The final ‘M’ in becoming a successful investor is ‘Mindset’.
Like I said in my previously, although the method and money rules are simple to understand, they are not easy to follow in reality. This is because you need tremendous discipline to work hard and follow the rules. If you do not have the mental discipline, emotions like laziness, pride, fear and greed will cause you to deviate from the rules and end up with losses instead.
A great metaphor I can give you is that of dieting to lose weight. Only 10% of people who enroll for a weight-loss program actually lose weight. This is because the majority of people do not have the emotional disciple to stick to the prescribed diet and required hours of exercise.
Successful investing is not that much different from successful dieting. This is why less than 10% of investors actually get rich, even after they have learnt the right strategies. The reason why so many of the students I mentor get rich is because I emphasize so much more on the mindset and the managing of emotions, than on merely the technical strategies.
Having the Emotional Discipline to Manage Drawdowns
One of the reasons many investors fail to follow the rules and succeed is because they get emotionally affected by losing investments and subsequent drawdowns in capital. A drawdown is a reduction in your capital as a result of a losing trade or a series of losing trades.
In the world of investing, stock prices do not go up in a straight line. Consequently, your capital (and wealth) does not go up linearly as well. It goes through a series of ups and downs (cycles) in order to move higher.
Your Capital Will Not Increase Linearly…
Your Capital Will Increase, with a Series of Drawdowns…
In real world investing, wins and losses do not come evenly distributed. Sometimes, you have many wins in a row and losses in a row (up to four to five at times). Even if you use an effective strategy and expect to achieve a win rate of 70% (and loss rate of 30%), this ratio does not always play out over a few trades. This probability only plays out over a larger sample size of many trades (>50).
Greed and Fear and the Recency Bias of Investors
The trouble is that many people are affected by ‘Recency Bias’ and get overconfident after a few winning trades and fearful after a series of losing trades. These emotions cause them to deviate from the rules and fail in achieving their profit goals.
For example, after a series of wins, your capital grows from $10,000 to $15,000. You feel confident in your investing strategy and start to get greedy. You decide to increase the risk per trade and potential returns. Sure enough, when the losses come, you end up losing more!
As you experience a series of losses and feel the pain of your capital sliding from $15,000 to $12,000, you get confused, angry and fearful. You will start to doubt your strategy and reduce your risk per trade (and potential profits). Then, when the wins come, you end up making less profit.
By adjusting your risk per trade based on how you “feel”, the net result is that over time, you are going to lose more and profit less. When you start to see your capital stagnating or declining, you will start to lose interest and abandon your investing plans. Some people will even hop from strategy to strategy, adding in more and more rules and technical indicators, hoping to search for the “ideal strategy” that will increase their winnings. Of course, it will never come.
Again, this is similar to person who goes to the gym five days in a row, and expects to see a significant weight loss. When he/she doesn’t get the instant results, he/she starts to lose motivation and abandon his/her exercise plans.
So, the key to becoming successful is to do your best to be emotionally detached from your investing decisions. Do not let the outcome of a few trades make you feel greedy or fearful. A few trades are statistically insignificant. The secret is to think statistically over the long term and not get emotionally affected by short-term swings and drawdowns in your capital.