Ways Great Traders Think
January 23, 2016
In college, I became fascinated with the financial markets. There is a certain amount of lore that surrounds trading – some rooted in legitimacy, and some outdated or utterly false. Movies like Trading Places show the raucous trading pits that once existed at the financial exchanges, and books like Liar’s Poker recounted the shenanigans of old school traders, while also documenting the shift from brawn to brains on Wall Street in the early nineties. More recently, traders have become figures of public scrutiny, following the implosion of the credit default swap and mortgage backed securities markets in 2007. Whether they be thought of as swashbuckling cowboys or of the uptight banker variety, all real traders are compensated for the risks they take, regardless of how they are calculated. Of course, more and more trading is done by computers each year, but humans are still integral to defining, implementing, and programming the strategy behind these order taking machines. There is a certain type of demeanor, and a way of thinking that pervades this profession. Thinking like a good trader has many applications outside of the buying and selling of securities. I go over a few in this passage.
Traders don’t usually make naked directional bets
Growing up, I used to look at the business pages of the newspaper to see what various stocks were selling for. I’d look up their percentage gains and losses over a day’s period and keep track of the best/worst performers. Early on, I thought that the name of the game was to make a prediction about the future – to buy super low and to sell sky high. Unfortunately, this is not the safest way to invest and the sentiment is still passed along by brokers, day traders, and pundits. We are bombarded with news of the latest glamour stocks (think Apple, Amazon, Tesla) and cases for why we should BUY BUY BUY! While long only (owning an asset with the hope that it will go up in value) is by far the most common strategy in most investment markets, it typically leaves people vulnerable to fluctuations in market prices that exist beyond the control of anyone’s “stock picking” abilities. When bad news hits, it can derail an investment. When the markets tank, they takes many people’s life savings along for the ride.
Some of the most prudent traders realize that their fortunes needn’t be tied strictly to the ups and downs of a market. Instead, they focus their analysis on key relationships and relative value. Relative value connotes the idea that performance be measured with respect to another investment, rather than on gross return. For instance, two bonds of the same notional amount pay 5% interest, but one trades at 95, while the other trades at 90. The 90 is a better relative value. The  a trader might acknowledge that he has no idea where the price of a Walmart bond will trade at tomorrow. However, she may have a more informed view about how a Walmart bond compares to a given Target bond in the marketplace. A new strategy might be in place where Walmart looks to undercut Target on prices where the two stores compete and preliminary data look promising. Instead of buying a Walmart bond outright, a trader might go long (purchase) a Walmart bond, and sell short a Target bond (borrow a bond from somebody, sell it immediately on the market for proceeds, and buy the bond back later – hopefully at a lower price) . This is called a pair trade, and it only takes into account the relationship between two entities: the Walmart bond, and the Target bond. If the price of the bonds goes up or down, it doesn’t matter – the trader can still make money as long as the Walmart bond she bought performs better in a relative sense than the Target bond she sold short.
Pair trades between assets that are highly correlated tend to be less risky trades, and they require less money to get into net net (you are buying something with proceeds generated by selling something else short, rather than buying something outright. The truth is that life is full of pair trades, but most people strictly relegate this thinking to the world of stocks, bonds, and derivatives, thinking in terms of mean reversion or statistical analysis.
One simple way that this thinking can be applied is toward the analytical framework we use to assess our work life. In a sense, switching a job can be a sort of pair trade. Perhaps you don’t feel that your future prospects are all that bright in your current role. Instead of money, think of time is the currency you pay your employer (most people believe that they are getting payed, but it’s just a trade off). You can go short your current gig, basically finding an exit plan that unlocks hours for a new step in your life, and with those hours available, you are free to shop for a new opportunity to spend those hours on. What matters in this case is a well defined set of standards, which might be as simple as a checklist.
-I want a commute fewer than 10 miles from my home
-I want a job with potential for a promotion every three years
-I want to be in the technology industry
-I want an opportunity that gives me a good “gut feeling”
-I want to work at a place that values honesty
-I want to make at least $55,000 per year
With a framework, you can analyze opportunities as they manifest themselves by running through this simple filter. You can also look for good trades by searching job boards, asking friends and family, or doing your own networking. You only take a trade that you’ve determined will leave you adequately better off than your current set of circumstances. This framework, and “lining up an exit before you enter” is the same mindset behind many good pair trades. So many of us don’t filter opportunities, we think in terms of good enough, or automatically assume that the grass is greener on the other side. With a bit of reflection and the extra effort required to come up with a quality test to run opportunities through, you’ll have simplified your life by narrowing down the key drivers of your decision from a sea of extraneous variables. You’ll also be less likely to be swept up by emotion (to leave a place in a panic for something that is not much better, or to buy into the hype of a new place without having a sober look at how you will respond to the job six months from now.
