With my second book summary, at least on the surface, I am risking to surprise some of my readers. The reason is that the subtitle reads “Why normal thinking never wins the trading game”. The word “never” is underlined on the book cover. My emphasis is on “trading game”. While I have neither secretly switched to day trading, nor do I pursue any such goals, nor do I play any type of game as a fundamentally driven analyst and investor, I have found it nonetheless very insightful to take on the perspective of a day trader. Quite a few of the book’s core messages indeed do resonate well with my own thoughts and approach on portfolio management as well as psychological strength in stock investing.
Summary and key takeaways from today’s Weekly
– I have finished reading a very interesting book from a day trader – not to become a day trader myself, but because this book is great on mindset and investing psychology.
– The core messages can be well applied to stock investing.
– A clear recommendation.
I have made it a habit to read paper books in the morning on workdays after I have brought my daughter to the kindergarten, but before I start with my actual work of researching and writing.
At least on most days this is the case.
Better on average 10–15 pages than nothing. Even though at first sight it does not sound like much, over time this compounds quite well. Assuming just 10 pages on say 200 days in a year, this results in 2,000 pages read. Not necessarily “on the go”, but at the end of the year it feels a little bit like that.
This is the equivalent of about six to eight “normal” books with 250–350 pages.
My message is not that six or eight or even ten books (when reading either shorter books or say 15 pages on average) are that big of a deal worth to be applauded. My point is the effort behind it is comparatively low, but it results in a rather surprisingly big outcome over an entire year. A good bang for the buck.
The latest book I have finished just a few days ago fits well into my blog.
It made a strong impression on me regarding the topics of investment psychology and mindset. On one or the other occasion, I have already written about some of the topics the author Tom Hougaard touches on in his “Best Loser Wins”.
It was a refreshing experience for myself as I see certain core messages as important and transferable to be successful in stock investing, despite it being a book about day trading. This is what I want to discuss today.
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Winning by not losing and “normal thinking”
This book is just a few years old, but I think it could be an evergreen if read in the right context. I stumbled upon it rather by accident.
It was shown to me on twitter. But I do not even know the concrete context anymore. What I do remember is it was praised as being one of the best books about this topic from a mindest perspective. This was important to me, as I am not interested in reading tea leaves (aka charts).
However, I am interested in investing psychology.
That’s likely why our roads crossed. The author is a danish day trader. He previously worked among others for a broker where he gained first hand experience on the shop floor so to speak before he until this day became a professional and profitable (!) trader around the financial crisis of 2008–2009.
On this occasion in his job, he observed the toxic trading behavior of mainly forex (i.e. currency) traders which in most cases kills their portfolios.
Little surprisingly, the majority of traders are losing money.
And this despite the fact that we’re living in a world where both, investing and trading, should have become easier than in the past. At least that’s the theory. We have the best, i.e. quickest and cheapest access to information, the lowest trading costs, the narrowest bid / ask spreads and the easiest access to brokers which logically thought should have created an edge compared to the old days.
The core problem Tom Hougaard identifies is human nature.
While the let’s call them investment tools have seen a major upgrade, human behavior and psychology clearly has not. And this is how he formed his investment philosophy of going against what he calls “normal thinking”, i.e. not engaging in what the majority does as the majority obviously must be doing something wrong.
The book is about how to handle losses – i.e. to become the best loser.
Self explanatory, it is not about how to lose the most money in the shortest amount of time, but how to train your mindset to accept losses. They need to be accepted and recognized for what they are. By minimizing your losses, you can focus on those trades (or stock investments in our case) that do work out.
One needs real winners to win. Not losers turned non-losers.
Cut the weeds and water the flowers, as Peter Lynch said. Or less metaphorically, cut the losers and let the winners run. I also read someday that one needs to be impatient with the losers, but very patient with the winners.
Hence, winning by not losing. At least that’s half the recipe for success.
Instead of hoping to flip a loss into a break-even position (which is mentally seen as a win, although this is clearly not the case financially), the author clearly advocates to admit that you were wrong when you were wrong and to burry the hope quickly.
This is also what I have said on numerous occasions – hope is not an investment thesis. You need to acknowledge when you were wrong (I am doing this, too, though not always quick enough) and just draw a line under it.
If you cut your losses quick enough, you can gain them back somewhere else with comparatively little effort.
The main difference I am seeing here between his trading and my stock investing approach is that I do not necessarily like mechanical stop losses like he and many other traders practice it.
