The 10 Lessons That Separate Amateur Investors From Traders Extraordinaire

The 10 Lessons That Separate Amateur Investors From Traders Extraordinaire
Reda Farran, CFA

over 2 years ago6 mins

  • There's no single winning formula in investing – you have to find your edge and stick to it, something maintaining a trade journal can help you do.

  • Risk management on individual positions, as well as at the portfolio level, are crucial to avoiding big drawdowns – and if you do experience one, take a break from trading.

  • Try to find trades with asymmetric payoffs, avoid trades based on hope, and learn to distinguish between trade outcomes and trade decisions.

  • Patience is key in investing because good trade opportunities are sporadic, which is why aiming for consistent profitability isn’t a realistic goal.

There's no single winning formula in investing – you have to find your edge and stick to it, something maintaining a trade journal can help you do.

Risk management on individual positions, as well as at the portfolio level, are crucial to avoiding big drawdowns – and if you do experience one, take a break from trading.

Try to find trades with asymmetric payoffs, avoid trades based on hope, and learn to distinguish between trade outcomes and trade decisions.

Patience is key in investing because good trade opportunities are sporadic, which is why aiming for consistent profitability isn’t a realistic goal.

Jack Schwager has spent the past 30 years interviewing some of the best investors and traders in the world, and his latest book, Unknown Market Wizards, features investors who – despite not having made a name for themselves in the investment world – have track records better than some of the best professional managers. And since they’re essentially regular people like you and me, I thought I’d look at the 10 lessons that set them apart…

1. There's no winning formula.

The approaches of the traders interviewed were fundamental, technical, a combination of both, or neither. How long they held their trades, meanwhile, ranged from minutes to months.

The main takeaway is that investing success is not about finding the right approach, but finding the right approach for you. That means one that’s compatible with your beliefs and personality. One of the traders, for example, started off by using technical analysis, but couldn’t understand why basing investment decisions off chart patterns should work. So he switched to fundamental analysis instead, and had a lot more success.

2. Maintain a trading journal.

A trading journal can provide two critical types of information: what you’re doing right and what you’re doing wrong. This is valuable information you can review to constantly improve your process by reinforcing the former and avoiding the latter.

One of the traders interviewed in Schwager’s book discovered from his trade journal that his biggest wins came from trades that shared several common characteristics. That helped him work out what his edge was, which led him to achieve stellar investment results. Speaking of his edge…

3. Know your edge and stick to it.

The goal of investing isn’t to be an expert on every asset class and every market. The goal of investing is to make money, and if that means having an edge in something as niche as small-cap biotech stocks, then by all means stick to it. If your edge is identifying stocks poised to benefit from big thematic trends, once again, stick to it and don’t be tempted to take trades outside your area of expertise just because you “should”.

4. Try to find trades with asymmetric payoffs.

The best trades are those where the potential pay-off is multiple times higher than the potential loss. For example, one of the traders interviewed in the book constantly searches for “ten baggers” – stocks that achieve a tenfold price increase. That potential 1,000% payoff is much greater than the theoretical maximum loss of 100% you can take when invested in a stock.

Then again, no good investor would hang onto a stock on track for a 100% loss, because virtually all successful traders have strict risk management policies in place to limit their losses. The easiest way to do that is through protective stop-loss orders, which limit your maximum loss on a trade and improve the payoff asymmetry. Just know that you don’t have to always wait for your stop to be hit: if, for example, you feel like your investment thesis is no longer valid after buying a stock, just sell – something that can reduce your losses in the long run.

5. Risk management at the portfolio level is crucial.

It’s not enough to just have stop-loss orders on individual portfolio positions – you also need to think about the correlations between your individual positions. If different positions are significantly correlated, it won’t matter if every position has a stop order: the different trades could all lose money together. If that’s the case, consider either cutting each position size or adding inversely correlated positions to the portfolio.

6. Take a break from trading if you experience a big drawdown.

Many of the traders interviewed in the book took a complete break from trading if their portfolios experienced a 10-20% drawdown, and there are two reasons why that’s a good idea. First, a big drawdown could mean whatever you’re doing isn’t working and that you need to reevaluate your trading process. Second, your emotions tend to get in the way when you experience a big loss, and you start to take suboptimal investment decisions in an attempt to recoup the loss. This can be a slippery slope that leads to an even bigger drawdown – one that can be avoided by taking a break to clear your mind.

7. If you’re hoping a trade will work, get out.

Let’s say you see some random stock or cryptocurrency you’ve never heard of going up: FOMO – fear of missing out – kicks in, and you buy it. Afterwards, you’re just sitting there hoping the stock or crypto will go up in price instead of having any real understanding of why it should be going up in value. If you find yourself hoping a trade will work, that’s a sure sign you’re gambling instead of trading based on a sound process. And if that’s the case, you’ll do yourself a big favor in the long term to exit the trade.

8. Distinguish between trade outcomes and trade decisions.

A bad trade outcome doesn’t necessarily mean it was a bad trade, and vice versa. If a trade that you impulsively put on without following your process ends up making money, it’s not suddenly a good trade: you just got lucky. Likewise, if a trade ends up in a loss and you’re a good trader, there are only two explanations. Either you followed your process and the losing trade was within the percentage of inevitable losing trades, or you made a mistake. That happens, and you’ll own it if you’re good at what you do. Bad traders, on the other hand, will always have some excuse for why they lost.

9. Be patient.

A trait all good traders and investors possess is patience – a hard trait considering it requires us to overcome our natural instincts and desires. There are two kinds of patience that are critical to investment success. First, the patience to wait for trading opportunities that are within your area of expertise and fit your specific criteria and process. Try not to be tempted to make suboptimal trades just because nothing has come along in a while. Second, the patience to stick with winning trades. When a trade is profitable, it’s tempting to prematurely exit to realize the profits. But a better strategy is to patiently ride your winners, and just realize some of the gains by selling small amounts along the way.

10. Consistent profitability is not a realistic goal.

Trade opportunities are sporadic, and aiming for consistent profitability in low-opportunity periods can actually be counterproductive, leading you to take trades that end up losing money. That’s what makes trading for a living so difficult: profits are inherently volatile with occasional losing periods, even when you need to pay your rent. So if you’re thinking of quitting your day job to trade, maybe don’t…

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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