There is an important place for unconstrained thinking, and creativity in our lives. However, in our daily lives, an excess of choices can be crippling and defer important moves. I also believe based on academic and anecdotal literature that we free ourselves to be better fulfilled and more creative by taking care of our basic needs and satisfying the fundamentals of our existence. Once a more general course has been determined, opportunities like jobs, relocation, and big purchases can be made more effectively with a relative/pair trade way of thinking.
Traders look at tertiary effects 
How do traders make money? How do they add value to society? When the system is functioning properly, traders add liquidity to a financial system and act on behalf of themselves or investors to allocate money towards the most promising ideas and best business operators. Without great analysts and traders, money would be more likely to flow toward the best advertised opportunities, instead of the projects most worthy of capital. Of course, this happens plenty in reality, and many research analysts on the sell side simply cover stocks as advertising for the big brokers/banks who will trade for clients. Undiscovered opportunities stand to yield better rewards than crowded trades. As more money pours into an investment, the prices of the stocks or bonds issued go up, leaving less of a margin for profit to those who buy in late. The window is not open very long for most trades.
In a world of instant communication and readily available information, most obvious opportunities are taken advantage of only a short moment after pertinent news breaks. This is a reflection of what academics call the efficient market hypothesis, which states that all current information is already priced into a security at the time of an investment decision. While markets might resemble efficiency for the most widely traded securities, there are a great many opportunities among lesser known investments. One of the ways that traders make big money is through analysis of tertiary effects. Most simple cause-effect relationships are already priced into a stock, however there are catalysts that effect asset values which are further removed, that the market does not necessarily anticipate.
One possible example would be tracing back a company’s supply chain. Perhaps Apple comes out with an updated sales estimate that is lower than Wall Street’s expectations. This will just about instantly be factored into its stock price, its bond price, the CDS points – all the way up and down the Apple chain. However, someone may astutely realize that the sales estimates are brought down most by stunted iPad sales projections, and look to Apple’s suppliers of integral iPad materials. If they are able to locate a supplier whose business is primarily driven by selling Apple iPad microchips or outer casings, an investment in or against them would be considered to hinge upon a secondary effect. The transparency and depth of capital markets in most modern economies means that even secondary effects are often priced in shortly after a piece of news breaks. Traders look for deep third degree relationships, and beyond. This is where value can be found. The causal link must be strong enough to hold over such a distance – it usually isn’t. However, these are the opportunities that most overlook in the market place. For instance, from this suppler traced back from your research of Apple, a trader might prod the company that sells the raw materials to this supplier, or perhaps make a bet on real estate and the local economy surrounding an impacted factory. This is merely a mediocre attempt to capture the way that some traders generate investment ideas.
Tertiary effects don’t need to stack up across a supply chain or the global economy – brokers love to blow smoke up retail investors’ asses, telling them how smart they are for considering ‘what happens to potato prices if South America has a warm year?’ – yeah, you’ve seen the commercials.
Multi-step logic can inform traders of inconsistencies within a company which are mathematically inconsistent. It might take a dozen premises backed up by evidence to get there, but events like liquidation waterfalls, investment ratios, and legal constraints can lay out a behavior that a company is bound to in a certain situations. Traders who dig deep enough and keep track of all the moving parts can make quick decisions about investing when key thresholds are breached (I am not talking about technical analysis). Here is an example of David Einhorn laying out an investment thesis where he uses logic and research to arrive at a confident buy/sell decision. This is one of the most transparent videos out there laying out the thought process of an elite hedge fund manager.
While Einhorn is an investor, rather than a trader (an important distinction that I will expand upon in another post), his reasoning resembles the logic behind some of the strategies that drive traders’ quick thinking in the market.
In our own lives, without ever opening up a brokerage account, we can challenge ourselves by thinking beyond simple cause effect relationships. Many of today’s political quandaries are argued with respect to a single explanatory and single dependent variable. Raising taxes will kill jobs! Taking guns off of the streets will lead to fewer murders! Rise above this fray. In truth, macro and societal issues are governed by many, many variables. However, for those relationships that are deemed valid and strong, take the mental exercise an extra step by asking “what next?”, or “what will this effect?”. When you take action at work, ask what this will have an influence on, and in turn how that second level change will influence your surroundings. I’ve noticed that this is important when programming a solution into a computer. Great software developers realize that if they change code, it’s often going to effect other parts of their script. I’m no genius developer, but I have become more aware of this issue in my experience of working with developers and doing a bit of programming myself.
Thinking beyond first degree causality can benefit your social life as well. While our guts will often serve us well, thinking out situations can allow us to appear well attuned, or containing a sixth sense. One simple example would be guarding personal information in the presence of a loose lipped person. If they are willing to share someone else’s business with you, there is reason to keep your own hand hidden, as they would likely be willing to divulge your information as well. Thinking about who word might spread to, or how the message might be handled is probably enough to guide your behavior. Perhaps this leads you to keep quiet, perhaps you still don’t give a damn what anyone thinks – either way, you made a clearheaded judgement about the situation, and will less likely to act in a way you regret. Again, this is just one of many possible opportunities to think beyond the direct result of an action.
