I read this book more than 5 years ago, but it remains one of the most memorable ones because so much of it resonates with my investing journey. I thought I’d share a few insights from the book.
1. Do not internalise your position
One of the key themes in the book is that it is dangerous (yet easy) to personalise the market because your focus has shifted from making good decisions to being right.
In a winning position, we tell ourselves “I’m right” to boost our ego. In a losing position, we justify our decision by constructing narratives such as “it is a bullish correction” or “it is going to bounce back”. They’re the same: we rationalize to preserve our pride and ego.
All losses are treated as failures. Loss has a negative connotation. It is easy to equate losing money in the market with being wrong. In doing so, you take what had been a decision about money (external) and make it a matter of reputation and pride (internal). An example of personalizing market positions is people’s tendency to exit profitable positions and keep unprofitable positions. It’s as if profits and losses were a reflection of their intelligence or self-worth; if they take the loss it will make them feel stupid or wrong. They confuse net worth with self-worth.
2. The stock market is a continuous event
The reason why it is easy to internalise a position is because the stock market is a continuous event. Unlike a game of soccer or blackjack where there is a start and an end, a position in the market can remain open indefinitely.
Losses from continuous processes are much more prone to become internalized because, like all internal losses, there is no predetermined ending point. The participant gets to continuously make and remake decisions that can affect how much money he makes or loses.
Because a losing market position is a continuous process, nothing forces you to acknowledge it as a loss. So as long as your money holds out, you can continue to kid yourself that the position is a winner that just hasn’t gone your way yet. The position may be losing money, but you tell yourself it’s not a loss because you haven’t closed the position yet.
3. The characteristics of a man defines the risk
Risk is not determined by the activity i.e poker or stocks. It comes from the individual.
A closer examination reveals that what determines whether someone is engaging in created or inherent risk is not the activity itself but the characteristics the person exhibits when engaging in the activity.
If a person approaches a business risk or risk in the financial market for excitement, then he is gambling—regardless of how much control he supposedly has over the outcome.
4. When you make decisions driven by excitement and impulse, you become part of the crowd.
Individual acts after reasoning, deliberation, and analysis; a crowd acts on feelings, emotions, and impulses. An individual will think out his opinions whereas a crowd is swayed by emotional viewpoints rather than by reasoning. In the crowd, emotional and thoughtless opinions spread widely via imitation and contagion.
It is not a function of a quantity of individuals that determines if a psychological crowd has formed. Rather, it is a function of the characteristics displayed. If a person is exhibiting these characteristics, then he is part of a psychological crowd and is making crowd trades.
5. Decide what type of participant you’re going to be
This seems elementary but most people don’t know what they want to be. The danger arises when we change our story based on market sentiment and price.
The plan you develop must be consistent with the characteristics and time horizon of the type of participant you choose to be. Changing your initial time horizon in the middle of a trade changes the type of participant you are and is almost as dangerous as betting or gambling in the market.
6. Have an exit plan before entering a position
You need to have an exit plan before entering a position, not after. Otherwise, you’ll be changing your exit plan based on the market narratives and price influence. Ask yourself: What do I need to see to change my mind (to exit this position)?
If you wait until after the position is established to choose your exit point or being moving the stop to allow more room for losses or alter the fundamental factors you monitor in your decision making, then you 1) internalize the loss because you don’t want to lose face, 2) bet or gamble on the position because you want to be right, and 3) make crowd trades because you’re making emotional decisions. As a result, you will lose considerably more money than you can afford.