What I prefer is to check and validate my initial thesis.
If doubts occur or the thesis has been clearly wrong (or circumstances changed later and altered the initial thesis dramatically like a lost lawsuit or a political decision, etc.), then it is time to just cut the loss.
But of course, the losses should not become too big as it gets disproportionately harder to gain them back with the remaining capital. This is tough balancing act everyone needs to decide on their own how to handle that.
By closing losing positions, you achieve two things.
The obvious one is you free up capital instead of keeping it tied into a loser. Not closing a loser produces opportunity costs, i.e. gains you have not made.
The other, not so obvious in the beginning, is that you also free up your mind. Else, it keeps you busy in a negative way, distracting you from what you should focus on: your winners. They are the ones that bring the performance.
A few hefty multi-baggers will be the ones that make you entirely forget about your losers, in case you have cut them early enough.
Speaking of multi-baggers, I am constantly on the hunt for clearly undervalued, attractive stocks from a risk and reward perspective.
I am publishing for my paid-members exclusive reports with stock ideas I have checked fundamentally. Low valuations are not everything, as there need to be concrete catalysts and solid stories with tailwinds to propel a stock higher over time.
In my 12-page, member-exclusive reports, I am frequently presenting such cases.
Don’t miss these opportunities!
But why do traders and investors alike engage in hoping in the first place?
The reason is cognitive dissonance. This is a state of experienced mental discomfort (or psychological stress). It occurs because two contradictory beliefs simultaneously confront each other in the head of the investor. Fear is fighting logic / rationality.
In a nutshell, our mind wants us to reduce the stress which is caused by fear. This natural survival instinct turns all other lights off and makes us practically remote-controlled.
The aspect of fear works in both directions:
- As funny as it seems, we fear losing profits, that’s why winners often are sold too early to “book profits” before they are lost again.
- On the other hand, we do not want to admit a mistake and realize a loss, that’s why by not realizing it, hope gains the upper hand. The losing position is being kept open and we think we have not lost (yet).
In both cases, we think to have kept our fear in check.
This aligns with the desire for instant gratification (booking small profits) and postponing unpleasant decisions (taking the loss).
The correct approach would of course be exactly the opposite.
The biggest blow is to load up even more of the losers, i.e. buying “cheaper” stocks. While the classical theory is that if you liked something at higher prices, you should like it even more at lower prices, this only applies if the thesis is still valid or was correct to begin with.
Averaging down is not always the best approach. Instead, averaging up could be even better.
To the contrary, the author is in favor of buying more (averaging up) of what has proved itself. This instantly reminded me of Warren Buffett buying more Apple (ISIN: US0378331005, Ticker: AAPL) stock, despite it having risen since his initial purchases. Though his average buying price has gone up, he in total has made much more than if he only kept his starter position.
In this context, the author also made a very on-point comment.
Though some won’t like it or see it as offensive, he made the comparison between betting on a successful CEO to continue to succeed against betting on a junkie trying to turn his life around.
Further, on p. 122 he writes the following:
“Adding to my wining trades is an absolute key trait of the successful trader. It reinforces correct behavior. It serves as an antidote to the temptation of wanting to take profit. […] Unfortunately, it’s only human nature to want to cut your winning trades. […] It’s also human nature to ride out the losses. […] I am stuck. I won’t close, I will wait.“
And then another one on pages 127–128:
“The purpose of adding to winning trades is at its heart an attempt to fight your normal behavior. In the beginning it is not about adding to your profitability. That will come later. The purpose is to stop you from taking half profits. […] When you start to think, ‘where can I add to my winning trades?‘ you are beginning to think differently.“
I think you get the point. You cannot achieve major hits when you castrate yourself.
One thing I’ve found interesting was Tom Hougaard’s passage on how super-performing sports stars control their minds. Even the biggest sports celebrities and most successful athletes make mistakes from time to time. You know, the missed penalty in an important match, a missed shot for the win during crunch time or an unforced error in tennis that throws you back.
But the key is not to get confused by them.
He writes for example about tennis players shouting their soul out their lungs when they produce a major miss. This is being done to reset and forget about it as quickly as possible to start with a fresh mind.
Errors happen. Forget it and focus on what you can control.
Applied to trading, respectively stock investing, this translates into dump and forget the loser. Focus on the new opportunity.
Expanding a bit on the subject of selling winners and keeping losers, the author mixes in the topic of hit rates. During his time at a broker he made the observation that traders on average have even surprisingly high hit rates, i.e. they are more often right than they are wrong.
