*by Brendan Moynihan & Jim Paul* 👨‍💻 **WORK IN PROGRESS** ___ ## Notes to Self >All I want to know is where I’m going to die so I’ll never get there. “A single man is a crowd, and a crowd is a single man” see Seneca Letter VII There are many ways to make money in the markets, but only a handful of ways to lose it all. Generalization: It's easier to identify bad decisions and refrain from making them than look for good ones (which creates space for wishful thinking). So there are less ways of making bad decisions and bad stuff than making good ones. Therefore, making good decisions has mostly to do with not making bad ones, much like Schopenhauer's advice on reading: "A precondition for reading good books is not reading bad ones: for life is short." Behavior define domain, not the other way around. ___ ## Reading Notes (2) Success seeds its own demise; it creates a distortion field by getting the ego involved into decision-making, pushing towards wishful thinking. This happened to Henry Ford, who came to believe he could not fail, thus starting his company's downfall in the 1920s. We can call this phenomenon the personalization of success. (3) "Success always obsoletes the behavior that achieved it." — Peter F. Drucker (3) Success tend to make people overestimate their role in achieving it, rather than attributing it to good decision-making that capitalized on opportunity, or luck. (8) The author tells he understood early on for himself that it's not what you do, but how much you get paid to do it that matters. (20) Knowing the right person to get something done will get it done. (20) "If you don't know it's a game and how to play it, you will stress out." (22) "You can either play the system or you can let the system play you. Pick one. I like playing the system because it's more fun and you win more." (34) Commodity exchanges have memberships; you buy a seat at the table to be allowed to trade there. (35) Get whatever edge you can get, even if it's just four letters on a badge: "LUCK". (36) Associate with the movers and shakers, so that you learn from the best. (37) Running aggressively when others are just afraid of ridicule makes you win. You don't even have to be good. Most people have a "I don't want to run because I don't want to lose" routine. (37) "Anytime you see a committee of more than ten, it isn't the real committee. There's a subcommittee somewhere making the decisions." Underlines the fact it's not realistic to make decisions when too many people are involved. (37) "I couldn't believe I had just been elected to the Board of Governors, and I didn't even know the Executive Committee existed, but suddenly I was on it. I had only been in town six months, and I was elected because I had presence, wore a vest and $80 shoes, knew a lot about the markets and knew a lot of people in the industry." (39) Luck pushes people to overestimate the share of their efforts in successes, seeding the seeds of a downfall. Once alert for opportunities, you become blind to pitfalls. (39) Other people's opinions are a lagging indicator: If you're evaluating yourself through them, you'll always be out of touch. In successes you'll believe you're great, in failures that you suck. Neither is true. (43) "Here I was thinking I could make money in Arabian horses, and I couldn't even ride one." (47) "There's nothing worse than two people who have the same position talking to each other about the position." (47) "One of the oldest rules of trading is: If a market is hit with very bullish news and instead of going up, the market goes down, get out if you're long. An unexpected and opposite reaction means there is something seriously wrong with the position." (50) Hot hand fallacy: Believing you can't lose and be left wondering how much you'll win instead of wondering if you can win at all. You watch losses with a smile instead of taking them. (53) Don't make information fit your scenario. (54) "Time is very painful when you're losing money." (54) "I couldn't get out of the market because as long as I had the position on, there was always the belief, the chance, the hope, that I could make back the money." (59) On overestimating you role in your successes: "Sure, I had made money in the markets, but it turned out that I really didn't know how or why I had made it." (60) Memes, aphorism and wisdom you don't really understand are dangerous. It makes you feel you know what you're doing because you think you have the culture and knowledge, but you can't apply it. (64) Learning how not to lose money is more important than learning how to make some. There are less ways to die than there are to live. (67) If you keep trying to make money, you'll ruin yourself; if you learn how to take losses first, you'll make money almost certainly. Wanting a result often prevents you from achieving it, because it makes you blind to what matters. As Charlie Munger puts it, "All I want to know is where I'm going to die so I'll never go there." (67) There are as many ways of making money as there are participants in the market, but only a handful of ways to lose it all. (68) Losing money is the result of