Simple Trading Rule #1 – Keep It Simple

When Genius Failed

“Life is really simple, but we insist on making it complicated.”

— Confucious

Many of the most beautiful, fascinating, effective (feel free to insert additional superlatives here) objects and ideas  in the world derive their superiority from simplicity.  A simple binary process in the form of zeroes and ones done effectively over and over again is the basis of the massive analytical power of today’s computers.  The most intricate and complex algorithms begin with the simplest of functions… “If this then that.”

You should approach your trading in much the same way.  Only you should stop at simple before it devolves into complex.

Some of the most egregious financial losses in history have resulted from supremely complex “can’t lose” approaches.  Fancy doo dads concocted by brilliant theorists that work best when contained inside the hallowed walls of ivory towers. On the contrary, many of the most sustained, replicable fortunes have been built as a result of a single, simple idea executed with maniacal precision and devotion.

This distinction is clearly pointed out by the implosion of Long Term Capital Management vs Bruce Kovner’s decades long profitability… Lehman Brothers’ collapse vs JP Morgan’s opportunistic growth during the Great Recession… John Paulson’s stumbles post the Great Short vs Warren Buffett’s  consistency based on a superior understanding of size impediments.  The losers in each of these examples have something in common… they each sought to use complex mathematical methods to extract riskless (or near riskless) profits from the markets.  The winners on the other hand accepted the rules of the game and used simple (albeit different) strategies to produce consistent profits. Even the success of High Frequency Traders is premised on a superior understanding (and implementation) of 2 fairly simple concepts… fractals and expectancy… More on these topics in a different post.

Interestingly, the failures of Long Term Capital Management, Lehman Brothers, Bear Stearns, John Paulson (eventually) and other catastrophic financial failures  can be attributed to violation of some simple trading rules…  Price can always go further than models suggest (LTCM), leverage can be both beauty and beast (Lehman and Bear Stearns) and liquidity is king (Paulson).  Each of these entities discovered that breaking these core tenets will eventually break you.  The jury’s still out on Paulson to a degree, but his subpar performance since “The Big Short” suggests he is well on his way to discovering much the same.

It’s no accident that simple approaches work best in investing.  A core principle of markets is that they are in constant flux… changing the way and degree to which they move as a result of the innumerable variables affecting them.  Highly complex trading approaches are (by their very nature) often rigid… confined by their nature to a need for precision and perfection.  Thus, when the market changes its character slightly, complicated approaches often lack the flexibility to shift and maintain a profitable relationship.  Worse, the creator of the approach will generally be unable to accept the need for change until it is too late, choosing instead to double, even triple down… forgetting that markets can remain irrational far longer than their account can remain solvent in the face of enormous losses.

For the sake of clarity, let me say that there’s definitely a place for “complex” trading approaches in the markets.  High Frequency Traders use supremely complex computer algorithms (premised on simple concepts) to generate great, consistent profits for themselves.  One of the world’s best hedge funds is Renaissance Technologies.   It’s a money management firm full of rocket scientists and egg heads who take complicated showers… and whose intricate approach has averaged 35% returns per year for more than 20 years on enormous sums of money (again the foundation is simple… the automated execution is complex).

What I AM saying is that complexity is not required… and, in fact, for the individual investor, it’s a bridge to nowhere good.  You’ll spin your wheels trying to find a super secret, complex strategy and likely be no more profitable than when you started.

If you’re interested in trading, but don’t know how to trade, learn a simple method (or follow someone who uses one).  Gain an understanding of the basics of price movement through chart analysis.  Once you understand chart basics, experiment with a simulated account using a variety of simple investing/trading approaches to find one that you like and that shows consistent profitability.  After investigating a sizable number of approaches, pick one… and stick with it.  Your account will thank you.

Your Mission (should you choose to accept it):

One of the most basic ways of keeping your trading simple (and more profitable) is keeping your losses small.  Small relative to your winning trades, but most people have to start with an absolute level of “small.”  With that in mind, consider deploying the following steps:

  • Examine your current stock holdings… If any single position is down 10% or more, consider closing it… If you still believe in the prospects of the stock you can always buy it back.
  • Examine your current stock holdings further… If the distance between your entry level and -10% multiplied by the size of your position is more than 3% of your portfolio, consider reducing the size of your position.  In some cases, this might mean closing the position altogether.  This is rudimentary form of position sizing and it’s a core concept in all trading (especially simple trading).  The formula is as follows: $ Risk = (Purchase Price – (Entry Price*.90))*# Shares Purchased
  • Keep your per trade risk (using the formula above) at or below 3% (2% is even more conservative) of your portfolio moving forward.

Applying these 3 steps alone will significantly improve your trading results.  You can thank me by following through and enriching yourselves.

You’re welcome.

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