The Mental Strategies of Top Traders

The Psychological Determinants of Trading Success

Ari Kiev

• Publisher: Wiley
• Year: 2009
• Print ISBN: 9780470509531
• eBook ISBN: 9780470561805
• Edition: 1
• Topic: Negocios y empresa
• Subtopic: Finanzas

An honest depiction of the challenges of trading and a clear explanation of what it takes to succeed

Trading tends to be a winner-take-all activity where a small number of traders are very successful, while the majority either lose money or generate relatively small profits. In The Mental Strategies of Top Traders, author Ari Kiev identifies and analyzes the characteristics of successful traders and shows you how to cultivate these same characteristics.

Successful trading, Kiev asserts, requires an unusual and sometimes contradictory blend of intellectual and psychological abilities, including the willingness to take risks, but in a very controlled manner; the discipline to develop high-conviction trading ideas in the face of unpredictable markets and incomplete information; as well as a strong drive to win, but also accept failure. Here, you'll discover how to achieve all this, and much more.

• Provides advice and solutions for traders struggling with today's volatile and stressful markets
• Authoritatively identifies key mental strategies of top traders
• Written by Ari Kiev, a highly respected figure in the professional trading community
• Analysis is supported by comments from contemporary traders and portfolio managers, many of whom struggled with the markets of 2008

Designed with the serious trader in mind, this book will put you in a better position to excel in today's tumultuous markets.

CHAPTER 1

Intellect, Instinct, and Guts

Understanding the Psychological Profile

At the age of 30, Charles Luckman was named president of the Pepsodent toothpaste company and later became president of Lever Brothers. Luckman knew from the age of nine that he wanted to be an architect but went into sales after graduating from the University of Illinois. Despite his great success in business, he eventually resigned from Lever Brothers to take up his architectural dream. From that point forward, he helped design such architectural wonders as the CBS Television City Center in Boston, the new Madison Square Garden in New York City and the NASA Manned Spacecraft Center in Houston. So, how did this businessman and architect who was once known as the “Boy Wonder of American Business” define success? “Success,” Luckman said, “is that old ABC—ability, breaks, and courage.”

Luckman’s life was a remarkable demonstration of an amazingly simple yet complex formula for success, something that I have been searching for in my work with traders. For many years now, I have been trying to define the key ingredients of successful traders and portfolio managers (PMs) by exploring a range of personality strengths and weaknesses among them. To do this, I have asked such questions as:

• What are some of the different combinations of traits that contribute to individual success stories?

• How much “talent” is inborn, and what can be learned?

• How can hedge fund managers recognize talent and capitalize on it?

• Can talent be developed in individuals who are lacking natural ability? What are the developmental challenges that individuals must overcome if they are to develop into world-class performers?

• What attributes may look beneficial in the hiring process but then prove to be obstacles to success?

• Ultimately, what is the ideal configuration of intellect, instinct, and guts that, when blended, create the highest performers?

Along these lines, I was fortunate to talk to one of the premier hedge fund managers on Wall Street. During our interview, we discussed his views on the qualities that he believes make for the most successful analysts and portfolio managers in the business. This is what he had to say:

Kiev: What are the basic principles of trading success?

P: These are the principles that I put on the wall once I gave them that mythical line of credit. My number-one is to know names. I think there are a couple of ways to make mistakes. One is to fall in love with the concept or thesis before you know the name. We will live or die based on whether we know the names better than anybody else on the street.

K: Is that the variant perception?

P: It may not be variant; it may be reinforcing. I am on top of consensus on a couple of my longs, but I don’t care because we are right. The market will have a lot of volatility. Some of that will be rational, and some of that will be stock prices leading you. Other than that, it will just be volatility. The reason the stock is down is because somebody else at a different organization is making a decision based on that person’s viewpoint. It may have nothing to do with this stock. That’s the dip that we are going to buy, and we are now going to fight this guy. He is selling; we are buying. How are we going to win that game? We are going to win that game if we know our names better.

K: How do you know it better?

P: You never really know you know it better, but we can tell whether we know our names holistically or whether we know our names intuitively. We can judge it relative to other names we know in our portfolio.

K: What do you mean holistically versus intuitively?

P: You have done all the work and you know the balance sheet, not only the numbers but also the business and how it works and the regulatory environment and the big changes in the business—not just a narrow subsegment.

Some of the analysts we had that didn’t succeed here, that we had to let go, when we asked them to look at a name they would write the bull points and the bear points, all the obvious stuff. Then they would say, “I will buy a one percent position,” or “I will short a one percent position,” or “I would do nothing.”