either faulty analysis or flawed application. There isn't one kind of analysis superior the the others, so we should concentrate on flawed application regardless of the analysis. Psychological factors are responsible for flawed application; they're either pathological, in which case you need the help of a specialist, or behavioral, which is what will be discussed here. (69) Personalizing the market gets your ego involved and infects your decision-making. (73) "I can't get out; I'm losing too much." — Loser's famous last words (74) The author keeps repeating gamblers do bad in the market and that gambling is not like trading. Yet Annie Duke, a poker player and author on decision-making, outlines how crucial it is to be able to take losses. As we'll see later in the book, this is because you can be speculating in poker and gambling in the markets. Your behavior dictates your activity, not the category you're applying it to. (74) In the markets, taking losses requires actively taking the decision to realize losses, as opposed to other types of business ventures where it's something you do passively. So the path of least resistance is not to take losses, which is why it's so fundamentally different from other activities. It's like poker in this sense, but unlike it it's a continuous process where there are no discrete events requiring you to take a decision. (74) Losing is associated with failing and being wrong; but they're not the same thing. Good decisions can yield bad results, and the reverse is also true. (75) External losses are objective, independent from the observer, and not subject to evaluation. Internal losses are dependent on the reaction and feelings of the observer. People can make internal losses out of external ones if they equate their self-esteem or internal state with success or loss, thus internalizing external losses. (75) Market losses should be viewed as part of the business, much like a farmer loses some of his crop to birds. (The [[Four Pests Campaign]] illustrates the point perfectly. Wanting to run away from crop losses completely, China got rid of sparrows, until they had to import them again from Russia because it turned out they were protecting the fields from worse while taking a small fee; this lead to a starvation.) Making external losses internal triggers more losses because you can't take the active action required to pull the plug. (76) Decisions can be good or bad; opinions can be right or wrong; facts cannot be discussed, they are. Decisions are taken without all the facts and might be good or bad after they've been made and only then. Using the terms 'right' and 'wrong' to talk about positions will make you personalize them, In doing so, you'll exit good positions to feel good and stroke your ego, and stay in bad ones to avoid taking the losses. (78) Five stages of internal loss. What is true of coping with death is true of coping with other kinds of losses. (82) It's easier to personalize losses in continuous processes. The stock market is the worst because you don't get margin calls. (87) Risk is the possibility of a loss; it's only a probability if you can assign a numerical value to something. Casinos are different from markets because they create the risk instead of handling inherent risk. But the difference between investing and gambling has more to do with the player himself and his behavior than the activity he engages in. (89) You can either be investing (long term with hope of return), trading (extracting bid-ask spreads), speculating (buy for resale), betting (being right or wrong about a certain event) or gambling (betting on chance). (90) Participating in the markets doesn't make you an investor, a trader or a speculator. (92) The player makes the game, not the other way around. (93) Ignorance of the type of risks one is undertaking (inherent or created) combined with that of the types of losses (from continuous or discrete events) is a disaster waiting to happen: One can easily end up gambling with continuous processes, because it leads to outsized losses, both because it requires action to stop the loss and because the more you lose the harder it is to take the loss. It's a vicious circle. (95) Psychological fallacies of probability. - Overvalue wagers with low probability of high gain (typically, lottery tickets) and undervalue those with high probability of low gain (typically, work) - Interpret the probability of successive independent events as additive rather than multiplicative; having thrown sixes four times in a dice game doesn't make it more likely to throw a fifth one, *au contraire*. - Monte-Carlo fallacy: Thinking that a run of successes failure is inevitable, and the reverse. As Annie Duke points out, people tend to stop too soon when they're winning and too late when they're losing. - Thinking the perception of the psychological probability exceeds that of the mathematical one if the event is favorable, and vice versa. For instance, the probability of buying the winning lottery ticket and being killed by lightning is 1 in 10.000 in both cases, yet the former seems much more probable than the latter to