How To Exploit The 80/20 Rule In Trading & Investing 3
While “Cut your losses quickly and let your winners run” may seem like simple and good advice, reality tends to be very different, as it is with all pithy market sayings.
What it doesn’t tell you is just how difficult it is to cut losses quickly while letting winners run. Even knowing what to do, our psychological and emotional makeup does not make it easy to actually do it.
The problem starts with the many, many times we do not get lucky, and must minimize our losses so as to be able to stay in the game.
Big losses in a Paretian environment tend to be catastrophic, and very difficult to recover from. Again, trailing stops are an invaluable tool here, as they help cap losses while locking in profits as the market moves in a position’s favor.
More importantly, trading in a way that takes advantage of Pareto effects is psychologically taxing.
This is due to the fact that a trader has to take many, many small losses, without knowing when the big trade is arriving, a process that has been referred to as “death by a thousand cuts”.
This causes mental and emotional stress, as our human minds generally feel the negative emotions that arise from consistent losses more acutely than the positive ones from large but irregular gains. Moreover, when trading in such a manner, one cannot afford to miss a trade, since any trade can be the big one.
As such, many people fail in successfully executing such strategies because of the psychological and emotional stress.
Of course, “taking many small losses” varies in form, largely depending on the trader’s strategy.
For CTAs (aka trend followers), small losses are known as “whipsaws”. This occurs when CTAs take positions in a market that they think is trending, but turns out not to be (no one knows beforehand when a market will trend).
A popular way these traders decide on whether or not to take a position is by looking at markets that are breaking out of previous ranges. Unfortunately, most breakouts turn out to be false moves, and prices quickly drop back into the previously established range.
When this happens, CTAs get stopped out and take the small loss, which is of course exactly what their strategy demands of them. However, since most breakouts don’t lead to robust trends, CTAs end up having to take many small losses before a nice trend comes their way.
Again, this is in line with their strategy and trading philosophy, but the stress of having to take so many consistent losses and seeing one’s trading account shrink accordingly causes many to give up.
A good real life example of this is the trading experiment run by Richard Dennis and William Eckhardt. The two men demonstrated that it is difficult, but possible, for anyone to be taught to become successful traders by adhering to trend following rules.
It goes without saying that when a trader gives up in a Paretian environment, they lose their chance at making back previous losses (not to mention profits on top of that), since they are no longer exposing their trading account to positive Paretian effects, i.e. the big one.
Consequently, it is a popular misconception that good traders are the most intelligent, most hardworking, and most risk seeking individuals.
These qualities can be useful, of course. But ultimately, good traders are the ones that understand that we live in a Paretian world. And have the mental and emotional stamina to consistently execute a trading strategy that is designed around Paretian realities.
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