Stock Market for Beginners

The stock market is fascinating because you can make the right decisions and lose money or make the wrong decisions and make money. Far too often, experienced investors get caught up in the day to day performance of their portfolio that they lose sight of the big picture of making long term profits. Here’s a very applicable quote from Edwin Lefevre in Reminiscences of a Stock Operator:

My plan of trading was sound enough and won oftener than it lost. If I had stuck to it I’d have been right perhaps as often as seven out of ten times. In fact, I always made money when I was sure I was right before I began. What beat me was not having brains enough to stick to my own game - that is, to play the market only when I was satisfied that precedents favored my play. There is a time for all things, but I didn’t know it. And that is precisely what beats so many men in Wall Street who are very far from being in the main sucker class. There is the plain fool, who does the wrong thing at all times everywhere, but there is the Wall Street fool, who thinks he must trade all the time.

The desire for constant action irrespective of underlying conditions is responsible for many losses in Wall Street even among the professionals, who feel that they must take home some money every day, as though they were working for regular wages.

Lefevre’s lesson rings true with my poker experience as well. I knew that I was a long term winner at the game, but far too many times, I would play hands that were negative expected value because for some reason I was bored and wanted action. In these times, I let emotion take over and the desire to win the current hand regardless of the theoretical correct play. Obviously, it’s difficult to realize when this deviation occurs until after the fact, and even more difficult to discover if you don’t keep some sort of performance journal (that’s why so many pros will keep poker or trading journals).

The same idea goes for investing. You can have the best trading strategy in the world, but if you don’t stick to the game plan, it’s worthless. I want to do a little thought exercise to see how we can conquer this obsession with the present and winning in the now.

Imagine that you created a trading or poker machine that always made good money in the long run. If you let it run over the course of a year unobserved, you’d be guaranteed a pretty substantial return. Now, let’s say that you could watch the robot’s performance on a daily basis. You would find that there would be great fluctuations in it’s daily performance: some days the machine would win big and some days the machine would lose big. If you were to watch the machine lose a large amount on one day, would it be wise to tell it to change its strategy? Obviously not. In fact, the only reason you might be tempted to tell it to change its strategy is because you became emotionally involved in the short term fluctuations. The best thing to do is to let the machine continue with its current strategy and it’ll continue to offer you solid returns.

Investor Psychology Summary

Hopefully you can see how this analogy can be applied to your trading philosophy. If you have a solid investing plan, you need to trade like a machine. Pull away from the emotional urge to win on a day to day basis and look at the big picture.

There is, however, one caveat to this concept. It assumes that you have a solid trading plan that has a positive theoretical long term expected return. If your strategy is not profitable, then sticking to your plan through downswings can make you go bankrupt. That’s why it’s crucial to keep a trading journal to monitor your performance. I will go into more depth on the importance of keeping a trading journal later on.

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