most people. (This is wishful thinking, people feed themselves a narrative about what they want is going to happen.) - People remember streaks in a long series of wins and losses and tend to minimize the number of short-term runs in their perception, thus thinking the infrequent more frequent than it is, and the opposite. - Mistaking unusual events for low-probability events. All hands in a card game are equally probable, but the ones with a special feature like regularity making them easy to remember creates an association with low probability. And if someone holds a number close to the winning one in a lottery, he tends to feel cheated and that a terrible bad stroke of misfortune has caused him to just miss the prize. (96) Examples. - People bet on independent events as though they are dependent on each other. - Financial markets events are unique and non-repeatable; this is case probability, not class probability. You can't assign a numerical value to risk in financial markets. "This means the probability of market events is not open to any kind of numerical evaluation. All you can actually determine is the amount of your exposure as opposed to the probability that the market will or will not go at a certain price. Therefore, all you can do is manage your exposure and losses, not predict profits." - Mistaking risk you're willing to take and hope for gain with actual probability. Placing a stop-order at $3 below market and another at $10 above market doesn't change the underlying probability of either event occurring. - Some dollars are bigger than others - There are two types of reward in the world: Recognition and money. Be sure you know the currency you want to trade. The green lumber guy thought he was trading lumber paint in green; did it matter that he was wrong on that? (103) Minsky model of crowds: 1. Speculation 2. Credit expansion 3. Financial distress 4. Crisis 5. Panic and crash (103) Holland's tulip mania. An historical event that illustrates how crowds panic. (103) Studies on crowds are done in rearview as something abstract, not studied as something that happens to an individual, which makes them of limited interest for decision-making. (104) What's important is understanding when you're part of a crowd. (104) A psychological crowd can be formed without any gathering. This applies to all decision-making. Displaying the signs of crowd behavior, whether or not the crowd exists or internalized, is enough to characterize crowd behavior and will lead to the same consequences for individual decision-making. (105) "Can you be classified as part of the crowd even if you're sitting in your den following the markets? Yes — if you're wavering back and forth like a candle in the wind, swayed by every news story or price change on the screen". (105) A crowd trade happens if you're evidencing tendencies, emotions and characteristics of the crowd in your actions and reactions to the market. (105) Individuals reason before acting, crowds act on impulse. (105) You need to recognize when emotionalism affects your decision-making. (105) Characteristics of an individual part of a crowd. - Sentiment of invincibility reinforced by dissolution of responsibility - Contagion / Hypnosis. You're mesmerized by the price movements on your screen. - Suggestibility. Acting with irresistible impatience, hanged to someone else's opinion or words. Crowds exhibit the same traits as those of manipulations, as they lead an individual to act outside of his normal behavior and against his own interests, like sticking with a losing position. (108) A crowd trade is determined by its characteristics, not by the obvious or non obvious presence of a crowd. Impulsiveness, irritability, incapacity to reason, exaggeration of sentiments, absence of critical judgement... are the stereotype of an emotional and losing market participant. (108) There are two psychological crowd models. (108) Delusion crowd model. You start from an expectant state of attention. You want to make money. You're in confirmation bias mode and you will fail to challenge a tip when presented to you. You will be a net loser. This is exactly what happens when someone tries to make back losses or is anxious to participate in the markets. (109) Illusion crowd model. Here, you already have a position on. You express or hear an opinion, and you repeat it to others (or someone else does it for you). It becomes linked to your identity. You start selling yourself your own ideas. Your reputation is on the line. It can be a winning a position (your ability to make 'smart' decisions) or a losing one (your ability to take losses). Regardless, you start identifying with your ideas. You're fucked. That's why 'traders don't talk about trades. (110) People spend money for two reasons: To feel better or to solve a problem. The former is dangerous, catastrophic, when you partake in the financial markets to generate emotions. Resorting to do so to achieve a psychological state is a psychological disorder. Emotions aren't bad, emotionalism is. (112) Focusing on individual emotions in your decision-making is confusing because both positive and