Wednesday, May 23, 2007

Can You Trade as Well as You Drive?

Ok, this is a post I've been meaning to write for a long time, and I finally just decided to do it.

I consider myself a good driver. Aggressive, yes. Fast, most certainly. But not dangerous or reckless. Some time ago, it occurred to me that driving and trading (or even investing in some respects) share many similarities. Good trading, like good driving, is very tactical. It is about acquiring as much information as quickly as possible and acting on it decisively. Sounds similar to trading to me.

Primarily, good driving, like good trading, is about control. Once you've lost control, be it of your portfolio or your vehicle, then nothing else matters. Whatever the circumstances, you have to be able to maintain control of your vehicle. You won't get every call spot on. But you can reduce the severity of the mistakes, and take advantage when opportunity is presented, if you have done so. Control is FUNDAMENTAL. Without it, all else is moot.

After control comes intelligence. This may be better termed knowledge. Knowledge of what is happening around you, behind you, in front of you, to the sides, on the on-ramp (or off-ramp) coming up. The more information you have (if you are good), the better the decisions you'll make. So you have to take in, process, and act on as much information as you can. You also have to know when you have too much information for your current state of being (e.g. while driving, if you're tired, then you need to maintain larger distances and slower speeds). You need to know whats important and what isn't. Or you have to be able to discern these distinctions VERY quickly.

Intelligence while driving comes from some basic maneuvers. Constantly checking your mirrors (and for the love of God, having them correctly configured in the first bloody place!). Staying away from vehicles larger than you so as to not obstruct your visibility. Keeping adequate distance from other vehicles at all time, to give yourself more reaction time and better options when things don't work out (e.g. you make a mistake or a sub-optimal calculation).

This last point about options is huge. As many commentators have written in various ways, trading (particularly) and investing are about probabilities. What is the probability that a particular outcome will occur, out of the entire range of possible outcomes. (Whether you have calculated for the appearance of a "Black Swan" is yet another matter.) Good defensive driving is similar. You are calculating the probability of a certain outcome - lane A continuing to move when lane B slows or stops; the chance that route X will flow better than route Y; the general latency and flow characteristics of a given path at a given time, especially in comparison to alternate paths. In both driving and trading, the best way to learn how to successfully calculate these probabilities is through observation and practice. It takes continued exposure to the patterns of the driving in various conditions to learn how to quickly calculate the probability of a certain outcome.

Next, you have to know your vehicle and its capabilities. The analogue in trading should be clear. What are the potential pitfalls of your portfolio - the asset allocation, the assumptions - and how do you mitigate those risks using your chosen devices? How can derivatives of various stripes juice returns, or reduce risk (hedge)? What security is best for a given time horizon and risk tolerance? What asset classes are even available for you to invest in given the resources you have at your disposal? If you don't know how your vehicle will perform, then you shouldn't be driving it. That knowledge is what allows you to make the quick adjustments required to minimize losses or make outsized gains.

Going hand in hand with the capability of the vehicle is the capability of the driver. You have to know at what level you are capable of performing. I know that, for all the "aggressive" maneuvers I perform in a car, I never do anything that I am wildly uncomfortable with. I know that when I make any move, especially those which raise the heart rate, I am essentially overriding the natural fear-based response and acting completely consciously and logically. After the move has been made, the fear subsides due to its nature - it is irrational.

So taking all of this together, it would appear that I have the tools and ability to be a better trader/investor. However, something is missing. If I were to guess, I'd probably say then missing ingredient is experience borne of practice. It takes a long time to become proficient at anything; I started driving around age 13, almost 19 years ago. Likewise, becoming the type of trader or investor I seek to become will require time, focus, and dedication. (A lot more time and a little more money to work with would be nice too.)

Time to get started!

Until next time...

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