Traders diversify to thrive
Another key tenant of investing and trading is to diversify holdings. In a world of so many complex connections, there are very few sure bets. A critical mistake of inexperienced traders is to swing for the fences with a single bet. In the short term, regardless of your thesis, an asset’s price can move against you. Market dynamics, technicalities, and other minutia shift financial instruments every day. Of course, unexpected news, can also lead to windfalls in profit or marks on a position. In the absence of superpowers, you are very unlikely to make accurate market calls on a short horizon. In order to mitigate some of this uncertainty, traders take multiple positions and create a diversified portfolio. These portfolios are not just for investors, or retirement accounts. They help to balance short term movements in the market that could otherwise wipe out an entire operation. You’ve seen in the news the disasters brought about by concentrated positions in sour investment products. Look no farther back than 2007/8, or 2001, when people had oversized exposure to mortgage credit and technology stocks. In these crisis situations, many people were hurt, but many of those who were not diversified went bust.
There are successful traders who “go all in” on a position, but they are a statistical anomaly in the entire world of trading, and a heavy survivorship bias in media coverage leads to the illusion that these men and women are more common, more skilled, and more likely to continue their streak than should be reasonably expected. For instance, John Paulson’s hedge fund made large bets against the subprime mortgage market, and his timing was near perfect. The fund made about $20 billion dollars off of this outsized bet, making over 100 percent on its assets under management in 2008. However, in subsequent years, the fund’s portfolios have continued to struggle, making other large (but unsuccessful) bets on gold, Greek sovereign debt, and the Puerto Rican economy. This is not to say that his investment theses aren’t well thought out, or that they will eventually turn profitable. However, a bad year in 2011 cost his investors up 52 percent of their capital depending on the fund they were in. To get back to even from a 50 percent loss, one must double their money from that low point. Returning 100 percent in a short period is a very tall order, and the Paulson funds have continued to struggle. Yet, John Paulson is still covered today as the man who beat Wall Street in the financial crisis of 2007/8.
This gets back to a point that I will reiterate shortly: even the best and brightest traders will get burned. Trading is not about being right all the time, it’s about managing risk. Surviving the tough times and living to fight in the prosperous periods is an ethos with no appeal to those looking to get rich quick. Adding fire to the flame, is the propaganda ground war waged against retail investors, playing into their hubris – “you too can beat the market consistently without extraordinary effort, a novel business model, or exceptional analysis.” It’s safe to say that the market is not perfectly efficient, academics have walked their views back from this extreme to a position of weak form or semi-strong form efficiency (where today’s price reflects all prior information, or all public information is factored into an asset’s price, respectively). However, in lieu of the evidence, very few consistently beat the market without luck, or some sort of extraordinary ability. Unfortunately, most people approach investing as a consumer, looking for confirmation of how they are right through the feel good advertising, and overstated advantages of the market tools they are equipped with. Many are simply buying a product after being buttered up about their abilities and potential without proper warning, or self reflection – that right there is a recipe for overconfidence.
I was lucky enough to work under an astute investor in college who had a great track record, and came from a family that revolutionized the securities brokerage industry. One of the first reading pieces that he gave me explained the value of defensive investing, essentially to prioritize the protection of your initial funds, over the doubling or tripling of your money in a short period. The piece talked about how harmful draw downs can be, the lowest point that your investment falls to, because of how percentage gains work. As mentioned above, a 50 percent loss of capital requires a 100 percent gain, just to get back to even. The farther you fall, the more that is required of an investor to get back to their starting point.  Here’s a little table showing what is required of an investor to break even after various losses on their portfolio. Keep in mind that the average return on equity investments ranges between six and ten percent per year, depending on which benchmark you consult.
Loss              % return to break even
10%                     11.1%
20%                    25%
30%                    42.86%
40%                    66.7%
50%                    100%
60%                    150%
70%                    233.3%
80%                    400%
If the below isn’t an incentive to pare losses, then I don’t know what is. Still, there are other reasons to avoid losing big, such as margin calls (for those using margin), forced liquidation, and fewer dollars of principle to distributed fixed costs over. Statistically speaking (using past data), you are less likely to see extreme losses when your portfolio is spread out over multiple investments. You don’t have to be a quant running option pricing models or monte carlo simulations to embrace the principles of sound risk management and diversification. You need only have investments that are spread across multiple industries, time horizons, and asset classes. Read up on Ray Dalio’s (Bridgewater Associates) All Weather Fund to see a brilliant case for diversification.
Most of your top hedge fund guys got to where they were, at least in part by having the discipline to limit the bets that they are most confident in to levels that will not cripple their fund in the event that they turn sour. This is not to say that you need to diversify into hundreds of tiny slices – being spread too thin has its own downside. However, there is a bit of a Pareto effect here, where a little bit of diversification can go a very long way, up to a point. Beyond that, you start to rack up excessive transaction costs and realize suboptimal net returns. However, the difference no diversification and moderately distributed risk can be huge, in that the latter will limit fatal draw down.  As Warren Buffet, once said, “Rule No.1: Never lose money. Rule No.2: Never forget rule No.1. There’s a reason why he didn’t declare Rule No. 1, “Make money”. Plenty of others heed the Siren call of quick riches, and they are usually not the ones covered in the media.