negative emotions are two sides of the same coin and tend to happen simultaneously. It's best to focus on avoiding emotionalism altogether instead, and learn the tell-tale signs of it. We can do this by understanding the psychological crowd. (113) Learn the symptoms to identify the disease. (113) Solitary manias and panics (if the crowd is reduced to one individual) can be just as bad if not worse, as it is amplified by the individual's fear or hope for gain. But let us not focus on fear or hope, and rather on the symptoms of crowd trades. (114) "People lose (really lose, not just have occasional losing trades) because of psychological factors, not analytical ones. They personalize the market and their positions, internalizing what should be external losses, confusing the different types of risk activities, and making crowd trades. Is there a single factor common to all of these errors, and can we determine a way to address that factor in order to avoid the errors?" (118) Bad decisions yielding good results inflate the ego. That makes it ever so harder to admit you're wrong when you're facing bad results; you double down instead, making your mistakes exponentially worse, and ensuring those will wipe you out. The more you win for the wrong reasons, the worse will be the fall, (118) All the mental processes, behavioral characteristics and emotions of a net loser are triggered by one thing, the uncertainty of the future. Otherwise nobody would ever take the losing side of a trade. You can't replace uncertainty with fake certainty, but you need a way to deal with it. (∗) List situations where people replace uncertainty with fake certainty. When they overrely on a certain type of instrument? How to measure it. Example: People tend to sell things on Friday to avoid weekend risks such as armed conflicts, OTC deals etc. Do prices on Friday always include weekend risks? (119) In the face of uncertainty, you can either be an engineer (deal with things where you don't have uncertainty), a gambler (play to play) or a speculator. Successful investing is successful speculating; you deal with uncertainty and incomplete knowledge through intellectual examination and systematic analysis. (∗) Can speculation be engineered? (120) Speculators don't try to predict the future. They adapt to changes. (121) The activity of speculating is defined by having a plan; otherwise it's betting, or worse, gambling (pay to see or pay to feel). (121) Delay intuition and decision-making until you have more facts. You need a plan begore deciding to enter the market. (121) There can be many plans, but there is only one way to make a plan. 1. Decide what type of participant you're going to be and what kind of risk you're willing to take. Are you going to be an investor or a speculator? This will determine the market and instruments that you deal in. 2. Derive a method of analysis from this, and select one that is compatible with your tolerance for exposure. Also look at what you find most people suck at doing. You might have an edge there. 3. Develop rules. 4. Establish controls. 5. Formulate and implement a plan. (122) 90% of the time, an 'investment' is a trade that didn't work. You shouldn't change your time horizon in the middle of a trade. Never. (122) Most stock players buy because of a fundamental story they believed. Then they don't get out when they should, because they have to chose between them being stupid or others. It's both easier and more convenient to thing the market is stupid. hat's how trades turn into 'investments'. (123) "Some people say cut your losses, but I've already lost too much." Force yourself out of the market if you're not trading at a margin with someone to do it for you. (∗) The advantages of futures and options is that they expire; unlike stock, you will be forced out of the market and it will require a new decision to keep a losing position. You have a forcing function, which is good. (123) You need to select a strategy, a method of analysis beforehand. Otherwise, because there are so many, you will keep jumping back and forth between methods to support what you think (confirmation bias.) (Today we can do backtesting. As Kahneman points out, algorithms tend to make much better decisions over time than humans.) (124) Left alone, analysis acts as a mere comment. It doesn't tell you when to get in, and when to get out. To translate your analysis into something actionable, you need to define what constitutes an opportunity for you. Rules are hard-and-fast. Tools (the method of analysis) have some level of flexibility. (124) Fools have neither tools nor rules. (124) "There's no perfect decision. One always have to pay a price which might mean passing up an opportunity." — Peter Drucker, Management. Follow your rules, and don't mind the things that might have-should have been profitable. (125) Controls are exit criteria (price order, time stop, condition stop....) According to Drucker, controls follow strategy. You need to pick your stop before entering the market, and you need to decide what is the maximum tolerable loss you will take first. (125) Again, you can't