But what breaks their neck is the above. They sells winner at too low gains and get crippled by huge losses that they don’t recover from.
On the other hand he writes about successful investors who can even have a seemingly low hit rate of 25%, but nonetheless have a tremendous performance. Why? Because they keep their frequent losses small and let their few winners become really big to pull up the average.
Even with an abysmal hit rate of 20–25% one can have market-beating returns.
Or in other words, the 25% of profitable winners need to surpass what the 75% of trades generated in losses.
That flows into my personal view of looking for high optionality cases.
High optionality refers to the upside being several times higher than the downside on a statistical basis. Simply put, try to make sure to find cases where the upside is for example a double while the stock is unlikely to fall more than 20%, resulting in a ratio of 5:1 in your favor.
Or, if you have even a case where the downside is 50% in the worst case, but the company can 10x due to catalysts in its favor, this on average will likely play out well, too – assuming the case is indeed very solid.
On the other hand, if valuations are stretched like we have with big tech stocks at the moment, a lackluster upside won’t compensate enough for the tremendous downside – seen from an optionality, respectively risk and reward perspective.
The rest of the book after this important observation are more about the importance of patience on one hand and how the author himself keeps his emotions muted.
Respectively, how he fights his “humaneness”.
On patience, he writes that you must be patient with yourself. But the thing is, you cannot just say “be patient”. This works probably in the same way like saying to an alcoholic “don’t drink” or “stop drinking”. Having had alcoholic issues himself in the past, he chose this example purposefully.
One needs to flip the switch inside oneself. This happens through experience, not theory or kind words.
This is hard to describe in theory. Other examples are one is afraid of water, but wants to learn swimming. “Jump in” is harder said than done. Or with smoking cigarettes, but wanting to quit.
I think you get it.
It is something one needs to go through and gain the upper hand on the own emotions to succeed. This needs to be practiced and doing mistakes is clearly part of it. If you’ve made certain mistakes, you know how it feels. Then you make sure not to get into this negative state or emotion again.
The above is followed by a statement that I’ve found on point: “Good trading goes against human nature“.
He elaborates on this statement with the example of chasing supermarket promotions. If you buy toilet paper at a discount, that’s likely great deal as you will sooner or later make use of it. You definitely saved money on that trade. But the stock market is not the same like a supermarket. This is crucial to understand, despite the majority having the same thought process, whether intentional or not.
In fact, a stock that has risen can even be more lucrative, when the case has been massively de-risked or new growth prospects have opened up. Or simply if management is underpromising, but overdelivering which can also happen.
But obviously, something must be wrong when the majority of people fail with this “normal thinking”. As the author says in the book on page 103:
“Hope features high on the list of reasons. As the saying goes, hope dies last. Our minds seem ill equipped to engage in risk management. Our minds have one primary objective: to protect us against perceived or real pain.“
By avoiding the pain, indeed investors suffer more than they need.
Another strong quote from page 104 (bold by me):
“As long as a losing position is open, there is hope that the position will turn positive. […] The worst I can do to myself and my psyche is to begin to hope. I don’t feel free in my thinking. […] When I close the position, I feel free again and I am opening myself up.“
He describes a process of not wanting to bow against the own ego and that many investors are not holding on their losing positions out of belief, but due to not being able to stand they have been wrong.
And then, as soon as the position reaches its black zero again – this is however not guaranteed and rather seldom the case if you were completely off with your assessment – the investors feels relieved from his pain.
What for? To have achieved exactly nothing from a financial perspective.
As he calls it, it is not trading the markets, but trading the own emotions.
Once you have understood this, or as the author writes, you get “disgusted with your own patterns”, you will make the switch. Leave the 90% who are wrong and become one of the 10% that do not participate in “normal thinking”.
The last parts are about controlling and training the own mind, practices the author himself is doing, how to trade through a slump which sooner or later occurs and how to embrace failures to grow.
I want to close with another quote from the book (chapter “Best Loser wins”) which perfectly sums it all up:
“I don’t entertain the idea of compounding my mistake by adding to my losing position. I have trained that trait out of my mind. It doesn’t even enter my mind anymore. My mind knows I want to be big when I am right, and I want to be small when I am wrong.“
Conclusion
I have finished reading a very interesting book from a day trader – not to become a day trader myself, but because this book is great on mindset and investing psychology.
The core messages can be well applied to stock investing.
A clear recommendation.
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