Trading is risky. So you must be a daredevil to trade.
While you need to understand the nature of risk to trade well, you don’t need to be a daredevil to get started. In fact, if you think that you must take on excessive risk to become a trader, you might have misunderstood trading as a business.
It’s true that cognitive biases are magnified when we engage in risky activities. To get ahead as a trader, you must be able to comprehend risk and handle them rationally.
But without in-depth research, it’s easy to misconstrue what risk means and how we react to it.
Fortunately, there has been an increasing stream of well-written books on risk. Their authors are experts on matters of risk, statistics, and probabilities.
With their help, laypeople like us have a chance to see risk-taking in an entirely different light.
Here are five risk lessons from five bestselling books.
The lessons below might not be the main lessons of the books, but they are points that I could relate to as a trader. While these books do not always address traders, the lessons on risk are applicable.
#1: Risk Versus Uncertainty
In Risk Savvy, Gerd Gigerenzer explained the difference between risk and uncertainty.
Risk: You don’t know what will happen next. But you know what might happen and the likelihood of each possibility.
Uncertainty: You don’t know what will happen. You don’t even know what might happen, not to mention the probability of any outcome.
Think about the difference between being blindfolded in your home and a random place on Earth.
Scenario 1 – Blindfolded In Your Home
You know what’s in your home and its layout. You know what’s in your room, and you can estimate the odds of bumping into each object. Moving around is risky.
Scenario 2 – Blindfolded In A Random Place
But what if you’re dropped off in a random place blindfolded? You don’t know if there’s a flight of stairs or a plunging cliff in front of you. You don’t know anything. Taking the next step is uncertain.
Which scenario do you prefer? I’m guessing the first one.
Now, why is this distinction important to you as a trader?
Because your job as a trader is to take on risk and avoid uncertainty.
As a trader, you need to focus on calculating how much you can win or loss and the probabilities of each outcome.
After intense studying and analysis, you might get an idea of what might happen and their chances. You can then choose to proceed if the odds favor you.
For instance, you know that you have 60% chance of earning $100 and 40% chance of losing $100 on a trade. You choose to take on this risk. It’s not an uncertainty.
In your trading process, you also must avoid uncertainties from beyond the market.
For instance, I only day trade in environments that I’m familiar with (e.g. home or office). In an unfamiliar environment, I don’t know if the Internet connection is stable or if blackouts are frequent. I don’t know what is likely to go wrong.
To operate in such an environment is to jump into uncertainty.
In your trading plan, aim for rewarding risk and avoid unnecessary uncertainty.
#2: Risk of Common Mode Failure
Douglas W. Hubbard’s The Failure of Risk Management is a detailed guide to the methods of risk management. It focuses on the common flaws and myths in the risk management industry.
A trader’s example is consecutive losses.
A long series of consecutive losses can cause your trading account value to drop. Eventually, it will expose you to a margin call. This risk is evident.
But there’s a more insidious risk many traders choose to ignore. That is the impact of consecutive losses on your emotions and willpower.
A streak of losses damages your confidence and makes you doubt your trading strategy. It can also cause overtrading as you try to make back the losses. These effects will speed up your market demise.
In both cases, the cause is consecutive losses. This is the common cause, wreaking havoc on both your financial and emotional systems.
It causes failures in two “systems”:
- Your financial ability to trade
- Your mental ability to make good trading decisions
You might think that financial risk and emotional risk belong to separate realms. But the fact is that they can be affected by a common cause.
Recognizing common mode risk will help you design a better trading plan.
In this case, you will recognize consecutive losses as a high-risk event. You can then try to manage this risk by altering your trading plan.
For instance, you might want to include a circuit breaker in your trading plan. It should prompt you to stop trading after a certain number of consecutive losses.
Think: what are other common mode risks in your trading plan?
#3: Never Say Never
Roger Lowenstein’s When Genius Failed tells the story of Long-Term Capital Management (LTCM).
The geniuses include a former head of bond trading at Salomon Brothers and two Nobel Laureates.
They did convergence trading which has the following traits:
- High probability
- Requires a high degree of leverage.
LTCM’s calculated probability of blowing up:
One in septillion (1 out of 1000000000000000000000000)
But it blew up. It was a big blow-up that required the Federal Reserve to intervene.
Time to take a second look at your auto-trading model that has been making money every day, yeah?
LTCM is a great cautionary tale for all traders.
Learn more it from Roger Lowenstein’s book.
#4: Know The Unknowns
The central theme of Nassim Taleb’s Black Swan is that we are far too confident. There are more unknowns that we think, and we need to be aware of them.
The point is that there are always unknowns in life. But we tend to focus on what we know while ignoring what we don’t know. (related: confirmation bias)
To fix this error in our decision-making process, we must actively focus on what we don’t know.
How can knowledge of unknowns help you as a trader? Make use of the unknowns to improve your trading plan.
Many traders choose to focus on what they know. For instance, they see a perfect chart pattern, and they want to trade it. They know that it’s a fantastic trade setup. They know that the volume is supporting their strategy. They know that they have a good reward-to-risk ratio.
They know everything. Hence, these traders take the trade.
But they should have factored in what they don’t know. For instance, an important upcoming economic announcement. The response of the market to that announcement is an unknown, at least to a technical trader.
If more attention is given to this unknown, they might go for a more sensible decision. They might decide to delay their trade entry or skip the trade altogether.
This mindset of respecting the unknowns relates to a trader’s ego. You need to put down your ego and recognize that there are things you don’t know.
Take the first step and become aware of the unknowns. Then, factor them into your thought process.
#5: The Irony Of Mitigating Risk
In Foolproof, Greg Ip highlighted that in some cases, the safer we feel, the more danger we are in.
Increasing our trading account equity sounds like a solid way to do so. It gives us a cushion to ride out the inevitable drawdowns of our trading strategies.
Taken at face value, having more money in our trading account reduces risk. It makes us feel safe.
But exactly because we feel safe, we start to relax our trading rules to take subpar trades. We ignore our position sizing models and overtrade.
I have indeed fallen victim to this effect. After accumulating profits in my trading account, I felt safe due to the financial cushion I’ve built. Then, things start going downhill as I deviated from my trading plan.
Don’t make this mistake.
Traders Should Be Risk Experts
Traders don’t just buy and sell. They assume and manage risks. Hence, traders should be risk experts.
Once again, these are the five books referred to in the lessons above. They explain a great deal more than what’s covered here. I highly recommend them.
- Risk Savvy: How to Make Good Decisions
- The Failure of Risk Management: Why It’s Broken and How to Fix It
- When Genius Failed: The Rise and Fall of Long-Term Capital Management
- The Black Swan: Second Edition: The Impact of the Highly Improbable: With a new section: “On Robustness and Fragility” (Incerto)
- Foolproof: Why Safety Can Be Dangerous and How Danger Makes Us Safe