In life, striving to diversify like a great trader pays dividends. For one, diversifying your income streams can be a great way to move towards living life on your terms. As soon as you don’t depend on a single paycheck to survive, you are no longer beholden to a tyrannical boss, or broken system. In my life, doing so has bolstered my own confidence and helped me to assess work through lenses of morality (should I be doing this?), fulfillment (is this what I want to be doing?), and balance (is this all that I’d like to be doing?) – none of which I could afford to do as recently as a year ago. This could be as simple as driving for Uber on the side, which I’ve tried, investing more of your savings in income generating vehicles, or creating a passive business on the side. Just like a trader, the available opportunities should be carefully vetted against your goals and lifestyle – not to diversify for diversity’s sake.
Options equate to security, and they help us to live as confident versions of ourselves. Spending time with different groups of people, reading on different subjects or viewpoints, and having multiple hobbies allow us to be less dependent on single outcomes, and to a point can offer greater satisfaction with life. However just like investing, we can over-diversify our lives, resulting in a chaotic personal life, and a miserable state of distraction. As they say, “everything in moderation, including moderation”.
Traders keep their emotions in check
There was a day when the traders of Wall Street went to war each day, and gut decisions decided victors and losers. While trading has always included an analytical component, cerebral and computational prowess now serve as competitive advantages that simply can’t be ignored. Aside from pure speed and accurate number crunching, what does modern trading architecture offer players that didn’t exist decades ago? The major difference is an approach to the market that is more objective, and less vulnerable to the mental short circuits built into most people’s brains.
Investing is such a tough game, not only because of time constraints and imperfect information, but also because of how humans are programmed to act in such an environment. We have survived for thousands of years by pooling together, and deciding by consensus – it’s not in our DNA to be contrarian. Take the famous mid century Asch conformity experiments, designed by their namesake, Solomon Asche. In them, a college student was put into a room with a group of people, who posed as other randomly selected college students, but were secretly confederates of the experiment lab. The participant was given a cognitive task, receiving two cards. The first card had a line on it, and the second card had three lines. They were asked to answer which of the three lines on card number two was the same length as that of card one’s line. There was a clear answer to this question, perhaps the first line on card two was the match. However, each person in the room was asked to answer aloud which line they believed was the match. Everyone was given the same materials, and this was common knowledge. The experimenter went around the room, first asking the confederates, who supplied the same incorrect answer on purpose. While the correct answer was the first line, they answered that it was the second. When it got to the final person, the participant, they answered in harmony with the rest of the room, rather than appealing to their common sense. The aversion to going against the grain was so strong, that over a third of participants answered incorrectly because of self doubt in the presence of naysayers. This can be compared to a score of higher than 99 percent correctness when no social pressure was applied.
The urge to conform runs so deep in many of us, that it can sway us into overconfidence, or outright despondence, strictly with reference to how our behavior compares to everyone else. There is a strong sense of vindication when others agree with our viewpoint, and a sense of loneliness, even physical pain (as this 2003 article from Science contends: http://science.sciencemag.org/content/302/5643/290.short) that accompanies our going against the grain. This often leads less fortunate traders to buy at the worst possible time, during the inflated and euphoric excitement of a market, and to sell at an equally inopportune point, when the sky appears to be falling and everyone is trying head for the exits simultaneously. The relatively few contrarians with the stomach to by when others are selling, and sell when others are buying, carved out a viable investment strategy for themselves in the past. Today, computer’s have better than nerves of steal, by the virtue that they do not have nerves at all. For better or worse, they analyze situations by no other merits than those contained within the presented data. Still, those who program these trading machines may have as much difficulty as ever in letting their surrogates buy or sell in these stressful times. Countless quotes and articles comment on this observation, and perhaps Sir John Templeton’s words sum this up best, “Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.”
Behavioral economists including Daniel Khaneman, Amos Tversky, Dan Arielly, Cass Sunstein, and Dick Thaler have spent their academic careers documenting the multitude of psychological miscues that humans are inclined to commit in the marketplace. A wonderful resource is Khaneman’s Thinking Fast, and Slow, a magnum opus that recounts his Nobel Prize winning collaborations with Tversky and others in the field of behavioral economics. Another is Nassim Taleb’s The Black Swan, which reconciles the backgrounds of a trader, and lifelong student of behavioral finance for readers from all walks of life.
Some of the key emotionally driven biases or heuristics which trip traders up are loss aversion (the tendency for people to counter-productively avoid opportunities framed in terms of loss rather than gains), confirmation bias (only seeking out opinions and research that corroborates our existing viewpoint), anchoring (the tendency to emphasize and rely too heavily on the first piece of information we are given), and the gambler’s fallacy (where perceived patterns dictate decision making for events that are actually mathematically independent). These are a cherry picked few out of scores, and I could write fifty posts on the different cognitive biases that have been discovered. However, they all rely on emotions and shortcuts rather than reason.
