6 critical rules to ELIMINATE emotion from your investment process
Emotional decision-making is the enemy of traders. Here are a few of the ways I’ve learned to eliminate emotion from my processes and become a more profitable (and productive!) investor.
1. Have a data-backed thesis
When you enter a trade based on a “feeling,” you’ll likely exit it based on a “feeling” as well. And that can be disastrous. Instead, require every trade you make to be based on a theory you have that is validated by some external data. For example, you might think XYZ stock is headed higher because 47% of the float is sold short, the social data indicates that consumers are buying products faster than Wall Street predicts, and if the stock breaks through that level you think there will be a short squeeze. That will force those short-sellers to exit their positions by buying the stock back, creating higher and higher prices.
Maybe you’re right, and maybe you’re wrong. However, now you have a thesis based on real data that you can benchmark against as the trade progresses. That’s far better than “it feels ready to pop.”
Example: In our Home Depot/Lowe’s pair trade, our thesis is that social data from LikeFolio is showing that Lowe’s is gaining traction among consumers.
2. Determine in advance what will prove your thesis wrong
Before you enter the trade, you need to understand what data in the future will prove your thesis wrong (or right). Exiting a position should be just as data- and thesis-driven as entering one. Remember, the goal is to keep emotion out of your trading decisions.
Commit to checking the data behind your thesis at a specific interval or point in time. Is your thesis still sound?
In the example above, we used XYZ’s short interest as a data point, along with positive social data as the stock is approaching all-time highs. You might determine that your thesis would be proven wrong if, 1) XYZ fails to move into new all-time highs in the next two weeks, or 2) XYZ’s short interest dropped off dramatically prior to new all-time highs, or 3) social data came back down to normal levels.
Again, the key here is that you determine BEFORE entering the trade what the scenarios are that prove your theory wrong and what data points you will be using to make that determination.
Example: Our warning and “position bearish” on Apple would no longer be valid if purchase intent volume on iPhone products began to improve, the Apple Watch started gaining consumer enthusiasm, or the company announced a new product that would be a catalyst for consumers. In any of those cases, our original idea for the trade would no longer be valid.
3. Position small enough to fly blind
The most common behavior I’ve seen among new traders is the propensity to take positions that are too large. This invariably leads to emotional reactions to price movements. In fact, it’s not uncommon to see new traders develop real fear within minutes of entering a position that is too large. To avoid emotional decisions, position small. You can always add more later as your thesis is proven true.
How small is small enough? When you enter a position, imagine yourself locked out of your brokerage account and without access to quotes for 3-5 days. If you can handle that kind of blind volatility, you’re fine. If you find yourself watching every tick and “cheering” for the next move—it’s time to reduce size dramatically. I’ve never heard a trader tell a story that ended with, “I didn’t take a large enough position.”
Example: With Disney, we suggested building a long term position over time at under $100, starting very small and moving up as the thesis was proven correct.
4. Define your maximum risk in advance
This adage goes along with positioning small. By defining your maximum risk on any trade to something you’re comfortable with, you can dramatically reduce emotion-based behaviors.
I’m a huge fan of using option-spreads to strictly define risk. Others are comfortable with Good-Til-Cancelled stop orders, which add a layer of discipline but cannot guarantee a maximum loss like option spreads. Another option is to find optimal put options, as David Pinsen of Portfolio Armor suggests in this piece on Tesla.
It’s really up to you. The key is to have a mechanical system in place that defines your maximum loss at a comfortable number.
5. Automate your profit taking
In stock trading, it is critical to eliminate decisions solely based on psychology as much as possible. This comes into play in a big way when it’s time to take profits. How many times have you met your initial profit goal, but decided to let the position ride? How many times has that resulted in the position moving against you and your winner turning into a loser?
All traders have experienced this, and it is the result of a little thing called “greed.” It’s in all of us -- the key is to find a way to manage it.
I asked Nick Fenton of TickerTank how he approaches profit taking and his theory was very clear:
“Automate, automate, automate! You should know your exact profit goal before entering any position. Determine that goal, enter the position, then set an automated profit taking order.”
For example, let’s say you sell the 100 puts in XYZ for a credit of 2.00. You determine you want to take profits once the puts have decreased in value by 50%. You would then set a Good-Til-Cancelled (GTC) order to cover your XYZ 100 puts at 1.00. This order will be “working” from market open to market close everyday going forward until XYZ 100 puts hit 1.00. If the puts do in fact hit 1.00, the order will automatically trigger and your profits will be booked.
Let’s do a quick stock example. You buy 50 shares of XYZ at 100.00 per share. Your profit goal is a 5% increase in the stock price. You buy the shares, then immediately create a GTC order to sell 50 shares of XYZ at 105.00. It’s that simple and it takes greed out of the equation!
Fenton added that you should ”NEVER modify your automated profits taking order if you see the position working in your favor. That defeats the purpose. Always keep it based off your initial profit goal.”
With our preferred broker, this kind of order entry is very fast, very easy, and effective.
6. Do something else for a while
OK – you’re ready. You’ve entered the trade.
You have your thesis.
You know what data points you’re looking for to determine if your trade is on the right track or not.
You’re positioned small enough to fly blind.
You’ve limited your max risk to something you are comfortable with.
Now what?
Hit the gym. Write something interesting. Play with your kids. Return at a time when you expect there to be new data that you can check against your thesis. Until then, nothing matters and the only possible influence you’ll have on the trade is an emotional reaction or action out of boredom—both of which are very negative and to be avoided.
By following these six steps, you will reduce emotional decision-making in your trading, regain the time and energy you would have spent worrying, and take more profitable, productive actions.
DISCUSSION: We dive deeper into these rules on the LikeFolio podcast-- LISTEN UP!