A pure listing of the bull points and the bear points is just a simulation. They are simulating that which Wall Street has told them or assimilating that which the company has told them. They are putting all the facts down on a page. They don’t know that name. They have summarized the Cliff Notes from that name.

I would say that in eighty-five percent of investment organizations that’s as far as they go. To know the name holistically is to do the other fifteen percent. So, when news comes out in which we have the best framework to interpret that news and make decisions as to whether this is nonsense or meaningful, whether this is underreaction or overreaction and how to move our portfolio, it all starts with, do we know our names? Do we know the industry?

Number two would be consistency. I need to remember this one as well. Sometimes we go into something saying, “We think for the next three years this company is structurally challenged. They are out of favor. Over the next three years, the company will not be able to perform. They cannot compound value. The stock is overvalued. Therefore, we think the stock is going to be down over forty percent over the next three years. It’s just a question of when, and we want to short this stock.” If we decided that’s the case, then we need to be consistent. If they have a good quarter, who cares? There is a time over a thirty-six-month period when there is going to be a couple of good months. Who cares? There are going to be times when we aren’t as long. There are going to be a couple of bad months. We cannot react to the twenty-five percent of data points that are good knowing that we have evaluated the landscape and that we know that seventy-five percent of the data points are going to be bad over time. That is a virtual certainty.

Number one, know your names. Number two, be consistent. Number three, ask yourself if your dollars have reflected your latest thinking.

K: Level of conviction?

P: I think a lot of times as the stock goes up, people like to have a bigger position because it’s a happy name. If a stock has gone from thirty-two to thirty-eight dollars, on the one hand it’s great, and you feel great about that name. But should you have twenty more dollars in that name today at thirty-eight? What really changed between point A and point B? Your story can get twenty percent better or in fact more than twenty percent better, but should it have more dollars allocated to that name at thirty-eight than you do at thirty-two? I think it’s like comfort foods. We all know that if we eat comfort food, we get fat, and it’s bad for us. Sometimes people just want to have it. It’s the irrational, but they want to have it. Holding onto a winner without selling is like comfort food. People need to be willing to let go.

Number four would be “no opportunity equals zero cost.” I think that some people get it in their minds that if they look at a stock and decide not to do anything and it goes up a hundred percent, then it cost them something. It cost them zero. They’re not any poorer.

K: As opposed to beating themselves for missing it?

P: I think people are allocating capital in names because they think there is a possibility that this is a big stock, and they just don’t want to miss it. So, they allocated a little more capital to the position. There is an instinct that we have to do a little more. They are afraid of the opportunity cost. So, those are my four cardinal rules.

K: How much are these rules rooted in fundamentals?

P: We are blessed and burdened with being rooted in the fundamentals. We are blessed with it because ultimately it helps us. We are burdened with it because it gives us conviction at times that may give us a sense of overconfidence. It’s so tangible. We can all say tangibly the stock trading at six times earnings is cheap, but if other people are making decisions about less tangible things we will be blind to it.

K: What else would you teach a new analyst/PM?

P: When a guy comes in as an analyst, we teach him other things. We teach him how to communicate, how to stand up in the names, financial analysis, business analysis, how to do proprietary research and develop sources. This is what I would say to the guy: “You have graduated. Now you have your own pad. Here are the four cardinal rules. Before you make a capital allocation decision, I want you to go through this checklist.”

K: You have guys that are smart analysts, that are the best of the best, and you think it’s time to give them a portfolio. How would you assess whether a guy has what it takes to run a portfolio? How would you differentiate? Is there a decision-making gene, a risk-taking gene? A risk management gene, as opposed to just an analytic gene?

P: We critically refer to it as head, heart, and balls. You have got to have all three.

K: What does the PM have that the analyst doesn’t have?

P: The analyst can only have a head and be a good analyst.

K: The PM has to have the heart and balls. Would you asses that from a guy’s life experience? He played football or was a Navy Seal?

P: I think people who are leaders, entrepreneurs, are competitive, athletically or otherwise. I think that all those things can tell you something about that. Also, somebody can have a perfect resume, you know, undergraduate at Yale, went to McKinsey, did a Harvard MBA, went to Goldman Sachs. I look at it and say, “The guy has never taken a risk in his life. This guy wants to be the middle-of-the-road guy. He is proficient. He would be a great manager. He may even be a great analyst, but it’s totally unproven as to whether he is a risk taker and a risk manager.”

K: Could he be taught that, or is it genetics or DNA? Would you take that Goldman Sachs guy?