As already is apparent, these biases can be responsible for disastrous consequences in trading. That being said, a major conclusion drawn from this body of research is that awareness of such biases and cognitive limitations is in many cases enough to largely mitigate their effect. We evolved to contain these “pitfalls” because they actually contributed to our survival and success as a species over long stretches of time. Heuristics save us time, and allow us to move on with intuitive quick wins. However, these mental shortcuts often do not account for logical consistency or perfect correctness – they simply serve as quick and dirty “back of the envelope” calculations for the rapid decision making of life. For instance, Loss aversion presumably prohibited our prototypical ancestors from taking undue risks that jeopardized survival. Those who did were more likely to be killed off.
Others are simply processing shortcuts within the brain that allow attention to remain on higher priority tasks. Also keep in mind that I am falling subject to the narrative fallacy, as described by Taleb in his works. Much of the above prescriptive advice strings together a convenient narrative about how the world came to work as it did. In reality, the observable phenomena that has been cataloged is largely iterative and random – not nearly as tidy as any blog post can account for. Nevertheless, we learn through narratives, and their effectiveness in passing on important information can outweigh the dangers of “dressing up messy data”. But I digress… back to my narrative.
In our daily lives, we can acknowledge that being logically consistent is not what makes us human beings, nevertheless, using sound principles and avoiding common pitfalls can improve our satisfaction with decisions. Becoming critical of framing in the information diet we consume can offset some of the emotional charging that comes with our intake of news and editorial opinions. Questioning whether events are independent or linked may help us to stay level headed in decision making. Accurately assessing how much control we have in an outcome can supply us with a reasonable mix of conviction and steadiness for a situation. And our restraint from excessively discounting the future, or complicated issues in favor of immediate or easy to grasp ones can allow us to plan properly for a life with fewer headaches and regrets.
Traders manage relationships
Traders may socialize with a wall of screens for a living, and many are not the shake hands and kiss babies type. However, that does not diminish the role of communication and relationships in the profession, and of the best are savvy lords over their social networks. A major underpinning of business is the coming together of people to settle an agreement or dispute. Institutional traders do a lot of business, and invariably must settle a number of disputes. While they are supported by a back and middle office, traders are largely accountable for the deals they conduct, and must offer their presence to build or maintain a book of business. One reason that traders work on their network is to know thy enemy. Building a relationship with others and learning their idiosyncrasies is one way to find an edge in the marketplace. While two sides of a trade take an opposing stance, their motives needn’t be zero sum, as a trade satisfies both parties’ objectives in that moment. When one side needs to liquidate a product to come up with quick cash, or they are selling because they believe prices will fall, the other side has its own agenda for acquiring that asset. It may have a business mandate, or retain a tax incentive for holding onto the product. The two sides may sometimes be at war, but they needn’t always be. Relationships come in handy, as they can facilitate bilateral transactions that take place without middlemen like brokers or exchanges. Traders can also offer special deals or good prices in order to build goodwill – in a sense I have your back, so watch out for mine one day. This may sound like microcronyism, but there are other objectives that I believe society is willing to prioritize over price efficiency (to a point), like the stability of trading relationships.
Another reason to build relationships, similar but not identical to the above, is in order to establish a market presence and a personal brand. If a trader wants to sell a block of bonds, she is going to call the person she trusts and respects first to see about interest. If someone has a track record of integrity and good business sense, then this is as much a consideration as price. Business is about the fluidity and pleasantness of an experience as it is about the transaction itself. America’s service industry is founded upon this notion, and good customer service is an enduring tenant of our commercial fabric. I do believe that there is an ethical dilemma when two traders use their relationship to collude against the larger market, or one counterparty greases the wheels for another with perks, only to gouge them on price – especially when a trader is working with principle given to them by clients. This is a conflict of interest, and unfortunately happens frequently. However, if a trader is competitive with the market on price, I believe that it is both morally acceptable and right to transact with the most trustworthy and highest quality relationship in the Rolodex, as this incentivizes higher standards across the market. Regardless of my view on the ethics, this naturally occurs, which is why good traders guard their reputation and master relationships.
Relationships matter outside of business. Letting others know we care, showing interest or concern, and displaying authentic positivity help to strengthen our ties with friends and family. While we are ultimately judged by our actions, being our true selves and remaining open towards others can enhance our character and appeal in the eyes of others. Traders attend conferences and make themselves known in their world. We can do the same by setting up coffee dates and allocating a portion of our budget to meet up with people in our business or share similar values. This has a positive social influence, and is also likely to pay financial dividends as well.
