Ray Dalio, founder of the world’s largest hedge fund, highlights the positive impact mistakes can have, when you don’t ignore them and put it into a neat little formula:

Mistakes + Pain + Reflection = Progress

1. Good process followed by a bad outcome = random bad luck; we have to expect this to happen – it is par for the course, but, I think, it is possible to use regime indicators to identify market environments that make bad luck more probable. We can then adjust exposure and reduce the overall losses caused by strings of bad luck.
2. Bad process followed by a bad outcome = mistake; we didn’t follow our rules and avoiding these mistakes is what we should concentrate on most.
3. Bad process that leads to a good outcome = mistake; this doesn’t cause a drawdown, but should be considered nonetheless – too often it is ignored. The combined number of mistakes will define their drag on return, as random luck will cancel out over time when the mistake sample gets bigger and bigger.

1. Changing market environment: this is extremely important to me as market regimes have the greatest influence on return over time and regime changes can be addressed in the investment process. Read the details about changes in market regime and resulting ideas on portfolio management in my next post – I will just list the essential points here:

• On February 2nd 2018 I got a strong volatility based warning sign of a possible regime change. Because 2017 was so extraordinarily quiet and previous warnings turned out to be very short term, I failed to react sufficiently.
• After some initial windfall profits in February and March, the shifting market environment resulted in essentially uncorrelated strategies moving in tandem through whipsaws caused by trade war rhetoric – causing high portfolio volatility and finally culminating in a drawdown throughout May and June.

2. Actual mistakes: these always boil down to the same few things. In 2017 I compiled a similar list that was leading to a small, but noticeable drag on return then:

• Good times (up until January 2018) led to overconfidence and performance chasing:
• Over-leverage in a low volatility environment makes a portfolio vulnerable to sudden reactions in the market. Failing to adjust leverage quickly and keeping it reduced for long enough, caused portfolio volatility to become too high, which in turn led to bad decisions.
• The major mistake was not to follow my exit plans: Stop losses were ignored and I even doubled down on losing positions – which is classic 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.
• Overconfidence also led to the introduction of poorly tested new ideas. This time I introduced an intraday opening-gap strategy and went to full exposure much to quickly. The strategy, while it does seem to have a slight edge, turned out to show strings of losses correlated with losses in other strategies – something I didn’t anticipate.
• I also don’t really react well to short term trading: the mistake cycle above gets even more pronounced at the shorter time frame – insights I already outlined some time ago in this article.
• Spending too much time in front of the screen leads to overtrading and impatience – I take profits early and losses late, which are among the most common trading mistakes. Impulsive decisions override the rules of my strategy sooner or later and these mistakes kill all profit potential. The boring, but essential, basics of portfolio management are getting neglected.

• In turn this drawdown triggered „revenge“ trades designed to make back lost ground as quickly as possible. Often this works, if the pullback is temporary, but in an extended change of the market environment this behavior can cause going down a deeper and deeper hole.

• Good process should lead to good outcomes over time.
• Stick to a written trading plan at all times. I introduced a checklist I go through before taking any trade – optimal execution is difficult and mistakes creep in through the smallest cracks.
• Take responsibility for all mistakes and good as well as bad outcome.
• Analyze which part of portfolio performance is due to skill and process, which to luck. There are no certainties in investing, only probabilities and individual outcomes are random to a very large degree.
• Integrate some tricks to modify known bad behavior in your trading plan, for example: revisit past mistakes when optimism is strong; be aware that your emotions need constant taming; etc.
• Simplify the trading plan so that essential risk exposure and warning triggers are crystal clear.
• Decisively adjust leverage with the strength of warning signals: for me these are mainly the inversion of the VIX Futures Term Structure and the violation of 275-day moving averages in different markets.
• If strong and extended warning signals point to a longer lasting regime change, patiently observe the market from the sidelines. In the first half of 2018 virtually all markets showed radically different behavior from the year before – that was very difficult to deal with for an extended period of time.
• Keep a large margin buffer to be able deal with adverse moves without being forced into taking action by margin constraints.
• Built ample reserves for living expenses to avoid having to withdraw money during a drawdown.
• I´m also thinking about building reserves to restock the portfolio after a drawdown. I want to be able to take better advantage of good opportunities when a drawdown creates pockets of value in the market.