Paul & Moynihan, What I Learned Losing a Million Dollars

If you weren’t active in the financial markets when this book was first published nearly twenty years ago, you owe it to yourself to read the new Columbia University Press edition of What I Learned Losing a Million Dollars by the late Jim Paul (1943-2001) and Brendan Moynihan. The basic tenet is that trying to figure out how to make money in the markets by imitating the most successful pros is a waste of time: “What one guy said not to do, another guy said you should do. … Think about it this way; if one guy did what another said not to do, how come the first guy didn’t lose his money? And if the first guy hadn’t lost, why didn’t the second guy?” (p. 63) Well, maybe he did. What the pros had in common was not a strategy for making money but an ability to control their losses. “Learning how not to lose money,” Paul reasoned, “is more important than learning how to make money.” (pp. 64-65)

Jim Paul was good at making money—and losing it—as he recounts in vivid detail in the first part of the book. But although he was nearly broke, he didn’t intend to give up on trading and get a “real job.” He therefore set out to examine “the mental processes, behavioral characteristics, and emotions of people who lose money in the markets” (p. 70) and how to modify them.

The first important distinction Paul draws is between external and internal losses. An external loss is objective; it’s a fact. “[W]hen Kentucky loses a basketball game, it is no more of a loss for a member of the losing team than for a spectator in terms of it being an external, objective fact.” But the player and spectator “could personalize this external loss if they equated their self-esteem with the success or failure of the team.” (pp. 75-76)

Traders are prone to internalize their losses; they tend to equate losing money in the market with being stupid or being wrong. That is, they personalize the objective loss of money and turn it into a loss of self-worth. Which, of course, accounts for people’s unwillingness to sell losing positions.

Traders may also fall victim to conflating discrete events and continuous processes. For instance, sports games and political contests are discrete events; the game ends, the contest finishes. A market position, however, is a continuous process with no predetermined end. “Betting and gambling are suitable for discrete events but not for continuous processes. … In betting and gambling games if you stop acting and do nothing, the losses will stop. But when investing, trading, or speculating, if you’re losing and stop acting, the losses don’t stop; they can continue to grow almost indefinitely.” (p. 94)

Many traders also succumb to fallacies in popularly held beliefs about probability. “Perhaps the most common fallacy to which market participants are susceptible,” Paul writes, “is money odds vs. probability odds. Many market participants express the probability of success in terms of a risk-reward ratio. For example, if I bought my famous takeover stock … at twenty-six dollars and placed a sell stop below the market at twenty-three dollars with an upside objective of thirty-six dollars, my risk-reward ratio would be three to ten. Risk three dollars to make ten dollars. It is clear that I don’t understand probability. Couching my rationalizations in arithmetic terms does not automatically lend credibility to my position. The three-to-ten ratio has nothing to do with the probability that the stock” will move a certain amount. “All the ratio does is compare the dollar amount of what I think I might lose to the dollar amount of what I think I might make. But it doesn’t say anything about the probability of either event occurring.” (pp. 96-97)

A side note here in case you're not familiar with this graphic Charlie Munger quotation: "If you don’t get elementary probability into your repertoire you go through a long life a one-legged man in an ass-kicking contest."

Paul stresses the need for a trading plan but recognizes that people, being human, will sometimes deviate from their plan. And so he gives a final piece of advice: “Speculating (and this includes investing and trading) is the only human endeavor in which what feels good is the right thing to do.” (p. 150) If the market starts going against you, and looking at prices going down is not fun, do what feels good: get out. If you have a long position on and prices are going up, keep feeling good; leave it alone.

What I Learned Losing a Million Dollars is a fast but enlightening read, worth much more than most “What I Learned Making a Million Dollars” books. I thoroughly enjoyed it.