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Recent PressDecember 16, 2013 – Tools Help Investors Wade Through All the Chatter on Twitter — Georgia Wells Wall Street Journal

You might never fail on the scale I did,
but some failure in life is inevitable.
It is impossible to live without failing at something,
unless you live so cautiously that you might as well
not have lived at all – in which case, you fail by default.
~ J.K. Rowling

December’s newsletter discussed exponential gains in investing, but truth be told, how we handle losing in life and the markets is more important to our long term prosperity than how we approach winning.  Like the life history of J.K. Rowling, there are many legendary successes that occurred following a series of losses and hardships. Yet, these stories are not reflective of what typically happens in financial markets, where any money lost must be recovered, and the greater the loss, the more arduous the recovery. (Consider that a loss of 50% requires a 100% return to recoup). Minimizing one’s downside is both an essential and an often-neglected half of the investing equation.

For most amateur investors these two words – risk management – are a prelude to drooping eyelids and a suddenly urgent need to check one’s phone.  Yet risk management is ESSENTIAL to good investing.  And risk management is all about minimizing the downside.  As Warren Buffet – not an investing slouch – noted:  Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.  And the best way to not lose money is to identify and prepare for potential losses in advance.

I think I am the single most conservative trader on earth in the sense that I absolutely hate losing money.
~ Paul Tudor Jones

Most of the world’s best investors are exceptionally uncomfortable with losing.  In fact, losses cause physical pain for many.  This stress of losses predisposes investors to the predictable consequences of chronic stress such as premature aging (as they say, traders age in dog-years).  Top investors learn strategies to manage the stress, and they go to great lengths to limit losses.  From painful experience they’ve learned that the market will find any vulnerability in their strategy and exploit it.

Top investors distinguish between losses as a part of doing business, when they were simply wrong despite following their process.  Such losses are part of being a risk-taker.  Most stressful is when a loss is preventable due to poor decision making or a flaw in risk management.

Interestingly, several top investors have told me they do not feel pain if a loss occurred within a properly executed framework.  In Steven Drobny’s excellent book Inside the House of Money, he interviews hedge fund manager Jim Leitner of Falcon Management.  Leitner describes his trading as being absolutely unemotional. “Losses did not have an effect on me because I viewed them as purely probability-driven, which meant sometimes you came up with a loss.”  Leitners attitude reflects an observation of Jack Schwager about top investors:  “You can’t be afraid to take a loss. The people who are successful in this business are the people who are willing to lose money.”

Most investors cannot simply detach from the pain of losses as Leitner does, and they use a variety of coaching, cognitive, behavioral, and biofeedback approaches to limit stress and improve decision making.

Paul Tudor Jones is widely renowned as one of the greatest traders in history. In Jack Schwager’s book Stock Market Wizards, Jones comments on how his life and trading have changed since a large loss he suffered during one of his first years as a professional trader: “Now I spend my day trying to make myself as happy and relaxed as I can be. If I have positions going against me, I get right out; if they are going for me, I keep them.” Jones optimizes his mental state during the trading day by reducing emotional interference, and one way of doing that is by cutting painful losers quickly.

The best investors limit their losses to very small amounts in any given bet.  They do this via 1) sizing, 2) identifying the nearest exit and the conditions under which others may try to fit through it (liquidity risk), and 3) appropriately hedging risks such as A) time decay, B) interest rate risk, C) event risk, and D) correlation risk.  Monitoring and planning for such risks has to be a disciplined habit.  As Vince Lombardi famously commented, “You don’t win once in a while, you don’t do things right once in a while, you do them right all the time. Winning is habit. Unfortunately, so is losing.”

And that is proper risk management hygiene.  The remainder of this newsletter is about why such hygiene is so difficult.

Today is a good day to die!
~  Sioux battle-cry, Dakotas

The phrase above is the translation of a Sioux battle-cry documented during the Battle of Little Bighorn in 1876, in which General Custer and 268 of his troops were killed by Sioux, Cheyenne, and Arapaho warriors.  The Sioux source phrase is more accurately translated, “I am ready for whatever comes.”  Such an attitude actually improves short-term performance by reducing performance anxiety, but long-term it sets up a dangerous precedent.

