How I Trade

Need for Guiding Principles

     In any stochastic domain, we frequently ascribe causality and see patterns when there are none present. Our evolutionary need to weave a series of events in a coherent, intelligible narrative amplifies this phenomenon. We often fail to take action at inflection points and act aggressively at inopportune moments. This is especially true in a noisy environment when there is constant comparison with short term/incorrect benchmarks or the performance of other’s pursuing similar goals.

     Its essential to have a set of guiding principles assisting us navigate this chaos and keep us anchored, especially when we are under pressure. They are the basis for the framework within which we want to operate and processes we want to develop and follow. They could be rudimentary thumb rules or an evolved set of values that we keep coming back to for inspiration and for validation. Sound guiding principles make us more focused and efficient. They are not limited only to intellectual pursuits. Most icons who went on to push the boundaries of what seemed possible were able to do so with the help of a deep set of values. In fields as varied as sports, music, martial arts, science, mathematics, literature — principles, whether developed or adopted, have been imperative for success.

My Trading Philosophy

     Domain knowledge and experience are essential for a trader. Significant progress can be made rapidly as far the as former is concerned, but the later by definition, takes time. One way to compensate for the lack of experience is to learn from the mistakes and successes of others. I have been particularly influenced by the ideas of Naseem Nicolas Taleb, Howard Marks and Michael Mauboussin. Some of the tenets of my, evolving, trading philosophy are:

•  Focus on the Process rather than Outcomes: This is difficult to do, as outcomes are objective and they are there for everybody to see while process stays in the background. 
• ‘Value’ is the Most Important Thing: Almost all the time and effort of a trader should be invested in assessing the value of the underlying security. What makes this task difficult is the fact that value is often hazy and dynamic because of changing business and macro economic environment. Hence traders should demand a ‘margin of safety’ when entering into trades. This entails selling securities that are trading at the upper end of the possible range of values and buying securities that are trading at the lower end. This is simple, but by no means easy. Once value has been established with a reasonable degree of confidence the trader can further pile on a trade in case market moves against him instead of squaring off at the worst possible time. 
• Value is Absolute: Value does not depend upon flows, liquidity or the latest fancy of the markets. This ‘Absolute Value’ is the difference between the discounted value of all future cash flows and the current market price. One has to cope with technicals but stick to value to avoid permanent loss of capital and generate returns sustainably. 
• Know What’s in the Price: A good business or a stock is not the same as a good investment. The difference is often the future growth and profitability that is already factored into the price. Markets have a tendency to extrapolate short term performance leading to trading opportunities. Even a rudimentary DCF analysis is often helpful in figuring out what is already ‘in the price’. 
• Maximize Serendipity: This means trying to get into positions where positive payoffs are nonlinear and disproportionate compared to negative payoffs. Such a portfolio is more resilient to shocks and less prone to whipsaws. Trading or investing based on ability to predict market movements is quite hopeless. All a trader can do is put himself in a position where more good things can happen to him — some of which may not even have been anticipated and become apparent only post-facto. 
• Trade broadly Contrarian: The best returns are made when the trader takes a correct position that is in contrast to the market consensus. Since most public information is promptly discounted by asset prices it helps to trade counter to the trend. Although this carries inherent risk of being too early which is indistinguishable from being wrong. 
• Mind the Cycles: There are underlying cycles in most market conditions. It’s extremely difficult to call the troughs and peaks of these cycles but what helps is knowing which end you are closer to and adjust risk accordingly. 
• Size Matters: Positions sizing is usually as important as the positions themselves. In a highly competitive activity like trading it’s only rarely that the investors gets a clear high conviction opportunity. On such occasions the size of the position should adequately reflect the strength of conviction and return expectations. 
• Think Probabilistically: Instead of being fixated on a single target price for stocks, it better to think about their expected values. This leaves room for other possibilities and helps in avoiding commitment/confirmation bias where one loses flexibility to consider views and data conflicting with the original thesis. 
• Errors of Omission are Acceptable: Its better to lose out on a winning trade due to lack to conviction rather than getting into something where one doesn’t understand the underlying dynamics correctly. This is easier said than done due to fear of missing out and peer pressures. As long as one doesn't have too many losers even a few winners can take care of the performance. 
• Trade with ‘Deliberation, Boldness and Persistence’: Trades should be initiated only after due analysis and review of all possible information available. Once a decision has been made its better to take a significant position right away. The trader needs to relentlessly keep questioning the original hypothesis for the trade and hold on to the position until it has been violated due to new facts coming to light.