The key to letting our investment strategies reach their full potential is to avoid as many mistakes as possible. A mistake is not a loss per se, but rather not sticking to your process, whether that has negative consequences or not, because over the long run it will.
My main fear is not that the future will be so fundamentally different from the past that basic risk premia will cease to be or that I´m not flexible enough to adjust strategies and develop new ideas to fit a changing market environment. It is that I will make so many mistakes that the actual results will be much worse than what they could have been.
What makes this complicated, is that, in my experience, no matter how much we read or hear about investing mistakes, we will still make them. And after we made them, often, even after making them several times, we will go ahead and do it again. Sometimes this cycle repeats for years at a time as investing tends to find your worst weaknesses.*
What has finally worked for me to start breaking this vicious circle, was to break through my overconfidence to gain awareness that this repetition of mistakes is actually my own doing and not “the markets” fault. After that I could identify, rationalize and correct some mistakes or develop a process that circumnavigates areas that are incorrigible. On the opposite side identifying major strengths allows me to concentrate my process on these.
I will tell about some of my experiences and specific mistakes and describe some of the workarounds, that I have developed. Someone else may have entirely different issues and solutions and my list only touches the surface. This is a very subjective area and, in my opinion, the most difficult aspect of investing, as it deals with taming your own behavioral biases. If you can´t relate to the problem, the workarounds may well seem to be absurd. Nonetheless they are an essential part of investing, that needs to be integrated into our process to avoid costly mistakes.
On the upside, analyzing these issues will have a positive impact on diverse areas of our lives.
The basic premise for being able to work on this is to „own” your process – embrace full responsibility for everything happening in your investing.
Interfering with sensible rules
I always try to meddle with things and have a strong urge to be active rather than just letting a good thing run.
A good example is one of my early investing experiences:
Several years ago, just beginning to embrace a systematic approach, I developed a simple and robust medium term trend following system using European CFD (an alternative to futures contracts that can be traded on a much smaller scale), that still is a very valid system, except for the CFD contracts carrying rather high overnight costs. A moving average crossover gives very clear entry and exit signals. After trading the system for some months, I analyzed what I had done and found that for about 80% of the trades I had used some kind of intuitive override and didn’t execute according to the rules. I either didn’t take the trade, took it before the actual signal or „improved“ the exit – mostly by letting losers run on a bit longer to give them some room to make some money back. Of course, falling prey to the loss aversion bias* cost so much in the end, it derailed a perfectly fine system.
This story has different implications for my investing approach:
I need to deflect myself from interfering too much, while still being aware and concentrated on all aspects of my portfolio.
For that, trading or research need to be just interesting enough to avoid the urge to „improve“ something for no real reason.
Action and excitement play no constructive role in investing, but we have to face the reality that we are not unemotional machines. To deal with the issue, I put enough short term strategies in my portfolio, that there is enough trading activity going on to quell those desires and to keep my interest awake. I even allow for flexible execution where it doesn’t matter much, to get the intuition that I´m actively making things better.
On the other hand research is a great way to make the portfolio more abstract and unemotional. I concentrate on the process and channel the urge for action away from the act of investing and its outcomes into research. Writing this guide has the same effect and that, and the way it makes me think more clearly about investing and life in general, are the main reasons I´m doing it.
Another great way to avoid getting caught like a deer in the headlights, staring at open positions and suddenly do something completely irrational out of fear or greed, is to try to view live trades as data collecting. It´s quite useful, because, I think, the most trustworthy test of a strategy is to use out of sample data from actual investing. And analyzing that data creates an additional layer of abstraction between me and my emotionally charged portfolio of open wins and losses.
For important allocation decisions that are less time sensitive I use a time lag between decision and execution to reflect on different implications and research alternative possibilities.
And still, the months since I first wrote down my investment plan have shown that small (and bigger) mistakes quickly add up to a significant drag on returns in practice. The problem still needs a lot more work, so my portfolio can live up to it´s full potential.
continue with the last part: 9 Writing down a plan