Since before the Battle of Little Bighorn to today, American culture has celebrated the risk-takers with the courage to go “all-in.”  This act of heroism – when it succeeds – creates legends, yet when it fails (and often even after it succeeds), it ultimately ends in devastating setbacks.  Taking an irreversible risk is like playing Russian Roulette.  When we succeed, we learn that we’re invincible and are more likely to do it again.  When we fail…

In the Superbowl being played today, the players are risking serious injury including concussive brain damage (mild traumatic brain injury) to win the game.  Of course, that risk is their conscious choice.  Based on the statistics of life outcomes of NFL players, that choice is of debatable wisdom.  According to a Sports Illustrated survey within two years of retirement, 78 percent of NFL players are bankrupt or in severe financial distress.

Forget about winning and losing; forget about pride and pain. Let your opponent graze your skin and you smash into his flesh; let him smash into your flesh and you fracture his bones; let him fracture your bones and you take his life. Do not be concerned with escaping safely… lay your life before him.
~ Bruce Lee

Bruce Lee is a hero and an icon, and he took big risks.  Like the NFL players, taking out-sized risks fueled his ascent.  Yet while this attitude may help win some important battles, if it is not used judiciously (and it almost never is), it often leads to a blow-up. A forensic scientist reviewing Lee’s cause of premature death declared it, “death by misadventure.”

So if all-in risk-taking is problematic, then what is the preferred alternative?

One of the more interesting results from our online personality tests, taken by more than 25,000 people, is that the best investors are humble.  They honestly don’t see themselves as more skilled than others.  As a result, they are more attentive to risks and take time to learn how to improve themselves.

Overconfident investors do not take the time to look for potential threats, because they see themselves as adequately skilled to handle danger.  Humble investors recognize they may be wrong, and they make efforts to limit their downside.

Returning to Drobny’s interview of Jim Leitner, Leitner notes, “…I’m really humble about my ignorance. I truly feel that I’m ignorant despite having made enormous amounts of money.”  Leitner approaches investing as an intellectual game, one that he loves to play. Leitner describes his favorite trade as one in which he made one tick overnight on the Swiss franc by relying on his wits, “…My wife still remembers me jumping up and down in the middle of the night screaming ‘I did it? I did it? … It was the most phenomenal feeling of control and creativity all coming together.”

The humble recognize that they may be wrong.  They have less need to protect their egos.  As a result, they have less fear of looking at what might go wrong in the future.

[I]n practice it is the negative that’s used by the pros, those selected by evolution: chess grandmasters usually win by not losing; people become rich by not going bust (particularly when others do); religions are mostly about interdicts; the learning of life is about what to avoid. You reduce most of your personal risks of accident thanks to a small number of measures.
~ Nassim Taleb, Antifragile

Taleb notes that “we know a lot more about what is wrong than what is right.”  Such negative knowledge is more robust than positive knowledge.  It is easier for something we know to fail than it is for something we know that isn’t so to succeed.

As a mental process, the search for potential risks should be easier than the identification of opportunities.  Yet once we see potential rewards, the loss avoidance system in our brain declines in activity.  As a result, we become biologically less able to perceive risks.  In order to reverse this cognitive bias, we must make a conscious effort to look for the negative and play the Devil’s Advocate.

To others, being wrong is a source of shame. To me, recognizing my mistakes is a source of pride. Once we realize that imperfect understanding is the human condition, there’s no shame in being wrong, only in failing to correct our mistakes.
~George Soros

In many fields, failure is a price of doing business.  Witness the successive setbacks of Abraham Lincoln as he made his way to the presidency.  Yet, Lincoln’s failures were all manageable, and none were irreversible.  In fact, political failure if often a prelude to success.  For financial failure, the equation is different.

In order to immunize yourself to losses, it’s important to start by approaching past losses like an objective investigator.  In medicine this is called a morbidity and mortality report, in which everyone on the medical team objectively looks at a medical error to understand what – if anything – could have been done differently.  Judgmentalism is not helpful during this exercise, because it’s impossible to learn while in an accusatory state of mind.

Like Paul Tudor Jones and George Soros above, we can learn from and adapt to our failures.  Keep in mind that a loss that is the result of an objective process is not necessarily a problem.  The key is to identify flaws in the process that can be corrected to improve future decision making.

While we are optimizing our minds for investment risk taking, we can also use new tools that are available – such as MarketPsych’s own!  🙂

Our text analytics data, derived from the real-time firehose of news and social media, is used for Risk Management applications including monitoring event risk, speculative risk, and crowding risk (see below).  If you represent an institutition, please contact us for a presentation on the risk management uses of our data.