A successful self trader – Rule # 4
We tend to define capital in plain monetary terms. Some may extend this definition to include political capital, social capital and intellectual capital. But for a trader or an investor, what matters most is the Mental Capital. It is the capacity to think clearly, irrespective of the noise in the market. It is a mix of intellectual and psychological capital. The best traders are never short on mental capital!
The crux of Mental Capital
Back in 1998, one of the best performing hedge funds was Long Term Capital Management (LTCM). A mix of spreads and arbitrage bets on global assets was largely driven by high-end programs and algorithms. As Russian bonds plummeted and the rouble tanked, LTCM bet its bottom dollar on a reversion to mean. Russia faltered, spreads widened and LTCM went bankrupt.
Hedge funds going bankrupt; is never a surprise. It happens all the time. What was unique about LTCM was that it was conceived and run by Nobel Laureates. Robert Merton and Myron Scholes had received the Economics Nobel in 1997 for their contribution to derivatives pricing. Eventually, it was this very approach that led to the bankruptcy of LTCM. Simply put, it was lack of mental capital!
To say that academicians are not cut out for the rough and tumble of trading is simplistic. There were many occasions when LTCM had to display mental capital, which they didn’t. When you go wrong and double your position it is bad. But when you also leverage this position, it could be disastrous. As Keynes put it, “Markets can be irrational, much longer than you and I can be solvent”.
3 WAYS TO DISPLAY MENTAL CAPITAL IN MARKETS
When in doubt, listen to the markets…
This is a cardinal rule. When you are logically correct but results are not showing, just pause. The market is, probably, trying to tell you something you are not able to decipher. At this point, just listen to the market.
Don’t set a time frame for mean reversals…
Overvalued markets correct and undervalued markets move up. Nobody doubts this theory. The problem arises when you try to set a time frame for this mean reversal. It gets worse when you leverage your mean reversal bet.
Always leave room for that decisive U-turn…
Most traders tend to fall in love with their market view. Don’t stack up trades in such a way that you have no room for a U-turn. There is no harm in doing an about turn, once you are convinced that your view was wrong. Keep room!
When you sit on a losing trade, it is not the monetary loss that matters. It is the mental capital spent that is important.” – Anon
6 WAYS TO PRESERVE YOUR MENTAL CAPITAL…
- Never ever add to a losing position. Reducing your cost of holding is always an illusory advantage. You not only block capital but also over-expose to one single story, which is anyways not working for you. Effectively, your precious mental capital is being allocated to the wrong trade.
- Let losses be small and profits large. This is a corollary to the first point. When you get into a trade and it goes against you, take a small loss. But you never become a millionaire by taking a series of tiny profits. Hold on to your big trades; if required with a trailing stop profit. It is worth putting mental capital here.
- For the best of traders, there are times when almost everything goes wrong. That is the time to be out of the market. Trying to play markets you do not fathom is akin to a game of Russian roulette. You know that the odds are stacked against you, but you never know which one could wipe you out.
- Mental capital pre-supposes a lot of intellectual capital. I am not just talking of your ideas, your insights and your virtually infallible reading of the market. I am also talking about the amount of rigor and hard work that you are willing to put in. That is what really counts in your mental capital.
- Control your fleeting emotions. This is important; in fact extremely important. Don’t get obsessed about the price appreciation you had to forego. Don’t bother about the multi-bagger you did not buy. More importantly, avoid chasing stocks you failed to enter at the right time, just to join the bandwagon.
- Finally, remember that all it takes is one trade; just one trade. This one trade is enough to make or break you as a trader. Paulson’s single biggest winner was shorting sub-prime mortgages. Einhorn’s biggest trades were shorts on Enron and Lehman. And then there is LTCM. Put your mental capital there!
WHY MENTAL CAPITAL IS SO IMPORTANT
Back in 1999, technology stocks were the flavour of the day. At peak valuations, stocks were quoting at 125-150 times earnings. It needed a lot of mental capital to stay of these stocks. But those who were caught on the wrong foot paid a huge price. In 2005, when the Sensex broke above 7000 for the first time, sceptics called it the end of the rally, but markets gave a different signal. Eventually, markets went up three-fold from there. Listen to markets!
There are myriad instances of specific stocks too. That is where your mental capital gets tested. Your mental capital is tested when you find Kingfisher attractively priced but market is saying something different. Mental capital gets tested when Eicher Motors rises 100-fold in 6 years between 2009 and 2015. Even as there are concerns on valuation, the stock continues to defy gravity. Mental capital typically sits on top of intellectual capital. It is your insight, refined by your ability to listen to markets.
TAKEAWAYS FROM THE “MENTAL CAPITAL” DEBATE…
A successful trader in Hong Kong once told me that he had followed only two rules in trading. Firstly, always buy into strength and sell into weakness. If you think that was simple, try applying it. Secondly, minor corrections against major trends call you to add to your position. But weakening or slackening of a major trend is a sure-shot sign to exit the position. He told me that this strategy had hardly failed him while trading India over the past 10 years. Call that Mental Capital 101!
As a trader or an investor you are exposed to a plethora of emotions; greed for the big trade, fear of reversals, frustration over missed opportunities, regret over bad decisions and panic over volatility. That is exactly where your mental capital gets tested to the hilt. Keep it simple. Listen to the market; stick to your trading rule book as far as possible; focus on what is working for you and learn to stay off when you don’t understand a thing. Finally, your mental capital will carry you through!