Traders back test
Markets are a social phenomenon, and traders are not scientists. Still, applying scientific principles like objectivity, skepticism, and a willingness to test hypothesis is still valuable.  George Soros likens finance to alchemy – a pseudoscience that does not follow the precise laws of our physical world, though he has acknowledged that valid patterns, sound reason, and a probabilistic mindset can improve a trader’s likelihood of success (and he has capitalized on thinking). In this light, we concede that theories can not be proven, only disproved. Many of the best traders use the tools they have available, being computer simulations, historical data, spreadsheets, books, and mentors, to test their views of the world against actual outcomes. As mentioned above, there is a case for efficiency, and markets are dynamic, so agents correct for past behaviors and compensate in the future. However, traders derive theories about systematic behavior in the market – correlations that have held strong over long periods of time in order to place future wagers. This is where they can derive value from, and the cycle of creating a thesis, testing it, choosing to keep or discard the theory, making a trade, and recording the result, and refining the thesis continues day in and day out.
The best are constantly learning from their mistakes and keeping good record of why their position turned out a certain way. Even if the markets are not a pure science, solid information and reflection do allow for a crude controlling of variables when future situations emerge. This awareness of self and the environment improves a trader’s ability to handicap odds and pinpoint the true catalysts driving risk and reward.
Peter Drucker said “what gets measured gets managed”. Traders manage exposure to risks, rather than people or products. Beyond the world of stocks and bonds, we can better manage our time, money, and relationships by tracking our actions. This does not need to be a grand effort – it might be a simple step like managing spending with an application like Mint, or a spreadsheet. It could include using a fitness app to look at our actual exercise streak, or it could be jotting a note down every time we catch ourselves in a bad habit. Tracking these behaviors frees us from the mental distortions of estimation. We may believe that we were more on track with our habits simply due to the mood we’re in, or our current level of motivation. However, the real data allow us to look back and more accurately take stock of what we did right, what we did wrong, and how to account for any differences over time.
Top Traders spend so long studying, that they internalize knowledge as intuition
There is plenty of mention above about the stereotypes associated with traders – that they are of the snap judgment “go with the gut” crowd. Compared to a research analyst, their decisions are faster paced, but that does not mean that such choices are devoid of strategy and deep thinking. Instead, I believe that this notion of intuition and fast thinking can be framed as the culmination of study and practice into near automatic behavior. Just like top athletes, artists, and other performers, the best traders give off the illusion of wizardry through constant honing of their craft. While many in the field are intelligent, it’s often discipline over raw intellect that separates the great from the good. Those who are willing to focus and study the dynamics of a market can commit what was once a mechanical process into fluid second nature.
Across disciplines, intuition is mistaken for a pure and unarguable gift. There is a case for inherent inclination, but it appears that dedicated practice and work lead to the consummate presence of “a natural” among top performers. See Dr. Daniel Chambliss’s study of Olympic swimmers for a more thorough investigation of this idea (http://academics.hamilton.edu/documents/themundanityofexcellence.pdf). If you accept this premise, that hard work and careful refinement lead to significant improvement, then you question and diminish the credibility of talent as an explanation for greatness. Yes it is true that there are physical and social advantages in the world, I don’t deny that, however, I do have a problem with the highly self defeating mindset that initial hurdles exclude someone from the winner’s circle in a definite way. Instead, be open to the hypothesis that talent is an overused social abstraction which allows us to excuse mediocrity in our own lives. After all, it’s very easy to pick up and move on without putting in hard work once you’ve rationalized the idea that “I never had a chance, he’s a prodigy”.
The ethic of mundane excellence opens us to the notion that we can achieve automaticity in a given field after enough dedicated practice. Those who love a subject or pursuit, like history or the drums, often do important learning away from their books or instrument. Psychologists have noted that much of the important legwork done by masters of a craft (even physical) occurs during mental rehearsal. If you love something and are thinking yourself through the motions of it on your own time, then you’re very likely honing that ability. This also addresses one of the top insecurities of those climbing the ladder – that pressure to perform at elite levels ebbs to such height that it might crush those not up for the challenge. While the stakes are higher as you approach the top, the practice and internalization of good habits allows performers to achieve them with the necessary confidence and composure to succeed. In a nutshell, practice gets us closer to perfect, and more consistently so.
Traders bury losses and move on
Another separating trait of great traders is their ability to learn from the past, rather than to wallow in it. To kill off a bad habit might be more valuable than forming a good one. In the same way, great traders who have taken a risk that is not paying off are more inclined to cut their losses for the sake of a better idea instead of making an emotional choice to double down on a sunk cost. There are analogues everywhere in our personal lives – for one, the choice to cut out bad influences or relationships at the cost of admitting that we were wrong to live with them for so long. I’ve struggled to make tough, but necessary decisions, failing to take action, under the guise of frugality. An example would be my failure to take my first car into the shop for a small repair. I bottomed out on a driveway, and knocked a component of my exhaust loose. For a while it made a noise, and nothing more. I was more concerned about the $300 I’d need to pay a mechanic to fasten the component than the long-term soundness of my vehicle. After months of this, the clunking got worse, until it climaxed one night on a major highway when I went head to head with a nasty pothole. That was the death knell of my car, as the entire exhaust mechanism came lose. The car could still drive (albeit with great strain), and I was STILL stubborn enough to keep out of the shop. A week later, the car sputtered, and made its last grunt. Luckily, I was at the top of a hill and coasted her in neutral for almost a mile into my girlfriend’s driveway. Instead of a $300 or even $500 repair, I now had a clunker that could not run. and a repair that cost more than the car’s value. Preventative maintenance is the inverse of cutting losses short – good traders do both.
