Ornithologists study birds. Entomologists study insects. Anthropologists study ancient civilizations.
As The Oxford Club’s Quantitative Strategist, I study global financial markets.
I develop ideas on how to gain an edge in the market. Then I use those ideas to develop a trading system. And I then test that system using some of the world’s most sophisticated software.
If you are an engineer, programmer or scientific researcher, you’d find the process very familiar.
But here’s the surprising (and harsh) reality… Developing a profitable trading system is only a small part of becoming a profitable trader.
I can recommend which stock or option to buy.
I can tell you where you should place your stop. And I can warn you to limit your bet size to match your risk appetite.
But none of this advice matters if you don’t implement it.
In fact, turning investment advice into money has little to do with the quality of the trading system… and almost everything to do with your psychology.
You may recall that last week I explained why psychology is the single most important quality of successful investors. Today I’ll expand on that idea…
Do You Take Your Medicine?
I recently came across a startling statistic: Patients fail to act on 50% to 80% of the information physicians give them.
Up to 80%!
That means much of the scientific research, the billions spent on developing new drugs, and the double-blind placebo testing is pointless.
Why? Patients don’t have the discipline to implement their doctors’ advice.
The parallel with investing and trading advice is clear.
I can give you the next trade generated by my best quantitative trading system. But it is utterly worthless to you if you don’t implement it.
Why Psychology Matters
Every experienced trader agrees that psychology is a critical factor in successful trading.
But I’d go even further… I believe psychology is the only thing that matters in trading.
Ironically, this is not a lesson professors will ever teach at Harvard, Stanford or Wharton Business School.
The reason is simple. Until very recently, the investment curriculum completely ignored psychology.
By arguing that 100% of investors were 100% rational 100% of the time, academics assumed psychology away.
Psychology was a black hole. And no financial economist was willing to crawl down to see what was there.
That changed in the watershed year of 2002.
That was the year a psychologist – Princeton’s Daniel Kahneman (in work he did with Stanford’s late Amos Tversky) – earned a Nobel Prize in economics.
Kahneman had never taken a single course in economics.
Kahneman and Tversky’s work questioned the assumption of homo economicus, the perfectly rational actor who appeared in textbooks but never in real life.
Kahneman and Tversky uncovered a slew of psychological biases. Together, they made individual decision-making irrational.
Unwittingly, Kahneman and Tversky gave birth to the new discipline of behavioral economics. (You can learn more about their remarkable story in Michael Lewis’ The Undoing Project: A Friendship That Changed Our Minds.)
As it turns out, the founding fathers of modern financial theory are just as irrational as the rest of us.
Harry Markowitz – the University of Chicago economist who developed the infamous “efficient frontier” in modern finance – never used his Nobel Prize-winning idea in his own investing!
Of course, the world’s best have long known that psychology trumps financial models.
You need to look no further than Warren Buffett.
Buffett described Benjamin Graham’s 1949 classic, The Intelligent Investor: The Definitive Book on Value Investing, as “by far the best book on investing ever written.”
Buffett credited Graham’s discussion of the manic-depressive “Mr. Market” as the single most important thing he had ever read.
Understanding Mr. Market’s irrational mood swings gave Buffett a massive edge in timing his investments.
The world’s top hedge funds also understand the importance of psychology in investing.
That’s why they employ trading psychologists to coach traders, in the same way that top athletes hire sports psychologists.
The late psychiatrist Ari Kiev was a mental health coach to all of S.A.C. Capital Advisors’ top traders.
In the television show Billions – inspired by the story of Steve Cohen of S.A.C. Capital – Wendy Rhoades is the in-house psychiatrist and performance coach at the fictional Axe Capital.
My one recommendation for you today is not a red-hot stock pick generated by my quantitative system.
Instead, it is to invest time into focusing on your psychology and how it relates to investing.
Start by completing trading coach Van Tharp’s free online investment psychology profile.
Once you complete it, you’ll have a much better idea of what kind of trading and investing suits you.
Psychology is rarely the place where successful traders begin.
But it is the place where all successful ones end up.