8 Avoiding mistakes

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 exist 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.

 
Behavioral Biases
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 our worst weaknesses. Behavioral biases that sabotage our investment process are deeply ingrained in our minds.*

What has finally worked for me to start breaking this vicious circle, was to temper my overconfidence in good times and gain awareness that this repetition of mistakes is wholly my own doing and not “the markets” or anybody else´s fault. After taking full responsibility, I could identify, rationalize and correct some mistakes or develop a process that circumnavigates areas that are incorrigible.
On the opposite side identifying my main strengths enables me to tailor my investment approach to these.
Nonetheless I am sure that setbacks and mistakes will be a constant companion in my investment journey and dealing with behavioral biases will be an ongoing process.

 
Take Responsibility
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 irrationalities. If you can´t relate to the problem, the solutions may well seem to be absurd. Nonetheless they are an essential part of investing, that needs to be integrated into our process to minimize costly mistakes over time – only reflection can lead to progress.
On the upside, analyzing these psychological issues will have a positive impact on diverse areas of our lives.
The basic premise to be able to work on this is to „own” your process – embrace uncertainty and take 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 then simply letting a good thing run patiently.
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 unambiguous entry and exit signals. After trading the system for some months, I analyzed how 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 the chance to make some money back. Falling prey to loss aversion bias* cost so much in the end, it derailed a perfectly fine system.


Research and write about investing
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 to work, trading and 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 some short term strategies in my portfolio, so that there is enough trading activity going on to quell those desires and to keep my interest awake.
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 – add to this the way it makes me think more clearly about investing and life in general and this provides the motivation to continue to contribute to my blog. During difficult times I will be able to go back and evaluate my actions against the theoretical process I have written down here. In essence I’m making myself accountable and have created a mechanism for reflection and improvement.


Analyzing Data
Another 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 collecting data. 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 profit and losses.


Restricting Screen Time
I also try to avoid unnecessary screen time and exposure to news – to not be overly influenced by what is hot and what is not.
I have a checklist to go through before taking a trade and 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. Often ideas that made perfect sense initially look quite different a day or two later.


Overconfidence
Many of my most prevalent mistakes can be traced back to overconfidence in good times. Seeing my capital grow leads to performance chasing through over-leverage, which in turn causes bad decisions during the next fluctuation to the downside.
Most commonly I fail to follow my exit plans: Stop losses are ignored and I even double down on losing positions – which is self-destructive behavior caused by loss aversion. This is connected to an increased illusion to be able to accurately predict short-term market movements whenever I get too close to the daily market gyrations – in reality these movements are largely unpredictable random noise.
Drawdowns lead to impatience and over-trading: I take classic “revenge” trades designed to make back lost ground as quickly as possible – often with the opposite result.


The gap between theory and practical implementation remains large.
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 return in practice. The problem still needs a lot more work, so my portfolio can live up to it´s full potential.


I plan to revisit this subject whenever a larger drawdown occurs to continuously work on improving the practical details of the process I outline here.
 


 
*Daniel Kahneman gives an in depth overview of behavioral biases in „Thinking Fast and Slow”


continue with the last part: 9 Writing down a plan