Of course, letting winners ride and curtailing losses applies to other forms of business, especially entrepreneurship. Those who can recognize that a bet is going sour can still get out alive if they took manageable risk in the first place, and acted quickly enough to stop things from getting worse. But what about having conviction? Doesn’t this contradict having confidence in a choice to see it through? When choices are made out of principles, we are better informed on when to continue rather than to stop. Those without a solid map of the environment, are left to more crude devices to guide them – one of these is our emotion tool pack. If a trader lays on a deal in anticipation of a high probability outcome, then they will stay in the deal as long as new data or information doesn’t emerge to change the thesis. One reason that blind speculators go bust is that they enter into a position without a backup plan or a real idea about what to do if they happen to be wrong. Good traders have a thesis and a standard that they abide by which kicks off a process to reevaluate the decision. Things appear to be random and chaotic when we aren’t analyzing with sound principles, and poor theories. It’s like walking through a dark room with a single match, when others are using a flashlight.
One final note on cutting losses short. Even though MF Global (a large brokerage) took a position that turned out to be correct, they chose to stick with a losing horse on their books, and went bankrupt before the marks turned around in their favor. Instead of looking to firm up their liquidity, living to fight again, they undermined a principled decision and kept exorbitant sovereign and repo trades on their books until it became far too late. What good does it do to be right, if you go bust?
Traders remain humble (at least in a few key ways)
Yes, Wall Street has a reputation for opulence. And yes, some on the inside take pride in that. Even though traders are thought of as blunt and outspoken, and even flashy, the ones who stick around tend to make a sober acknowledgement – that they will have done extraordinarily well if they were right sixty percent of the time over a career. Most people underestimate the challenge of performing better than the market, let alone doing so over any consistent time period. The law of large numbers dictates the increasing difficulty of consistent returns, and additionally the competition of investors with improving technology and mutating strategies make it difficult to cash in on the same trade over and over. Sure, you can flip a coin to land on heads three times in a row, but good luck doing it ten times (you have 1/1024 odds). It’s all but a prerequisite to hang on that a trader sizes up their slim odds of repeated success. It’ a low probability that you will achieve greater than market returns with little work, and certainly no guarantee that you will with much hard work.
That insecurity is fuel that fends off complacency, and puts a higher burden of proof on the trader to deem a trade worthy of capital. Having these realistic and modest expectations are so important for two reasons. They allow for resilience in the face of adversity, and they mitigate the “rush” of confidence that can follow a windfall profit. Traders diversify, isolate relationships with spreads, and look for systematic ways to exploit relationships, like locational arbitrage. They are putting as little capital on the line as possible to reap a percentage gain, and keeping enough of a reserve on the sidelines to provide for any reasonable contingencies. This is all because the market can be merciless to those who take bold risks with overconfidence. Even those with a logical case and all the reassurance in the world may find themselves on the wrong side of a trade. You could have all the reason in the world to believe that oil will fall in price this year… until news breaks out of nowhere that Saudi Arabia arbitrarily decides to cut production. Good luck covering your short. Lay on top of this the political elements of being on a team that trades, where conflicts of interest and cultural norms may lead to tremendous pressures to act and invest a certain way. These can cloud judgement and make it even more difficult to arrive at the best possible analysis. Finally, lifesaving lessons may be learned in times of distress, and fatal errors committed in times of great confidence.
Acting out of a conservative viewpoint can save us in time of distress, yet vigilance is hardest to maintain at points when it is needed most – we are most susceptible to risks that we have written off. Instead of becoming a doomsday pessimist, smart traders show great maturity by assessing opportunities in the light of a worst case scenario, and then deciding whether the risk is still worth it. Looking back to major investor blow ups, such as long term capital management or Bear Stearns, their faltering prospects are rooted in a failure to give downside enough consideration when times seemed good. Whether it be the formation of a model with an insufficient worst case assumptions, or the hubris of management to ignore red flags for the sake of quick profits and greed. We look back on the housing crisis of 2007 and ponder how the assumption that housing prices would not fall could hold any weight, yet at the time, it was extremely unpopular to contest this notion – additionally, those who did contest were forced to sit out from the festivities of the market, leading up to its freeze. Everyday, people make the right trade, but with the wrong timing and lose money. Maybe they were too early or late. Simultaneously, bad trades make money all the time, and people will end up wrong in their thesis, but still profit for a different reason. Having the maturity and the discipline to battle these head and tailwinds allows the fortitude to continue searching for the signal in the noise.