calculate the probability of a trade being profitable. You can only calculate and manage your exposure. So all you can do is manage losses, not predict profits. (∗) Can backtesting still work when everybody is using the same data? Surely gazillions of strategies have been discovered. Could synthetic data allow to develop original strategies? (126) It matters less what the plan is than there is a plan, because there are so many ways to be successful. However, there is only one way to devise a plan. (126) You must decide, in order: Stop, entry, price objective. Those will act as forcing functions for the important moments of your trades. (126) Picking your exit after your entry makes the former a function of the latter. It will create the equivalent of a drunken's sailor walk, as Hamming puts it. (127) "The first step in planning is to ask of any activity, any product, any process or market, 'if we were not committed to it today, would we go into it?' If the answer is no, one says, 'How can we get out — fast?'" — Peter Drucker, Management. See Andrew S. Grove at Intel getting out of the RAM business they invented. (127) In markets, you need not be committed beforehand. So you can ask about the exit first. Your entry should be a function of your exit. (127) Missed profitable trades cost zero dollars. Poor controls or no controls will cost you everything. (128) Scenario planning: "A structured, disciple method for thinking about the future and a technique for anticipating developments in fluid political and economic situations." — Russia 2010 and what it means for the world, Yergin and Gustafson (∗) Think of all the things that could lead to various outcomes so you have watchposts to look for, like David Goggins has (backstops?) (128) Trying to predict means you're betting, which traps you in trying to be right. (129) "A preoccupation with wanting to be right or wanting to be perceived as being right explains people's tendency to focus on why the market is doing what it is doing instead of what it is doing." Knowing why doesn't get you your money back, or your life back if you're about to be in a car accident and you focus on why someone is acting stupid on the road instead of getting yourself to safety. Follow your plan and watch the money. (∗) Please don't start with why. (132) "Many market participants reject the casino view of the market in word but not in deed." (132) Having a plan brings the positive aspects of games to the market; they allow you to create discrete events from continuous processes by bringing rules into the equation. (133) Instead of monitoring all your emotions, just look out for the characteristics of crowd behavior. (∗) "Am I experiencing intense hesitation because of internalized external pressure?", one asks. (133) "Weak is he who allows his actions to be controlled by his emotions, and strong is he who forces his actions to control his emotions." If you're not doing the latter, you're unconsciously doing the former, which is LeBon's description of crowd behavior. See also Da Vinci quote on self-mastery. (135) If you enter the market without a strategy, you will eventually lose everything. At one point or another, the market will be against you. Your timing will never be perfect. A plan allows you to distance yourself from your emotions when making decisions, because your decisions will be made in advance for you. Don't bring a sword to a gunfight, and don't make decisions while experiencing high emotions. (∗) This is why optimizing for profit leads to certain ruin. Your timing will be off sooner or later. You need a margin of safety. (136) People typically don't make plans for their death, like organ donation. Those decisions, however, can't be make during a crisis, as the situation is too dramatic. (136) Effective decision making requires following a plan, and resisting the urge to tweak it when emotions get stronger. (∗) Just like at the beginning of a race, when almost everybody outpaces themselves and kill their performance. Do groups always run too fast? (136) Having a plan gives you a litmus test to distinguish between thinking and emotionalism. Thinking is deductive, it precedes action. Emotionalism is inductive, actions triggers thinking. (138) Ayn Rand's way: Refrain yourself from expression opinions before you can think about it, and even then, don't. Opinions makes you enter crowd mentality. You don't have to answer: this is the opinion trap. You can do it the Franklin way if you must, by replacing the expression of opinions with taking responsibility for your deductive thinking and expressing it as such. (138) If participating in the markets feels exciting, you're probably doing it wrong, and gambling. You should be following a plan and waiting for either buy or sell criteria to materialize. It should be boring. (139) "Confused semantics is responsible for a lot of the confused thinking about the market." Words matter, Words condition your behavior. Saying "I'm right" involves your ego, which you will try to protect. You should remove it from conversations, like the culture Andrew S. Grove tried to develop at Intel. (139) Edison