Once upon a time three people each gave $100,000 to a money manager in what they hoped would be a highly profitable venture. The money management firm adhered to a carefully tested trend-following methodology. It set up separate accounts for each client and managed each of the accounts identically. Risk never exceeded 3.5% of capital on any market traded, and the average historical loss per losing trade was under 2%.
The first client was retired and filled with wanderlust. So, he decided to take off and travel the world. He didn't return for 14 months. In his stack of mail when he arrived home were 14 brokerage statements. He sifted through them and opened the most recent one. He was pleasantly surprised to discover that his initial investment had grown from $100,000 to $227,000.
The second client was also hoping for above average returns on her $100,000 investment. As soon as she received her monthly brokerage statements, she quickly opened them to see how well her account was doing. For four months in a row, she watched her account balance grow from $100,000 to $170,000. Needless to say, she was thrilled.
Then, however, things seemed to change. Over the next two months, she watched her account balance fall from $170,000 to $161,500 and then to $133,000. That $37,000 drop in two months really spooked her. She worried that, if it were to continue, she might be back to breakeven or even worse. She called the manager and closed her account, walking away with $137,000.
The third client was different. He had a lot of time on his hands and was computer literate. He loved the idea that he could check his account online anytime, 24 hours a day. Since he was home most of the time, that's exactly what he did.
For the first month, he only checked his account once or twice. At the end of the first month, he was pleased to see his account was up by over $20,000. The next month, he decided that he wanted to take a closer look and see how the manager achieved such fine returns. At least once a day, he logged onto his account and tried to understand it.
As he watched his account day after day, however, he became nervous. On some days, he'd see his balance grow by as much as $15,000, only to see it drop $5000 the next. He wondered what in the world was going on. So, instead of checking his account daily, he decided he'd better watch it at least two or three times a day. Sometimes he'd see nothing at all; other days, he'd see his balance change dramatically. Although his account was up another $20,000 at the end of the month, he found the movement in his account to be intolerable. He called the manager, closed the account, and walked away with $140,000.
There was one money manager handling three identical accounts in an identical fashion. After the first two months, each account had grown by $40,000, but the third client had quit. After another four months, the remaining two accounts had grown by at least $37,000, but the second client had withdrawn. After 14 months, the first client, who had not quit, saw his account grow from $100,000 to $227,000.
What set these clients apart from one another?
Their investment was conceptualized on one timeframe, but two of the clients managed the investment on a shorter horizon. We see the same dynamic among traders who get shaken out of good trade ideas when they replace their profit targets with tick-by-tick market scrutiny. Take Friday's trade, for example. Shortly after the jobs report, we spiked to 1324 on the S&P futures, pulled back, and then failed to take out that level as interest rates soared. By the time the market opened for its regular session and bounced back to 1322, market weakness was apparent. As I posted to my research blog, only two of the 17 stocks I track in my basket of representative issues were making new highs for the week despite the seeming S&P strength. A trade back to the previous day's midpoint of 1316 was statistically likely, providing quite a few points of profit potential. A couple of upward jukes of more than a point each, however, were enough to scare many traders out of milking that trade.
Anxiety results from the perceived threat of uncertainty. Once we have a profit in a trade, we have something to lose. Uncertainty is now perceived as a threat. That leads us to cope by asserting (over) control, managing the trade on a different timeframe from the one that had initially led to the trade. At that point, we are no longer truly managing the trade. Instead, we're managing our own anxiety.
That is the very definition of emotional disruption of trading: when what we do to avoid loss prevents us from winning. The ability to tolerate uncertainty separates the trader who trades to win from the one that trades to not lose. We can only benefit from demonstrated edges in the market if we can allow those edges to unfold. But how can we learn such patience? Brett's next article will outline ways we can improve our ability to sit in good ideas.
