How to Bounce Back

Some traders take setbacks in their stride, others are crushed by losing money. How can you build resilience into your trading strategy?

---

One of the books I return to most often is the short, enigmatic but endlessly inspiring and thought-provoking Missing Out by the psychologist Adam Phillips. In the book’s title essay, Phillips writes eloquently about the way that the paths we do not take in life give shape to the path we end up choosing. He argues that we are haunted by these unlived lives – they are constantly stepping alongside us, offering either a critique or a celebration of our choices. I – like many, I suspect – once harbored dreams of playing professional sport (for me it was basketball). Notwithstanding my lack of an NBA Championship ring, I find that I’m largely happy with how things have gone so far according to Phillips’s model of the world (although a life without regret is a life without risk).

I thought about Missing Out in the context of the work we’ve been doing on the skills and psychology of traders. ‘Prospect Theory’, the classic 1979 paper by Daniel Kahneman and Amos Tversky, represented an important milestone in the understanding of decision making under uncertainty. Central to their theory is the idea of loss aversion – the way that people experience the pain of losses more than the pleasure of gains. The chart below shows this phenomenon graphically, illustrating the flattening kink that occurs around zero, with the value function rising at almost half the pace in positive territory that it falls at values below 0.

For corporate managers, loss aversion explains their reluctance to shut down underperforming projects and influences decisions on mergers, acquisitions, and dividend payouts. Regarding asset prices, it sheds light on the persistence of high average stock market returns (Thaler's equity premium puzzle), the significant volatility of stock returns (the excess volatility puzzle), volatility clustering in stock returns (the GARCH effect), and the predictability of stock returns through various factors over time and across different stocks. It also explains why traders are more likely to hold onto losing stocks too long (to avoid the pain of loss) and sell winners too early – the Disposition Effect.

There are hard-wired evolutionary reasons for this behavioral quirk (a good paper on that here). But I’m interested in the way that traders are often haunted by specific losses, as if these missteps, rather than being opportunities for learning, represent inflection points in a career, moments of disaster from which there is no returning. I have seen good traders destroyed by their inability to bounce back from these setbacks.

Phillips urges us to view our unlived lives as sources of inspiration and affirmation, rather than mourning the what-might-have been. For traders, this is all about how we deal with the fact that, at best, we’ll only be right just over half of the time. An important – perhaps the most important – characteristic of a successful trader is the way they recover from their lowest ebbs.

Allowing yourself to recognize the place of chance and exogenous effects in investment is the first step here. We then need to learn to acknowledge and digest our own errors without permitting ourselves to be haunted by them. We know that it is human to overvalue what we can no longer possess (or what we perceive that we might have gained). We need to understand these biases and incorporate them into our investment process. We need to learn to minimize our use of reference points – markets are relative and entry and exit points are only useful in as much as they reflect what is going on more broadly within and beyond the asset class.

There are also different types of losses. As my colleague Henry Neville, CFA VictoryShares US 500 Volatility Wtd ETF pointed out in a recent article, there are asset classes that deliver small but regular drawdowns, or asset classes where drawdowns are rare but spectacular. The former, I suspect, might make you more resilient as a trader.

There are, as I said earlier, strong evolutionary reasons that humans have an in-built pessimism. We feel our losses more intensely than we cherish our successes. In finance, it feels like there’s another rational reason for this psychological quirk. In a geometric world, where returns are compounded, anything we can do to mitigate or minimize our losses has enormous potential benefit. A 50% loss requires a 100% gain to break even. We fear drawdowns because they can be genuinely catastrophic. It’s why any number of investment titans cite some variation of Edwin Lefevre’s maxim in Reminiscences of a Stock Operator (1928): “Cutting losses quickly is the foremost rule of speculating.”

I would add to this a supplemental, more nuanced piece of advice: be guided by the paths not taken. Understand counterfactuals but don’t allow yourself to be haunted by them. Frame every setback in the optimistic light of a career that accrues insight and experience over time. Be resilient, be courageous, embrace failures as an unavoidable, but not defining, part of life in the markets.

By Steven Desmyter, Contributor