This humbled approach works wonders in other areas of life. You needn’t expect the worst to happen, only to acknowledge it and have a course of action in the unlikely event that it does occur. This allows us to fundamentally change our thinking, and leads to better outcomes. For one – to assume that your job is secure is probably one under-assessment of risk. To take for granted that our friends and family will be with us for the foreseeable future is another. Considering that our job may be cut, even if we perform well and like it is a valuable mental exercise. It may compel us to expand our network, and to meet others in the field, perhaps to retool and train ourselves. All of this not only prepares us for the worst, it also fortifies our current position by allowing us to be more confident, and better able to perform at a high level. Realizing that bad fortune can end our own lives, or those around us helps to frame priorities and create a more fulfilling existence where we seek to get the most out of our time and relationships.
Nothing sums up this mentality better than the high school dating scene. If you were shy like me, approaching a crush was intimidating. There was a reinforcing system, where the shy people had less of a chance at finding a date, while those who were confident and tried approaching a guy/girl had better odds. Even if both of them were equally good looking, intelligent, funny, engaging, etc., the confident guy who found a girlfriend signaled to everyone else that he was desirable. Pretty soon, people were drawn to him or to the female “queen bee” equivalent. Because of this, the star quarterback/cheerleader was likely to feed that they had less to lose, with more options, and was able to approach the person they like most with strength and self assurance, thus raising the odds that things would turn out great. Those who put themselves in hedged positions with limited downside are better able to capitalize on the upside, since we are not held back by fear of loss or judgement. This is why I believe in having strong personal finances so much – those who are not shackled by the need for an income can more freely explore their options, and will be less likely to endure a soul crushing job or ethical dilemmas for the sake of making rent. “Fuck you money” may sound like a crude term, but it’s a vindicating ideal when you consider the corrupt or domineering people that you can tell off if you don’t need their money.
Traders pay their brokers well
A final observation about good traders, and business people in general is that they pay their brokers well. Even the most successful acknowledge that they can’t do everything alone, and that a team of talented associates is hugely valuable. Brokers help to line deals up between two parties. Their business has largely been relationship driven, and continues to be, even in the face of technological advances. Plenty of middlemen are useless, and serve as nothing more than a toll collector without adding any value to a transaction, but good brokers are critically important, often serving as king makers. Because a broker does not take risk in a market (they don’t hold an inventory), they are often better suited to get the scoop on competitors in a marketplace in a way that competing traders cannot. With a more integrated view of the market, good brokers no how to match people together in ways that are win win. If I’m in a position to befriend a king maker, so long as I size him up to be good and honest, I fully intend to let him know that his service is appreciated. This goes contrary to the convention of the securities industry, in which many risk takers (traders) look down at brokers as glorified assistants who “work for them”. I am baffled by this sentiment, as both professions are on fairly equal footing in terms of compensation, responsibility, and engagement at the highest level.
One of the best traders that I know, who received multi million dollar bonuses for many years spoke about the top brokers he knew with a sort of reverence. It’s funny because this man treated his team of analysts, assistants, and other supporting staff like they were a vital link. While he did not take mistake lightly, he always let his people know that he had their back, and that they were a vital part of his operation. He is still one of the people that I admire most. I know for a fact that these people he recruited to work alongside him could make or lose his year with a large enough mistake, even if they were only getting paid $30,000 a year by the company. His way of acknowledging responsibility afforded him a truly loyal team, that would follow him rather than the company in the future. Do you think he was the first person notified when a good deal came up? Do you think that the analysts and staff were quick to defend him and look out for his back? Yes on both counts.
So many people have it backwards – they look at climbing the ladder as a personal testament of individual success, rather than the culmination of effort by the teams they are a part of. I hate freeloaders as much as the next guy, but why make our lives more difficult by refusing guidance from mentors, support from the best practitioners, relationships with the best brokers? There’s a sort of arrogance to turning these down on the grounds of pride. Great traders generally aren’t afraid to go against the norm, but they still execute their plans with the help of a team. These same misguided people may aspire to higher positions so they can push others around, or feel superior. I find the opposite to be a better path, to bring others to the top with you. Building a small army of allies is a great way to build credibility and insulate yourself from the political pitfalls of business. As long as we are maintaining a mind and voice of our own, I don’t see much to lose from keeping other great performers at our side.
The above is only a small list of traits I have seen among great traders. This profession is appealing to many because of the idea that one can reach great heights by out-thinking the competition. It’s more entrepreneurial than most jobs out there. You are left to your own devices to make money, and as long as you do so without breaking the law, you don’t need to buy your boss a fruitcake to stay out of the cross hairs. There are traders who perform extremely well for reasons other than those mentioned above, and many who don’t fit the picture I have described above. As mentioned, there are plenty of anomalies, or people who have figured out exceptional systems to capitalize on. What I have described is a set of commonly observed mindsets and characteristics among those who have succeeded in this profession, many of whom have parlayed the same cocktail of intelligence, vigilance, and opportunism to succeed in other areas of life. Go find out for yourself by interviewing your own cast of characters – use the tips from my networking in finance article to test the above statements, and to hone your individual path to success.

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