didn't take failures personally, and neither should you. (∗) Thinking about what success, failure, work means to you involves your ego, which you'll try to protect, preventing you from making progress. You switch into tardigrade mode even before any of the possible outcomes happen and become hermetic to change, because you already internalized the losses or wins from those possible outcomes by anticipation. This is the case because you tie your self-worth to things that are not under your control. Since you cannot control them, you pretend they don't exist, much like a child closes his eyes or hides under the blanket to make danger or fear go away. In tardigrade mode, you stop taking risks, and there can be no gain without exposure. (140) Nathaniel Branden, Psychology of Self-Esteem, 165: Your self image "should not be dependent on particular successes or failures, since those are not necessarilly in a man's direct, volitional control, and / or not in his exclusive control. If a person judges himself by criterion that entail factors outside his volitional control, the result, unavoidably, is a precarious self-esteem that is in chronic jeopardy." (140) "Participating in the markets without a plan is like ordering from a menu that has no prices and then letting the waiter fill out and sign your charge card receipt." (∗) With continuous processes, losses or gains occur gradually. This triggers rationalization even more. Because you rationalize, your ego is involved. (141) Senato Sam Nunn, September 1993, on the idea of sending US troops to Bosnia (NBC nightly news): "We ought to have an exit strategy before committing troops." (142) Compare that with Johnson. "It was Johnson's custom to reach a decision inwardly and then make it appear the decision was the result of consultation and debate." (∗) This is the same as [[Implementation Intention|implementation intentions]] and the identification of obstacles to your results first. Answer "What's my exit?" before committing any type of resources. This externalize the situation. Premortem exercises, as defined by Annie Duke and invented by Gray Klein follow the same principles. "What defines success and failure?" is a question that helps identify pitfalls in advance and address them instead of following plans that you like until your grave. (143) Make preparations for all outcomes. See NASA's leader in Netflix documentary who wrote two speeches, in case the mission was a success or a failure. It prevents you from internalizing and helps identifying potential blowups. (∗) The best way to make good decisions under pressure is to not make decisions under pressure. By reducing their set, you reduce the amount of mistakes you can make. (143) Morgan Stanley's success is largely due to the fact they're fanatical about scenario planning. "Avoid disasters and seize opportunities" is their motto. They have people write blue books with worst-case scenarios constantly, focusing attention on what can go horribly wrong and kill the company. (∗) Dig out Alain Minc, 10 jours qui ébranleront le monde. (147) A plan doesn't guarantee success, but its absence guarantees failure, because you'll be making most decisions under pressure, which is something we suck at. Fail to plan, plan to fail. (148) Good outcomes of bad decisions teach you the wrong thing if you result, analyzing decision quality as a function of their results. This creates a [[Random Reward Schedule|random reward schedule]] and prevents learning. (148) Random reward schedules are the strongest form of reinforcement to get someone to do something by repetition. (∗) Dig out experiment with random flash of lights and the personalization of success. (∗) Predictability disengages; monkeys start pressing buttons only when they want a banana, not continuously, and stop after getting it. This is dangerous for continuous processes such as the markets. (149) "If you don't know what's making the profitable trades profitable, you won't know what to repeat in order to repeat profits, or avoid losses." Statistically, bad decisions with good outcomes are the exception not the rule. They only work once, when you repeat them you start losing. (150) It's like taking a multiple-choice test in school, not knowing the answers, and going with your gut by ticking random answers. You might get one or two right, but on average, you'll fail by a large measure. (∗) Protect yourself from yourself. (150) Speculating is the only human endeavor where what feels good is the right thing to do. This is the case because there is an inverse relationship between your threshold for pain and your success in the markets. If you feel pain, get out right away. (∗) Munger doesn't do trades that would prevent him to sleep at night. Is this because humans have this inner ability to detect and evaluate risk and probability? (∗) My experience with tariffs' buy that felt calm versus buying from Greenblatt's advice not having any idea what I was buying and what analysis was behind it. (∗) Keep positions that leave you equanimous, but expand the territory of what leaves you equanimous by means of analysis and scenario planning.