“Everything should be made as simple as possible, but not any simpler.”
Albert Einstein

The following excerpt from Futures magazine mirrors our thoughts:

Copyright 2001 Futures Magazine

The mistakes of the best and brightest include:

1. Not diversifying because they know they’re right. Smart people know they’re smart. They’ve made good grades all their academic lives and maybe collected a few scholarships along the way. They’ve got multiple degrees. They can recall obscure pieces of information on many topics. People tell them they’re smart. All of this can go to these people’s heads if they’re not careful. Eventually, they get taught a lesson in trading: They cannot outsmart the market.
2. Not using a sell strategy. Smart people know they’ve stacked the odds in their favor and they have done their homework. They don’t believe they can fail. Maybe they’ve never failed at anything significant before in their lives. Who needs a sell strategy when you know you’re right? The market has ways of proving people wrong.
3. Averaging down in a losing position. Smart people know the investment idea was good before, so it’s an even better deal now if you can buy in cheaper, right? Wrong. The market can continue lower. Investing further in a losing position can severely beat up a portfolio and sometimes put investors out of the game.
4. Thinking that exhaustive, long-term studies of a strategy can predict the future. Like the disclaimer says, past performance does not predict future results. This is actually true and backed up by countless studies of traders across many markets, across many strategies and across many time periods. Smart people sometimes think that, by taking vast sums of data and analyzing it to death, they have an edge in predicting what the market will do next. Blowups can and will occur when the market does something it has never done before. [Great example of smart people trying to predict. It won’t work.]
5. Over-optimizing a strategy using historical data. Because smart traders have the mental ability to think up all sorts of ways of trading, they can come up with countless parameter sets in their strategies to trade a historical database with wonderful results. The problem generally becomes that they are fighting the last battle in the markets in their simulations, not necessarily the next one that they should be concentrating on. They don’t give themselves sufficient what-if scenarios that might occur and don’t prepare for the what-ifs properly.
6. Searching for perfection. Intelligent traders can come up with so many potentially better ways to trade that they sometimes spend most of their lives searching for perfection. Often the better approach is trading the best strategy they have at the moment and realizing they can work at making it better over the long run. You’ll never have the perfect trading strategy. Just give it the best shot you can each day and never stop trying to make it better.
7. Frequently changing an existing losing trading strategy to a better strategy. Smart people often have very active minds that can dream up all sorts of new, better ways to trade. Some ways even can be quite complicated to satisfy their intellectual firepower. But, if you make the assumption that all strategies have their day in the sun and their day in the doghouse, then moving away from a losing strategy may be foolish. The strategy that looks hot right now may become cold down the road and this year’s mediocre strategy may become next year’s star performer.

Einstein’s instruction to make things as simple as possible but not simpler is the complete rebuttal to every item on this list. Each of the seven mistakes is a form of intelligence becoming a liability: the confidence that comes from being smart producing overconcentration, the refusal to use exit rules, the rationalization of averaging down, the belief that enough data produces predictive power, the optimization that fights the last war, the search for a perfect system, and the abandonment of a sound approach when it underperforms. Every one of these mistakes is enabled by the same cognitive capacity that makes the trader feel qualified to override their rules. Intelligence without discipline is the exact combination that produces the most spectacular failures in trading.

The sell strategy failure in point two is the most lethal on the list. A trader without a sell strategy is holding every losing position indefinitely by default. The entry is a decision. The absence of a sell strategy means the exit is determined by exhaustion, capitulation, or zero. There is no version of trading without a sell strategy that produces consistent results over time. The smart trader who “knows they’re right” and therefore does not need a sell strategy is the investor who held Enron from $90 to 50 cents. The market proved them wrong. The exit rule would have gotten them out at a fraction of the total loss.

Point seven deserves particular attention for trend following practitioners. Systematic approaches have drawdown periods. During those periods, the temptation to switch to something that has recently performed better is strong. But the strategy that underperformed last year in a choppy, range-bound environment may outperform significantly next year when trends develop. Abandoning a sound systematic approach during its difficult period to chase a recently successful alternative is how investors perpetually exit the strategy they should hold and enter the strategy that is about to underperform.

Frequently Asked Questions

Why does intelligence become a liability in trading?

Because the same cognitive capacity that allows smart people to succeed in most domains, confidence in their own judgment, ability to rationalize, comfort with complexity, produces specific failure modes in trading. Markets do not reward intelligence. They reward the consistent application of sound rules. A trader whose intelligence produces overconfidence, rationalization of losses, and constant strategy revision is using their intelligence against themselves.

Why is the absence of a sell strategy so dangerous?

Because without a predefined exit condition, every losing position is held indefinitely by default. The exit happens at zero, at capitulation, or when the emotional pain of holding becomes unbearable. None of these produce rational outcomes. A sell strategy defined before entry removes the emotional decision entirely and limits the maximum loss on any position to a predetermined amount.

What is wrong with exhaustive analysis as a basis for market prediction?

Past performance does not predict future results in the specific sense that matters: the market will eventually do something it has never done before, and no analysis of historical data can prepare for that event. Over-optimization using historical data produces strategies that performed well in the past by fitting the specific patterns of that data, which is curve-fitting rather than discovery of a durable edge.

Why should traders not abandon a losing strategy for a better one?

Because all strategies have periods of underperformance. The strategy that underperforms in the current environment may be exactly the right strategy for the next environment. Chasing recently successful strategies produces a cycle of buying yesterday’s winner at its peak and exiting yesterday’s loser at its trough. The investor who holds a sound systematic approach through its difficult periods captures the full return of the strategy. The investor who exits during the difficult period captures only the losses.

Trend Following Systems
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