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Risk Management, Stock Market, EMOTIONS AND PROBABILITIES
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Trading is so exciting that it often makes amateurs feel high. A trade for them is like a ticket to a movie or a professional ballgame. Trading is a much more expensive entertainment than the cinema.

Nobody can get high and make money at the same time. Emotional trading is the enemy of success. Greed and fear are bound to destroy a trader. You need to use your intellect instead of trading on gut feeling.

A trader who gets giddy from profits is like a lawyer who starts counting cash in the middle of a trial. A trader who gets upset at losses is like a surgeon who faints at the sight of blood. A real professional does not get too excited about wins or losses.

The goal of a successful professional in any field is to reach his personal best —to become the best doctor, the best lawyer, or the best trader. Money flows to them almost as an afterthought. You need to concentrate on trading right—and not on the money. Each trade has to be handled like a surgical procedure — seriously, soberly, without sloppiness or shortcuts.

Why Johnny Can't Sell

A loser cannot cut his losses quickly. When a trade starts going sour, he hopes and hangs on. He feels that he cannot afford to get out, meets his mar-

gin calls, and keeps hoping for a reversal. His paper loss grows until what seemed like a bad loss starts looking like a bargain. Finally, his broker forces him to bite the bullet and take his punishment. As soon as he gets out of a trade, the market comes roaring back.

The loser is ready to smash his head against the wall — had he hung on, he would have made a small fortune on the reversal. Trends reverse when they do because most losers are alike. They act on their gut feelings instead of using their heads. The emotions of people are similar, regardless of their cultural backgrounds or educational levels. A frightened trader with sweaty palms and a pounding heart feels the same whether he grew up in New York or Hong Kong and whether he had 2 years or 20 years of schooling.

Roy Shapiro, a New York psychologist from whose article this subtitle is borrowed, writes:

With great hope, in the private place where we make our trading decisions, our current idea is made ready.... one difficulty in selling is the attachment experienced toward the position. After all, once something is ours, we naturally tend to become attached to it. ... This attachment to the things we buy has been called the "endowment effect" by psychologists and economists and we all recognize it in our financial transactions as well as in our inability to part with that old sports jacket hanging in the closet.

The speculator is the parent of the idea. ... the position takes on meaning as a personal extension of self, almost as one's child might. . . . Another reason that Johnny does not sell, even when the position may be losing ground, is because he wants to dream. . . . For many, at the moment of purchase critical judgment weakens and hope ascends to govern the decision process.

Dreaming in the markets is a luxury that nobody can afford. If your trades are based on dreams, you are better off putting your money into psychotherapy.

Dr. Shapiro describes a test that shows how people conduct business involving a chance. First, a group of people are given a choice: a 75 percent chance to win $1000 with a 25 percent chance of getting nothing —or a sure $700. Four out of five subjects take the second choice, even after it is explained to them that the first choice leads to a $750 gain over time. The majority makes the emotional decision and settles for a smaller gain.

Another test is given: People have to choose between a sure loss of $700 or a 75 percent chance of losing $1000 and a 25 percent chance of losing nothing. Three out of four take the second choice, condemning themselves to lose $50 more than they have to. In trying to avoid risk, they maximize losses!

Emotional traders want certain gains and turn down profitable wagers that involve uncertainty. They go into risky gambles to avoid taking certain losses. It is human nature to take profits quickly and postpone taking losses. Irrational behavior increases when people feel under pressure. According to Dr. Shapiro, "bets on long shots increase in the last two races of the day."

Emotional trading destroys losers. If you review your trading records, you will see that the real damage to your account was done by a few large losses or by long strings of losses while trying to trade your way out of a hole. Good money management would have kept you out of the hole in the first place.

Probability and Innumeracy

Losing traders look for "a sure thing," hang on to hope, and irrationally avoid accepting small losses. Their trading is based on emotions. Losers do not understand the key concepts of probability. They have no grasp of odds or random processes and have many superstitions about them.

Innumeracy — not knowing the basic notions of probability, chance, and randomness — is a fatal intellectual weakness in traders. Those simple ideas can be learned from many basic books.

The lively book Innumeracy by John Allen Paulos is an excellent primer on the concepts of probability. Paulos describes being told by a seemingly intelligent person at a cocktail party: "If the chance of rain is 50 percent on Saturday and 50 percent on Sunday, then it is 100 percent certain it will be a rainy weekend." Someone who understands so little about probability is sure to lose money trading. You owe it to yourself to develop a basic grasp of mathematical concepts involved in trading.

Ralph Vince begins his important book Portfolio Management Formulas with a delightful paragraph: "Toss a coin in the air. For an instant you experi­ence one of the most fascinating paradoxes of nature — the random process. While the coin is in the air there is no way to tell for certain whether it will land heads or tails. Yet over many tosses the outcome can be reasonably predicted."

Mathematical expectation is an important concept for traders. It is called the player's edge (a positive expectation) or the house advantage (a negative expectation), depending on who the odds in a game favor. If you and I flip a coin, neither of us has an edge — each has a 50 percent chance of winning. But if you flip a coin in a casino that skims 10 percent from every pot, you will win only 90 cents for every dollar you lose. This "house advantage" ere-

ates a negative mathematical expectation for you. No system for money management can beat a negative expectation game over a period of time.

A Positive Expectation

If you know how to count cards in blackjack, you can have an edge against a casino (unless they detect you and throw you out. Casinos love drunk gam­blers but hate card counters). An edge lets you win more often than you lose over a period of time. Good money management can help you make more money from your edge and minimize losses. Without an edge, you might as well give money to charity. In trading, the edge comes from a system that delivers greater profits than losses, slippage, and commissions. No money management method can rescue a bad trading system.

You can win only if you trade with a positive mathematical expectation— a sensible trading system. Trading on hunches leads to disasters. Many traders act like drunks wandering through a casino, going from game to game. Slippage and commissions destroy those who overtrade.

The best trading systems are crude and robust. They are made of a few elements. The more complex the systems, the more elements that can break. Traders love to optimize their systems using past data. The trouble is, your broker won't let you trade the past. Markets change, and the ideal parameters from the past may be no good today. Try to de-optimize your system instead — check how it would have performed under bad conditions. A robust system holds up well when markets change. It is likely to beat a heavily opti­mized system in real world trading.

Finally, when you develop a good system, don't mess with it. Design another one if you like to tinker. As Robert Prechter put it: "Most traders take a good system and destroy it by trying to make it into a perfect system." Once you have your trading system, it is time to set the rules for money management.

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