P: I am not sure if you start learning it at thirty-four years old—it may be starting too late. You can teach an adult to ice skate, but it’s a lot easier to teach a five-year-old. He is going to be a better, more natural skater over time.

I don’t think that I was born with a risk gene. I think I learned risk management because I started gambling on horses and making probability bets when I was a kid. I think I was competitive because I was playing hockey, and that just became my nature. I think that those were all learned responses. I wasn’t born with those. They were learned from the time I was young.

Can you teach somebody who has come through one path for forty years to take a different turn? I don’t know. I don’t think so. I can tell on that organization chart that we have some guys who are phenomenally good. For example, one analyst is the proverbial example I gave you. He is a Yale undergraduate. He went to Merrill Lynch investment banking, and then he came here. He succeeded in everything he did. He had a four-point-oh GPA. You give him a complex problem, he goes away. He comes back, and he knows everything. I don’t want to glass-ceiling him, but I have no idea if he will ever be a good trader or a good risk manger. I have an enormous amount of confidence that he is going to be a terrific analyst. So, I view him as someday a director of research but not a portfolio manager.

K: Could you pick someone who you would say could become a portfolio manager?

P: Yeah, Brandon.

K: What does he have that is different from the Yale grad?

P: They both have an emotional balance. They are true to themselves, and they are centered. They are consistent. They are self-confident. They have a framework. They are incredibly detail-oriented. You know a lot of people look at the pieces of the puzzle and see what’s there. You also need to see what’s not there and what’s missing. I think they have great vision and have great ears. I think they are self-competent. It’s hard to figure out what the differential skills are. It may just simply be a practicality about them. I think that a great analyst is prone to be over-theoretical. Whereas I think a great portfolio manager is immensely practical. It’s not about whether it’s fair or unfair that the stock goes up or down based on the fundamentally technical or other reasons. They look at it practically.

My job is to make investment decisions that are going to be profitable. I think that an analyst is prone to believe in hindsight that the market made a mistake and he didn’t. Whereas I think a portfolio manager is inclined to look at the situation and say, “What can I draw upon to improve?” In terms of pattern recognition, you need to go back and figure out what the pattern was that you should have seen.

K: Which the analyst may be reluctant to do.

P: The analyst may be more narrow-minded in his thinking and just become exasperated. He may think, “I have hit every earnings estimate that I have ever had. Why am I not making money?”

K: So, what if you have a guy with an incredible resume? What does he need beyond the resume that can be picked up in an interview and review of his history?

P: He can be an idealist. He has to be comfortable and define his job, not from an intellectual perspective, but from a practical perspective. He would need to understand that everything is seated at the table.

What are the basic principles of success? Are there specific genes that make success easier for some than for others? Are some people cut out for some positions for which others are not? Can principles of success, like those outlined earlier, be learned or forced? These were the questions that were discussed. The answers are worth considering when evaluating anyone for employment in a hedge fund as an analyst or portfolio manager. But the answers aren’t cut and dry.

The measure of someone’s potential success can perhaps never be completely known, but a lot can be discovered through a careful review of psychological tests, personal history, and intense interviews in which the individual’s life experiences, past professional experiences, and ways of dealing with risk, stress, life events, success, and failure can be evaluated in order to determine a person’s characteristic ways of functioning in the world.

A psychological profile can be created in various ways, using standardized psychological tests, interviews, reference checks, and the like. Whatever tests you use, it is important that you consider certain dimensions of behavior I believe are critical to a trader’s edge. These include how well a trader:

• Makes decisions

• Generates ideas

• Handles adversity

• Manages himself and others

• Sets and works toward goals

• Conceptualizes and engages in abstract reasoning

• Personally engages in action in his approach to work

• Solves problems and makes decisions

• Generates creative ideas about the instruments and companies being traded

• Takes risk in an appropriate way

• Leads and empowers others in pursuit of stretch goals and targets

You also want to evaluate how an individual handles research projects you give him to assess the quality of his work, his diligence, his ability to think creatively, and his sense of urgency and thoroughness. How receptive is he to criticism? How original is his thought process? Take your time here and do not rush to judgment. This real-time evaluation will give you more color on how he is...

Table of contents

• Title Page
• Copyright Page
• Dedication
• Acknowledgements
• Introduction
• CHAPTER 1 - Intellect, Instinct, and Guts
• CHAPTER 2 - Planning for Action
• CHAPTER 3 - “Fire in the Belly”
• CHAPTER 4 - Thinking Outside the Box
• CHAPTER 5 - Separating Emotions and Decisions
• CHAPTER 6 - Nurturing Team Players
• CHAPTER 7 - Leadership
• Index