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The one weird trick to being a good trader

In both equities and crypto, something I’ve always heard people say is: “I’m bad at market timing.” And here’s what I always tell them: “No one is good at market timing.”

Anyone who tells you they are is either 1) new to trading or 2) a liar.

That does not mean it’s impossible to be a good trader — very few are (trading is really hard!), but some are better than others. 

What sets the good ones apart, however, is not the ability to pick market tops or bottoms (I’ve never heard a real trader say they can).

Nor is it about being better informed, smarter or good at spreadsheets.

Instead, the best traders set themselves apart by being good at just two things: risk management and behavioral psychology.

Helpfully, if you’re good at one of these, you’re probably good at the other too, because the same underlying traits are required for both — non-quantitative things like temperament and judgment.

That’s not to say you need a particular type of temperament or judgment to be successful, you don’t — if trading selected for a certain type of person, there’d only be one type of person in trading. (There’s not.)

But I do think there’s a single trait common to those who manage to stick around.

So here's my one weird trick to being a good trader: Know thyself.

Your personal trading strategy

Do you think in probabilities or absolutes?

If the former, you should aim to have lots of small winners; if the latter, you should aim for a few big winners.

Are you a Bayesian rationalist (reassessing your view with every new data point) or a true believer (using every new data point to add to your conviction)?

You cannot Bayesian your way to a 100-bagger (to hold a position that long, you have to have some irrational belief in it), so if that’s your way of thinking, don’t swing for the fences.

Are you a dabbler skimming the surface on a diversity of topics? Or do you enjoy going down rabbit holes?

The former’s trading book should include lots of positions; the latter’s, just a few.

Are you naturally contrarian or conformist?

The former will be a “swing trader,” going against the trend; the latter will be a trend follower.

Any one of these strategies might work for you. Or its opposite. 

But not both!

No one, for example, consistently makes money being long value stocks when that’s what’s working and then makes money again being long momentum stocks when that’s what’s working.

You have to pick one strategy (value or momentum, in that example), pursue it to the best of your ability and hope for the best.

This is the unintended message of Market Wizards, Jack Schwager’s much-loved series of interviews with legendary traders.

All of his trading wizards had one basic idea that they cashed in on when the market happened to reward that idea.

Which is to say, they didn’t make money by jumping from one idea to the next — they made money by waiting long enough for their one idea to work.

Schwager noted that all of the traders he spoke to had a trading strategy that “fit their personality,” and I think that’s what gives you the conviction to wait for your time to come.

To make it in trading, you really have to know who you are.

Be a little delusional

Being self-aware is your only chance to overcome the behavioral finance quirks that bedevil investors, such as loss aversion, anchoring and recency bias.

But traders have to be even more self-aware, because nearly every theory in the broad field of behavioral psychology is applicable to trading.

Motivated reasoning: Interpreting new information to confirm a preexisting bias might turn a small loss into a large one.

Confirmation bias: Selectively seeking out information we already agree with (following a bunch of bitcoin maxis on Twitter, for example) is like voluntarily wearing blinders.

Self-deception: Overestimating our ability to assess risk exposes us to risks we don’t know we’re taking.

Wishful thinking: The line between thinking a long position will go up and wanting it to go up is barely perceptible.

Illusory superiority: Are you sure you’re smarter than the collective hive mind of markets?

That short list is only a sample of the self-inflicted impediments to trading success — and it gets worse.

To be a good trader, you have to be self-aware enough to be cognizant of all these behavioral pitfalls — but you also have to embrace them.

If you weigh all information equally, you’ll be paralyzed by indecision; if you don’t confirm your bias at least a little bit, you’ll never hold a position for long enough to profit; if you don’t somewhat overestimate your judgment, you’ll never even take a position; if you truly respect the market, you won’t try to beat it.

How can you do both?

Neil deGrasse Tyson quips that a great challenge of life is “knowing enough to think you are right, but not knowing enough to know you are wrong.” 

This is nowhere more true than in trading.

Thank you for coming to my TED Talk

I've oversold today’s newsletter with the clickbait subject line (but you knew that).

Even with a Dalai Lama level of self-knowledge, it's not clear that trading will work for you — because it's not clear it works for anyone.

When the great behavioral psychologist Daniel Kahneman did a study of investment advisors, he determined — to his surprise — that they were playing a game of chance, not skill — nothing in their investment returns suggested that successfully picking stocks is a replicable process.

This accords with my personal experience.

Over the years, I’ve collected a lot of anecdotal evidence that trading is mostly luck and very little evidence that it’s mostly skill. 

Traders at banks that make money one year are likely to lose it the next; successful hedge funds are better at raising money than they are at managing it; the best equity analysts are better at sales than they are at analysis.

In a way, though, I think this levels the playing field.

If banks, hedge funds and full-time analysts don’t have an edge, it suggests that trading might be mostly about behavioral psychology.

If so, self-knowledge — something you can control — may really be the one weird trick to being a good trader. 

Your trading strategy needs to match your personality, for sure, and you have to strike just the right balance between self-awareness and self-belief.

You might do it!

But let’s not indulge in wishful thinking: Even the best traders don’t beat the market for long.

— Byron Gilliam

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