from a fundamental misunderstanding of the market (i.e. not employing a sound strategy), from a lack of risk management, or from ignoring their rules, if they have any, to favor impulsive and emotional responses.
Many of these you will understand as fallacious and learn to avoid as a byproduct of going through the technical part of this course, as a solid foundation of understanding the “Why” behind technical rules will help us stick to them more consistently. The rest we will tackle later explicitly.
Amateur
- ‘believing’ in a company or an industry
- having favorite stocks, getting ‘married’ to a stock and ‘sticking’ with it through loss, feeling ‘honor’ in losing money when sitting in a stock
- not cutting losses when they’re still small and neglectable. ‘hoping’ price will come back
- buying stocks of companies that they know or like
- buying laggards, hoping they will catch up with the leaders
- buying on a whim, impulse, feeling
- average down
- making decisions based on emotions
- buying down-trending stocks due to low valuation
- buying the dip
- always trading the same relatively large size, sometimes going all-in
- selling into weakness
- discuss with/listen to friends, family, online tips, financial media, company or government officials, etc
- buying when “everybody” is in stocks and making money, or more notoriously, buying just because sentiment is bad
- operating on their own opinion and knowledge, and worse, insisting on it against what they see is truly happening with a stock
- operating on hope
- trying to predict the market
- diversifying into many stocks
- not looking at details
- not making a plan for every and any outcome
- not thinking in probabilities
- …
Pro
- interested only in whether something generates a profit
- ‘dating’ stocks, blowing out any position or stock the moment it stops profiting them, feeling horror at the idea of riding any stock through losses
- cutting losses religiously, as every fatal loss initially starts small
- buying what the market indicates is the best stock
- buying the leaders, the strongest of the market
- buying after weighing reward/risk & careful analysis
- average up
- buying only up-trending stocks, irrespective of valuation
- buying new High prices
- trading large in benign/healthy markets, small or zero in hostile
- selling into strength
- clinically isolating their mind and decision-making
- buying when sentiment is bad but good opportunities present
- operating on knowledge gained from multiple market cycles, via personal experience or deep historical studies of stocks and market environments
- operating on reality, i.e. what the market tells them
- evaluating what happens now and positioning in accordance with it
- concentrating money in few select stocks
- getting out of losing propositions and quickly redeploying money into good ones
- having a plan or contingency in place for anything
- understanding odds and thinking in probabilities
- …
Psychology affects how we deal with our inner impulses
But even when having a strategy, following through with it and sticking to its rules is, as I wrote above, one of the most challenging parts of stock speculation. The self-discipline of following a set of rules, when there is no one else but ourselves to stop us from falling off the path.
It’s important to realize that in the stock market, there is no such thing as fortunes made from a single massive winning trade. Of course, following Pareto’s “80/20” principle, not all your winning trades will make money equally, in fact, a lot of money in your career will be made from a select number of opportunities that were well exploited.
What I want to say is that speculation in stocks is not about dabbling around, doing this and that, and hoping for that one-hit wonder that will make us rich – that’s not a plan, that’s a wish. And such wishes rarely come true in the markets, because even if you get such a wonder, you will have more likely than not achieved it with questionable methods, you will be encouraged by your massive win to trade even more and larger (“why stop at 1 million when you can have 10?”), and then your problematic approach will take your money away again.
Wyckoff describes this effect well:
“Why does the lucky gambler lose eventually? They are apt to be carried off by getting away with a profit that at the very next opportunity they will think they have Wall Street by the tail and will plunge with all they have made and more, eventually making a loss.”
What I want to say instead is that market fortunes come from the consistent application of your strategy over a long time frame. That means, you need psychological tools to consistently overcome your shortcomings which are apt to derail your trajectory of success, because a single fluke, a single massive loss caused by oversight or neglect, can set you back years or blow your account out terminally.
Once we have gone through the technical part of stock speculation in this course, I will teach you the psychological tools that I know that will give you a way to consistently override the flaws of human nature. However, in the end, there is only one thing that can teach you something truly – losing money, feeling pain. Thus, if you take nothing away from this course but one thing, let it be the need to always cut losses and manage risk. That way you can make mistakes and deeply ingrain lessons learned in your mind without taking any serious damage.
I learned that there is an incredible beauty in mistakes because embedded in each is a puzzle and a gem that I could win if I solve the puzzle and use to avoid mistakes in the future — Ray Dalio
This guide gave you an introductory overview of how psychology affects how we operate in the stock market in a pivotal way. We will revisit this topic in the last part of this course – because it is the without doubt the most important one.